Corporate Social Responsibility as a Signalling Device for Foreign Direct Investment

Abstract

A rise in CSR (corporate social responsibility) has accompanied rise in foreign direct investment (FDI) to developing countries in the 1990s. CSR may be serving a signalling function when the entering firm is of an unknown type. Although countries are now competing keenly to attract foreign firms, even so, excessive tax or excess transfers by firms can still cause a Prisoner’s Dilemma structure to the payoffs resulting in an inefficient Nash equilibrium. CSR allows the accommodating firm to reveal its type, making cooperation the equilibrium outcome. The game differs from standard models since signalling changes the payoffs. A unique separating equilibrium exists where only the accommodating firms signal. But, under certain parameter values, a pooling equilibrium where all firms signal, becomes possible. A number of results are derived including the size of CSR expenditure required as a fraction of profits. An example demonstrates their relevance in practical situations.

Key Words:

• Foreign Direct Investment
• Corporate Social Responsibility
• Signalling
• JEL Classifications: O19, F23, C72, D82

Notes

1. Calculated from statistics available at http://stats.unctad.org.

2. Theories developed to explain multinational FDI include profit differentials, portfolio diversification, micro and macro imperfection based theories that highlight transaction costs, product cycles, and the strength of currencies. Dunning (1993) and Agarwal (1980) offer broad surveys. This literature concludes that FDI makes the spatial optimization of an interrelated set of the firms’ activities possible, and factors that attract FDI to developing countries are political stability, government policies and cheap labour. Chakrabarti (1998) shows that market size, expected growth, and skilled labour dominate for the more recent period. More recent work uses firm level data to explore the role of heterogeneous firm level assets, and distinguish between greenfield investment and cross border acquisitions. Nocke and Yeaple (2004) find that factor price differences drive the former and it involves more efficient firms.

3. There is a tendency for FDI to concentrate in geographically contiguous areas or in countries with close cultural or political ties (UNCTAD, op. cit.). Since large new areas are now accessible to FDI it is all the more necessary to understand how firms can become an integral part of very different societies.

4. Expenditure to build up trust and social capital lowers transaction costs (Fukuyama 1995). Many corporations are recognizing the business returns to such expenditure. Among Indian companies making such expenditures are the Tata, Anand, Forbes‐Marshall, Thermax, Mafatlal, Lalbhai, Escorts, and SAIL groups. An American corporation that adopted such policies very early was Sears Roebuck, which spent millions of dollars on donations. The company directives explicitly state that this is not mere charity, but as a wise investment of corporate funds to improve the communities in which company units are located, and indirectly sales (Weil 1977). But recompense to such expenditure is indirect, uncertain, and depends on the actions of others. The literature on CSR dates from around this period. An early contribution was Carroll (1979).

5. John Strachey, a famous Marxist scholar, told Schelling (1980) that until he read Schelling’s book, he had simply not understood that non‐zero‐sum conflict was possible. He had known that conflict could co‐exist with common interest, but had taken for granted that they were essentially separable, not aspects of an integral structure. The interaction between FDI and a host is a good example of conflict combined with common interest.

6. It is becoming an active research area. For example, the William Davidson Institute of the University of Michigan announced a workshop for 19 May 2005 on ‘Social Enterprise and Entrepreneurs in Emerging Markets: Framing the Issues.’

7. A Tata Energy Research Institute‐ORG Marg survey on CSR rated information technology and telecommunications industries as the best (report by Abhijit Majumder and Anshika Misra in Times of India, Mumbai Edition, 22 September 2002). Mehta (2003) in a survey of CSR practices among 30 companies found that the top two areas of intervention were education and health; 80% of the companies contributed in the first area and 66% in the second.

8. Report by Nandini Lakshman in the Business Standard, 10/11 April, 1999.

9. The seminal paper on labour quality was Spence (1974). Vickers (1986) uses such a model for the analysis of monetary policy. Analogously, its longer‐term commitment and low rate of discount, which lower its cost of signalling, and higher payoffs from cooperative play, which raise its productivity, make a firm of high quality.

10. The game can also be applied to analyse the case of a large number of firms entering, in which case p would stand for the proportion of F_M – type firms. To be able to analyse the situation in a game players have to know each other’s payoffs, and knowledge. Under incomplete information, encapsulating all the uncertainty under probability distributions on types allows analysis to proceed.

11. It is therefore not necessary that the high discount factor firm will be able to outbid the other. The latter may have lower costs. Moreover, firms compete with those supplying similar goods. Even if infrastructure firms have higher discount factors, they will compete with firms in the same field, not with those supplying consumer products.

12. One way to understand this difference is that a firm with a longer‐term commitment will enter into collaboration with a local voluntary agency or an NGO with an upfront commitment and a longer period over which it is made. Other firms would prefer to make only a monetary commitment. Mehta’s (2003) survey showed that out of 30 sample companies 57% chose a monetary contribution while 73% entered into collaboration.

13. Since δ = 1/(1 + r), where r is the discount rate, therefore δ ≤ 1. If the future is discounted at a low rate the discount factor at which it is valued is high. But high δ firms do not ignore market conditions. They would exit if expected profits fell below reservation profits.

14. If we consider our host to be an Asian country, since a large share of FDI is going to such countries, high Asian savings ratios, ranging from 20 to 50%, provide indirect evidence of low discount rates. Panel data estimates of the intertemporal elasticity of substitution in consumption for Asia are 0.8 compared to 0.2 for Latin America. Capital markets are never perfect, so that the market rate of interest does not reflect the consumer’s rate of discount. Even so, Japanese interest rates are one of the lowest in the world. The firm’s rate of discount is a choice variable, a decision on the payback period, reflecting management strategy.

15. Mas‐Colell et al. (1995) use this concept in the context of a labour‐signalling model.

16. Some evidence on the level of expenditure comes from a survey conducted on 30 companies listed on the Indian National Stock Exchange. Thirty percent of the companies who responded to the question said that their CSR expenditure varies from 1% of net profit to 12% of profit after tax (Mehta, 2003).

Additional information

Notes on contributors

Ashima Goyal

An earlier version was presented at the India and Southeast Asia meetings of the Econometric Society, at ISI, Delhi. I thank (without implicating) K. Basu, G. Gupta, K.J. Joseph, P. Levy, A. Mishra, D. Quah, G. Ranis, B. Saha, T.N. Srinivasan and R. Subramanium for useful comments or discussions, and T.S. Ananthi for help with the word processing. I am grateful for very constructive comments, which considerably improved the paper, from two referees of this journal. I am also thankful to the Fulbright Foundation for funding and Claremont Graduate University for hospitality during revision of the paper.