Rational Management Responses

to External Effects
JOHN C. NARVER*
University of Washington

This paper is a discussion of the external or side effects of business

and rational responses to these external effects for profit-maximizing firms.*
Some people would argue that the rational response for the profit-maxi-
mizing firm is to do nothing about its external effects until required by
law; whereas others, as we in this paper, argue that the rational response
for the profit-maximizing firm is to take some action.
The first section of the paper deals with the meaning of externalities,
of which pollution is a fundamental type, and the phases of a solution to
such problems. In the second section, the paper deals with rational re-
sponses for the profit-maximizing firm regarding its externalities, in which
many aspects of the popular arguments against the rationality and the
practicability of independent corrective action by a firm are examined.

AN OVERVIEW OF EXTERNALITIES AND SOLUTIONS

We agree with Friedman [9] that the overall goai of the firm is to
maximize profits or, more correctly, to maximize the present value of the
firm. But, we add that today, voluntary actions regarding external effects are
essential for such wealth maximization. Having stated the argument in brief,
we acknowledge, as Friedman implies, that probably the ideal solution to
external effects or other social problems is enactment of socially just and
economically sound legislation which would have the merit of leaving little
or nothing to the judgment and timing of businesses in regard to correcting
the problems. But, the "ideal solution" can, in many cases, be a long
time in coming. The logical question, then, must be: What, if anything,
can we say about the "social responsibility" of business in the interim? Re-
garding pollution, no doubt comprehensive pollution regulations are the

* John C. Narver is Associate Professor of Marketing and Coordinator of Faculty

Research, Graduate Schooi of Business Administration, University of Washington.
^The present paper is adapted from a paper preserited October 23, 1970 at the
Pacific Northwest Poiiution Control Association and Pacific Northwest industriai Waste
l\/ianagement Conference meetings in Victoria, Canada.

99
100 Aeademy of Management Journal Mareh

ideal answer, but until such time as they are formulated and enforced (dur-
ing which time the cumulative effects of pollution mount, indeed rendering
some waters, such as Lake Erie, to an irreversible inability to support life),
voluntary action may be rational, both socially and privately. We stress:
To get socially sound, effective legislation passed is very difficult and takes
time and, of course, a law itself without effective enforcement and/or
willing compliance is largely irrelevant.^
Let us turn briefly to a consideration of externalities and the specific
case of pollution. Externalities, in general, are economic consequences
conferred on a firm (or person) through no choice of its own. These external
effects may be either costs or benefits. An external diseconomy means that
because of someone else's actions, one's costs are higher, i.e., polluted
water for a fish hatchery which requires pure water. An external economy,
on the other hand, is one in which there are reduced costs of operation
due to an outside source, such as more highly skilled labor of a type
required by a firm coming into a market.
The basic nature of an external effect is that actions of individuals have
effects on other individuals, for which it is usually not feasible to charge or
recompense them. The man who pollutes a stream is, in effect, forcing
others to exchange good water for bad. The people who have been forced
to exchange good water for bad might be willing to make the exchange
at a price, but it is not feasible for them acting individually to avoid the
exchange or to enforce appropriate compensation [10].
With an external diseconomy, the cost borne by either some third
party or the community at large is a cost that does not automatically enter
into the private cost and demand calculations of the producer. As a result,
the social costs of such production usually exceed the private costs. Thus,
the basic cause of social costs is that the pursuit of private gain places
a premium on the minimization of the private costs of current production.
Accordingly, the greater the reliance the economic system places on pri-
vate incentives, the greater the probability of external "unpaid" social
costs unless appropriate measures to avoid minimizing the private costs
are taken [9]. With the social costs inadequately imputed to the sources
of pollution, prices of the polluters will be artificially lower with the result
that more pollution occurs than is desirable from society's viewpoint as
a whole [13, p. 80).
The rational solution of virtually any problem, especially the environ-
mental problem, may be seen as requiring three phases: (1) setting criteria,
(2) establishing standards, and (3) implementing the corrective action [15].
Regarding pollution, setting criteria implies ascertaining the biological and

- Congressional committee fragmentation is but one reason for the difficulty in pass-
ing sound environmental legislation. See "Pollution: Everyone's In On the Act," Business
Week (January 24, 1970), pp. 116 ff.
1971 Rationai Management Responses to External Effects 101

economic conditions required for various possible uses of a resource.

Thus, criteria, the respective requirements for specific alternative uses,
are the scientific basis for decision-making concerning the suitability of
the resource to support designated uses. The uses may be single or multi-
purpose and may include one or a combination of types of recreation and
aesthetics, commercial purposes, agriculture, industrial uses, etc. We
see, then, that the essential feature of setting criteria is the acquisi-
tion of technological, biological, economic, social, and other relevant facts
to provide a sound basis for policy and standards decisions as to optimal
resource use. We stress the important distinction between defining criteria
on the one hand and setting policy and standards on the other. Whereas
criteria are the analyses of effects and interrelationships of different
assumed uses of water or any other resource, establishing standards is
the policy which specifies uses and quality levels. Standards are estab-
lished ultimately by governmental or other authority and specify whatever
prevention and/or abatement is required to achieve the desired quality.
Because establishing standards is an extremely difficult task, it should
utilize many perspectives and incorporate value judgments as well as the
objective economic and scientific data. Standard-setting must—though
unfortunately it frequently doesn't—involve the notion of acceptable risks.
In general, certainty (zero risk) is too expensive from both private and
social standpoints, and the innocent-until-proven-guilty basis (high-risk)
is also potentially too expensive. This is not to say that low risk or, at times,
even zero risk is inappropriate; it is to say that a policy of zero risk as
a general rule is uneconomic. Accordingly, establishing pollution standards
is far more compiex than the simplistic notion of "eliminating all pollu-
tion" or opposing all construction of nuclear and fossil fuel power plants,
hydroelectric dams, or other power-generating devices. Also, it is more
compiex than the equally simplistic notion of continuing to engage in any
activity until it is certain that ecological harm is being effected at some
substantial level.^

The complexity in setting criteria and establishing standards was

seen recently when for 5 days a panel of state and federal water
quality experts held hearings on the effects of the discharge of heated
water into Lake Michigan. At the hearings, there was a lengthy proces-
sion of witnesses, inciuding scientists appearing on behalf of the Depart-
ment of the Interior and conservation groups. They testified that if thermal
wastes weren't strictly controlled now, the lake would soon go the way
of Lake Erie and be unfit for marine life and human recreation. Other
scientists with equally impressive credentials testified on behalf of the
industries which used the lake water for a variety of cooling purposes.

" In principle, one wiii continue to improve resource quality to the point that the
cost of the last unit of effort in quality improvement is equal or exceeds the benefit
derived from the last unit of effort [10, p. 20]. See also Sanford Rose, "The Economics of
Pollution," Fortune (February 1970), p. 120.
102 Academy of Management Journal March

Generally, the scientists claimed that putting the heated water back into
the lake isn't dangerous. The debate, in short, was a standoff, and, in
one sense, could have been dismissed as an interesting and educational
demonstration of the inconclusive nature of scientific evidence—except
that the issue is anything but theoretical [2, p. 16]. Thus, even when the
purposes for which one seeks abatement or redemption are stated, there
still can be considerable difficuity in arriving at acceptable standards.
Seemingly absent in many of these discussions is the concept of an
acceptable (from a total ecological standpoint) level of risk. The final phase
is implementing corrective action, which is the enaction of appropriate
corrections implied or specified by the standards. At times complex inter-
firm as well as private-public structures will be required for complete
compliance with standards.

RATIONAL RESPONSES TO EXTERNAL EFFECTS

We turn now to the most critical part of this discussion, namely,

rational responses by firms to external effects. There are two fundamental
questions: (1) Why should a profit-maximizing firm voluntarily assume some
amount of extra cost?; and (2) Precisely how can the profit-maximizing
firm assume these costs but yet not commit suicide in the market place?
With respect to the first question, it is only by such behavior (which
can be of various sorts) that a firm can best attain its purported goal of
maximizing the market value of the firm. This reasoning is based on the
objective evidence of the present and future environmental expectations
of society, customers in product markets, and investors and lenders in
capital markets. The present market-value of a firm depends only minimally
on the current earnings of the firm. More important are the expected
earnings and the expected variability (risk) in regard to future earnings.
The lower the expected earnings and/or the greater the expected variability
(risk) perceived by the capital market, the lower the present market-value
of the firm.* In the case of external effects (specifically pollution), the
present market-value of the firm is based ultimately on the capital market's
perception of product-market demands and expected variability of earnings
as affected by various potential legal and product-market risks.
With respect to the second question, how, there are a variety of pos-
sible responses for the firm. Considerations include the purely internal
efforts to reduce the disparity between social costs and private costs,
assisting in establishing factual criteria, and/or assisting in setting equit-
able public policies and quality standards, and/or implementing corrective

' Discussion of the valuation of the firm may be found in virtually any current man-
ageriai finance text. See for example, Myron J. Gordon, The Investment Financing, arid
Vaiuation of the Corporation (Irwin, 1962), and J. F. Weston and E. F. Brigham, Managerial
Finance (Holt, Rinehart & Winston, 1966).
1971 Rational Management Responses to External Effects 103

action. But there is a second and essential element in how a firm viably
can engage in these costly activities: the rational firm, upon assuming
whatever analytic, legislative, and/or technological actions, will then inform
fully both its product markets and the capital market of its actions. Socially
responsible behavior, absent communication of such actions, is at best
irrational and at worst possibly suicidal. It is precisely because the environ-
mental awareness and expectations of society and customers are chang-
ing, and, hence, the capital market's risk perceptions are as well, that firms
must inform of their substantive social actions. We return to the communi-
cation issue in a subsequent section.

Let us consider some evidence for the basic premise—which restated

is—a rational firm in order to maximize its present market-value will both
voluntarily engage in costly activities in regard to its side effects and
communicate the fact of its action precisely because the environmental
expectations of society, in general, and customers, in particular, are ever-
rising. To ignore these fundamental changes would induce the capital
market to perceive lower expected earnings and/or impute a higher risk
factor resulting in a lower present value to the firm.
In the following order we shall consider (1) evidence that society's
and customers' environmental awareness and expectations are rising; (2)
some economic fallacies regarding the costs to a firm in dealing with its
external effects, the allocation of the costs, and the passing on of the
costs in higher prices; (3) some evidence that firms already recognize
the connections between certain types of "social responsibility" and the
explicit communication of such actions and profits; (4) evidence that both
the debt and equity portions of the capital market recognize the changing
environmental demands of society and customers and, thus, the foregone
profits and/or substantial legal risks to the recalcitrant firm; and (5) the
probable costs to a firm if it attempts to deceive society regarding its
external effects and environmental actions.
First, a perhaps relatively easy question, what evidence is there that
society's environmental awareness and expectations are rising? Our gen-
eral response is that there is a new citizen/consumer emerging. Consider-
ably before the dust of Earth Day had risen, let alone settled, such spokes-
men for the ecological and consumer movement as Rachel Carson, Ralph
Nader, Paul Ehrlich, John Galbraith, Lewis Mumford, David Brower, Ken-
neth Boulding, Robert and Lenore Reinow, and John Gardner, not to
mention Henry David Thoreau, enjoyed a substantial following. One can-
not dispute that our society is definitely changing, since now even grade
school children are relatively sophisticated on matters of pollution and
ecology.
How do we characterize this new citizen/consumer which we argue
is emerging? One close and astute observer of the American social scene
104 Academy of Management Journai March

and marketplace. Commissioner Philip Elman [7] of the Federal Trade

Commission, calls the contemporary change in the citizen/consumer no
less than a real revolution:
The reai revoiutions in worid history have been the revolutions in human
vaiues, ideas, feeiings, and tastes. Mani<ind is passing through such a cuiturai
revolution now. Unmistaicable signs of its presence are ail about us, here at
home and abroad, in aii parts of the giobe and among aii ciasses of peopie.
Generated primariiy by the yourig, its essence is a new birth of freedom for
the individuai; a joyous iiberation of the human spirit; insistence on truth
and honesty in personai reiations; a totai rejection of hypocrisy and cant;
a renewed concerri for the uses to which power, pubiic and private, is put, and
a fixed determination that it be used to preserve and enrich iife, iiberty, and
the pursuit of happiness, not to destroy them, to protect the beauties of nature
and the good earth, not to iay them waste, its consequence, we may hope, wiil
be to close at iast the ancient gap between the ideals men preach and the
injustices they practice in their daiiy iives. its sure effect, in any event, wiii be
to transform radicaily the structures and institutions of society, poiiticai and
economic as weii as sociai . . . . His expectations of you, your products, and
the way you seil and advertise them, wili be vastiy different from those of his
parents; and you wiil do weii to mari( these differences and to respond to them
(emphasis added).

Within this revolution of values, we note specifically society's increas-

ing interest in establishing and preserving a quality environment. Pacific
Northwest Bell commissioned Louis iHarris and Associates to examine
public attitudes in Oregon and Washington on environmental problems.
The survey, conducted in January 1970, produced the following results:
Question: "What are the two or three most serious problems facing
your community?"
Response: In both Oregon and Washington, pollution in its various
forms was cited more often than any other problem area
(that it was cited first was especially interesting in view of
the poor economic conditions in January 1970).
Question: "What do you think are the two or three most serious
problems facing the whole state of (Oregon) (Washington)?"
Response: In Oregon, 98 percent of the respondents mentioned pollu-
tion; in a poor second place was the economy mentioned
by 43 percent. In Washington, 56 percent of the respondents
mentioned pollution and 66 percent mentioned the economy
(however, the Boeing cutbacks and econoniic slowdown
was primarily a King County/Northwest-Washington pheno-
menon, thus, only this sector of the state ranked the eco-
nomy ahead of pollution).
Presently, there are more than 150 national organizations as well as
thousands of local groups of one type or another which are interested
in conservation. Two of the oldest organizations, the Sierra Club and
the National Audubon Society, have doubled their membership in the last
3 or 4 years.
The cross-section of support that conservation engenders in our
society was easily seen in 1969 when a broad coalition of citizens lobbyed
for a larger pollution appropriation in Congress. Specifically, the Citizens
Crusade for Clean Water, which encouraged Congress to vote $800 million
1971 Rationai Management Responses to External Effeets 105

for pollution control instead of the $214 million requested by President

Nixon, was a coalition of some 40 organizations coordinated by the Isaac
Walton League. In addition to the Sierra Club and other predictable con-
servationists, the cause attracted the A.F. of L. - C.I.O., the United Auto
Workers, the U.S. Conference of Mayors, The League of Women Voters,
and the National Rifle Association [8, p. 144].
The history of the 1969 San Francisco Bay Conservation and Develop-
ment Commission Act is an enormous testimonial to the increasing cross-
section support for a quality environment. In 3 years, the Save the Bay
Association working uninterruptedly sending out communiques on new
developments, ringing hundreds of telephones, and promoting its cause
on radio and television, expanded its support from 5,000 to 22,000 dues-
paying members. More than 200,000 signatures were gathered on petitions
asking Governor Reagan to support the bill establishing the San Francisco
Bay Conservation and Development Commission. In fact, so many telephone
calls were made in support of the bill that the President Pro-tem of the
Senate had to plead with conservation groups to cut them off so that
state business could be transacted [18, p. 148].

The Survey Research Center of the University of Michigan, asking

what program people thought government should spend money on, found
the biggest vote was 64 percent for air pollution abatement, which topped
the 62 percent who chose education [3, p. 73].
As 1970 progressed, some people suggested that environmental con-
cern might be a passing fancy—in spite of all the evidence of a deep-
seated revolution of values in general and a recent history of environ-
mental activism in particular. Those suggesting a possible diminution of
fervor for a quality environment based their arguments in part on the low
visibility of the issue in some 1970 political campaigns [14, p. 10]. But,
any doubts concerning the permanency of the quality-environment issue
were laid to rest in the November 1970 election. As Gladwin Hill [6, p. 10]
reported: "Crusaders for environmental reform chalked up victories from
coast to coast in the first national election in which conservation issues
figured prominently." From these and other empirical indications, we may
conclude that environmental awareness and expectations are widespread
and continually rising.

Second, one frequently hears from business that even though society's
attitudes are changing, the substantial costs to the firm in dealing with
externalities can not be passed on in higher prices. This frequently voiced
objection—that the costs would be high and the firm could not pass them
on to the customer—is a several-fold oversimplification. First of all, it
assumes that all costs would be high, which is erroneous. This ignores the
fact that socially responsible behavior in regard to pollution covers a variety
of actions. The actions could be in the realm of either legislative effort
106 Academy of Management Journal March

seeking socially sound policies and regulations; anaiytical activities con-

cerning the criteria; or technological activities in regard to implementa-
tion, among which the costs, of course, will vary. Moreover, the objection of
"exorbitant" cost assumes that the firm itself must perform all aspects
of any activity rather than employ outside specialists, establish joint ven-
tures, or otherwise effect scale economies in the effort. One estimate,
however, expresses doubt that over the long run environmental control
wiii figure unduly in any industry's cost. The estimate states that even in
electric power generation where the problems of air and water poilution
are joined, meeting maximum standards will add oniy 5 percent to
production costs.^
Another oversimplification, if not error, in economic reasoning implied
in the popular argument is that whatever the costs, they must be borne
(1) in the immediate period, and (2) by the directly invoived product or
¡products. (Little wonder there is the popular assumption of economic
suicide if a firm deals with its side-effects.) Thus, the argument implies, for
example, that forest products firms (those in both lumber and paper pro-
ducts) would charge their paper-mill, pollution-control expenditures soiely
to paper products and largely in the immediate period. Correctly viewed,
most pollution-controi expenditures are in the nature of investments in the
sense that expenditures today will yield a stream of future benefits. Such
investment expenditures are no different than renovating a lunch room or
engaging in research and development—in neither of these cases is it
rational to charge the cost to just a few products or attempt to have an
immediate cost recovery. Because of less price sensitivity in some markets
of the firm than in others, the firm accordingly should spread the costs
disproportionately into the less sensitive markets, as well as amortize the
cost over some reasonabie time period. We recognize that cost-spreading
runs head-on into the concept of decentraiized profit centers in the firm.
But, after all, the total firm is the correct maximizing unit, especially if we
assume the firm's goal as present-value maximization.
Aside from oversimplifications concerning costs, this same frequently
voiced objection also suggests a credibility gap. Many firms acknowiedge
society's strong rising interest in the environment, but then automatically
conclude that their customers are not that same society and, thus, that
iheir customers will not pay anything for poiiution controi. We have aiready
noted that the costs of social responsibility regarding poilution are not
uniformly high and, in many instances, wouid not iead to higher prices if
they were coupled with rationai cost allocation. But that begs the question:
on what grounds do firms assume that at least a substantial block of

^Business Weei< (April 11, 1970), p. 86. Moreover, the costs are always iess with
j3revention than with cure, it is estimated that the costs of curing pollution once it exists
are on the order of 16 times the costs of prevention. Ibid.
1971 Rationai Management Responses to External Effects 107

customers in a substantial number of markets would not pay more for

pollution control? Have firms really assessed the question, or have they
generalized from one or two casual observations? Are not, at least in
part, purchasing agents, corporation presidents, and ultimate consumers
also members of this same society which we have admitted is ever-more
environmentally aware and adamant? The evidence would suggest that
many intermediate and ultimate customers are willing to assume additional
costs for a higher quality of life.

Before elaborating, let us recognize at the outset that whatever costs

of pollution control have to be passed on as higher prices, many customers
are already paying for the pollution effects in one way or another by taxes,
by inconvenience, or in other tangible and intangible ways. So, in effect,
any higher price resulting from pollution control is more a transfer than
a net increase. As such, it is a more equitable price in that to a greater
extent only the producers creating the problem and direct users are involved.
There is mounting evidence that a sizeable and increasing number
of citizen/consumers care sufficiently about the quality of their life to pay
for an improved environment. Respondents in the Pacific Northwest Bell-
Louis Harris survey were asked if they would be willing to accept a $200
increase in total family expenses to improve the environment. In Wash-
ington 30 percent and in Oregon 28 percent of the respondents responded
that they would. Those saying "no" to $200 were asked if they would accept
a $100 increase in total family expenses to improve the environment. In
Washington 51 percent and in Oregon 47 percent of this latter category
would be willing to accept such increase. Thus, the approximately three
in ten in both states who would accept a $200 increase coupled with the
approximately five in ten of the residual group willing to accept a $100
increase constitute a significant percentage for whom an increase of at
least $100 would be acceptable. In both states, approximately 50 percent
of all respondents who were college graduates would accept the $200
increase. Also among all respondents, the 21-29 age group was most
willing to accept the $200 increase.
A survey conducted for the National Wildlife Federation found that
75 percent of a sample of 1,500 adults would be willing to pay something
to improve their surroundings [3, p. 73]. The passage of environmental
bond issues is another piece of evidence of not only the rising social
concern for a higher quality of life, but willingness to pay something for
it. Bonds for water, air, recreation, and the like have passed more readily
than any other kind in recent years. In June 1969, the previously mentioned
Citizens Crusade for Clean Water reported that eight out of nine statewide
votes for air pollution bonds had been approved since 1964. Among local
issues, Cleveland voted a $100 million water pollution abatement issue in
1968. In the fall of 1969, Suffolk County on Long Island approved a $300
million issue which they had rejected a few years earlier. San Francisco
108 Academy of Management Journal March

has committed $1 billion to the mass transportation system, including

$30 million just to clean up Market Street [3, p. 74].
If we define the cost of an activity as the amount of foregone oppor-
tunities and allow that a person's time has a monetary equivalent, one
has to be impressed with the substantial personal "expenditures" people
have willingly made in behalf of environmental issues. Volunteer groups
of one type or another have spent countless hours in environmental causes
providing clean-up crews, doorbell ringing, lobbying, and political cam-
paigning, etc.
We may conclude that in general a substantial number of citizen/con-
sumers are willing to pay (at times, a substantial amount) for a quality
environment. At this point in the argument, we have established only that
the costs of social responsibility regarding pollution are not uniformly
high, but even if some costs have to be passed on, nontrivial segments of
substantial numbers of markets would be willing to pay more.
Third. The objection that pollution costs cannot be passed on implies
passivity in regard to demand magnitude and elasticity. Thus, in our argu-
ment, we so far have looked only at the costs of correcting externalities
and the extant willingness of consumers to accept higher prices. The point
to which we now turn is, given whatever extant willingness of consumers
to pay for pollution control, a firm can affect the demand for its current
products as well as effect new markets. Thus, the previous discussion of
costs and current willingness-to-pay is only one part of the voluntary
action/wealth maximization argument. We contend that a firm, by address-
ing its external effects, can gain more control over the revenue function,
for in many markets such voluntary actions in regard to side effects will
change customer perceptions of the firm and thereby increase both de-
mand and the inelasticity of demand.
In any theory of the firm vis-a-vis externalities or in general, it is
important to remember the frequently overlooked point that cost minimi-
zation is not necessarily profit maximization, let alone wealth maximization.
The discussion of revenue (demand schedules and elasticity) vis-a-vis ex-
ternal effects may be divided into two parts: (1) evidence that customers
would pay more for a product from a "socially responsible" firm than for
the same physical offering from a competitor which is perceived to be
less socially responsible; and (2) new uses (new markets) for some of
the components of air, water, or solid-waste pollution.

We turn first to the former. From our previous discussion of the

willingness of consumers to pay more in general for an improved environ-
ment, one intuitively could argue that they similarly would favor a socially
responsible firm—specifically a higher-priced socially responsible firm—
to other competitors. Obviously, for consumers rationally to do so, they
1971 Rationai Management Responses to Externai Effects 109

would have to perceive utility (we would suppose psychic in largest part)
from the firm disproportionateiy greater than the higher cost to them.
Is there evidence that firms have perceived a connection between
voluntary social actions and favorable market response? That is, do we
find evidence that firms engage in philanthropy or other "responsible"
behavior in part, at least, to differentiate themselves from their competi-
tors? If philanthropy or other types of social actions were to be used as
competitive tactics, we would expect to find them only in rivalistic markets
(oligopoly par excellence), pitting firm against firm. We would not expect
to find them as competitive or differentiating techniques in either purely
competitive (completely impersonal) markets or monopolized markets
(where differentiation is irrelevant). A study by Johnson of charitable con-
tributions and the apparent motivations of firms supports our expectation
that philanthropy is perceived by firms in rivalistic markets as one positive
means of differentiation. Analyzing the philanthropic-constribution ratios
of three different industry structures—competition (atomistic), monopoly,
and rivalry«—for the period, 1936-1961, Johnson states.
The significant association of rivairy with higher-than-average contribu-
tion ratios—and the iack of any general tendency for the largest-sized firms
to give at the highest rates—confirms the prediction that corporate contribu-
tions are motivated by a striving for competitive advantage.'

We do not say that intermarket differences are the sole explanation of

corporate philanthropy. The evidenced relationship between the desire for
differentiation and corporate contributions is sufficient to support our ex-
pectation; however, we would agree with Johnson there are also other
determinants of unknown magnitude, such as tax benefits.« But the latter
would not explain the particular observed intermarket difference.
A necessary implication of the "philanthropy-for-the-purpose-of-differ-
entiation" argument is that the firm fully communicate to its product and
capital markets the fact of its charitable giving. Otherwise, in regard to
differentiation, the initial expenditures would be irrational. It would follow
that a firm, having to some degree addressed its pollution externalities,
similarly would always immediately convey this fact to its product markets.
Another implication of voluntary actions vis-a-vis the environment is
that the actions need not be limited to one's own external effects. For
example, recognizing the increased interest in conserving our natural re-
sources, the firm might insist on buying inputs made of recycled material,
which would find favor with a substantial and increasing number of citizen/
consumers. If many firms bought only recycled paper, there could be a

"The sectors comprising each type of structure were: competition (agriculture);

monopoly (utilities, finance, and mining); rivalry (manufacturing, services, trade, and
construction). Johnson, "Corporate Philanthropy: An Analysis of Corporate Contribution,"
Journai of Business, Voi. 39, (October 1966), p. 496.
'ibid., p. 503.
d., pp. 503-504.
110 Aeademy of Management Journal March

substantial resource economy. The American Paper Institute estimates

that each ton of recycled paper eliminates the need to cut seventeen
trees [1].
We may conclude that there is reasonable empirical evidence relat-
ing a firm's voluntary social actions, at least in some areas, to increases
in demand and demand inelasticity for Its products. From previously cited
evidence, we may infer that voluntary actions regarding externalities is
translatable into increased receptivity for a firm in its product markets.
Thus, given the environmental concern in society, voluntary actions in
regard to external effects, coupled with informing the market of one's
actions, is rational behavior in seeking differentiation.
The second means by which attention to external effects can lead to
more control over revenue is the recycling and reclaiming of pollutants
in water, air, or solid wastes, either in their present form or with additional
processing. In recycling and reclaiming, firms in effect are seeking new
internal or external markets. For example, the clarifier sludge of paper
mills is finding use as a land fill [1]. A sweeping conception of pollution
in terms of recycling and, hence, the development of new internal or
external markets, was offered by Aaron J. Teller, former Dean of Engineering
at Cooper Union [16, p. 651]: We can no longer look at pollution as some-
thing to get rid of. We have to look at pollution as unused resources.
With careful consideration, not only will firms increasingly be able
to find uses for some of their currently undesirable joint products, but
also a careful reflection on the nature of their technology and capabilities
of their resources will suggest many additional markets to which the firm's
productive know-how and capabilities can be addressed. Firms too often
succumb to a sense of predestination or mission with respect to current
products, feeling obligated to pursue current paths. The far more rational
approach is for the firm to analyze carefully its productive capabilities
and then to continually assess potential markets to determine to which
of them the resources at that time could most efficiently be addressed.
Accordingly, the most useful concept of a firm is not in terms of its current
products, but rather in terms of it comprising one or more pools of re-
sources which can respond to a range of wants—and at any one time,
of course, manifesting those resources in a specific form (specific goods
and services)."
To summarize the revenue implications of certain voluntary social
actions, firms may, and in rivalistic markets do, utilize such actions as

"The concept of firms as pools of resources is discussed and the implications

explored in John C. Narver, "Supply Space and Horizontality in Firms and Mergers,"
St. Johns Law Review (Spring 1970). Of course, the concept of recycling waste materials
is a recognition of both the potentiai markets for output from waste materials and the
adaptability of resources in utilizing these materials.
 1971 Rationai Management Responses to External Effects m

a means of differentiation. The proposition holds for firms' pollution exter-

nalities as well as any other social problems for which there is sub-
stantiai citizen/consumer concern. The actions may reiate to some aspect
of current inputs or outputs, or to recycling of pollutants, but in either case
the rational firm fuily communicates its acts to the product and capital
markets.
A parenthetical note on pricing. The firm at any time faces markets
with varying degrees of demand elasticity. By means of differentiation, it
attempts to increase the inelasticity of demand. The obvious implication
is that the wealth-maximizing firm must continually analyze its markets
to locate and enlarge the segments that are less price-sensitive. As pointed
out in economic theory, rational pricing calls for isolating market segments
in terms of preferences and varying the markups over costs in accord-
ance with the respective sensitivities to price.^o
The whole of prices and pricing of course is far more complex than
simply the amount one writes on a price tag. A transaction is an exchange
of scarce resources of the customer for perceived value from a seller.
The price tag frequently is only one element in the perceived value of
an offering. Competitive pricing often is complex. In industrial pricing,
as well as in consumer pricing, many times the tag or list price remains
unchanged, but the total bundle of utiiity is increased or decreased to
effect price decreases and price increases respectively. Thus, to retard
immediate competitive matching, the rational firm may compete by alter-
ing accompanying services leaving the list or tag price alone, and
thereby avoiding also the psychological reactions of some customers to
changes in the tag or list price."
Fourth. There is some suggestive evidence that the debt and equity
markets are, as we have posited, increasingly sensitive to the actions of
firms with respect to pollution, among other areas. Of interest in this
part of the discussion is the capital market's perception of firms' expected
earnings and risk in a society with rising environmental awareness and
demands. To the capitai market there are at least four closeiy related
reasons for perceiving iower expected earnings or greater risk in the
earnings stream: (1) failure to deal in any degree with side effects, thereby
ignoring an opportunity for positive differentiation and market gain; (2)
insensitivity or misrepresentation in product and input markets in regard
to citizen/consumer desires, thereby increasing the probability of negative
responses such as economic boycotts; (3) failure to reclaim or recycle

" F o r a basic discussion, see for exampie, Donald S. Watson, Price Theory and its
Uses (Boston: Houghton Miffiin, 1968), Chapter 17.
" A discussion of the complexities of prices and pricing may be found in John C
Narver and Ronald Savitt, The Marketing Economy: An Anaiytical Approach. (New York-
Holt, Rinehart and Winston, 1971), Chapter 13. i-i^ . \
7,72 Academy of Management Journal March

effluents, thereby losing not only an opportunity for positive differentiation

but also new internal or external markets as well; and (4) through recal-
citrance or even spurious claims, firms subjecting themselves to legal
actions, including class-action legal suits.
Turning now to some evidence of the capital market's concern with
firms' behavior vis-a-vis the environment, the First Pennsylvania Bank in
the summer of 1970 instituted a program to channel low interest loans
to companies investing in pollution control equipment. As of July 4, 1970,
the bank had sold 300 earth bonds worth about $200,000. Interest rates
ranged from 5 percent for 90-day bonds to 5V4 percent for 2-year bonds.
The bank lends money at preferential rates at about V2 point below the
going rate to environment conscious companies. The First National Bank
of Miami in the summer of 1970 introduced nearly identical pollution
bonds, and both Security National Bank in Oakland and Winters National
Bank and Trust in Dayton were offering similar programs. Chase Man-
hattan Bank recently appointed a coordinator of environmental systems
to help the bank's industrial clients formulate antipollution plans and
obtain financing. Chemical Bank in New York is offering nonprofit loans
to New York landlords who are required to install $15,000 cleansing
devices on some 13,000 apartment house incinerators.
But perhaps the toughest environmental stand of all has been taken
by the more than 70 banks in relatively unspoiled Maine and Vermont
which have signed a bankers' pollution code directing them to extend addi-
tional credit for pollution abatement and also to refuse financing for
projects that "encourage or abet pollution" [3, pp. 19-20].
Sensitivity is rising also in the corporate share market, in which,
according to some observers, a company's social policy will have an
increasingly important effect on its stock price. The Council on Economic
Priorities, a research firm created in the spring of 1970 and oriented to
research on companies' social responsibility, has been called the "Dun
and Bradstreet for the socially concerned." The Council will make detailed
monthly reports on how well business serves society in four areas: (1)
defense contracts, (2) environment protection, (3) minority hiring, and
(4) overseas investments. Some effects of the Council already are apparent.
The first report prompted the president of one mutual fund to unload a
block of shares in one company cited, giving the reason that "information
like this will hurt a company sooner or later." The impetus of the Council
on Economic Priorities was a Boston Synagogue that wanted a "peace
portfolio." The organizer of the Council drew it up and got 600 enquiries
from investors. The initial response of potential customers is encouraging,
and the head of the College Retirement Equities fund which invests
some $1.2 billion says, "If the Council generates hard factual information,
it has to become an ingredient for decision-making." Dr. Leroy Brininger
of the National Council of Churches says there is a growing awareness
7977 Rational Management Responses to External Effects 773

of churches to use investment programs to assist in the changing social

roles. And, John Westergaard, President of Equity Research Associates,
states, "Anyone doing analysis without a sociological input is doing an
incomplete job. Management is going to be pressured, and a company
with a poor score card will have long-term bad effects [3, p. 85].
Fifth. It is clear why the rational firm will communicate the facts of
its voluntary actions to both its product and capital markets. But the
next obvious question is, "How are society in general and customers in
particular to distinguish between substantive and exaggerated claims?
Why couldn't a firm simply deceive society as to its efforts in correcting
side effects?" The answer is that deception would be self-defeating, if not
suicidal, given society's rising education level and everbroadening environ-
mental awareness and expectations, not to mention the constant probings
of the corps of energetic workers with Ralph Nader and others.
The emerging citizen/consumer will not easily be sold a bill of goods.
As Commissioner Philip Elman of the Federal Trade Commission states:
The younger generation—soon to be the prirriary consumers of business
wares and ultimately the leaders of this country—wiil not be persuaded by, nor
toierate, the silly commercials and advertising gimmicks that are so prevalent
today. Tomorrow's consumers wiii be more concerned with the safety and ecology
aspects of a soda bottle than its color, size, or accompanying jingle. With higher
ievels of education than any previous generation of Americans, these consurners
of the future wiil want food products that have a full complement of nutrients
and not merely a pretty paci<age. Business must adjust—and soon—to a
generation that is no longer over-awed by the flashiness of television; a
generation that questions, rather than biindly accepts, the gospel of the modern-
day hawi<ers; a generation that will not sit idiy by if products are not honestly
advertised or do not perform as promised [7j.

In short, society is developing a higher doubt factor in regard to

environmental claims. There is a rising reluctance to accept readily state-
ments concerning serious matters such as pollution, as well as an in-
creasing probability of detection of spurious claims. In such a world,
devious actions could be immensely costly for firms, for lost good-will
in product markets will induce perceptions of increased risks and de-
creased expected earnings by the capital market. In such a world, once
a firm lost its credibility, it would be difficult and expensive to regain
it. If the firm utilized additional spurious claims to re-establish a favorable
perception, but these claims were similarly detected, the problem for
it would have risen exponentially. Aside from any deceptive statements,
there is ample evidence that even under the best of conditions, once atti-
tudes are formed it is extremely difficult to alter them by persuasion alone
[12, pp. 58-61]. Thus, in even the simplest case, the costs of a tarnished
reputation could be substantial.
The rising doubt factor of society, increasingly protecting it from
bogus claims of firms, is reinforced by a consumer movement—or better
stated, an ecological and consumer movement—which is more vigorous
than ever. Commissioner Elman sees the new movement of the 197O's as
114 Academy of Management Journai March

a fresh state—with less talk and more action [7]. One action front is
Congress where new consumer legislation will surely be forthcoming; a
second front is the private action of consumer groups and concerned
citizens, including consumer lawsuits—and class-action suits—that are
being filed in growing numbers. Also, citizen groups have begun to
intervene and plead the public interest before federal and state agencies,
supported by a burgeoning legion of able and dedicated public interest
lawyers; on a third front are the expanding consumer protection activities
of federal agencies; and on a fourth front, is the activism by state and
local consumer and environmental agencies. Thus, not only is there a
real and growing doubt factor among individuals, but there is also an
expanding ecological and consumer surveillance and redress system, both
governmentally and privately based. It would be increasingly cavalier and
expensive for a firm to mislead the citizen/consumer regarding its
environmental actions.

SUMMARY

The argument in the present paper is that the assumed goal of the
firm is to maximize its present market-value, but it is oniy by voluntary
actions with respect to externalities (specifically pollution) that a firm
can maximize its wealth. In brief, the components of the argument are
that such actions regarding external effects may be at the expense of
short-run profits. But, diminished short-run profits do not necessarily affect
the present market-value of the firm; rather, the critical determinants of
present market-value are the expected earnings (expected revenues vis-
a-vis expected costs) and the expected variability (risk) of the earnings
stream. In a society showing ever-rising environmental awareness and
expectations of firms, there are many potential legal and economic risks
to which the capital market is increasingly sensitive. In regard to its pol-
lution, the rational firm will voluntarily incur added costs pertaining to
the criteria, standards, or implementation phases of reducing the social
cost-private cost difference. In an equally important second step, the
rationai firm will then communicate to ¡ts product markets the fact of its
actions so as to differentiate itself and thereby to more than proportion-
ately increase its revenues. The logical end, of utmost importance to the
wealth-maximizing firm, is that the favorable product-market response will
tend to induce a lower perceived risk and/or higher perceived expected
earnings in the capital market.
1971 Rational Management Responses to External Effects 115

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