A notable trend has emerged: outsourcing non-monetary sanctions to firms that enforce penalties internally and more efficiently for employee misconduct. In a new paper, we examine this trend, focusing on the deterrence and policy implications of transforming corporations into self-policing firms.
The trend is driven by growing demand for corporate social responsibility and the rise of prosocial investments since the 1980s. During this period, pension funds have increasingly considered environmental, social, and governance (ESG) factors, pushing firms to account for their social and environmental impacts. Even without investor pressure, government enforcers delegate corporate policing responsibilities to companies, which are well-positioned to monitor their own operations. For example, the recent policy of the U.S. Department of Justice (DOJ) encourages companies to penalize rogue employees through compensation clawbacks. Firms, particularly those that settle cases with the government, are obligated to oversee their employees and face significant sanctions for non-compliance.
The standard law and economics analysis of deterrence recommends fines as the preferred formal punishment for deterring rogue. This approach seems persuasive, even irrefutable, considering that fines are almost costless to a society. In contrast, government-imposed non-monetary sanctions, such as imprisonment, seem inefficient due to their high costs relative to their benefits. However, what if self-policing firms could efficiently impose non-monetary sanctions?
In fact, many traditional legal studies have emphasized the importance of non-monetary punishments. For instance, Cesare Beccaria, often called the father of modern criminal law, showed how forced labor could affect people’s expectations of future punishment in his well-known work, “On Crime and Punishment.” Rousseau and Hegel also argued that punishment can deter potential offenders and restore public confidence in the legal system.
In our paper, we begin by incorporating the essence of efficiency wage theory into the law and economics model of corporate deterrence. By doing so, we can analyze the prospective wealth of an employee who faces the opportunity for wrongdoing as well as the risk of being detected and punished by the firm. For example, if an agent’s wrongdoing is detected, he loses his job and reputation, along with the opportunity to receive compensation due to clawbacks, thereby losing time to earn money, but not the money itself. The value of the penalties imposed on him is represented by the value of time lost, measured as the gap in his prospective wealth between when he is given earning opportunities and when he is not. This gap is primarily driven by the compensation he would receive from his employer. Since self-policing firms see an increase in labor demand with greater deterrent power, and this deterrent power positively correlates with an agent’s compensation, their labor demand may ultimately be represented by an upward slope.
Using this result, we compare the labor market outcomes for non-policing and self-policing firms in a setting with a standard upward-sloping labor supply curve. Because the labor demand of non-policing firms is downward sloping, a market with non-policing firms has, at most, a unique equilibrium. In contrast, since the labor demand of self-policing firms can be potentially upward sloping, a corresponding market with self-policing firms may exhibit multiple equilibria. The equilibrium associated with the highest compensation maximizes employment, production, and the value of each self-policing firm.
This finding provides a rationale for imposing a minimum compensation requirement, which serves as a device for maximizing social welfare. At the value-maximizing equilibrium, employment and output levels are maximized, alleviating a regulator’s concern that the requirement might lead to increased unemployment and reduced production.
However, we also demonstrate that a minimum compensation requirement is not always effective for prosocial investors or regulators. When firms that self-regulate don’t do so adequately, increasing compensation does not enhance hiring incentives. In these cases, the absence of multiple equilibria renders the minimum compensation requirement ineffective. We outline the criteria for how much of a shortfall in self-regulation leads to the ineffectiveness of the requirement.
Our model’s predictions align with previous evidence. For instance, a study on employee discipline across plants indicates that higher wage premiums are associated with reduced shirking and fewer disciplinary dismissals, especially when labor market conditions increase the cost of job loss. Furthermore, prior research shows that wage hikes can lead to more modest environmental abatement efforts among state-owned firms – considered prosocial due to their ownership structure – compared with those of privately owned firms. These results suggest that prosocial, self-policing firms can benefit from increased compensation to mitigate harm to society.
Our paper combines the theory of deterrence with an efficiency wage model to investigate a self-policing firm that seeks to deter wrongdoing by identifying and punishing wrongdoers through the removal of their opportunities to earn income. Since a self-policing firm’s compensation level determines the prospective wealth that a rogue employee may lose, it is positively associated with the firm’s deterrent power and potential hiring incentives. Consequently, labor demand is potentially upward sloping, and multiple equilibria may exist. When multiple equilibria are present, the one associated with the highest compensation maximizes social welfare. The key takeaway from this paper is that a minimum compensation policy can serve as a device for self-policing firms, illuminating the underexplored connection between deterrence and labor policies.
This post comes to us from Kentaro Asai and Tatsuhiko Inatani at Kyoto University Center for Interdisciplinary Studies of Law and Policy. It is based on their recent paper, “Economic Analysis of Corporate Non-Monetary Sanctions” available here.