From market failure to organisational failure

In this paper, we argue that environmental economists who have dedicated their attention to problems of market and regulatory failure have been remiss in ignoring the potential for failure in the one institution that actually manages environmental resources ‐ the business firm. Traditionally the firm has been modelled as a unitary, rational, optimising persona ficta. There is, however, abundant empirical and theoretical evidence to suggest that the business firm is an imperfect institution in that there are systematic deviations between the environmental objectives of the firm's leaders (principals) and the actions of the firm's employees (agents) which determine environmental performance. In the paper, we draw parallels between the causes of market failure and public policy tools to correct them on one hand and the causes of organisational failure and the management tools suited to their remedy on the other. Although much of the paper is concerned with the interrelationship between public policy that promotes sustainability and business policy to fashion a sustainable enterprise, our work is relevant irrespective of the reason why a firm's principal may want to improve environmental performance. No matter what the reason, the principal must concern him‐ or herself with operationalising objectives in management systems. It is consistent with the precautionary principle to assume that employees will do what the firm measures and rewards, not what its principal says is important. We build a verbal model, based on the language of principal‐agent theory, to analyse how different management instruments might be employed to improve the firm's environmental performance. The model is one of three decision makers in a vertical hierarchy. Each of the first two has various instruments at its disposal to influence the behaviour of the agents subordinate to it. In the end, the goal is to ensure consistency between social, economic, and personal objectives. The specific management tools we analyse, with reference to the formal modelling which has appeared in the literature, include the compensation system, quantification and monitoring of non‐financial objectives, internal pricing, horizontal task restructuring, centralisation vs. decentralisation of decision making, and corporate sanctions of agents for negligence. We conclude the paper by reiterating that the corporate policy statements to the effect that the firm should respect the environment are insufficient to ensure that result. In addition, firms' principals must operationalise that goal in the systems of measurement and control which govern the behaviour of those who really matter ‐ the employees.