Structure of Organizations for Production of Public and Private Goods

1. Structure of Organizations for Production of Public and Private Goods Shyam Sunder Program on Non-Profit Organizations (PONPO) Yale University April 3, 2012 Production of Public and Private Goods

2. Private Good Organizations • Private good organizations produce and sell goods for a price to customers • Customers can discipline managers by denying them revenue directly • Shareholders can control hired managers by offering them compensation linked to net income Production of Public and Private Goods

3. Public Good Organizations • Public good organizations have beneficiaries, not customers • Weaker or no customer discipline: beneficiaries cannot directly deny revenue • Need a different decision-management-control structure: bureaucracy (Weber) • Efficient production of public goods is more difficult Production of Public and Private Goods

4. Overview • Organizations viewed as a set of contracts among agents • Accounting and control as a contract implemetation mechanism • Classify and study organizations by economic nature of their output, not legal form • Compare resource flows, management structure, decisions, and accounting in public and private good-producing organizations Production of Public and Private Goods

5. What are public and private goods? • Pure public goods satisfy two conditions: • Zero marginal cost of serving an additional user • Nonexcludability: those who do not pay still benefit. • Examples: National defense for citizens of U.S. Public radio in city Production of Public and Private Goods

6. Pure private goods do not satisfy either condition • Examples: a cup of coffee, car, suit • Most goods and services lie in between the two extremes of pure public and pure private goods Production of Public and Private Goods

7. Production of Public and Private Goods

8. Cries in the Wilderness • Bolton: Don’t Put Government Financial Accounting in a Strait Jacket • Drebin: Is Accounting that is Good for General Motors Good for Detroit? • Mautz: Should Government Emulate Business? Production of Public and Private Goods

9. Legitimate Reasons for Different Structures • Imposing business practices can cause considerable harm • Bureaucracy is an efficient solution to a difficult problem • Efficient production of public goods is more difficult • Example: Besselman, Arora and Larkey Study of Defense Department Production of Public and Private Goods

10. Lack of Theory of Organizations to Produce Public Goods • Management curricula linked to private good economics • Absence of economic theory of public good organizations • Economics and management courses emphasize private goods only. • Contract theory of organizations can help • An example of a lack of theory driving out teaching and practice Production of Public and Private Goods

11. A Framework for Contract Theory of Organizations • Chester Barnard, President, Bell Telephone Company of New Jersey • Functions of the Executive 1937 • Herbert A. Simon, Administrative Behavior, 1946 Production of Public and Private Goods

12. Production of Public and Private Goods

13. Production of Public and Private Goods

14. Necessary Conditions • 1) Individual Condition: Each participants expects to receive at least the opportunity cost of contributions he/she makes to the organization • 2) Aggregate Condition: Contributions of all participants can produce enough output to meet the expectations of all Production of Public and Private Goods

15. Comparing Private and Public Good Organizations • Resource flows • Residual Claims • Product Market Discipline • Decision Making • Product • Investment • Accounting and Control Production of Public and Private Goods

16. Resource Flows • Unreciprocated outflow to beneficiaries • No quid pro quo • Need unreciprocated inflow (tax, gifts) • Capital versus revenue account cash flows • In Public good organizations, capital flows are “revenue” contributions Production of Public and Private Goods

17. Production of Public and Private Goods

18. Production of Public and Private Goods

19. Residual Claimants • An economizing device in private good organizations • Reduce the number of contracting relationships • Residual claimant given control (susceptible to others' non-performance) • All agents can protect their interests directly Production of Public and Private Goods

20. Stock Market Consequences of Residual Claims • Trading in residual claims (stock market) • Creates private incentives to gather and produce information • A large information industry exists • Capitalizability of residual claims induces interest in longer term resource flows Production of Public and Private Goods

21. In Contrast: Public Goods Organizations • No tradeable residual claims • Weaker incentives to search for information • Weaker concern for the longer run (e.g., Social Security debates) Production of Public and Private Goods

22. Defining Managers’ Contracts • Private Good Organizations make it self-enforcing: by linking compensation to the residual (subject to control and audit) • No product market discipline  No link between managerial compensation and the residual Production of Public and Private Goods

23. Product Market Discipline • Customers of private good organizations negotiate terms • No transaction if not satisfied • Customer can withhold revenue • Residual-based contract for managers possible Production of Public and Private Goods

24. Public Good Organizations Have Beneficiaries, Not Customers • They cannot withhold resources directly (not so easily) • Much higher cost of imposing discipline on managers • Can be forced to consume resources of poorer quality Production of Public and Private Goods

25. Private Good Contract in Public Good Organization • Dysfunctional • Simple for managers to maximize the residual by cutting the quality or quantity • This makes the organization becomes redundant • Efficient structure for private goods is not efficient for public goods Production of Public and Private Goods

26. Redistribution of Decision Rights • This Problem in public good organizations is addressed by redistribution of decision making responsibilities • Managerial contract delinked from residual Production of Public and Private Goods

27. Product Decision Rights • Managers have information, expertise, and decision rights in private good organizations • In public good orgs., the governing body specifies what is produced, quantity, quality, and who gets them, because it pays for them • Residual generation is irrelevant because the net residual is negative Production of Public and Private Goods

28. Product Decision Rights in Public Good Organizations • The informational advantage of managers in private goods is left unused in public goods (Hayek dec.) • Managers not offered incentives to look for newer types of public goods • They may still do so to seek promotion and power, retain jobs Production of Public and Private Goods

29. Investment/Production Decision Rights • Managers choose residual maximizing quantity, quality of pvt. gds. using their information • Delegation of quantity decisions possible through linkage between residual and remuneration • Investment decisions are derived decisions from the quantity decisions Production of Public and Private Goods

30. Investment/Production Decision Rights in Public Goods Orgs. • In public goods, governing bodies make quantity and quality decisions, • And therefore, they must also make the capital investment decisions Production of Public and Private Goods

31. Accounting and Controls • Differences between internal control and financial reporting • Differences often misinterpreted as prima facie evidence of poorly designed or poorly run public-good organizations Production of Public and Private Goods

32. Accounting and Control Differences • Entities • Funds • Consolidation • Assets/Depreciation • Revenue (cash versus accrual) • Budgets Production of Public and Private Goods

33. Entities, Funds and Consolidation • Restrictions on use of funds to make each fund a separate entity • Governing bodies direct funds to implement their production decisions • Beneficiaries cannot discipline the managers • Segregation of funds is a device to implement the contract Production of Public and Private Goods

34. Detail in Public Good Financial Reports • Even small public good organizations have lengthy financial reports • Why do they not aggregate? Production of Public and Private Goods

35. Reports Reflect the Decision Structure • Governing boards make product/investment decisions • Public good organization reports comparable to middle management reports • Each fund serves a different constituency • If funds cannot be commingled, why consolidate? Production of Public and Private Goods

36. Fixed Assets and Depreciation • Private‑good: Record and value of long‑term assets at acquisition cost • Expense as cost of production over life • Use of standard formulas (e.g., linear depn.) • Statistical inaccuracy vs. objectivity • Valuation of individual assets and the residual rights for transactions • Useful for traders Production of Public and Private Goods

37. Public Good Organizations • Residual rights not traded • Sale of fixed assets infrequent • Uniqueness of many assets (Mount Rushmore) • Dominant market position • Nonmonetary disclosure of assets • Not sure if some assets are liabilities Production of Public and Private Goods

38. Depreciation in Private Good Organizations • Three functions: • Estimating the residual surplus • Information value of residual surplus • Important statistic for all (viability, renegotiation) • Charging depreciation to the cost of production for pricing decisions • Induce managers to goal congruence Production of Public and Private Goods

39. In Public Good Organizations • none of the above three reasons applicable • No residual claimant • Public goods are not sold • Production investment decisions made by governing bodies Production of Public and Private Goods

40. Accruals and Revenue/Expense Recognition • In Private good organizations, realization principle represents the quid pro quo with the customers • No quid pro quo for transactions in public-good organizations • In absence of quid pro quo, applying accrual principle is chasing form, not substance Production of Public and Private Goods

41. Budgets, Appropriations and Encumbrances • Governing bodies of public-good organizations appropriate funds for specific items • The budget is an authorization to spend Production of Public and Private Goods

42. Which one is the Independent Variable? • Legal charter • Internal Revenue Service Rules on tax status • Economic characteristics of organization’s output Production of Public and Private Goods

43. Considered Polar Cases Only • Pure public and pure private goods are two polar cases • Most goods, and organizations that produce them lie in between • Rich spectrum of opportunities for study of organizations, economics and accounting controls Production of Public and Private Goods

44. Four Characteristics of Bureaucracy (Weber) • Fixed wage • Impersonal rules • Tenure in job • Promotion from inside Production of Public and Private Goods

45. Bureaucracy As A Dirty Word • Bureaucracy is the oldest form of management • Does not receive a fair shake in press • Perhaps overused in welfare state • But it is necessary for many functions • Lack of understanding leads to misguided attempts at reform that can backfire Production of Public and Private Goods

46. Unequal Race • Efficient production of public goods is more difficult than private goods (lack of customer discipline on managers) • Always room for improvement in current practices • An integrated economic theory of management and structure for production of private vs. public goods may help direct more attention to teaching and research in this significant segment of national economy and help fulfill SOM’s motto of serving business and society Production of Public and Private Goods

47. Thank You • The working paper, talk, and slides are available at • http://www.som.yale.edu/faculty/sunder/research.html • or email to shyam.sunder@yale.edu Production of Public and Private Goods