Structure of Organizations for Production of Public and Private Goods Shyam Sunder Faculty Research Seminar Yale School of Management April 18, 2018 8/4/2019 Production of Public and Private Goods

Compare Public and Private Good Producing Organizations Private good organizations produce and sell goods and services for a price to customers Customers can impose discipline on them by denying revenue Shareholders control manager-employees by offering them residual-based compensation Public-good organizations serve their beneficiaries, not paying customers Weaker or no customer discipline It makes the task of establishing managerial control to promote efficient production of public goods a more difficult challenge Bureaucracy as a solution 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods Overview Barnard, Simon: Organization as a set of contracts Accounting and control as a contract implemetation mechanism Examine organizations by economic nature of their output, not legal form Compare resource flows, management structure, decisions, and accounting and control in public and private good-producing organizations Unit of analysis: decision makers, not organization as a whole Examples and implications 8/4/2019 Production of Public and Private Goods

Accounting Teaching by Subject Subject Area Auditing Financial Managerial/Cost MAS/Systems Taxation Government Research All current Teaching (In percent) 11 44 21 5 10 1 3 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods Calls for Reforms Arthur Andersen: Sound Financial Reporting in Public Sector: A Prerequisite to Fiscal Responsibility Coopers & Lybrand: Financial Reporting Practices of American Cities: A Public Report Touche Ross: Public Financial Reporting by Local Governments Robert N. Anthony: Tell It Like It is 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 8/4/2019 Production of Public and Private Goods

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? 8/4/2019 Production of Public and Private Goods

Legitimate Reasons for Different Accounting and Management Structure 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’s procurement policies 8/4/2019 Production of Public and Private Goods

Lack of Theory of Organizations to Produce Public Goods Management curricula rooted in private good economics Under-development of economic theory of public good organizations Economics and management courses mostly emphasize private goods Contract theory of organizations can help An example of a lack of theory driving out teaching and even practice 8/4/2019 Production of Public and Private Goods

A Framework for Contract Theory of Organizations Chester Barnard, President, Bell Telephone Company of New Jersey: Functions of the Executive 1936 Herbert A. Simon, Administrative Behavior (1946) and “A Comparison of Organisation Theories,” (RES 1952-53) 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 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 8/4/2019 Production of Public and Private Goods

Functions of Accounting for Participants Measures resource contributions Determines inducements Compares contributions to inducements (Two other functions relate to potential participants) 8/4/2019 Production of Public and Private Goods

Special Problems in Control of Managers At the procedural hub of the contracts Control resources and information Monitor and negotiate with others Difficult to measure their contributions/inputs Can appropriate resources and information Misappropriation difficult to detect Devising a scheme to induce managers to contribute what is expected of them 8/4/2019 Production of Public and Private Goods

What are public and private goods? Pure public goods satisfy two conditions: Non-rivalrous consumption: zero marginal cost of serving an additional user Non-excludability: those who do not pay still benefit. Examples: National defense for citizens of U.S.; city streets and lighting, public safety 8/4/2019 Production of Public and Private Goods

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 8/4/2019 Production of Public and Private Goods

Comparing Private and Public Good Organizations Resource flows Residual Claims Product Market Discipline Decision Making Product Investment Accounting and Control 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 1. Resource Flows Unreciprocated outflow to beneficiaries No quid pro quo Need unreciprocated inflow (taxes, gifts) Capital versus revenue account cash flows In Public good organizations, capital flows are “revenue” contributions 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods Public Good Organizations 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods Private Good Organizations 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 2. Residual Claimants An economizing device in private good organizations Reduces the number of contracting relationships Residual claimant given control (because susceptible to others' non-performance) Other agents can protect their interests more directly 8/4/2019 Production of Public and Private Goods

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 shareholder interest in longer-term resource flows 8/4/2019 Production of Public and Private Goods

In Contrast: Public-Goods Organizations No tradeable residual claims (its NPV is negative) Weaker incentives to search for information Weaker concern for the longer run (e.g., Social Security debates) 8/4/2019 Production of Public and Private Goods

Defining Managers’ Contracts Private Good Organizations make it self-enforcing: by linking managerial compensation to the residual (subject to controls and audit) No product market discipline  No link between managerial compensation and the residual 8/4/2019 Production of Public and Private Goods

3. Product Market Discipline Customers of private good organizations negotiate terms In most cases, they directly observe the quality and quantity of what they get No transaction if not satisfied Customer can easily withhold revenue with little effort Residual-based contract for managers is possible in this case 8/4/2019 Production of Public and Private Goods

Public Good Organizations Have Beneficiaries, Not Customers They cannot withhold resources directly (not so easily) Much higher cost of imposing discipline on managers May not know of the quality/quantity of benefits until too late Have only costly recourse when offered substandard benefits (complain, vote) 8/4/2019 Production of Public and Private Goods

Private Good Contract in Public Good Organization Dysfunctional Would be simple for managers to increase the residual by cutting the quality or quantity of public services (this would make the organization redundant) Efficient structure for production of private goods is not efficient for public goods 8/4/2019 Production of Public and Private Goods

4. Redistribution of Decision Rights This Problem in public good organizations is addressed by redistribution of decision making responsibilities Managerial contract is delinked from the residual 8/4/2019 Production of Public and Private Goods

4.1 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 Positive residual generation is irrelevant because the net residual is negative 8/4/2019 Production of Public and Private Goods

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 their jobs (RedCross) 8/4/2019 Production of Public and Private Goods

4.2 Investment/Production Decision Rights Managers choose residual maximizing quantity, quality of private goods using their information Delegation of quantity decisions possible through linkage between residual and remuneration Investment decisions are derived decisions from the quantity decisions; delegated to managers with oversight rights 8/4/2019 Production of Public and Private Goods

Investment/Production Decision Rights in Public-Goods Orgs. In public goods, governing bodies make quantity and quality decisions Governing bodies have to provide funds for investment (no internal generation of funds) And therefore, they must also make the capital investment decisions 8/4/2019 Production of Public and Private Goods

5. Accounting and Controls Differences between internal control and financial reporting Often misinterpreted as prima facie evidence of poorly designed or poorly managed public-good organizations 8/4/2019 Production of Public and Private Goods

Accounting and Control Differences Entities and Funds Consolidation Fixed assets/depreciation Revenue (cash versus accrual) Budgets 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 5.1. Entities and Funds External 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 from governing body 8/4/2019 Production of Public and Private Goods

5.2 Detail in Public Good Financial Reports (No Consolidation) Even small public good organizations have lengthy financial reports Why do they not aggregate? 8/4/2019 Production of Public and Private Goods

Reports Reflect the Decision Structure Governing boards make product/investment decisions Reports of public-good organization comparable to middle management reports Each fund serves a different constituency If funds cannot be commingled, consolidated reports do not serve the needs of various constituents 8/4/2019 Production of Public and Private Goods

5.3 Fixed Assets and Depreciation Private‑goods: Record 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 security traders 8/4/2019 Production of Public and Private Goods

Public-Good Organizations Residual rights not traded Sale of fixed assets infrequent Uniqueness of many assets (Mount Rushmore; Lincoln Memorial) Dominant market position Nonmonetary disclosure of assets Not sure if some assets are liabilities 8/4/2019 Production of Public and Private Goods

Depreciation in Private Good Organizations Three functions: Estimating the residual surplus Information value of residual surplus for valuation and trading Important statistic for all (viability of firm, contract renegotiation) Charging depreciation to the cost of production for pricing decisions Induce goal congruence in managers 8/4/2019 Production of Public and Private Goods

In Public Good Organizations none of the above three reasons is applicable Residual has negative value, not traded Public goods are not sold; no pricing Production/investment decisions made by the governing bodies 8/4/2019 Production of Public and Private Goods

5.4 Accruals and Revenue/Expense Recognition In Private good organizations, realization principle reflects the customer quid pro quo No quid pro quo for transactions in public-good organizations In absence of quid pro quo, applying accrual principle would be chasing the form, not the substance of transactions 8/4/2019 Production of Public and Private Goods

5.5 Budgets, Appropriations and Encumbrances Governing bodies of public-good organizations appropriate funds for specific items The budget is an authorization to spend Public good organizations permit little managerial discretion on spending 8/4/2019 Production of Public and Private Goods

Which one is the Independent Variable? Legal charter Internal Revenue Service Rules on tax status Economic characteristics of organization’s output 8/4/2019 Production of Public and Private Goods

Considered Polar Cases Only Pure public and pure private goods are two polar cases Most goods, and organizations that produce them lie in between (partially rivalrous, excludable, common pool, and club goods) not considered here Rich spectrum of opportunities for study of organizations, economics and accounting controls 8/4/2019 Production of Public and Private Goods

Characteristics of Bureaucracy (Weber) Pre-specified duties Fixed hierarchy Fixed wages Impersonal rules Tenure in job Promotion from inside by technical criteria (e.g., degree x from recognized college) 8/4/2019 Production of Public and Private Goods

Bureaucracy As An Epithet 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 often backfire 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods 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 our motto of serving business and society 8/4/2019 Production of Public and Private Goods

Production of Public and Private Goods Thank You shyam.sunder@yale.edu 8/4/2019 Production of Public and Private Goods