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Structure of Organizations Structure of Organizations for Production of Public for Production of Public and Private Goodsand Private Goods

Shyam Sunder, Yale UniversityShyam Sunder, Yale University

American Accounting Association’s American Accounting Association’s International Visiting LecturerInternational Visiting Lecturer

Bogazici University, IstambulBogazici University, Istambul

October 9, 2000October 9, 2000

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Compare Public and Compare Public and Private Good Private Good OrganizationsOrganizations

Private good organizations produce Private good organizations produce and sell goods for a price to and sell goods for a price to customerscustomers

Customers can impose discipline Customers can impose discipline on themon them

Shareholders control manager by Shareholders control manager by offering them net income based offering them net income based compensationcompensation

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Public Good OrganizationsPublic Good Organizations

Public good organizations have Public good organizations have beneficieries, not customersbeneficieries, not customers

Weaker or no customer disciplineWeaker or no customer discipline Efficient production of public goods Efficient production of public goods

is very difficultis very difficult Solution is bureaucracySolution is bureaucracy

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OutlineOutline

Organizations as a set of contractsOrganizations as a set of contracts Accounting as a contract implemetAccounting as a contract implemet

ation mechanismation mechanism Compare resource flows, managemCompare resource flows, managem

ent structure, decisions, and accouent structure, decisions, and accounting in organizationsnting in organizations

Examples and implicationsExamples and implications

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Faculty Teaching by Faculty Teaching by SubjectSubject

Subject AreaSubject Area

AuditingAuditing

FinancialFinancial

Manageral/CostManageral/Cost

MAS/SystemsMAS/Systems

TaxationTaxation

GovernmentGovernment

ResearchResearch

All current Teaching All current Teaching

(In percent)(In percent)

1111

4444

2121

55

1010

11

33

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Calls for ReformsCalls for Reforms

Arthur Andersen: Sound Financial Arthur Andersen: Sound Financial Reporting in Public Sector: A Reporting in Public Sector: A Prerequisite to Fiscal ResponsibilityPrerequisite to Fiscal Responsibility

Coopers & Lybrand: Financial Reporting Coopers & Lybrand: Financial Reporting Practices of American Cities: A Public Practices of American Cities: A Public ReportReport

Touche Ross: Public Financial Reporting Touche Ross: Public Financial Reporting by Local Governmentsby Local Governments

Robert N. Anthony: Tell It Like It isRobert N. Anthony: Tell It Like It is

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Four Characteristics of Four Characteristics of BureaucracyBureaucracy

Fixed wageFixed wage Impersonal rulesImpersonal rulesTenure in jobTenure in jobPromotion from insidePromotion from inside

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Cries in the WildernessCries in the Wilderness

Bolton: Don’t Put Government Bolton: Don’t Put Government Financial Accounting in a Strait Financial Accounting in a Strait JacketJacket

Drebin: Is Accounting that is Good Drebin: Is Accounting that is Good for General Motors Good for for General Motors Good for Detroit?Detroit?

Mautz: Should Government Mautz: Should Government Emulate Business?Emulate Business?

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Legitimate Reasons for Legitimate Reasons for Different AccountingDifferent Accounting

Imposing business practices can cause considerable harm

Bureaucracy is an efficient solution to a difficult problem

Efficient production of public goods is a lot more difficult

Example: Besselman, Arora and Larkey Study of Defense Department

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Lack of Theory of Lack of Theory of Organizations to Produce Organizations to Produce Public GoodsPublic Goods

Management curricula linked to Management curricula linked to economicseconomics..

Absence of economic theory of public Absence of economic theory of public good organizationsgood organizations

Economics and management courses Economics and management courses emphasize private goods only.emphasize private goods only.

Contract theory of organizations can help Contract theory of organizations can help An example of a lack of theory driving out An example of a lack of theory driving out

teaching and practiceteaching and practice

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A Framework for Contract A Framework for Contract Theory of OrganizationsTheory of Organizations

Chester Barnard, President, Bell Chester Barnard, President, Bell Telephone Company of New Telephone Company of New JerseyJersey•Functions of the ExecutiveFunctions of the Executive 19371937

Herbert A. Simon, Herbert A. Simon, Administrative Behavior, 1946

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Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Customers

VendorsGovernment

Managers

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Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Customers

VendorsGovernment

Managers

Public

Goo

dsTax

es

Goo

ds a

nd

Serv

ices

Cas

h

Compensation

Skills

SkillsCompensation

Res

idua

lR

ight

s

Equ

ity C

apita

l

Interest

Loan

Capita

l

CashGoods and Services

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Necessary ConditionsNecessary Conditions

1) Individual Condition: Each 1) Individual Condition: Each participants expects to receive at participants expects to receive at least the opportunity cost of least the opportunity cost of contributions he/she makes to the contributions he/she makes to the organizationorganization

2) Aggregate Condition: Contributions 2) Aggregate Condition: Contributions of all participants can produce enough of all participants can produce enough output to meet the expectations of alloutput to meet the expectations of all

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Functions of AccountingFunctions of Accounting

Measures resource contributions

Determines inducementsCompares contributions to

inducements

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Special Problems in Special Problems in Control of ManagersControl of Managers

At the procedural hub of the contractsAt the procedural hub of the contracts Control resources, have informationControl resources, have information Monitor and negotiate with othersMonitor and negotiate with others Difficult to measure their contributionsDifficult to measure their contributions Can appropriate resources and Can appropriate resources and

informationinformation Misappropriation difficult to detectMisappropriation difficult to detect Devising a scheme to induce managers to Devising a scheme to induce managers to

contribute what is expected of hercontribute what is expected of her

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What are public and private What are public and private goods?goods?

Pure public goods satisfy two Pure public goods satisfy two conditions:conditions:

Zero marginal cost of serving an Zero marginal cost of serving an additional useradditional user

Nonexcludability: those who do not Nonexcludability: those who do not pay still benefit.pay still benefit.

Examples: National defense for Examples: National defense for citizens of U.S. Public radio in citycitizens of U.S. Public radio in city

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Pure private goods do not Pure private goods do not satisfy either conditionsatisfy either condition

Examples: a cup of coffee, Examples: a cup of coffee, car, suitcar, suit

Most goods and services lie Most goods and services lie in between the two in between the two extremes of pure public and extremes of pure public and pure private goodspure private goods

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Comparing Private and Comparing Private and Public Good OrganizationsPublic Good Organizations

Resource flowsResidual ClaimsProduct Market DisciplineDecision Making

•Product•Investment

Accounting and Control

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Resource FlowsResource Flows

Unreciprocated outflow to beneficiaries

No quid pro quoNeed unreciprocated inflow (tax, gifts)Captial versus revenue account cash

flows In Public good organizations, capital

flows are “revenue” contributions

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Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Beneficiaries

VendorsGovernment

Managers

Public

Goo

dsTax

es

Goo

ds a

nd

Serv

ices

Cas

h

Compensation

Skills

SkillsCompensation

Fin

anci

alR

esou

rces

Interest

Loan

Capita

l

Goods and Services

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Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Customers

VendorsGovernment

Managers

Public

Goo

dsTax

es

Goo

ds a

nd

Serv

ices

Cas

h

Compensation

Skills

SkillsCompensation

Res

idua

lR

ight

s

Equ

ity C

apita

l

Interest

Loan

Capita

l

CashGoods and Services

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Residual Claims

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

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Stock Market Stock Market Consequences of Residual Consequences of Residual ClaimsClaims

Trading in residual claims (stock market)

Creates incentives to gather and produce information

A large information industry existsCapitalizability of residual claims

induces interest in longer term resource flows

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Public Goods Public Goods OrganizationsOrganizations

No tradeable residual claimsWeaker incentives to search

for informationWeaker concern for the

longer run (e.g., Social Security debates)

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Defining Managers’ Defining Managers’ ContractsContracts

Private Good Organizations make it self-enforcing: link compensation to the residual (accounting and audit)

No product market discipline No link of managerial compensation to residual

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Product Market DisciplineProduct Market Discipline

Customers in PGOs negotiate terms

No transaction if not satisfiedCan withhold revenuesResidual-based contract for managers possible

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Public Good Organizations’ Public Good Organizations’ BeneficiariesBeneficiaries

Cannot withhold resources directly

Would continue to consume resources of poorer quality

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Private Good Contract in Private Good Contract in Public Good OrganizationPublic Good Organization

DysfunctionalSimple 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

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Redistribution of Decision Redistribution of Decision RightsRights

This Problem in public good organizations is addressed by Redistribution of decision making responsibilities

Managerial contract delinked from residual

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Product Decision RightsProduct Decision Rights

Managers have information, expertise, and decision rights in private good

In public goods, 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

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Product Decision Rights in Product Decision Rights in Public Good OrganizationsPublic Good Organizations

The informational advantage managers in private goods is left unused in public goods

Managers not offered incentives to look for newer types of public goods

They may do so to seek promotion and power, retain jobs

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Investment/Production Investment/Production Decision RightsDecision Rights

Managers choose residual maximizing quantity, quality using their information

Delegation of quantity decisions possible through linkage between residual and remuneration

Investment decisions are derived decisions from the quantity decisions

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Investment/Production Investment/Production Decision Rights in Public Decision Rights in Public Goods Orgs.Goods Orgs.

In public goods, governing bodies make quantity and quality decisions,

And therefore, the capital investment decisions

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Accounting and ControlsAccounting 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

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Accounting and Control Accounting and Control DifferencesDifferences

EntitiesEntitiesFundsFundsConsolidationConsolidationAssets/DepreciationAssets/DepreciationRevenue (cash versus accrual)Revenue (cash versus accrual)BudgetsBudgets

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Entities, Funds and Entities, Funds and ConsolidationConsolidation

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

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Detail in Public Good Detail in Public Good Financial ReportsFinancial Reports

Even small public good organizaations have fat financial reports

Why do they not aggregate?

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Reports Reflect the Reports Reflect the Decision StructureDecision Structure

Governing boards make product/investment decisions

Public good org. reports comparable to middle management reports

Each fund serves a different constituency

If funds cannot be commingled, why consolidate?

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Fixed Assets and Fixed Assets and DepreciationDepreciation

Private‑good: Record and value of long‑term assets at acquisition cost

Expense as cost of production over lifeUse of standard formulas Statistical inaccuracy vs. objectivityValuation of individual assets and the

residual rights for transactionsUseful for traders

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Public Good OrganizationsPublic Good Organizations

Residual rights not tradedSale of fixed assets infrequentUniqueness of many assets (Mount

Rushmore)Dominant market positionNonmonetary disclosure of assetsNot sure if some assets are liabilities

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Depreciation in Private Depreciation in Private Good OrganizationsGood 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

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In Public Good In Public Good OrganizationsOrganizations

none of the above three reasons applicable

No residual claimantPublic goods are not soldProduction investment

decisions made by governing bodies

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Accruals and Accruals and Revenue/Expense Revenue/Expense RecognitionRecognition

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

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Budgets, Appropriations Budgets, Appropriations and Encumbrancesand Encumbrances

Governing bodies of public-good organizations appropriate funds for specific items

The budget is an authorization to spend

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Which one is the Which one is the Independent Variable?Independent Variable?

Legal charterLegal charter Interal Revenue Service Interal Revenue Service

Rules on tax statusRules on tax statusEconomic characteristics of Economic characteristics of

organization’s outputorganization’s output

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Considered Polar Cases Considered Polar Cases OnlyOnly

Pure public and pure private Pure public and pure private goods are two polar casesgoods are two polar cases

Most goods, and organizations Most goods, and organizations that produce them lie in betweenthat produce them lie in between

Rich spectrum of opportunities for Rich spectrum of opportunities for study of organizations, economics study of organizations, economics and accounting controlsand accounting controls

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Bureaucracy As A Dirty Bureaucracy As A Dirty WordWord

Bureaucracy is the oldest form of Bureaucracy is the oldest form of managementmanagement

Does not receive a fair shake in pressDoes not receive a fair shake in press Perhaps overused in welfare statePerhaps overused in welfare state But it is necessary for many functionsBut it is necessary for many functions Lack of understanding leads to Lack of understanding leads to

misguided attempts at reform that misguided attempts at reform that can backfirecan backfire

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Unequal RaceUnequal Race

Efficient production of public goods Efficient production of public goods is more difficult than private goods is more difficult than private goods (lack of customer discipline on (lack of customer discipline on managers)managers)

Always room for improvement in Always room for improvement in current practicescurrent practices

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Thank YouThank You

The working paper, talk, and slides The working paper, talk, and slides are available atare available at

http://www.som.yale.edu/faculty/http://www.som.yale.edu/faculty/sunder/research.htmlsunder/research.html

or email to or email to shyam.sunder@yale.edu shyam.sunder@yale.edu