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What about Public Goods?

Shyam Sunder, Yale University

Rethinking Capitalism

Bruce Initiative at the University of California at Santa Cruz

April 9, 2011

Rethinking Capitalism

• Even capitalist economies need public goods

• Estimates 30-40 percent of the total economy

• Private owners of capital have little incentive to provide public goods, and state and NGOs step in to fill the space

• The problem of organizing and managing efficient production of public vs. private goods

• Take a break from focus on more visible markets to look inside the organization at less visible elements

• Triumphalism: extending the private good model to production of public goods

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Cries in the Wilderness

• Bolton: Don’t Put Government in a Strait Jacket

• Drebin: Is what is Good for General Motors Good for Detroit?

• Mautz: Should Government Emulate Business?

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Compare Structure of Public and Private Good Organizations

• Private good organizations produce and sell goods for a price to customers

• Customers impose discipline on them by denial of revenue for unsatisfactory performance

• Shareholders control managers by offering them net income based compensation

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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 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

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Public Good Organizations

• Public good organizations have beneficiaries, not customers

• Weaker or no customer discipline

• Efficient production of public goods is far more difficult challenge

• Solution to the problem of efficient production of public goods: bureaucracy

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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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Legitimate Reasons for Different Management Structure

• Efficient production of public goods is far more difficult

• Imposing business practices can cause considerable harm

• Bureaucracy is an efficient solution to a difficult problem

• Example: Besselman, Arora and Larkey Study of Defense Department on dysfunctional consequences of introducing business practices

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Lack of Theory of Organizations to Produce Public Goods

• Management curricula linked to economics.• Absence of economic theory of public good

organizations• Economics and management courses

emphasize private goods only.• An example of a lack of theory driving out

teaching and practice

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Four Characteristics of Bureaucracy

• Fixed wage

• Impersonal rules

• Tenure in job

• Promotion from inside

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Special Problems in Control of Managers

• At the procedural hub of the contracts• Control resources, have information• Monitor and negotiate with others• Difficult to measure their contributions• Can appropriate resources and information• Misappropriation difficult to detect• Challenge: devising a scheme to induce managers

to contribute what is expected of her

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Comparing Private and Public Good Organizations

• Resource flows

• Residual Claims

• Product Market Discipline

• Decision Making

– Product

– Investment

• Accounting and Control

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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

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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 Consequences of Residual Claims

• Trading in residual claims (stock market)

• Creates incentives to gather and produce information

• A large information industry exists

• Capitalizability of residual claims induces interest in shareholder monitoring the longer term resource flows

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Public Goods Organizations

• No tradeable residual claims

• Weaker incentives to search for information

• Weaker concern for the longer run (e.g., Social Security; budget debates)

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Defining Managers’ Contracts

• 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 Discipline

• Customers of private good organizations negotiate terms

• No transaction if not satisfied• Customer can withhold revenue• Residual-based contract for

managers possible

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Public Good Organizations’ Beneficiaries

• Cannot withhold resources directly

• Would continue to consume resources of poorer quality

• Highly indirect disciplinary mechanism (voting, delay, aggregate)

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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

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Redistribution of Decision Rights

• 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 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 Public 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 yet do so to seek promotion and power, retain jobs

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Investment/Production Decision 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 Decision Rights in Public Goods Orgs.

• In public goods, governing (financing) bodies make quantity and quality decisions,

• And therefore, they also make the capital investment decisions

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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

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Accounting and Control Differences

• Entities• Funds• Consolidation• Assets/Depreciation• Revenue (cash versus accrual)• Budgets

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Reversing Dependent and Independent Variables

• Legal charter and IRS rules on tax status => output and structure

• Economic characteristics of organization’s output => legal charter and the structure

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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

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Bureaucracy As A Dirty Word

• Bureaucracy is the oldest form of management

• Does not receive a fair shake in press

• Perhaps overused

• But it is necessary for many functions

• Lack of understanding leads to misguided attempts at reform that backfire

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Unequal Race

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

• In enthusiasm for managerial organization for production of private goods, it is easy to be tempted to think that the same form of organization can be used for public goods

• Analysis tells us that it is not so

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Thank You

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

• shyam.sunder@yale.edu