1. 6/28/2015Production of Public and Private Goods 1 What about Public Goods? Shyam Sunder, Yale University Rethinking Capitalism Bruce Initiative at the University of California at Santa Cruz April 9, 2011

2. 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 6/28/2015Production of Public and Private Goods 2

3. 6/28/2015Production of Public and Private Goods 3

4. 6/28/2015Production of Public and Private Goods 4 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?

5. 6/28/2015Production of Public and Private Goods 5 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

6. 6/28/2015Production of Public and Private Goods 6

7. 6/28/2015Production of Public and Private Goods 7

8. 6/28/2015Production of Public and Private Goods 8 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

9. 6/28/2015Production of Public and Private Goods 9 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

10. 6/28/2015Production of Public and Private Goods 10

11. 6/28/2015Production of Public and Private Goods 11 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

12. 6/28/2015Production of Public and Private Goods 12 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

13. 6/28/2015Production of Public and Private Goods 13 Four Characteristics of Bureaucracy Fixed wage Impersonal rules Tenure in job Promotion from inside

14. 6/28/2015Production of Public and Private Goods 14 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

15. 6/28/2015Production 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

16. 6/28/2015Production 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

17. 6/28/2015Production of Public and Private Goods 17 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

18. 6/28/2015Production of Public and Private Goods 18 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

19. 6/28/2015Production of Public and Private Goods 19 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)

20. 6/28/2015Production of Public and Private Goods 20 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

21. 6/28/2015Production of Public and Private Goods 21 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

22. 6/28/2015Production of Public and Private Goods 22 Public Good Organizations’ Beneficiaries Cannot withhold resources directly Would continue to consume resources of poorer quality Highly indirect disciplinary mechanism (voting, delay, aggregate)

23. 6/28/2015Production of Public and Private Goods 23 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

24. 6/28/2015Production of Public and Private Goods 24 Redistribution of Decision Rights This Problem in public good organizations is addressed by redistribution of decision making responsibilities Managerial contract delinked from residual

25. 6/28/2015Production of Public and Private Goods 25 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

26. 6/28/2015Production of Public and Private Goods 26 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

27. 6/28/2015Production of Public and Private Goods 27 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

28. 6/28/2015Production of Public and Private Goods 28 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

29. 6/28/2015Production of Public and Private Goods 29 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

30. 6/28/2015Production of Public and Private Goods 30 Accounting and Control Differences Entities Funds Consolidation Assets/Depreciation Revenue (cash versus accrual) Budgets

31. 6/28/2015Production of Public and Private Goods 31 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

32. 6/28/2015Production of Public and Private Goods 32 Detail in Public Good Financial Reports Even small public good organizations have lengthy financial reports Why do they not aggregate?

33. 6/28/2015Production of Public and Private Goods 33 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?

34. 6/28/2015Production of Public and Private Goods 34 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 Statistical inaccuracy vs. objectivity Valuation of individual assets and the residual rights for transactions Useful for traders

35. 6/28/2015Production of Public and Private Goods 35 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

36. 6/28/2015Production of Public and Private Goods 36 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

37. 6/28/2015Production of Public and Private Goods 37 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

38. 6/28/2015Production of Public and Private Goods 38 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

39. 6/28/2015Production of Public and Private Goods 39 Budgets, Appropriations and Encumbrances Governing bodies of public-good organizations appropriate funds for specific items The budget is an authorization to spend

40. 6/28/2015Production of Public and Private Goods 40 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

41. 6/28/2015Production of Public and Private Goods 41 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

42. 6/28/2015Production of Public and Private Goods 42 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

43. 6/28/2015Production of Public and Private Goods 43 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

44. 6/28/2015Production of Public and Private Goods 44 Thank You http://www.som.yale.edu/faculty/sunder/res earch.htmlhttp://www.som.yale.edu/faculty/sunder/res earch.html shyam.sunder@yale.edu