1. 7/13/2015Production of Public and Private Goods 1 Structure of Organizations for Production of Public and Private Goods Shyam Sunder Yale University National Science Council, Taiwan August 27, 2002

2. 7/13/2015Production of Public and Private Goods 2 Compare Public and Private Good Organizations Private good organizations produce and sell goods for a price to customers Customers can impose discipline on them Shareholders control manager by offering them net income based compensation

3. 7/13/2015Production of Public and Private Goods 3 Public Good Organizations Public good organizations have beneficiaries, not customers Weaker or no customer discipline Efficient production of public goods is difficult Solution to the problem of efficient production of public goods: bureaucracy

4. 7/13/2015Production of Public and Private Goods 4 Outline Organizations as a set of contracts Accounting as a contract implemetation mechanism Compare resource flows, management structure, decisions, and accounting in organizations Examples and implications

5. 7/13/2015Production of Public and Private Goods 5 Faculty 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

6. 7/13/2015Production of Public and Private Goods 6 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

7. 7/13/2015Production of Public and Private Goods 7 Four Characteristics of Bureaucracy Fixed wage Impersonal rules Tenure in job Promotion from inside

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9. 7/13/2015Production of Public and Private Goods 9 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?

10. 7/13/2015Production of Public and Private Goods 10 Legitimate Reasons for Different Accounting 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

11. 7/13/2015Production of Public and Private Goods 11 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. Contract theory of organizations can help An example of a lack of theory driving out teaching and practice

12. 7/13/2015Production of Public and Private Goods 12 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

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15. 7/13/2015Production of Public and Private Goods 15 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

16. 7/13/2015Production of Public and Private Goods 16 Functions of Accounting Measures resource contributions Determines inducements Compares contributions to inducements

17. 7/13/2015Production of Public and Private Goods 17 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 Devising a scheme to induce managers to contribute what is expected of her

18. 7/13/2015Production of Public and Private Goods 18 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

19. 7/13/2015Production of Public and Private Goods 19 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

20. 7/13/2015Production of Public and Private Goods 20 Comparing Private and Public Good Organizations Resource flows Residual Claims Product Market Discipline Decision Making –Product –Investment Accounting and Control

21. 7/13/2015Production of Public and Private Goods 21 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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24. 7/13/2015Production of Public and Private Goods 24 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

25. 7/13/2015Production of Public and Private Goods 25 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 longer term resource flows

26. 7/13/2015Production of Public and Private Goods 26 Public Goods Organizations No tradeable residual claims Weaker incentives to search for information Weaker concern for the longer run (e.g., Social Security debates)

27. 7/13/2015Production of Public and Private Goods 27 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

28. 7/13/2015Production of Public and Private Goods 28 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

29. 7/13/2015Production of Public and Private Goods 29 Public Good Organizations’ Beneficiaries Cannot withhold resources directly Would continue to consume resources of poorer quality

30. 7/13/2015Production of Public and Private Goods 30 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

31. 7/13/2015Production of Public and Private Goods 31 Redistribution of Decision Rights This Problem in public good organizations is addressed by redistribution of decision making responsibilities Managerial contract delinked from residual

32. 7/13/2015Production of Public and Private Goods 32 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

33. 7/13/2015Production of Public and Private Goods 33 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 do so to seek promotion and power, retain jobs

34. 7/13/2015Production of Public and Private Goods 34 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

35. 7/13/2015Production of Public and Private Goods 35 Investment/Production Decision Rights in Public Goods Orgs. In public goods, governing bodies make quantity and quality decisions, And therefore, they also make the capital investment decisions

36. 7/13/2015Production of Public and Private Goods 36 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

37. 7/13/2015Production of Public and Private Goods 37 Accounting and Control Differences Entities Funds Consolidation Assets/Depreciation Revenue (cash versus accrual) Budgets

38. 7/13/2015Production of Public and Private Goods 38 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

39. 7/13/2015Production of Public and Private Goods 39 Detail in Public Good Financial Reports Even small public good organizations have lengthy financial reports Why do they not aggregate?

40. 7/13/2015Production of Public and Private Goods 40 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?

41. 7/13/2015Production of Public and Private Goods 41 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

42. 7/13/2015Production of Public and Private Goods 42 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

43. 7/13/2015Production of Public and Private Goods 43 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

44. 7/13/2015Production of Public and Private Goods 44 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

45. 7/13/2015Production of Public and Private Goods 45 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

46. 7/13/2015Production of Public and Private Goods 46 Budgets, Appropriations and Encumbrances Governing bodies of public-good organizations appropriate funds for specific items The budget is an authorization to spend

47. 7/13/2015Production of Public and Private Goods 47 Which one is the Independent Variable? Legal charter Internal Revenue Service Rules on tax status Economic characteristics of organization’s output

48. 7/13/2015Production of Public and Private Goods 48 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

49. 7/13/2015Production of Public and Private Goods 49 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

50. 7/13/2015Production of Public and Private Goods 50 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

51. 7/13/2015Production of Public and Private Goods 51 Thank You The working paper, talk, and slides are available at http://www.som.yale.edu/faculty/sunder/res earch.html or email to shyam.sunder@yale.edu