6/13/2014Production of Public and Private Goods 1 Structure of Organizations for Production of Public and Private Goods Shyam Sunder Program on Non-Profit Organizations (PONPO) Yale University April 3, 2012

6/13/2014Production of Public and Private Goods 2 Private Good Organizations Private good organizations produce and sell goods for a price to customers Customers can discipline managers by denying them revenue directly Shareholders can control hired managers by offering them compensation linked to net income

6/13/2014Production of Public and Private Goods 3 Public Good Organizations Public good organizations have beneficiaries, not customers Weaker or no customer discipline: beneficiaries cannot directly deny revenue Need a different decision-management- control structure: bureaucracy (Weber) Efficient production of public goods is more difficult

6/13/2014Production of Public and Private Goods 4 Overview Organizations viewed as a set of contracts among agents Accounting and control as a contract implemetation mechanism Classify and study organizations by economic nature of their output, not legal form Compare resource flows, management structure, decisions, and accounting in public and private good-producing organizations

6/13/2014Production of Public and Private Goods 5 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

6/13/2014Production of Public and Private Goods 6 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

6/13/2014Production of Public and Private Goods 7 Accounting Teaching by Subject Subject Area Auditing Financial Managerial/Cost MAS/Systems Taxation Government Research All current Teaching (In percent)

6/13/2014Production of Public and Private Goods 8 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

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6/13/2014Production of Public and Private Goods 10 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?

6/13/2014Production of Public and Private Goods 11 Legitimate Reasons for Different Structures 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

6/13/2014Production of Public and Private Goods 12 Lack of Theory of Organizations to Produce Public Goods Management curricula linked to private good 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

6/13/2014Production of Public and Private Goods 13 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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6/13/2014Production of Public and Private Goods 16 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

6/13/2014Production of Public and Private Goods 17 Functions of Accounting Measures resource contributions Determines inducements Compares contributions to inducements

6/13/2014Production of Public and Private Goods 18 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 them

6/13/2014Production of Public and Private Goods 19 Comparing Private and Public Good Organizations Resource flows Residual Claims Product Market Discipline Decision Making –Product –Investment Accounting and Control

6/13/2014Production of Public and Private Goods 20 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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6/13/2014Production of Public and Private Goods 23 Residual Claimants 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

6/13/2014Production of Public and Private Goods 24 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 interest in longer term resource flows

6/13/2014Production of Public and Private Goods 25 In Contrast: Public Goods Organizations No tradeable residual claims Weaker incentives to search for information Weaker concern for the longer run (e.g., Social Security debates)

6/13/2014Production of Public and Private Goods 26 Defining Managers Contracts Private Good Organizations make it self-enforcing: by linking compensation to the residual (subject to control and audit) No product market discipline No link between managerial compensation and the residual

6/13/2014Production of Public and Private Goods 27 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

6/13/2014Production of Public and Private Goods 28 Public Good Organizations Have Beneficiaries, Not Customers They cannot withhold resources directly (not so easily) Much higher cost of imposing discipline on managers Can be forced to consume resources of poorer quality

6/13/2014Production of Public and Private Goods 29 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

6/13/2014Production of Public and Private Goods 30 Redistribution of Decision Rights This Problem in public good organizations is addressed by redistribution of decision making responsibilities Managerial contract delinked from residual

6/13/2014Production of Public and Private Goods 31 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 Residual generation is irrelevant because the net residual is negative

6/13/2014Production of Public and Private Goods 32 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 jobs

6/13/2014Production of Public and Private Goods 33 Investment/Production Decision Rights Managers choose residual maximizing quantity, quality of pvt. gds. using their information Delegation of quantity decisions possible through linkage between residual and remuneration Investment decisions are derived decisions from the quantity decisions

6/13/2014Production of Public and Private Goods 34 Investment/Production Decision Rights in Public Goods Orgs. In public goods, governing bodies make quantity and quality decisions, And therefore, they must also make the capital investment decisions

6/13/2014Production of Public and Private Goods 35 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

6/13/2014Production of Public and Private Goods 36 Accounting and Control Differences Entities Funds Consolidation Assets/Depreciation Revenue (cash versus accrual) Budgets

6/13/2014Production of Public and Private Goods 37 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

6/13/2014Production of Public and Private Goods 38 Detail in Public Good Financial Reports Even small public good organizations have lengthy financial reports Why do they not aggregate?

6/13/2014Production of Public and Private Goods 39 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?

6/13/2014Production of Public and Private Goods 40 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 (e.g., linear depn.) Statistical inaccuracy vs. objectivity Valuation of individual assets and the residual rights for transactions Useful for traders

6/13/2014Production of Public and Private Goods 41 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

6/13/2014Production of Public and Private Goods 42 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

6/13/2014Production of Public and Private Goods 43 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

6/13/2014Production of Public and Private Goods 44 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

6/13/2014Production of Public and Private Goods 45 Budgets, Appropriations and Encumbrances Governing bodies of public-good organizations appropriate funds for specific items The budget is an authorization to spend

6/13/2014Production of Public and Private Goods 46 Which one is the Independent Variable? Legal charter Internal Revenue Service Rules on tax status Economic characteristics of organizations output

6/13/2014Production of Public and Private Goods 47 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

6/13/2014Production of Public and Private Goods 48 Four Characteristics of Bureaucracy (Weber) Fixed wage Impersonal rules Tenure in job Promotion from inside

6/13/2014Production 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

6/13/2014Production 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 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 SOMs motto of serving business and society

6/13/2014Production of Public and Private Goods 51 Thank You The working paper, talk, and slides are available at earch.html or to