Economic theory of organizations, property rights, and social value

The concepts of social value and property rights are important compo- nents of the analysis of organizations and managerial decision making. Differences in the approaches taken by economists and organization theorists from other disciplines appear to stem from their respective treatments of these two components. Organization theorists explain organizations as social units. Economists explain organizations as cost- minimizing structures, minimizing either transactions costs (Coase, 1937 and Williamson, 1975) or costs of ownership (Hansmann, 1996).

What is the origin and basis for cost minimization as an objective of an organization? Beckert (1996) states that competition ‘points to systemic limitations for the possibility of irrational behavior  on  the part of the firm’ (p. 816, italics in the original). Clearly cost minimiza- tion is a necessary but not sufficient condition for an organization’s existence in a competitive environment. Without minimizing cost an organization cannot survive in a competitive world faced with a scarcity of resources. Cost minimization as a subgoal therefore derives from a competitive market system where firms must minimize cost as a prerequisite to maximizing profit, their ultimate objective, or where nonprofit organizations must explain revenue requirements to potential donors.

What does cost minimization require? Private property rights are essential to cost minimization.6 Property rights systems are based, of course, in the culture and traditions of society. Interestingly, economists tend to reject either culture or tradition as a rationale for specific orga- nizational forms, as if this were somehow inconsistent with the princi- ple of cost minimization (see, for example, Hansmann, 1996, pp. 294–5. An important exception is Tirole, 1988). Yet clearly this is not the case. Free market systems where cost minimization is clearly important illus- trate this. The US, founded on the culture of individual freedom and private property rights, is a prime example of the relationship between culture and relevant social and economic objectives.

Alternatively, the question of the basis for cost minimization can be restated: What is the point of minimizing costs if no rights are attached to this action? The culture of collectivism or socialism suggests that organizations will be less viable, or that organizations will be designed on an alternative premise to cost minimization. In China, organizations were designed to provide revenues to the central planning authority that subsidized and thus promoted the authority of the central state (He, 2002). In Japan, for example, the keiretsu focus on the nature of social relationships of the individuals included in the organizational network rather than on the cost.7

The policy of codetermination in many Western European countries also demonstrates the importance of cultural characteristics and social norms. Pejovich (2000, p. 66) states that ‘[c]odetermination is a major post-war social experiment in Western Europe.’ He considers this an inefficient policy, but is countered by Furubotn and Richter (2000) who demonstrate that this is an alternative rational response to risk bearing by labor who invest in human capital. Blyth (2002) attributes the different responses to risk bearing by labor in the US and Western European countries to ideas that derive from alternative cultural orien- tations, that is, the British–US capitalistic orientation and the Western European socialistic orientation. He examines the different periods of significant institutional changes that occurred in the US and Sweden in response to the economic problems of the depression in the 1930s and inflation and unemployment in the 1970s. In both periods he finds that differences in ideas about the roles of labor, business, and government gave rise to quite different policy responses articulated through institu- tional changes in each country. For example, the policy response to the depression was a larger role of government through the National Recovery Administration (NRA) in the US as a way to assist the private sector by increasing income and spending through public employment. In Sweden, however, the policy response was the development of the Sveriges Socialdemokratiska Arbetareparti (SAP), or Swedish Social Democratic Party, which incorporated labor and business participation into the policy decisions of government. Blyth points out the implica- tions in these cases of ideas and culture on decisions:

Without reference to the differences in the ideas informing each of these projects, and thus how these ideas shaped perceptions of pos- sible coalition partners, the precise form that these coalitions and their supporting institutions took is very difficult to explain. In sum, changes in ideas about the causes of a given crisis make constructing certain coalitions possible and others impossible. (p. 255)

His point can be applied to any decision situation by substituting ‘deci- sions’ for ‘projects’ and ‘solutions’ for ‘coalition partners’ and ‘coalitions’. Further, in each of these policy responses cost minimization was not an objective. This changed in the US response to the economic crisis in the 1970s, when policy and institutional structures were altered in the US.Blyth again demonstrates the importance of  ideas  and  culture  in this period: ‘The ideas of monetarists, new classical economists,  and public choice theorists were used to attack and delegitimate existing institutions … The actual economic efficacy of these ideas – that is, the extent to which they constituted useful technical knowledge – was not the issue. The ability of these ideas to affect change was’ (p. 258).

Culture and tradition are therefore important in the economic analy- sis of organizations, and are exhibited through the property rights struc- ture associated with a particular organizational form. Considering property rights explicitly, I now examine the extent to which the economic analysis of the firm may be considered an economic analysis of organization. To do this I address two specific questions. The first of these is: how transferable is the economic analysis of the firm to the analysis of alternative organizational forms? The second question is: what are the effects and the limits of applying the economic analysis of the firm, based on a system of well defined private property rights, to organizations that face a different property rights structure?

The first question concerns the theoretical validity of applying an analytical framework based on well defined private property rights where organizational and managerial objectives are the same to organi- zations characterized by very different rights structures. The theory of the firm originated in neoclassical economic theory of individual behav- ior. In this theory the firm is modeled as an individual profit maximiz- ing entity, where organizational and managerial objectives are indistinct, with well defined private rights. These rights include both the rights to the residual, where residual or profit maximization is the objective and rights to the control of the resources required to generate the residual that is to be maximized. Neoclassical theory, then, states that the firm (both organization and manager jointly) has a specific objective (profit maximization), the right to access and use that object (the maximum profit), and the right to control the use of resources (inputs) required to attain that object (the maximum profit).

Applications of this approach to alternative organizational forms where the property rights structures differ have altered the objective to reflect the different rights but not the basic theoretical (that is, neoclas- sical) approach (see, for example, Niskanen, 1971; Pauly and Redisch, 1973 and James and Rose-Ackerman, 1986). These theories of alterna- tive organizations, then state that the public bureau or nonprofit organi- zation and also the manager have a common specific objective (maximize budget or maximize income or maximize revenue), the right to access and use that object (the maximum budget or income or revenue), and the right to control the use of the resources (inputs) required to attain that object (the maximum budget or income or revenue).

The benefits of the neoclassical approach to these alternative organi- zational forms are primarily its simplicity and the ease of comparison across organizational forms. Yet the benefits are questionable. The sim- plicity requires that important differences in property rights structures be ignored. The resulting comparisons are at best not revealing of the outcomes of relevant behavior and at worst tautological. The objectives of budget and income and revenue are each gross values. Outcomes therefore necessarily occur at larger outputs than the output associated with the residual (that is, profit, which in these contexts would be defined to be net budget or net income or net revenue). The predictions are not reflecting behavior; rather they reflect the mathematics of the model given the assumed objective.

The theory of the firm developed beyond this simple neoclassical approach of a profit (or budget or revenue or output) maximizing entity to managerial models. Here property rights are less well defined because the residual (object) rights of the organization and control rights of managers are separable. Positive monitoring costs yield economic prop- erty rights to the manager. This analytical framework transfers more easily to alternative organizational forms where this condition of sepa- rability exists. As Part II of this work shows, inefficiencies arise in each case. The inefficiencies are measured against the outcome of the neo- classical profit maximizing firm. The variation in the degree and form of inefficiencies is due to variation in devices available to the group with the object rights to monitor the managers who have control rights.

What are the effects and limits of such theoretical applications? This second question concerns the predictive value of these models and their usefulness for their application to policy issues.

As Carroll (1990) has demonstrated, transferring economic models based on one property rights structure to an organizational form based on a different property rights structure can be problematic. When the implications of the variation in rights structures are accounted for, the predicted outcomes for the alternative organizational form are likely to be incorrect. There is a spectrum of possible outcomes that may occur; the response predicted by the application of an inappropriate rights sys- tem could still be possible, but is highly unlikely. Policies designed on the basis of such a highly unlikely response most certainly are going to generate unexpected and in some cases perverse outcomes. That is, if a policy is designed to generate an increase in efficiency, and that policy is applied to an alternative organizational form with a different property rights structure than the policy analysis assumes, then the policy will have the unfortunate and unintended effect of creating even greater inefficiency. Clearly this is an undesirable outcome for economists who are interested in increasing net social value.

This perverse response to a supposedly well designed policy also will occur even when assumed economic objectives such as output or rev- enue maximization are employed. This has been illustrated for appli- cations of the budget maximizing model to bureaus (Carroll, 1990) and to managerial utility maximizing models in nonprofit organizations (Carroll and Humphreys, 2000). Consideration of organizational objec- tives as proposed by organization theorists that differ from the assumed economic objectives alters the predicted outcomes even more (Zhou, 1997 and Blyth, 2002).

Furthermore, the difference in assumed versus actual objectives alters not just the predicted outcomes but the interpretation of those out- comes as well. For example, when the organizational objective related to distributional effects in public bureaus and nonprofit organizations is considered, an apparently inefficient outcome predicted by the applied economic model may actually serve to increase efficiency. This can occur in a situation where a redistribution effect of a program or policy allows segments of the population with undeveloped skills or talents to have greater access to resources, such as an educational or vocational program. The additional access as a result of redistribution can result in larger long term economic growth than would otherwise occur (Milgrom and Roberts, 1992). That is, in terms of Figure 3.1, the pro- duction possibilities curve that illustrates society’s resource constraint would no longer be the same. More or better resources become available to society as a result of the altered distribution of benefits. The social constraint as illustrated by that curve therefore moves farther outward. This has the effect of expanding the economic opportunity set that is available for all members of society, even those not directly benefiting from the program’s redistribution. Distribution is therefore an impor- tant component of social value that is often ignored or simply missed in the transfer of an analysis based on an economic market-based model to organizations that operate in both market and nonmarket environ- ments. The predictions and interpretations of these models that focus exclusively on allocation of resources may illustrate economic efficiency but are not likely to capture social value.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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