Property rights systems are clearly important to decisions of individu- als and of organizations concerning investment in and exchange of resources. Property rights that include the right to control a resource and the right to obtain the return from a resource provide a basis for efficient use of resources when the holder of the right has wealth max- imization as his or her objective. The individual or organization that holds these rights can increase wealth by investing in resources that will generate a return. There is an incentive first, to acquire resources that may be productive, and second, to promote the productivity of these resources in order to maximize the value of the resource and the expected return that can be obtained from its use. Property rights there- fore establish incentives for the efficient (or inefficient) use of resources by individuals and organizations that hold the rights. That is, property rights establish incentives for efficient (or inefficient) decisions.
The foregoing discussion has referred frequently to both individuals and organizations as holders of rights and as decision makers with respect to the use and allocation of resources. The discussion so far has treated organizations much like individuals, that is, as monolithic enti- ties which themselves make decisions. This treatment of organizations is a reflection of the neoclassical model of efficient markets, where the decision making entity for supply is the producer. In the neoclassical model, no distinction is made between an individual producer and a firm; the producer is considered to be the organization of production known as the firm.
In reality, of course, organizations are structures that are made up of multiple individuals. Organizations may be relatively simple, such as a small partnership, or they may be complex, such as a corporation or a government bureau. In law, and under various property rights sys- tems, organizations do have certain rights. A business partnership or corporation may own a resource, such as land or other physical assets. The rights of ownership of the resource are held by the partners or by the shareholders of the corporation. Ownership of land and physical assets may be given in law to government bureaus or to nonprofit organizations also. For bureaus and nonprofit organizations, there are no shareholders, however. We consider this aspect of ownership later.
Regardless of the degree of complexity, it is clear that organizations do not make decisions; individuals do. Whether there are partners, or shareholders, or neither of these, decisions concerning the acquisition and use of resources are made on behalf of the organization by individ- uals. Individual partners or shareholders decide how much of their cap- ital they want to invest in resources to be used by the organization. Partners and shareholders have residual rights associated with their decision to invest. Control rights vary depending on the nature of the partnership and the corporation. For example, in a small family held corporation, shareholders may have significant control rights. In a large publicly held corporation, shareholders may have no control rights.
For public bureaus and nonprofit organizations, there are no clear legal residual rights. Property rights systems in public bureaus and non- profit organizations therefore differ from the property rights systems in for-profit corporations. The implications of this for decision making behavior and efficiency in use of resources in alternative organizations are explored below and in detail in later chapters.
As noted above, property rights in society establish incentives for individuals in a market or in the economy. Similarly, property rights in an organizational structure establish incentives for individual decision makers within the organization. In the economics of organization, there is general agreement that property rights affect incentives and that incentives are important in the decision making process. There is some debate, however, as to the way that property rights and incentives direct decisions. Mirrlees (1976) and Milgrom and Roberts (1992) demonstrate the importance of the level, or intensity, of incentives. They show that increased incentive intensity tends to increase the efficiency of deci- sions. Pfeffer (1990) shows that distribution or relative intensity of incentives affect the efficiency of decisions in organizations. Williamson (1990, p. 186), states that ‘[i]ncentive differences, rather than unchanged incentive intensity, thus characterize firm and market organization’ (italics in the original). Incentives derive from property rights systems; incen- tive differences derive from differences in property rights systems. I explore in later chapters the details of the way that property rights sys- tems differ across the alternative organizational forms of the for-profit corporation, the public bureau, and the nonprofit organization. At this point I examine the relationship of the theory of property rights to incentives and decision making in alternative organizations.
The theory of property rights has developed more fully since the 1960s (Coase, 1960; Demsetz, 1964, 1966, 1967 and Furubotn and Pejovich, 1972, 1974c). There remain, however, different interpretations of property rights theory, particularly in the context of organizations. Differences in interpretations in the theory of property rights include conceptual differences as well as differences in application. Furubotn and Richter (2000) focus on the distinction between absolute property rights and relative property rights. Absolute property rights refer to ownership in assets that are ‘directed against all others (as, e.g., property in land or other tangibles) but they also include intangibles such as copyrights and patents’ (p. 77). Relative property rights arise primarily out of contractual arrangements and refer to claims on ownership. These claims may be exercised against only those individuals who are party to the contractual arrangement. Although in their analysis they consider only property rights in physical assets, they note that assets may be physical, intangible, and human.
In relation to organizations, Furubotn and Richter (2000) go on to state that ‘all organizations are characterized by the assignment of absolute property rights in combination with a regulation indicating how these property rights can be used or transferred. And this arrange- ment can be interpreted as the governance structure or constitution of an explicit or implicit relational contract’ (p. 271). Their concept of absolute property rights is consistent with the legal concept of rights that some theorists adhere to (see, for example, Alchian, 1969 and Furubotn and Pejovich, 1974c).
Other theorists distinguish between economic property rights and legal property rights (see, for example, Demsetz, 1967; Alchian, 1987 and Barzel, 1997). Alchian provides an economic interpretation of prop- erty rights as the right to partake of or use a good. Barzel defines this concept as follows: ‘Economic property rights over a commodity (or an asset) … [are] the individual’s ability, in expected terms, to consume the good (or the services of the asset) directly or to consume it indirectly through exchange …(p. 3, italics in the original). Following Demsetz (1967), Barzel then states: ‘Legal property rights are the rights recognized and enforced, in part, by the government’ (p. 4, italics in the original).
As the foregoing discussion shows, the efficiency of the outcome of any decision to use, alter, or sell a resource varies by type of rights system in force. The property rights so assigned provide the incentive (or disincentive) to invest in a resource. Where effective economic property rights and legal property rights are identical, behavioral incen- tives clearly derive from the legal system of rights. However, where effective economic property rights and legally defined property rights are not identical, then behavioral incentives do not derive explicitly from the legally defined rights. Rather, behavioral incentives are directed by effective economic property rights.
The distinction between legal property rights and economic property rights arises within the context of organizations and managerial deci- sion making. The legal property rights are most well defined in the case of for-profit corporations, and least well defined in the cases of the pub- lic sector bureau and the private nonprofit organizations. Legal residual rights are granted to shareholders in the case of corporations. Legal rights may be granted to either the state or the taxpaying public in the case of public sector bureaus, but the process of exercising those rights is unclear. That public bureaus are not in the business of generating profits muddies the legal concept of residual rights. In the case of non- profit organizations no legal residual rights are granted; indeed they are legally forbidden as a condition of tax exempt nonprofit status in the US. In all cases, however, legal control rights are granted to the party in the organization who makes the primary decisions regarding resource use in the organization, that is, the manager.
The economic property rights derive to a large extent, although not completely, from the legal residual control rights. Because of their legal right to the control of resources, managers in any of the organizational forms of for-profit corporation, public bureau, or nonprofit organiza-tion, have economic property rights in organizational resources. Organization managers are therefore in a position to expropriate at least some of the legal property rights of residual return from owners. The degree to which this may occur varies by organizational form, however, corresponding to the legal residual rights in place and to the transac- tions costs and information conditions that apply to the enforcement of the legal rights. In addition, the nature of the environment in which the organization operates conditions the relevant property rights struc- ture and, therefore, managerial incentives.
The predicted responses to property rights and associated incentives are predicated on the assumption of wealth maximization, that is, unbounded rationality. In models of unbounded rationality where there are no information problems or transactions costs, and perfect agent behavior is the norm (that is, the neoclassical model), legal residual rights are fully known and are binding. In this case legal and economic property rights are indistinguishable. Managers make decisions that promote the interests of the legal residual claimant. In this context managerial decisions in corporations, where the legal residual claimant is well defined, should be efficient. By comparison, managerial deci-sions would be predicted to be inefficient in public bureaus and in non- profit organizations where residual rights are either not clearly delineated or are not defined at all. If residual rights in the public sector are clearly defined to accrue to the taxpaying public, then managerial decisions in a public bureau would be predicted to be efficient under conditions of the neoclassical model.
The efficient outcomes in corporations and, possibly, public bureaus predicted by the neoclassical model are mitigated by positive transac- tions costs. That is, the neoclassical assumption of zero transactions costs does not hold. Positive transactions costs are predicted to be low for shareholder transactions in the private sector who own tradable shares, but significant for citizens in the public sector (who must move to a different political jurisdiction to ‘trade’ their public ownership rights). The efficiency of the outcomes in corporations and public bureaus are also affected by the informational constraints imposed as a result of the hierarchical structure of a complex organization. It is pos- sible that the manager may be optimizing on behalf of the residual claimant. That is, the corporation manager may be seeking maximum shareholder return and the public sector bureau manager may be seek- ing maximum net benefits for the public. In these situations, however, these objectives are subject to additional information constraints that arise from the hierarchy of the complex organization. In either form of organization (corporation or bureau), managerial decisions are unable to achieve the same level of efficiency that would be possible in the absence of the constraints imposed by the hierarchical structure of the organization.
In models of bounded rationality, the problems posed by imperfect information are compelling and go beyond the situation of an addi- tional constraint on an optimization problem. Under conditions of bounded rationality, legal and economic property rights can coincide no longer. Legal property rights exist. They are, however, more difficult and costly to understand and enforce. Therefore legal property rights are less effective. That is, there is slack in legal rights. The result of slack in legal property rights is that economic property rights become the primary effective rights. The economic property right to residual control guides the decision process of framing the issue, developing alterna- tives, establishing targets, and processing information. The result is that the right of residual return may be expropriated by the decision maker who does not have the legal residual right. The context in which this may occur and the ways in which economic property rights may be exercised varies by organizational form. This and the environment in which the organization operates together determine the slack in legal rights. These issues are central to my comparative analysis of manage- rial decision behavior.
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.