Property rights and multi-sector industrial organization

Consider now the extension of industrial organization analysis beyond the private proprietary sector to include public sector bureaus and non- profit organizations. I first address the issue of the extent to which policies based on the traditional industrial organization model may be applied separately to public sector bureaus and nonprofits. I then con- sider the implications for industrial organization theory and policy in the context of multi-sector industries, that is, industries that include organizations from more than one sector or organizational form.

1. Industrial organization and public sector bureaus

The property rights structure facing public sector bureau managers who operate in a political market environment differs significantly from the property rights structure facing private sector corporate managers. These differences have been the source of theories that predict bureau (and public sector) inefficiency. However, these differences have not been considered in the proposals of policies to reduce these inefficiencies. Proposed policies include altering the industrial organization of the pub- lic sector by making it more competitive and privatizing (or devolving) the supply of public sector services (see, for example, Niskanen, 1971, 1975 and De Vita, 1999).

When the differences in property rights are explicitly considered, however, these policy proposals can have the perverse effect of increas- ing public sector inefficiency (Carroll, 1990). Utility maximizing legis- lators who seek to stay in office put greater weight on programs that benefit constituents or political action committees than on efficiencies that result in cost reductions which are spread nationally and provide a relatively small constituent benefit. Utility maximizing bureau managers have similar interests in getting programs and projects approved, although for different reasons. Bureau managers may prefer larger budgets or larger staff to increase their prestige, authority, and income potential. These preferences are consistent with bureaus seeking more or larger pro- grams and inconsistent with cost reductions associated with increased efficiency. In the political environment where a bureau manager has economic property rights, competition takes on a political rather than economic form.

Multiple bureaus competing to provide the same service to legislators therefore are less likely to engage in price competition associated with efficient production that minimizes cost, such as that which would occur among firms competing to provide the same service at the lowest price to consumers in the private sector. Rather, bureaus are more likely to engage in nonprice competition of a form that promotes program benefits that appeal to the political interests of the funding legislators. The political form of bureau competition, when effective, can have the perverse effect of supplying more or larger programs than is optimal. This type of competitive behavior would be exacerbated in the US federal sector with the ability of legislators to permit deficit spending and to raise the debt ceiling, as has recently occurred (Weisman, 2003). At the state and local levels of government in the US deficit spending is not legally permitted. In these jurisdictions legislators have attempted to solve the constraint problem by finding alternative sources of fund- ing such as lotteries and revenues from slot machines. This has occurred despite analysis that shows that these revenue sources generate negative net economic benefits (Carpenter, 2003). The point here is that bureau managers act on their economic property rights and use competition to demonstrate positive net political benefits to the investors in public sector production rather than to engage in efficient production.

In addition to these behavioral effects there are issues of feasibility associated with altering the industrial organization of the public sector that have not been considered in the development of these policy proposals. It has not been made clear, for example, how the budget appropriations would be parceled out across competing bureaus or how the bidding system among competing bureaus would proceed. In the neoclassical world of for-profit firms on which this policy is based, effi- cient firms or winning bidders enter the industry or continue to pro- duce. Inefficient firms, or losing bidders, exit the industry and no longer produce. Proposed restructuring of the public sector, to be effective, would require the creation of additional bureaus that would bid for budget appropriations. The viability of such a system requires either the existence of multiple bureaus that would require continued legislative funding or the creation of new competing bureaus each budget period with only the winning bidder(s) surviving. The former situation would entail subsidizing and monitoring those bureaus who are not the current winning bidder(s). This may occur in part because of the constraints imposed by the Civil Service system that virtually guarantees continued employment to those hired in the public sector. The latter situation of creating new competing bureaus each budget period would entail legislative time and resources that would add nothing to their expected utility but would impose additional costs on legislators. Given the prop- erty rights structure that exists in the public sector, restructuring its industrial organization is clearly both economically inefficient and politically infeasible.

Privatization or  devolution  of  public  sector  supply  is  accomplished through contractual arrangements between the bureau and a private sec- tor corporation or nonprofit organization that has submitted a winning bid (De Vita, 1999). Difficulties with alternative contractual arrange- ments resulting from the different rights structures in the two sectors are well known, as noted by McKean (1972). Generally, privatization policies suggest that supply is shifted from the public to the private sector, with the implicit assumption that the number of competitive firms and/or nonprofit organizations increases and the number or size of bureaus correspondingly decreases.

This outcome is unlikely for two reasons. First, public sector contracts achieve better performance when the contracting organization has been in operation longer and has more experience with the specific govern- ment agency that is providing funding (Peat and Costley (2001)). Thus successful bids for supplying a service to a bureau are more likely to come from existing viable corporations or nonprofit organizations that are more likely to be known to the bureau letting the contract. Accordingly, there is likely to be no increase in the number of firms or nonprofits but rather an increase their size as they take on more contracted projects.

The utility of the manager of the contracting organization (whether for-profit or nonprofit) is also increased due to the prestige and author- ity associated with the larger staff and size of the organization.

Second, public sector bureaus tend not to go out of business (Kaufman, 1976). Even in those rare cases where this has occurred, as with the Civil Aeronautics Board in 1985, the constraint system imposed by the Civil Service system results in shifting public sector employees to other bureaus.1 Thus, there is less reduction in the size of the public sector than would be predicted as a result of privatization.

2. Industrial organization and nonprofit organizations

The property rights structure facing managers of  nonprofit  organiza- tions differs from both that of for-profit corporations and that of public sector bureaus. Nonprofit managers are subject to neither the legal residual claims of owners/shareholders as are corporate managers nor the political constraints imposed by legislators and government mandates. Nonprofit managers are subject to monitoring, however, by investor/ donors as stakeholders, boards of directors or trustees, and regulatory authorities. Managers are monitored for adherence to the social or pub- lic service mission of the nonprofit organization as well as for fiscal integrity. Both of these are required to maintain the nonprofit organi- zation’s tax exempt status.

Thus the nonprofit manager with control rights exercised through decision authority has economic property rights to the resources of the nonprofit organization. Managerial utility in a nonprofit organization derives from authority, prestige, output and revenue. Managerial inter- ests may not be inconsistent with the interests of the stakeholders who are their monitors, however. The nonprofit mission defines its output, albeit in general terms. Differentiating this output from that of other nonprofit organizations promotes managerial utility by developing relationships with specialized staff, clients, and donors to provide a spe- cialized service that provides authority, prestige, revenue, and auton- omy to the nonprofit manager. Specialized service also benefits the clients who are served by the nonprofit, and permits potential donors to make a more informed decision concerning the investment of their donated or granted funds. This increases the utility of all stakeholders by increasing the likelihood of their ability to obtain nonpecuniary returns from their use of the service (for clients) and their investment (for donors). A differentiated and specialized service also may increase the likelihood and effectiveness of monitoring the manager through targeted funding of a distinguishable and observable service, reducing stakeholder transactions costs (Young, 2001b).

The primary implication of the property rights structure for the organization of nonprofit industries is that nonprofit competition may not be efficient, despite a requirement for fiscal integrity. The primary focus on organizational mission of providing a specialized charitable or social service with no residual rights to any individual promotes mana- gerial utility but not cost minimization (Steinberg, 1987). Mergers, which can capture scale economies, are not promoted by nonprofit managers who are likely to lose utility derived from control, autonomy, authority, and personal relationships with staff, for example. In one case of consolidated buying groups for medical products, proposed scale economies have not materialized, which further reduces the incentive of nonprofit managers to consolidate (Walsh and Meier, 2002). That mergers among nonprofit organizations have been rare even during periods of multiple for-profit corporate mergers suggests support for this predicted effect (Wolf, 1999).

There have been some mergers of nonprofits, however. Some consol- idations among nonprofits have occurred through the creation of fund raising umbrella organizations, such as the United Way of America, Boy Scouts of America, and Girls United, whose success has depended on the autonomy and individual identities of the affiliated local nonprofit organizations (Young, 2001a). In addition, there has been some collu- sive activity among nonprofits that has been subject to antitrust litiga- tion (Philipson and Posner, 2001). For example, a group of Ivy League colleges attempted to increase scholarships to minorities without increasing costs through collusion to deny scholarships based on merit rather than need. The National Collegiate Athletic Association (NCAA) lost an antitrust suit accusing it of colluding to fix prices of college football telecasts (Carroll and Humphreys, 2002). In addition, nonprofit trade and engineering, medical and legal professional associations have also been successfully prosecuted in antitrust collusion cases. I consider further the subject of mergers and collusive behavior of nonprofits and antitrust policy in my discussion of multi-sector industries below.

3. Multi-sector industrial organization

The focus of traditional industrial organization on the behavior and performance of for-profit corporations ignores the effects of industry participation by public sector bureaus and nonprofit organizations. This is especially important in the policy arena, where policy outcomes are highly dependent on the definition of the relevant market. In a number of industries, either or both of these alternative organizational forms supply services alongside for-profit corporations. Multi-sector industries include health care services, elderly and child care services, education, insurance, package delivery, legal counsel, sanitation services, and museums, among others.

Steinberg (1987) notes a number of ambiguities related to the defini- tion of markets and market structure in mixed or multi-sector industries. These include pricing structures, where revenues derive from sales and fees and other sources that do not  apply  to  all  organizational  forms, such as grants. Part of this issue concerns whether revenues to  non- profits form other sources, that is, contributed revenues from donations or grants, replace some fee-based revenues or add to them. I examine efficiency implications of this issue in Chapter 8. The issue here is the impact of these configurations on the industrial organization of a multi- sector industry. Donations and grants are fixed revenue, that is, these revenues are not systematically related to the level of output (James and Rose-Ackerman, 1986). If contributed revenues replace fee-based rev- enue, there would be no effect on the relative competitive positions of nonprofit and for-profit suppliers. If contributed revenues add to fee- based revenues, then the relative competitive position of  nonprofits would be improved. Nonprofit suppliers would be in the position to increase their output or the quality of their existing output relative to for-profit firms. In the former situation, nonprofit output could replace for-profit output, with no change in industry output but a change in the composition of suppliers in favor of nonprofits. Alternatively, the addi- tional output could correct a market failure where industry output had been too low as a result of positive externalities. In the latter situation where quality of output is improved, the effect would be to differenti- ate output, such as a nonprofit hospital that includes benefits of teach- ing or research versus a for-profit hospital that provides health care services but with no teaching or research facilities. Both cases provide consumers more choice,  either  of  the  type  of  supplier  where  output is the same, or in the level of quality associated with the supplier. The industry structure would remain competitive but the form of the competition may change.

A second source of ambiguity is the use of structural measures, such as the concentration ratio or Herfindahl–Hirshman Index, that require the relevant product and geographical markets to be clearly defined. Empirical research on the effects of mixed industries tends to show that for-profit firms are more efficient but product type is often not clearly defined so that the efficiency effect may reflect variations in output not accounted for (Borjas, Frech, and Ginsburg, 1983 and Boardman and Vining, 1989). An exception is Frech (1976) who controlled for output variation and defined a ‘standardized product [as] physician services insurance (Part B) claim processing for the Medicare program’ (p. 143). He showed inefficiency in nonprofit performance through higher per unit processing cost and lower quality service through higher error rates and longer processing time. The implication of his result is that higher quality of service increases profit, although he offers no explanation for the quality variation across organizational forms. The study was com- pleted prior to the change in industry structure through managed care health insurance services which increased competition and has lowered costs for nonprofit as well as for-profit suppliers. This suggests that non- profit organizations as well as for-profit firms and managers respond to competitive pressures in an industry.

A third source of ambiguity is in the appropriate measure of organiza- tional size. This may be based on revenues, which as noted may derive from a number of sources. Alternative measures of size include employ- ment or assets. Employment includes volunteer labor for many nonprof- its or public organizations. The use of only paid employees could be a misleading metric, however, underestimating the size of nonprofits relative to for-profit firms.

A fourth ambiguity is in the measure  of  output,  which  frequently  is not homogeneous across organizational forms, such as with quality variations. This is an important issue in market definition and in defin- ing the nature and extent of competition that may take place. As noted above, problems with measuring output and  capturing  quality  varia- tions may yield misleading interpretations of relative costs across orga- nizational forms. Output  measurement  even  without  quality  variations is a problem across   all   organizational   forms   in   service   industries. In many service industries input measures are used to approximate out- put, such as billable hours for legal services, or tangible outcome meas- ures are used to approximate intangible outputs, such as test scores for learning in education.

A fifth issue, of course, is the variation in tax treatment across organi- zational forms. Newhouse (1970) first suggested that the differential tax treatment afforded nonprofit organizations created an entry barrier faced by for-profit firms as potential competitors. James and Rose-Ackerman (1986) propose that differential tax treatment results in crowding out of for-profit firms by nonprofit organizations. This assumed identical output across organizational forms. Empirical research has not shown this to be the case, however (Hansmann, 1987b and Chang and Tuckman, 1990). The implication of this research is that differential tax treatment more likely corrects a market failure through its promotion of nonprofit serv- ice provision either through additional output or quality variations, such as greater trust or the possibility of improved care through higher quality staff in hospital and nursing care facilities (Weisbrod, 1988 and Borjas, Frech, and Ginsburg, 1983).

My focus here is on variations in property rights across organizational forms. As I show below, some of the ambiguities noted by Steinberg (1987) are related to the variation in property rights as well as objec- tives. Here I address the following questions: What are the implications of organizations with very different property rights structures operating and competing in the same industry? How do the alternative incentives that direct managerial decisions affect predictions of industrial organi- zation theory and the expected impact of policies based on these predictions?

A multi-sector industry is one where decisions about the allocation of resources are made by (1) utility maximizing corporate managers who prefer efficiency to increase discretionary  profit,  growth  to  enhance staff, authority, and income, and risk to increase growth and prestige;

(2) utility maximizing bureau managers who prefer growth to increase output, or staff, authority and budget; and (3) utility maximizing non- profit managers who prefer increased quality, authority, and output. The minimum profit constraint imposed on corporate managers results in more efficient (that is, lower cost) production than would occur in a bureau or in a nonprofit organization (unless these latter organizations are pure output maximizers). This cost outcome, however, is higher than the minimum cost of a neoclassical firm. This occurs because out- put and inputs are above the optimal levels as a result of cost shifting of risk and growth effects from the manager to shareholders in the corpo- ration. A bureau manager rationally emphasizes program benefits relative to reduced costs of providing the service. This political market strategy results in larger than optimal quantity of services. If the bureau is subject to a cost (budget) constraint the bureau manager may respond to this by providing a lower quality of services than would be supplied by a for-profit corporation (Niskanen, 1971; Lindsay, 1976 and Carroll, 1990). A nonprofit organization, operating as a monopolistic competi- tor at its breakeven point, would provide a smaller output at a higher quality and higher per unit cost than the neoclassical firm, but also than the corporation or bureau.

Thus,  multi-sector  competition  is  necessarily  imperfect  competition, with multiple interdependent structures coexisting. Unlike the compe- tition of the neoclassical models of for-profit and nonprofit organiza- tions analyzed by James and Rose-Ackerman (1986), competition across organizational forms is not likely to be in the form of price competition.

In one sense the market may be considered to be segmented, with each organizational form operating within its own niche. The competition among the segments is very real, however, for the quality and source variation provide users with alternative attributes and associated sup- pliers from which they may choose. The implication of this imperfect multi-sector competition is that output is not at the optimal level or produced at the minimum cost. Whether output is too large or too small relative to the efficient neoclassical level of output depends on the composition of organizational forms in the industry.

Variations in monitoring systems also exist across organizational forms. Corporate managers are monitored through capital and manage- rial markets. Bureau managers are monitored by legislators and citizens groups. Nonprofit managers are monitored by their boards of directors, by investor (donor and grantor) audits and grant requirements, and by government authorities. Differences in the effectiveness of these alter- native monitoring systems may not be significant, however. As shown in Chapter 5, the extensive information required for effective monitor- ing by shareholders reduces their ability to fully respond to managerial misbehavior. The ability of shareholders to monitor managerial behav- ior in for-profit corporations is therefore  not  significantly  greater than that of legislators as investors in bureaus and donors as investors in nonprofit organizations, even considering that shareholders have tradable shares. Hansmann (1996, p. 245) on the point of managerial behavior concurs. He suggests that nonprofit organizations may not dif- fer significantly from for-profit firms. Recent reported salary data which show that compensation of CEOs of nonprofit hospitals and health care services providers is similar to compensation levels of for-profit corpo- rations provides additional support (Goldstein, 2003).

For corporations and nonprofits, boards of directors also serve a mon- itoring role. The effectiveness of these groups has been questioned, although for different reasons. Williamson (1963) examined implica- tions of composition of the board for managerial monitoring in corpo- rations. He found evidence to suggest that internal representation is frequent and reduces effective monitoring. Miller (2002) found that nonprofit board members tend to be supportive of managerial decisions rather than act in a monitoring role. The primary reason for this is that the manager is likely to be mission oriented, as are the board mem- bers and that board members do their effective screening during the hiring process. Brown (2002) compared behavior of boards of nonprofit organizations with boards of for-profit corporations and found little difference.

One difference, however, is what the investors (and board members who do monitor) in each of these organizations are monitoring for. Shareholders in a corporation seek maximum profit and lower cost; donors to a nonprofit seek a return that is nonpecuniary via type and quality of services provided and are less concerned with cost. Legislators monitor bureaus, but both have a bias in favor of larger outputs and are also less concerned with cost, which is largely borne by those outside of their political arenas. Thus, breakeven operation is not optimal for shareholders, but may be optimal for legislators and donors who seek maximum output or quality. The objective of monitoring to promote economic efficiency thus varies considerably across organizational forms and the competitive outcomes that increase the benefits to the monitoring group will vary accordingly.

The prediction of variation in efficiency across organizational forms is supported by Boardman and Vining (1989). They analyzed the rela- tionship between ownership structure and profitability and other per- formance indicators across 500 non-US large industrial organizations, including mixed enterprises, state owned enterprises, and private for- profit corporations. They found that mixed enterprises and state owned enterprises were less efficient than the private for-profit corporations. Their interpretation of their statistical results did not indicate variations in quality or certain other characteristics of output that would reflect alternative managerial preferences associated with different rights struc- tures, however, as I do here. Thus what is observed to be inefficient performance in production and profitability may be a reflection of variation in other aspects of ownership or sectoral differences, such as alternative objectives.

An additional aspect of multi-sector industrial organization is that of differences in revenues and costs facing nonprofit managers that arise from alternative funding sources and differential tax treatment. As dis- cussed earlier, nonprofit organizations receive lump-sum or fixed fund- ing from donations and grants obtained from either individuals or institutions. These may be the sole source of revenues to the nonprofit or may be revenues that are in addition to those obtained from sales or fees, such as tuition or hospital charges. If revenues from donations and grants are the sole revenue source, nonprofit output associated with the breakeven point will be even lower than already predicted. If revenues from donations and grants are added to revenue from fees or charges, the output chosen  by  a  utility  maximizing  nonprofit  manager  may be either higher or lower than the output of a neoclassical firm. The outcome depends on the degree to which managerial preferences for quality, staff, etc., raise costs above the minimum level. For nonprofit organizations and corporations that have comparable revenues from fees and sales, output chosen by a utility maximizing nonprofit man- ager who values quality will be lower at its breakeven point than the output level chosen by a utility maximizing corporate manager who exhibits preference for efficiency for maximum discretionary profit as well as growth and risk.

Nonprofit organizations face greater capital constraints than do corpor- ations, however. As shown in Chapter 7, to some degree, then, grants and donations are analogous to investment capital raised by corpor- ations in their issue of stock. This is particularly true for those donations which are made as endowments for which the principal must be fully or mostly kept intact while the earned interest may be used as operat- ing revenue. The difference between sources of capital and associated property rights for nonprofit organizations and for-profit corporations has an implication for monitoring as well. Although there is an analogy between grant and donations to nonprofits and investment capital raised by corporations through public stock offerings, the former are not tradable shares while the latter are. An important effect of this is that outside monitoring is more limited for nonprofits than for for- profit corporations because outside takeovers through stock acquisitions are not possible with nonprofit organizations.

The issue by nonprofits of tax exempt bonds and the use of tax cred- its are also sources of nonprofit investment capital (Brody and Cordes, 1999). Thus, these funds may be considered as investment capital and may not be treated entirely as earned revenue in a comparative analysis. Bowman (2002) shows that when the effect of endowments on non- profit managers’ decisions to borrow funds is explicitly considered there is less difference between efficiency in financing decisions between for-profit corporations and nonprofits. His study examines only large nonprofit organizations with assets greater than $10 million in order to provide a reasonable comparison with for-profit corporations. Restrictions associated with some grants or donations, such as those that permit only earned interest to be used for nonprofit operations, may limit the manager’s decision authority directly, however. In addi- tion these restrictions impose indirect limits on the nonprofit manager’s decision authority through monitoring by regular audits of the use of the restricted funds.

As noted, nonprofit organizations also receive differential tax treat- ment relative to for-profit corporations. Newhouse (1970) was one of the first economists to consider the tax exempt status of nonprofit organizations as an entry barrier that affects the competitive structure of industries that include both for-profit corporations and nonprofit organizations. The entry barrier effect has been emphasized in more recent comparative analyses as well (see, for example, James and Rose- Ackerman, 1986; Steinberg, 1987 and Brody, 1996). The implication of the relatively lower costs to nonprofit organizations is that they crowd out for-profit corporations. This, of course, assumes no differentiation of product via quality, for example, between nonprofit and for-profit producers. Recent empirical evidence suggests that crowding out may not occur, however (Hansmann, 1987b and Chang and Tuckman, 1990). Thus, differential tax treatment of nonprofit organizations would not alter the implications of multi-sector competition derived above.

Nonprofit organizations are also subject to antitrust policy, as are for-profit corporations. Although nonprofits face a nondistribution con- straint, a nonprofit organization has some interest in creating a profit or budget surplus. Some economists attribute this to the promotion of nonprofit managerial utility through internal allocation of excess budget to managerial expense preferences such as staff or output (Migué and Bélangér, 1974; Brody, 1996 and Philipson and Posner, 2001) Others note that profit is essential for long term growth and development (Tuckman, 1993 and Wolf, 1999). In the multi-sector health care services industry, hospitals have been increasingly involved in profit making activities (Starkweather, 1993). In any case, profit can be a motive for anticompetitive behavior even by nonprofit organizations. There have been a number of antitrust actions to block mergers of nonprofit hospi- tals that have been regarded as anticompetitive (Eckel and Steinberg, 1993 and Philipson and Posner, 2001). Philipson and Posner also demonstrate that nonprofit organizations which have an output prefer- ence are not sensitive to costs. Nonprofits also engage in research and development activities that promote socially valuable innovations. They propose that because lost revenues from not having legal rights to returns from their innovative activity are equivalent to incurred costs, these nonprofits should be eligible for patent and copyright protection exemptions from antitrust (2001, p. 11).

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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