Social regulation policy is designed to correct market failures resulting from imperfect information and incomplete property rights in markets such as occur with externalities. Rather than a single policy, social regulation is a set of policies that set standards or requirements which affect the production and/or consumption process, such as nutrition labeling requirements, product and worker safety standards, nondis- crimination measures, environmental regulations, and zoning laws. These standards and requirements affect costs and therefore social reg- ulation, while not setting prices directly, indirectly affects market prices and resource allocation.
Because misspecified or incomplete property rights are a source of market failure, property rights are central to social regulation. My con- cern here is not with the effect of property rights in markets as a basis for social regulation, however. Rather, I focus on the effect of property rights in organizations of supply on the response of managers to social regulation in the different organizational forms.
1. Social regulation in for-profit organizations
In the neoclassical model of the firm, the manager (decision maker) either is also the owner or is a perfect agent, maximizing owner profit. There are predictable responses by a profit-maximizing firm to a cost- increasing regulation. These are that the firm will (1) choose the lowest cost means of compliance, or (2) comply to the level where the marginal cost of compliance and production equals the marginal revenue under compliance, or (3) comply to the level where the marginal cost of compliance equals the marginal cost of noncompliance, which is the expected value of the penalty for noncompliance. In any of these, resources are shifted from production to compliance with the regulation. The extent to which this occurs depends on the amount of expected monitoring and thus on the risk of penalty. Maximum firm profit is reduced relative to the pre-regulation profit maximizing scenario.
In the managerial model of a firm or corporation, the decision maker is an imperfect agent who maximizes utility derived from income, pres- tige, input preferences, and discretionary profit, subject to a minimum profit requirement by shareholders. In this setting the manager has eco- nomic property rights and has some ability to divert resources from owners to the manager’s utility. Because even under conditions of perfect agency owner profit is reduced as a result of social regulation, lower shareholder profit would be expected to occur for shareholders in a managerial model. That is, shareholders, made aware of the new regulation (say, by government announcement) anticipate higher costs and lower profit. From the manager’s point of view, the minimum profit constraint is reduced by virtue of the shareholders’ expectation of post-regulation reduced reported profit. The decision maker therefore now faces two constraints: a lower minimum profit constraint and a regulatory constraint. What decision behavior can be predicted in this situation?
Given asymmetric information of the manager vis-à-vis shareholders, it is unlikely that these two constraints simply offset each other. The utility maximizing manager is likely to overstate costs of compliance to reduce shareholders’ expectations of post-regulation profit to a lower level. This serves to reduce the manager’s minimum profit constraint to a lower level than would occur if shareholders had full information. The effect of this is that the manager could be in a position of being less con- strained in the post-regulation scenario by shifting most or all (inflated) costs of compliance to shareholders. Thus, managerial discretion and therefore also managerial utility may be increased with social regulation relative to the pre-regulation period.
If the manager has specific input preferences, such as for staff to increase power and autonomy, then the manager may choose a method of compliance that is not a cost minimizing method, unlike that response predicted by the neoclassical model of the firm. Alternatively, compliance may increase prestige in the community and possibly income, for example, through enhanced reputation that provides more bargaining leverage or the possibility of additional or new consulting services. This would entail use of resources to advertise the nature of the compliance, promoting community goodwill, and may result in overinvestment in compliance by the manager. In either case, resources are shifted from production activity that increases shareholder profit to alternative uses of resources that benefit the manager in the post- regulation period. This outcome occurs because of the property rights system that exists in the corporate form of for-profit organization where shareholders have legal residual rights and the manager has legal con- trol rights. In this organizational environment the manager is in a posi- tion to take advantage of information asymmetries, gaining economic property rights in shareholder residual that permits reallocation of resources in a different way than that predicted under the usual (that is, neoclassical) type of for-profit firm.
2. Social regulation in public organizations
Although public sector organizations (bureaus) are most usually associ- ated with the role of imposing and enforcing regulations, they are also subject to social regulation in their operations and in the provision of services. Public organizations provide services in the areas of hospital and health care, education, housing, printing, and land management and construction, among others. These organizations must meet regu- latory requirements for equal opportunity, worker and consumer safety, and resource conservation and environmental quality, for example.
As we have seen, a common view of the public sector is one charac- terized by separation of ownership (the public) and control (bureau manager) which, combined with the lack of a capital market to disci- pline managerial behavior, leads to opportunistic and inefficient behav- ior by bureau managers. For owners in public sector organizations, individual monitoring costs are high relative to the expected individual benefits of monitoring bureau managerial behavior. This has the effect of altering the right to appropriate returns from owners (the public) and legislators (representatives of the public) to the public organization’s decision maker (bureau manager). In this framework, the bureau man- ager thus has an incentive to promote a use of resources that may be monitored in such a way so as to promote the manager’s objective.
With this rights structure, in the neoclassical (budget maximizing) model of public organizations discretionary budget is irrelevant and the bureau manager has economic property rights to total budget. Thus the bureau manager’s incentive to comply with social regulation is based on those regulatory responses that will increase the total budget. The bureau manager is more likely to comply when compliance may raise costs that are likely to be funded. The total budget of the US Veterans Administration would be increased, for example, for compliance with regulations that require new equipment that increases worker or patient safety in public hospitals. Where compliance may have the effect of reducing total budget, the decision maker would be less likely to com- ply, or would comply, but to a lesser degree. This could occur with the use of benefit–cost analysis as the basis for project acceptance (and corresponding budget expansion) where the analysis yields unfavorable results. Such a situation could arise, for example, when compliance with environmental standards related to medical waste raises the cost of providing health care services to the point of lowering the estimated benefit–cost ratio, reducing likelihood of funding and thus effectively reducing total budget. This response has been observed in the provision of water resource projects by the US Army Corps of Engineers (Hanke and Walker, 1974 and Grunwald, 2002a,b).
In the context of the managerial model of public sector organizations, consider again legislators as investors in public sector organizations and therefore as principals with an expected political return, and bureau managers as the agents who provide the services that legislators are willing to fund. As investors, legislators have a greater motivation for monitoring bureau managerial behavior. With the assignment of legis- lators to budget review committees that are consistent with the interests of their constituents and specific interest groups, that is, their political interests, the likelihood of monitoring increases. In the context of the managerial model, however, bureau managers have better information on the bureau’s production function and therefore have discretionary ability.
With this rights structure, bureau managers would be expected to comply with relevant social regulations by reallocating resources to those which are more observable and which also reflect the preferences of the decision maker. This could occur through increasing staff size, for example, rather than changing the composition of labor (staff) employed in the bureau, or to change the composition of different inputs such as by increasing the staff/capital ratio in the bureau, as a way to promote equal opportunity.
3. Social regulation in nonprofit organizations
Nonprofit organizations that supply commercial and social services, such as nonprofit hospitals, nursing homes, schools, theater and dance companies, and museums are also subject to social regulation. The neo- classical model of nonprofit organizations assumes revenue or output maximization subject to a breakeven constraint. In this model compli- ance with social regulations is likely to increase cost, thus requiring greater revenue to meet the breakeven constraint, or reduced costs in other areas of the nonprofit operation.
With strict revenue maximization as the objective of the nonprofit organization, compliance with social regulation provides a rationale for soliciting greater funds through grants and donations. Compliance would be incorporated into budget requests. Full compliance would be predicted in this case under the assumption of zero transactions (solici- tations) costs. With strict output maximization as the objective, less than full compliance is likely unless monitoring is effective, even if transac- tions (solicitations) costs are zero. This outcome is predicted because the higher cost of compliance has the effect of either reducing output when there is no revenue increase or using any revenue increase to meet com- pliance requirements rather than to increase output. When monitoring is effective compliance occurs and maximum output is reduced.
The managerial model of nonprofit organizations assumes that non- profit decision makers maximize their utility which depends on prestige, income, and discretionary revenue. The sources of utility affect the form of compliance. For example, Title IX gender equity regulations in the US require that women’s and men’s athletic opportunities in educational institutions be offered in proportion to their relative student body popu- lation. The goal of Title IX regulations is to increase women’s sports opportunities to come into parity with those already offered for men. Nonprofit collegiate athletic directors (the decision makers) for whom men’s sports such as football and basketball generate prestige, income, and revenue do not comply by adding or expanding women’s athletic opportunities. Rather, they comply with Title IX gender equity regula- tions by reducing those sports programs for men which have little or no impact on the athletic director’s utility or which do not promote their ‘brand equity,’ whether or not they have a positive impact on the men who have been participating in these athletic activities (Gladden, Milne and Sutton, 1998 and Carroll and Humphreys, 2000). Similar decision behavior would be expected at hospitals, schools, orchestras, and other nonprofit organizations where those services or attributes that promote managerial utility are maintained and compliance with equal opportu- nity, safety, or environmental regulations could be met by reducing those services that carry less weight in the decision maker’s utility function.
4. Implications of property rights for social regulation
Social regulation, by affecting the production process, and, therefore, relative costs of inputs, effectively alters the rights structure facing the decision maker. When the decision maker is not a perfect agent for a profit-maximizing owner, effects of social regulation differ from the effects predicted by the neoclassical model. True costs of compliance with any social regulation are known by the manager/decision maker but not by investors, whether these individuals are corporate sharehold- ers, public sector legislators, or nonprofit donors. In most organizational settings, a utility maximizing manager with economic property rights has no incentive to minimize cost of compliance. One reason is that the manager may choose to shift the costs of compliance to the investors who have more limited information on the organization’s production function. A manager who is interested in a larger budget or greater (donated) revenues may use the argument of higher costs of compliance to achieve this. Alternatively, a manager may indulge his or her prefer- ences for staff (to increase the size of the organization and the manager’s corresponding authority and prestige) or capital (to increase observable inputs for a bureau or enhance quality of service for a nonprofit).
There are, however, some circumstances where cost minimization may be a managerial response to social regulation. This could occur when the manager has a preference for discretionary profit or budget, and costs may not be fully shifted to the investors. Minimizing the cost of compli- ance with social regulation does not necessarily indicate increased effi- ciency, however, for the cost savings are allocated to activities or resources that increase managerial utility, such as office amenities or additional output beyond the socially efficient level.
Evaluating social regulation in alternative organizational forms where different property rights systems are in place suggests that the predicted response is not likely to be efficient in the way predicted by the neo- classical model. Compliance with social regulations that enhance dis- cretionary profit or budget, or total budget or revenue, or output, may correct the market failure that called for the regulation in direction, such as increased output when market output is too small. But the mag- nitude of the correction may be inefficient due to managerial economic property rights that create incentives to expand discretionary profit or budget or output to a higher than socially efficient level. Even if the socially efficient level of output is supplied, it is likely to be produced at a higher than minimum cost as managers reallocate resources within the organization in favor of their own preferences.
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.