Unbounded rational decision making: managerial models of alternative organizational behavior

Managerial models of organizations are based on the premise that cer- tain assumptions of the neoclassical model do not hold. In particular, transactions costs, which include monitoring costs, are positive. There is separation of ownership and control of resources in the organization and corresponding imperfect agency behavior on the part  of  the  manager. The manager/decision maker has his or her own interest and  prefer- ences that are distinct from the interests and preferences of the organi- zation itself and of its owners and investors. Thus the objective function of the decision maker is no longer identical to the objective function of either the organization itself or its investors or owners.

In the preceding chapters on the firm, the public bureau, and the nonprofit organization I examine the issue of separation of ownership and control for each organizational form. For the corporation, owner- ship is clearly defined and unambiguous in terms of property rights. Alchian (1987) speaks at length to this point and the way that owner- ship rights facilitate specialization and the rise of the corporate form of private profit-maximizing organizations:

An advantage of the corporation is its pooling of sufficient wealth in firm-specific resources for largescale operations. Pooling is enabled if shares of ownership are alienable private property, thereby permitting individuals to eliminate dependence of their time path of consump- tion on the temporal pattern of return from firm-specific investments. Alienability is enabled if the shares have limited liability, which frees each stockholder from the dependence on the amount of wealth of every other stockholder. The resultant ability to tolerate anonymity, that is, disinterest in exactly who are the other shareholders, enables better market alienability. (p. 1032)

Consider now the public bureau and the nonprofit organization, where the concept of ownership is less clear. In my earlier chapters I have defined ownership in the same sense as that of Alchian, that is, as those who invest, or pool sufficient funds, in organization-specific resources for operation of the organization. Alchian makes four points with reference to the pooling of wealth to create the corporation. One is that pooling requires private property rights. A second point is that these rights are alienable, that is, ownership is transferable. His third point is that for the rights to be alienable, the rights must have the fea- ture of limited liability. Finally, his fourth point is that alienability is more likely if the holders of the rights are anonymous and disinterested (that is, in the identity of other rights holders). To what extent are these points reasonable and applicable to the alternative organizational forms of the bureau and the nonprofit organization?

I argue that while some establishment of rights may be required, alienability (that is, transferability of  ownership)  is  neither  necessary nor sufficient for pooling of wealth. I discuss in detail the forms of own- ership rights that may exist for public bureaus in Chapter 6 and for nonprofits in Chapter 7. I am concerned here with the relationship between pooling and alienability of those rights.  Public  bureaus  and many nonprofit organizations are complex organizations that are not analogous in their structure to single proprietorships. Rather, they are dependent on resources obtained from multiple sources. In Alchian’s terms, bureaus and nonprofits require and obtain pooling of funds to operate. Bureaus produce as a result of the  pooling  of  tax  revenues which are then appropriated by legislators who expect a political return that may be pecuniary or nonpecuniary or both. Nonprofits produce as a result of the pooling of funds through multiple donations and grants from individuals and institutions who expect a nonpecuniary return in the form of services provided for some third party.

Concerning public bureaus, one important difference is that the pay- ment of taxes, the source of the pooled funds, is not a voluntary action. Tax payments, of course, are not alienable across taxpayers. Another difference is that taxes are paid directly to the general government fund, not to a particular bureau or program. The use of tax funds is then deter- mined by specific decisions made by legislators on the appropriations. As I point out in Chapter 6, it is true that legislators are making deci- sions about the use of other people’s (taxpayers’) money, not their own. Legislative appropriations decisions are voluntary in that they have discretion over how the funds are to be allocated, however. In terms of their funding decisions that reflect the actual pooling of funds for any particular bureau, legislators incur an opportunity cost associated with each funding choice. Legislators decide where their appropriated funds will go (that is, which bureaus and programs they will fund) and how much they allocate or invest (what the size of the appropriation is). Thus, the funds are pooled by legislators through the appropriation process.

For nonprofits, like investments in for-profit corporations, the act of contributions through donations and grants is strictly voluntary. These contributions are not alienable from one donor to another, however. The funds are paid directly to the organization as with an initial public offering of stock in a corporation, but there are again important differ- ences. One, as I discuss in Chapter 7, is that the returns are not pecuniary as they are for corporate shares. Another difference is that donation is not subsequently tradable as shares are. For the nonprofit organizations who receive the contributions, however, these are pooled funds avail- able for allocation through the managerial decision process, as in a corporation.

In each case of either nonprofits or bureaus, pooling of funds occurs without the legal characteristic of transferability associated with the rights that investors in these organizations hold. There is a difference in the pooling process between nonprofits and bureaus, however, which is another difference between corporations and bureaus as well. For legis- lators, their right to the use of political funds may be considered alien- able in a limited way, in the sense that they can trade votes for each other’s appropriation choices, that is, there is logrolling. While this is not a legal property right, it is an economic property right. The practice of vote trading is a true transfer of a right, for it requires a legislator to give up his or her vote (usually on another issue or different appropria- tion) to get a favorable vote from another legislator. Vote trading relates to the issue of anonymity raised by Alchian, which I discuss below. My point here is that pooling of funds to promote the organization of activ- ities in alternative organizational forms is observed to occur even in the absence of true alienability.

The last two points raised by Alchian relate to limited liability associ- ated with the property right and the anonymity of the holders of those rights. I would agree with the former point but not with the latter. It is highly unlikely that contributors to nonprofit organizations would be willing to donate or grant funds if they would face unlimited liability with respect to the use of those funds. And even if contributors find that they have been cheated and that no service has been provided as a result of their contributions, they have lost the amount of their invest- ment in the nonprofit, and nothing more.4 This is much the same as the situation faced by shareholders in a corporation. As for legislators, they, too, have limited liability with respect to the use of the funds that they appropriate. If they make exceedingly bad choices over time, it is possi- ble that they could lose campaign contributions and/or votes, but to that extent their liability is limited.

On the point of anonymity, I believe that Alchian is referring to the impersonal nature of the neoclassical-like world of share trading. It  is true, of course, that shareholders need not know who  is  buying  the shares that they sell, or whose shares they are buying. It is equally true that donors need not know who else has contributed to a particular nonprofit organization. There may be some influence on particular con- tributors from the knowledge that a particular individual or institution has chosen to fund a nonprofit in which  they  are  interested.  But  this, too, could be said of shareholders who may be influenced by financial advisors or others who provide investment information. The influence may be limited to simply knowing the amount of funds already donated (or shares purchased), providing a greater sense of security  in  their choice of investment. Some donors prefer  anonymity,  however,  which can be guaranteed under some circumstances. But the relevance of Alchian’s point has to do with the ability to subsequently trade shares once offered to the public, which is not possible for donors and grantors to nonprofits. The lack of alienability of donations makes this issue irrelevant with respect to nonprofits.

With respect to bureaus, however, legislators who operate in a politi- cal environment are neither anonymous nor disinterested in the deci- sions of other legislators. Indeed, this is one of the ways that the political market differs from the purely economic one. I would also argue that the pooling of funds for specific bureau programs and projects derives from the lack of both anonymity and disinterest in the political market, because of the practice of vote trading that takes place. The expected return here of course is not an economic one but the political return in the form of campaign contributions and votes.

Thus, many of the points that Alchian makes in his statement regarding the pooling of wealth as a basis for the rise of the corporate form of for-profit organization also relate to the bureau and to the non- profit organization. All three alternative forms of organizations operate through the use of pooled funds and are therefore subject to issues of separation of ownership and control. Ownership is associated with the pooling of funds, and control is associated with the use of these funds.5 Thus the managerial model may be applied to each of these organiza- tional forms.

The managerial model of the firm as originated by Williamson (1963) focuses on the corporate form of organization and proposes that the shareholders and managers have different objectives. Shareholders, who are investor-owners, have as their objective maximum profit, that is, the greatest possible return on their investment in the firm. Managers, who are the decision makers regarding resource use in the firm, have as their objective maximum utility, which depends only in part on shareholders’ value.

Managerial models of a bureau incorporate three levels of objectives: taxpayers, or the public, legislators, and bureau managers (see, for exam- ple, Migué and Bélangér, 1974; Lindsay, 1976 and Niskanen, 1975). These models assume that taxpayers have as their objective maximum net ben- efits from publicly supplied services which are most often presumed to be net benefits to society. Legislators are assumed to maximize their political benefits of publicly supplied services, such as votes or tenure in office. Bureau managers are assumed to maximize their utility which is also assumed to be unrelated to either taxpayer value (maximum net social benefits) or legislative value (maximum political benefits).

Managerial models of nonprofit organizations such as those origi- nated by Newhouse (1970), Pauly and Redisch (1973), and Clarkson (1981) primarily focus on the managerial objective of utility maximiza- tion where, with the legally imposed nondistribution constraint, any issue of ownership is assumed to be moot. As noted in Chapter 7, how- ever, the role of donors and grantors as investors is not insignificant. Therefore the consideration of their objective of maximizing a return (either pecuniary or nonpecuniary) on their investment in the non- profit may alter nonprofit managerial behavior from that predicted on the basis of no ownership.

As in the neoclassical model of organizations,  exogenous  constraints are imposed on the manager/decision maker in each form of organ- ization. These constraints are market related and usually reflect com- petitive input and output prices. Unlike the neoclassical approach to analysis of organizations, however, some constraints on the manager/ decision maker are endogenous. Endogenous constraints derive from the objective function of the relevant principal and also from internal structural characteristics of the organization.

The objectives and constraints of managerial models of decision mak- ing in the firm, the bureau, and the nonprofit organization are specifi- cally derived from the property rights (residual and control rights) associated with each organizational form. For the firm property rights of shareholders are attenuated by the necessary organizational structure of the corporation. Legal and economic rights are no longer identical as they were in the neoclassical model. Legal rights are nominally unchanged. Shareholders, who have legal residual rights, choose their investments so as to obtain the greatest possible return. Their choice of investment in firms as complex organizations in the form of  the  corporation  entails legal assignment of control rights to managers. Economic rights,  how- ever, are changed relative to the rights associated with the neoclassical model. In the managerial model of the firm, economic rights are redis- tributed from the shareholders to the  manager/decision  maker  who, with legal control rights, is in a position to expropriate at least some economic residual rights.

The implication of the managerial model of the firm is that the man- agerial firm is inefficient relative to the standard set by the neoclassical firm. The decision maker has the incentive to produce the profit maxi- mizing output, but this output is produced at higher than minimum cost. The difference in cost is accounted for by the manager’s economic residual right. The manager expropriates some residual from sharehold- ers via overinvestment in managerial preferences relative to shareholder preferences for resource use within the corporation.

In managerial models of the bureau, the outcome is either allocative inefficiency or production inefficiency relative to the standard set by the neoclassical model of the firm. Given a utility maximizing bureau manager, and the inability to appropriate personal pecuniary residual, the bureau will produce a larger than optimal output if appropriation of only pecuniary residual is considered. This result is the same (alloca- tively inefficient) outcome as that of the neoclassical bureau model. If the manager is in a position to appropriate residual in a nonpecuniary form, the bureau will produce the output that maximizes residual but does so at a higher than minimum cost. This result is essentially the same (economically inefficient) outcome as that of the managerial model of the firm, where the manager expropriates residual in the form of input preferences, such as excess staff, or office perquisites.

There is some quantitative difference between the outcomes of the managerial firm and the managerial bureau, however. The managerial firm requires some normal or expected return to the shareholders, which places an upper bound on managerial ability to expropriate shareholder residual (that is, on managerial economic residual rights). The property rights structure in the public sector can have the effect of raising this upper bound if legislative political incentives minimize monitoring of bureau production activity. This can happen for a num- ber of reasons. First, the opportunity time cost of monitoring may be high for legislators relative to the expected benefits of that use of their time. Second, the political benefits of more output (services for constituents) may exceed the political benefits of cost reductions (con- stituent share of lower taxes). Third, special interest groups may bias legislators in favor of higher levels of specific bureau services over which the legislators have budgetary control. Thus political preferences may exacerbate the inefficiencies associated with the managerial model of a bureau relative to the firm. This result is consistent with Becker (1983) who shows that competition among political pressure groups is efficient for group members but which favors those in political power. Becker’s model does not explicitly consider the role of legislators and bureau managers in the allocation process, however. The higher levels of spe- cific bureau services predicted by Becker would be preferred by members of the successful pressure groups who apparently satisfy preferences of legislators. It is not clear how this outcome would be affected by the decision process of bureau managers.

The inefficiencies  just  described  are  based  on  comparison  to  the standard set by the model of the neoclassical firm and the important assumptions associated with that model, namely, no market failures. If market failures in the private sector exist, for example, negative exter- nalities such as pollution or congestion, then the outcome of overpro- duction in either the bureau or the nonprofit organization may serve as a correction of such market failures. Legislative behavior, focused on political benefits, is usually also taken to be inefficient by diverting resources from providing social benefits to uses that increase their own private political benefits. The additional effects brought on by legislative incentives may also serve to correct market failures that result in under- production. I comment further on this point later.

Managerial models of nonprofit organizations show them to be allocatively or economically inefficient relative to the neoclassical firm. As with a bureau, given a utility maximizing nonprofit manager and the legal nondistribution constraint, a nonprofit will produce a larger than optimal output at the breakeven level in the short  run  but  not  in  the long run if appropriation of only pecuniary residual is considered. This is the same outcome as the neoclassical nonprofit organization  when there are no cost or revenue differences between a nonprofit organiza- tion and a firm, that is, when nonprofit and for-profit firms are identical in every way except in ownership. If the residual may be appropriated by the nonprofit manager in a nonpecuniary form, a utility maximizing nonprofit manager will overinvest in those attributes of the service (for example, quality) or the organization (for example, staff) that increase managerial satisfaction relative to the amount or quantity of services provided.

The efficiency implications of this type of managerial behavior are ambiguous when attributes of services are considered. Differentiating its service by increasing quality of output directly, or indirectly through increasing quality or quantity of inputs, has the dual effect of increas- ing cost and demand relative to what would occur with a homogenous product. The effect on output level relative to the efficient level depends on the relative effects on cost and demand. One of the theories of the exis- tence of nonprofit organizations is that the market that includes only for- profit firms fails to provide appropriate choice to consumers (Hansmann, 1987a and Weisbrod, 1988). Evidence from these and other studies sug- gests that consumers obtain greater satisfaction from increased choice, providing support for the suggestion that higher quality of services provided through nonprofit organizations promotes efficiency (see, for example, Weisbrod and Long, 1977 on the employment services industry and Ostrom and Davis, 1993, on education).

The efficiency implications of nonprofit decision behavior in a man- agerial model is further complicated by the addition of donation and grant (fixed) revenues and cost reductions  through  tax  exemption and (possibly) volunteer labor. Consider first the addition of donation and grant revenue. These have the effect of shifting nonprofit demand to the right and can be interpreted as representative of the (additional) value of the service to investors in the nonprofit organization (over and above the value exhibited by fee-paying consumers). Managerial prefer- ences may be consistent with the higher demand for specific attributes of a service. This could be the case, for example, if the product or serv- ice is differentiated through higher quality that provides additional ben- efits to consumers as well as additional utility to the manager through greater prestige and reputation. Cost reductions through tax exemption may serve to subsidize managerial preferences for service or input attrib- utes, such as better location. This, too, may reflect a consumer benefit.

The efficiency implications of these revenue and cost effects depend on the prevailing market conditions. The outcomes of nonprofit mana- gerial preferences, further increased by these revenue and cost effects are inefficient if the market outcome that would result in fewer such attributes and lower output level is efficient. That is, if the neoclassical outcome is efficient, then variation in attributes of either service or organization, such as quality, from the neoclassical outcome as a result of managerial utility maximizing behavior results in inefficiency. If donor and managerial preferences are consistent and aligned, however, then the perceived overproduction of services or overinvestment in quality or other attributes would be an efficient outcome. In addition, in the presence of market failures, such as externalities or asymmetric information, nonprofit outcomes in the managerial model serve to increase efficiency relative to that which would occur with the neoclas- sical firm. The revenue and cost effects that promote this outcome also therefore promote efficiency under conditions of market failure. Thus, if society prefers quality variation, the nonprofit organization results would also reflect increased social efficiency.

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.

Leave a Reply

Your email address will not be published. Required fields are marked *