Unbounded rational decision making: neoclassical models of alternative organizational behavior

The neoclassical view of organizations, regardless of organizational form, is essentially one of a production function with no attention to internal organizational structure. To summarize, there is a single focused objec- tive function for the organization as a whole. The decision process is an organizational response to exogenous factors that serve as constraints and as managerial monitoring systems such that there is no agency prob- lem. That is, there is no issue of separation of ownership and control in the neoclassical model. Outcomes for levels of output, cost and residual, and corresponding degrees of efficiency in production and social allo- cation follow from the specified objective function, constraints, and organizational response.

Consider first the alternative organizational objective functions. The neoclassical model of the firm assumes profit maximization as the primary objective. The comparative analysis here subscribes to this assumption, although other possible firm objectives, such as sales or growth maxi- mization subject to  a  minimum  profit  constraint,  are  considered  later. A neoclassical model of the bureau assumes budget (that is, total revenue) maximization as the primary objective, as in Niskanen’s original model (1971). A neoclassical model of a nonprofit organization may assume either revenue maximization (as in Niskanen, 1971) or output maximiza- tion (as in James and Rose-Ackerman, 1986).1

Constraints on these neoclassical organizational objectives derive from the market environments in which the organizations operate. For a firm, competitive input and output markets constrain the decision maker/organization to minimize costs, if not in the short run, at least in the long run. For a bureau, constraints are imposed by a political mar- ket (demand) that dictates the value of the service to be provided and by the resource constraints (costs) that the bureau faces. The effective- ness of these constraints varies by assumption.

The assumptions of the alternative neoclassical models  of  a  bureau may be any one of the following: (1) Political market (demand) con- straints and cost constraints are both completely ineffective, that is, nonbinding. In this situation the model of the bureau is one of budget or output maximization. (2) Political market constraints are ineffective (nonbinding), while cost constraints are effective (binding). In this case the bureau is unconstrained by any legislative monitoring. It must cover its total costs, however. Thus the model of the bureau is one of maxi- mizing its budget or output subject to the constraint of breaking even.

(3) Political market constraints and costs constraints are both effective (binding). In this case legislators are  effective  monitors.  The  model  of the bureau is based on legislative demand for services and requires that the bureau at least break even. Niskanen’s models of a bureau invoke either (1) or (2); models developed by Breton and Wintrobe (1975) and Weingast (1984, for example) invoke (3).

For neoclassical models of a nonprofit organization, constraints may be imposed by revenue sources, such as donations and competitive out- put markets, and resource constraints (costs). The effectiveness of these constraints also varies by assumption. The models typically assume an ineffective constraint from sources of revenues through donations and grants. In addition, these models may assume an effective (binding) com- petitive output market (sales or fees) and cost constraints. Alternatively, they may assume competitive output market and costs constraints  that are both ineffective (nonbinding) because of  donations,  tax  subsidies, and volunteer labor. For examples of these variations, see Niskanen (1971), Tullock (1971), and James and Rose-Ackerman (1986).

The objectives and constraints in these neoclassical models of the firm, the bureau, and the nonprofit are derived from the property rights (residual and control rights) ascribed to each organizational form. For the firm, property rights are assumed to be private and complete, so that legal rights and economic rights are identical and there is no agency problem. These full and enforceable rights provide the incentive for maximizing profit (the residual) and minimizing per unit cost in the long run by the organization/decision maker. The output of the firm is allocatively efficient, using the minimum resources to maximize con- sumer value, thus maximizing social value. The neoclassical model of the firm thus sets the standard for efficiency in production.

In the neoclassical approach to alternative organizational forms, the outcomes of these models are also derived from property rights and are measured against the efficiency standard set by the competitive value- maximizing firm. In neoclassical models of the bureau and the nonprofit organization, residual rights are either so widespread as to be effectively zero (for the bureau, with citizen-taxpayer ownership) or legally zero (for the nonprofit, with no legal residual rights). In this context there is either an infinite principal–agent problem or no principal–agent problem at all because the principal as a separate owner is either irrelevant or nonex- istent. In either case the notion of a separate principal is ignored and the decision maker (manager) becomes identical to the organization (bureau or nonprofit), just as the decision maker is identical to the firm. In these models the bureau and nonprofit is each simply a production function which faces different property rights, and so have different objectives and constraints, than a for-profit firm.

For the neoclassical bureau, the lack of an effective legal residual right permits the organization/decision maker to appropriate the residual right. In the political market environment of the public sector where personal or individual residual appropriation is not possible, the bureau itself has economic residual and control rights. Thus, the objective of budget maximization derives from the public sector property rights sys- tem. The bureau has an incentive to overproduce at the level where total budget (revenue) is the maximum possible. This larger than opti- mal output level occurs where marginal benefit of the bureau’s service is zero (if no cost constraint exists) or at least less than the bureau’s mar- ginal cost of providing the service (if a cost constraint is imposed that the bureau must meet, such as a breakeven constraint). This inefficient outcome occurs in both the short and long run.

Niskanen (1971) proposed that this inefficient outcome derived not only from public sector property rights but also from the special circum- stance of bureau monopoly power. Carroll (1989, 1990, 1993b) has shown that bureau monopoly power is neither necessary nor sufficient for the outcome of overproduction in a neoclassical model of a bureau. She shows that monopoly power is not an empirically valid assumption and that given the public sector property rights system employed by Niskanen, competition increases rather than reduces bureau inefficiency. For a neoclassical nonprofit organization, the property rights associ- ated with the nondistribution constraint permit the organization to appropriate any residual which then may be used to produce a higher level of output. The nonprofit organization thus has an incentive, based on its property rights system, to produce output to the point where it breaks even. In neoclassical models of a nonprofit organization that faces the same revenue (from sales or fees only) and cost conditions that a firm does, in the short run the nonprofit organization produces larger than optimal output. The overproduction derives directly from the assumption of the breakeven condition. Overproduction results because the nonprofit organization/decision maker equates revenue and cost on the average rather than at the margin, as a profit maximizing firm would do. However, in the long run in competitive output markets with costless entry there will be no residual so that the nonprofit’s outcome is efficient and identical to that of a profit maximizing firm in long run equilibrium, all other things equal (James and Rose-Ackerman, 1986).

When other things are not equal, such as revenue conditions because of donations and grants and/or cost conditions because of tax exemp- tions or volunteer labor, neoclassical predictions of nonprofit behavior vary from the efficient long  run  outcome.  In  these  models  donations and grants do not affect property rights but do affect revenues of the nonprofit organization. In particular, because donations and grants are not systematically related to the level of output, these  are  considered fixed revenues. The fixed revenues do not replace sales revenues, how- ever. Rather, the fixed revenues from donations and grants are assumed to be added to the revenue from sales and fees that a  comparable for-profit firm would earn ( James and Rose-Ackerman, 1986). The addi- tional fixed revenue results in a higher level of output supplied by non- profit organizations at their breakeven point relative  to  the  efficient profit maximizing firm’s output in the short run but not in the long run if entry is possible.

The effect of donations and grants when added to sales revenue to increase output is exactly offset by the reduced output of firms and non- profits that obtain no grants or fixed revenues. If all nonprofit organi- zations have equal access to donations and grants in addition to revenues from sales and fees, then long run output is lower than the efficient output that would have been supplied by firms. This occurs because the breakeven point for all nonprofit organizations occurs at a level below capacity (where average cost is falling because the per unit value of the fixed revenue is also falling).2 Tullock (1971) shows that the effect of donations and grants reduces nonprofit output because the total revenue obtained from donations is used for promotional pur- poses. This is based on his assumption that the output of the nonprofit organization has no value to the donors.

Variations in costs across firms and nonprofit organizations may occur because of preferential tax treatment of nonprofits which would reduce their fixed costs. This may have the effect of increasing output produced by nonprofits relative to that produced by firms, for the nonprofit organization captures the additional residual in the form of higher output. If nonprofit organizations and for-profit firms compete, the long run implication is that for-profit firms are replaced by non- profits that are given tax subsidies and therefore can provide the iden- tical service at lower unit cost and price.

The efficiency implications of the neoclassical approach to alternative organizational optimizing behavior when outputs are identical across organizational forms but property rights and objectives differ can be summarized as follows.3 Neoclassical profit maximizing firms are effi- cient in production and allocation. These organizations produce the optimal output with the greatest social value at the lowest per unit cost. Neoclassical budget maximizing bureaus are inefficient. Neoclassical bureaus produce larger than optimal output even under competitive conditions. Neoclassical output maximizing nonprofits are efficient if they are structurally identical to neoclassical firms and operate under perfectly competitive conditions. Neoclassical nonprofits are inefficient under all other conditions. If nonprofits have alternative sources of revenue, such as donations or grants, and entry may occur, neoclassical nonprofit output is lower than optimal. If nonprofits receive preferen- tial tax treatment and competitive entry reduces market price, neoclas- sical nonprofits will produce a lower output than would have occurred without the special tax treatment. If entry is restricted, then neoclassi- cal nonprofits will produce a larger than optimal output.

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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