Objectives, governing approach and the agency problem in public sector and pvt sector organisations

Objectives, governing approach and the agency problem in public sector and private sector organisations

Sam Choon Yin (12/2004)

Introduction

            It has been well documented that the public sector has much to learn from management practices in the private sector (see for example Dopson and Stewart, 1990) thus suggesting that there are certain commonalities between running the public sector and private sector organisations. Precisely because of this, one should not discount the fact that the reverse is possible, that is, private sector organisations could also emulate some of the good practices from the public sector.

It has often been suggested that the public sector is distinct because it possesses monopoly power in markets which it commonly intervenes. While this is true in some cases, the distinction does not apply for some public services offered by the government like in education, health and housing. Moreover, it should be recognised that the notion of the bureaus being inefficient has to be treated as an exception rather the rule. The perception that a non-profit organisation has no intention or incentive to be efficient is not entirely correct. A public enterprise could be subject to scrutiny by the ‘tougher’ Finance Ministry, thus requiring it to apply common project evaluation tools like net present value and internal rates of return to assess projects and avoid subjecting the enterprise to stricter control by the Ministry of Finance. Also, the public sector is often accused of being too bureaucratic in the Weberian sense. As a consequence, decision-making becomes too problematic and time consuming. However, it should not be forgotten that private corporations too are susceptible to the problem albeit under a different name which economists have termed as ‘diseconomies of scale’. Micro economists have predicted that as firms get too large, diseconomies of scale may set in arising from bad management, difficulty to communicate corporate policies with workers and poor industrial relations. The effect comes in the form of rising average cost of production thus affecting the firm’s profitability and competitiveness.

In this essay, we explain that there are other commonalities between the public sector and private sector organisations. They will be illuminated in subsequent sections. It is our modest attempt to stimulate a debate on this issue.

 

Objectives

It is generally believed that the main objective of private sector corporations is profit maximisation. This notion has been questioned recently by Michael Jensen and Kevin Murphy in their extensive study on executive remunerations. In their monograph, they pointed out that the value maximisation objective might fail to ‘tap into the energy and enthusiasm of employees and managers to create value’ (Jensen and Murphy, 2004, p. 16). Without having an idea of what the maximum value is, corporate managers may be tempted to maximise short-term profits by manipulating the reporting system like moving revenue from the future to the present and expenses from the present to the future even if such moves result in lower value of the firm over a long run. Jensen puts the blame partly on short-term targets set externally by financial analysts and investment houses which lead to overvaluation of equity prices (Jensen, 2004). He defines overvalued equity as one where the existing firm’s stock price is higher than its underlying value, so high that the managers cannot, except for pure luck, deliver to justify the value. There are several reasons why a firm’s equity price may be overvalued, including (1) the emergence of ‘something new’ like high-tech and telecommunication firms and internet ventures, (2) misled data furnished by the professional managers represented in the firm (they have the incentive to inflate performance measures to enjoy higher prestige, power, pay and greater ability to access cheap loans), (3) the existence of misinformed investment banks, research houses and audit firms about the future prospect of the firm, and (4) the existence of a large number of na´ve investors. Because the Chief Executive Officers and Chief Financial Officers suffer if they cannot meet the expectations of the capital market and analysts, they may choose to manipulate the financial statements, leading to loss of reputation and intrinsic value of the firms that are caught doing this. This was the case for Enron, EToys and Nortel among others.

Jensen (2001) has argued that it might be more suitable to provide an operational objective for organisations, one which the managers and employees could be more closely related to. He has suggested change in the long-term market value as the scorecard that managers, directors and others could use to assess success and failure of an organisation. Notice that it is the long-term value creation that is being emphasised. In his view, a firm should have a single objective to meet. This is unlike the stakeholder approach which direct corporate managers to serve multiple masters. Jensen warns that the firm may end up short-changing all of them since ‘without the clarity of mission provided by a single-valued objective function, companies embracing stakeholder theory will experience managerial confusion, conflict, inefficiency, and perhaps even competitive failure’ (Jensen, 2001, p. 9).

This resembles to some extent the objective of the public sector if one is to follow the Musgravian functions of the government - to achieve stability, equality, and efficient allocation of resources - all of which attempt to bring the nation into sustainable economic development (Musgrave, 1959). While Musgrave acknowledges that some of the objectives (like between equity and efficiency) are conflicting, it is the duty of the government to recognise and manage them well so that the long-term growth of the economy is not jeopardised. In this respect, having a single objective to guide decision-making is essential. Otherwise, the governing elites cannot be evaluated in any practical way. They may instead possess exclusive power to pursue their person interest – like spending on their pet projects – without being held accountable (and possibly at the expense of the masses) for their actions because it is possible for them to claim that the decisions made were meant to maximise the interest of some constituencies.

Accordingly, implicitly specifying a single objective – like that of achieving sustainable economic development - for the public sector is useful to guide decision makers, and resolve to some extent the trade-off problem alluded above. This is similar to the solution proposed in Jensen (2001) for private sector organisations. This seems also to be the conceptual specification in guiding Singapore’s public sector. Many observers have recognised that the ruling party People’s Action Party (PAP) is economic-growth oriented. Since elected in 1959, the PAP has won majority votes in every election. Its popularity with the people was due mainly to the strong economic growth that many perceived to have been brought about by PAP’s high standards of public governance even if this had come about at the expense of rising welfare standards and political freedom.

Consider the former. It is well known that the welfare system in Singapore is relatively weak (Asher and Rajan, 2002). A significant burden of the social welfare is borne by the individuals’ themselves. The PAP is against the idea of spoon-feeding the people with cash or transfer payments. Financial assistance schemes are rare such that even if they are provided, they are given on an ad-hoc basis and merely act as temporary measures. Even PAP MPs recognise this. For example, Wang Kai Yuen, the chairman of the Government Parliamentary Committee for Education commented:

The government is very careful when it comes to spending money on social services and nailing it down to the very last cent. But us gives large sums of money to ventures, like the S$2 billion for the life sciences. Sometimes, we don’t seen to the same measuring yardstick for expenditure (quoted in Ho, 2003, p. 237).

In fact, in 1994, Lee Kuan Yew (as Senior Minister then) had wanted to introduce the One-Man-Two-Votes system with preference given to Singaporeans who were between 35 years old and 60 years old. It was exposited that older people with families tend to be more politically matured, and less adventurous with their votes. But they were also deemed more attractive to the PAP because they could counter the threat posed by an ageing population for more welfare assistance (Ho, 2003, p. 104).

It has also been suggested that Singapore’s smallness promotes centralisation of the political system. Her vulnerability to external forces and intolerance of failure enhance the desire to specify sustainable economic development as the single objective to safeguard against economic recessions and crises. Consequently, critics see this as an excuse for autocratic rule, for silencing oppositions and for emphasising the need to attract and retain good people to lead the government (thus justifying the high salaries paid to the elite). In other words, political freedom is somewhat sacrificed for the sake of attaining sustainable economic development, a single objective as defined by the ruling party.

 

Governing approach

While the notion of devising a single objective coincides between the public sector and private sector organisations, so are the means to achieve it. In private sector organisations, the idea of incorporating the interest of stakeholders has long been advocated by Edward Freeman in his seminal work on ‘Strategic Management: A Stakeholder Approach’ (Freeman, 1984) which has gained increasing recognition among firms around the world. Jensen (2001) provided a modified version of the stakeholder approach for private sector organisations. He did not discard the approach per se but argued that advocates of the stakeholder approach had not dealt with in a convincing manner the potential conflicts that may arise among the stakeholders, for instance, between the firm and employees, and between the firm and suppliers, thus leaving managers with a theory that make it impossible to make purposeful decisions.  Jensen nevertheless believes that to create long-term market value for the firm the stakeholders interest must be cared for since a firm cannot maximise value of it ignores the interest of its stakeholders. In Jensen’s words, the firm ‘must pay attention to all constituencies that can affect the value of the firm’ (Jensen, 2001, p. 13). He coined the term ‘enlightened stakeholder approach’ to acknowledge the important role to be played by the stakeholders while recognising the challenge of handling potential conflicts of interest among them. Ultimately, the firm should aim to maximise its long term value.

Similarly in a democratic regime, the public sector has to work closely with various stakeholders to achieve sustainable growth, including the business community and civil organisations like the NGOs. Current Prime Minister of Singapore Lee Hsien Loong has recently outlined four principles of governance, one of which calls for nation building whereby everyone should be given a stake on the nation. Chamber and Ritcher (2004) include those whom the government taxes, creditors and those whom the government provides goods and services as stakeholders of the government. To achieve sustainable economic development, good governance must be present to gain the support and cooperation from these stakeholders. For example, to encourage voluntarily compliance to tax rules, the Singapore government has simplified tax procedures, leveraged on technology and increase certainty on tax matters. The government has also made the effort to link the benefits of paying taxes to the tax burden incurred by the taxpayers. These include raising the standards of corporate governance of the Inland Revenue Authority of Singapore (IRAS), and forming the Cut Waste Panel in September 2003 which seek suggestions from public on how waste can be cut in the public sector. Doing these successfully helps to further improve the budgetary position of the city-state.

More importantly perhaps is the willingness of the Singapore political leaders to talk about and lay out their position on such issues. They had no intention to hide from the fact that political freedom is quite restricted in Singapore. It is well known for example that Lee Kuan Yew tended to be more hands-on in the policy making process. He once toiled with the idea of implanting the ‘One-Man-Two-Votes’ system to limit the voting rights of politically immature and adventurous citizens. He had also questioned the need for citizens to participate in policy making, but instead favoured the ‘do-it-alone’ approach. In Lee’s words:

‘You mean that ice-man knows the consequences of his vote? Do you honestly believe that the chap who can’t pass primary six knows the consequences of his choice when he answers a question viscerally, on language culture and religion? But, we know the consequences. We would starve; we would have racial riots. We would disintegrate’ (quoted in Ho, 2003, p. 338)

 

‘If I were in authority in Singapore indefinitely without having to ask those who are governed whether they like what is being done, then I have not the slightest doubt that I could govern much more effectively in their own interests’ (quoted in Ho, 2003, p. 339).

            On the other hand, it is generally agreed that Goh Chok Tong adopted a more consultative style of governance. During his tenure as Prime Minister of Singapore, the Feedback Unit, Institute of Policy Studies and Government Parliamentary Committees were set-up to garner inputs and feedback from the citizens. Policy initiatives concerning the Elected Presidency, Vehicle Quota Schemes and Government Parliamentary Committees were debated openly (as opposed to the Graduate Mother Scheme in 1984 which was implemented without being debated in the Parliament). Goh’s approach thus coincides more closely to the stakeholder approach than Lee’s. It is relatively more difficult for Goh to manage stakeholders’ interest as compared to his predecessor.

           

Agency problem

Let me proceed to highlight the third similarity between private sector and public sector management. It may not be surprising to some of you that both the public and private sectors organisations are susceptible to the agency problem. This problem on modern private corporations was first observed in Berle and Means (1932) as more private corporations were run by professional managers who did not own them. In the US, it was believed that this began when great capitalist entrepreneurs like Vanderbilt, Rockefeller, Morgan and Harriman handed over the control of their corporations to ‘outsiders’ thus broadening the ownership. There is essentially a separation of ownership and control. Such an arrangement creates problems when the principals (professional managers) make decisions that are not in tandem with notion of maximising the interest of the agents (shareholders).

            A result of the agency problem is corruption. One should recognise that the corruption problem is not limited to the public sector but susceptible too in private sector organisations. Consider the following. Professional managers in private sector organisations may be able to offer contracts to someone close to them without going through formal or proper procedures. In banks, managers may offer loans to a friend or relative without proper checks on his/her credit worthiness thus subjecting the banks to unwanted but minimisable risk. With respect to procurement, it is possible for a manager to purchase materials at a higher price because he/she has received bribes from the seller. It is also possible for a manager to travel excessively and furnish his/her room with unnecessary electronic gadgets instead of returning excess cash to the shareholders. More seriously perhaps is the act of manipulating company financial statements like hiding liabilities and inflating profits to reward managers more than what they actually deserve partly attributed to executive compensation schemes (Jensen and Murphy, 2004).

The agency problem is also common in the public sector. The sector is, in a theoretical sense, owned by the citizens, but managed by a few appointed by the voters. On one extreme of the spectrum, there may be the case where government’s executives make all the decisions without consulting the citizens but communicate with them only during election campaigns to win votes. A democratically elected person may have perceived that being elected actually endorses him/her to make decisions on behalf of others without the need to seek public support on policies he/she proposes.

Public choice school led by James Buchanan, Gordon Tullock and William Niskanen recognise this problem in the public sector. In their seminal works, Buchanan and Tullock (1962) and Niskanen (1971) described politicians as self-interested individuals just like anyone else, whom are very much interested in maximising their personal interest rather than that of the public which they supposedly represent. The problem may be worsened by the fact that the citizens and politicians are generally not able and perhaps unwilling to monitor public sector managers. A reason may be that the citizens perceive their voices to be unimportant in initiating any changes thus undermining their interest to seek costly information and internalise part of the government failures.

Like private sector organisations, a consequence of the above is corruption. Engaging in acts of corruption (like bribery, extortions, cronyism and nepotism) is common among public officers to reward themselves more than what they actually deserve. Of course, the ideal case is to recruit public officers who genuinely enjoy serving the public, the old and poor, in which case, minimal incentives are required to motivate them. In reality however, observing the true interest and personality of public officers is not possible. As a consequence, offering material incentives and imposing monitoring mechanisms are deemed necessary to better align the interest of the principals and agents. Mitigating the corruption problem usually involves a combination of opportunity-reducing and incentive-reducing strategies. The former includes measures to deregulate the industries, privatise public enterprises, leverage on technology advancement (like the use of electronic tax-filing system), and raise the penalty costs and the perceived probability of catching the offenders. Reducing the incentives for corruption may require the government to pay competitive salaries to public officers to a level that is at least comparable to their counterparts in the private sector.

Jacek Tittenbrun, in his interesting analysis of the public choice theory, has suggested that it may be useful if political leaders have the upper hand of the public managers so that the latter could be pressured to comply with formal rules that are beneficial to the society (Tittenbrun, 1996, pp. 58-59). Interestingly, this resembles very much the common remedy suggested to mitigate the agency problem between shareholders and professional managers in private corporations in terms of board reforms and restructuring. Basically, board composition and the board’s role matter. In addition to forming, debating and approving strategic decisions, board members have been asked to chair board committees like compensation committee, nomination committee and audit committee, to better monitor the behaviour of the professional managers. These are guidelines that have gained the support from a majority of the firms.

            To align the interest of the principals with that of the agents, the former has relied almost exclusively on the power of incentives (in terms of compensation and other benefits in kind) offered to agents. This has been a common practice in private corporations. Dixit (1997) points out that in the case of large private organisations, incentives tend to be relatively less successful in motivating the agents. The reason being that in larger organisations, an agent may be required to perform several tasks, some of which have outcomes that are not easily identified and measured by the principals. Such tasks are likely to have a low powered incentive because the outcomes are not likely to serve as a useful indicator of effort. Conversely, there are tasks whose outcomes are more accurately observed and thus possess high-powered incentive. But considering all these tasks together, ‘the existence of some inaccurately observed (or unobservable) dimensions of outcome pulls down the power of incentives for all tasks’ (Dixit, 1997; p. 230 in the edited book by Basu, 2003).

James Wilson (1989) has observed that in a typical bureaucracy, the government agency gains dimensions of efforts (inputs) and result (output) which are not easily identified or observed by the principals, not surprisingly because the agents could hide knowledge and actions from the principals. His analysis on the government bureaucracy is essentially a mirror image of what is also going on in private sector organisations as alluded in Dixit (1997). Wilson (1989) also observes that each agent (government agency) has to deal with several principals almost simultaneously, which include the media, courts, interest groups, supervising ministries and interested citizens. Because the principals have different objectives, Wilson argued that the principals might impose a variety of constraints on the agency instead of incentive schemes to motivate the agents to do a better job.

Jean Tirole (1994) went to the extent to suggest that having multiple principals may be beneficial to the government agencies particularly if the principals have dissonant objectives. He gave the example of a government agency having to serve the interest of two principals; the spending ministry which has a direct control of the agency, and the finance ministry, which Tirole labelled as a tough ministry. The former is modelled in such a way that it behaves ‘softly’ toward the agency. It is responsible in developing the agency, thus having the incentive to provide aids to the agent even if it might have failed quite miserably (the government continues to finance the inefficient project till its completion). One way to internalise the problem, as Tirole suggests, is to subject the government agency to control by the finance ministry if further borrowings are required. In this way, there is an incentive for the agent to complete the project efficiently to avoid being under the control of a tougher ministry that cares very much about budge deficits.

Interestingly, the case of a multiple principals is also applicable in private sector organisations. For instance, the stakeholder management approach, which has been gaining acceptance, essentially puts the firm as the common agent while a collection of stakeholders (workers, creditors, suppliers, etc.) are treated as principals, each of them possibly having its own agenda on what to expect from the firm. As such, the evolution of multi-principals may weaken the power of incentive in the context described in Dixit (1997). Our point here is that microeconomics analysis could and have been applied to better understand the internal organisation of the government and private sector.

A related issue to the agency problem concerns budget maximisation. Public enterprises are often accused of demanding strong budgets from the sponsors without much concern about raising efficiency. The budgets are usually obtained by an appropriation or grant from the government. William Niskanen in his seminal work on Bureaucracy and Representative Government has modelled the behaviour of bureaus in such a way that the utility function of the bureaucrats is linked to the total budget such that the higher the budget, the better off the bureaucrats are. Higher budgets appears to maximise a number of variables that enter into the bureaucrats’ utility function including pay, patronage, prestige, perquisites, output, ease of making changes and ease of managing the bureau. Because of the need of collaboration from subordinates so as to increase the tenure of more senior bureaucrats, there is a demand for even more budgets from the sponsors. At least two effects were predicted to occur (1) stronger preference in the bureau for costly capital-intensive production process, and (2) shifting of the expenditures from the future to the present. Essentially, to justify the increased in the budget, the bureaucrats may resort to choosing projects that are relatively easy and quick to complete, and try whatsoever means to see that the targets are achieved even if the measures do not create value to the society in the long run.

In 1991, Niskanen modified his assumption from one where bureaucrats are interested in maximising total budget to one that maximises discretionary budget (Niskanen, 1991). The latter is referred to as the difference between total budget and the minimum cost of producing the output expected by the political authorities. This is in recognition of the fact that it is also in the interest of the bureaucrats to minimise cost of the projects so as to enhance their chances of meeting their personal objective as defined in the utility function.

Interestingly, almost similar problems appear in private corporations. Michael Jensen has, in recent years, written several papers describing the fundamental problems of corporate budgeting systems (see for example Jensen, 2003). He has argued that the corporate managers are playing a budgeting game. The game involves tying the managers’ compensation to budgets and targets such that the managers are paid not for what they actually do (real achievements) but what they do relative to some targets. This has essentially led to the corporate managers (1) setting targets that are easy to achieve and/or (2) manipulation of financial statement or via other means to ensure that the targets are achieved, even if these come at the expense of long term growth of the organisation. Should the managers realise that the targets have not been met, they may attempt to accelerate shipments to the customers (even if they know that the stocks would be returned the next year) and push-up revenue for the current year while attempting to move expenses from this year to the next. Such measures may be adopted even if the overall profits could be reduced for both years. It is also possible that the managers deliberately announce increment in the products’ price in the following year, not for any reason except to encourage customers to place their orders earlier so that the managers could meet their targets and obtain the promised bonuses.

The solution to the problem as Jensen suggests, is not to discard the budgeting system but to change the way people are rewarded. Bonuses in his view should be a function of actual work done and accomplishments, not work done relative to the set targets in the budgets (that is, whether the targets have been met or otherwise). The suggested solution involves encouraging the firms to reward staffs that are genuinely concerned with the long-term of the firm therefore promoting persons of higher intrinsic motivation to work while short-term materialistic ones are avoided, a practice that has been advocated by Human Resource managers in the public sector. Thus, problems relating to budget are not exclusive to the public sector. Private sector organisations are also susceptible to the problem.

 

Implications

            There are a whole lot of studies in the public sector management literature (like in the areas of recruitment, compensation, performance measurement etc.) which suggest that managing a private sector organisation is not very different from managing a public sector related organisation. While it is not possible for me to go into the details here, I do wish to remark that the current discussions have wrongly focused too exclusively on (1) privatisation of public enterprises and (2) promoting private sector management practices to public sector enterprises. Ironically, it is the private sector organisations that were in trouble during the 1997-98 financial crisis. Emulating some of the useful lessons from the public sector may mitigate some of the problems that they face.

Thus, there are at least two implications which could be derived from the discussion so far. First, because of the commonalities between management of the public sector and private sector organisations, it is possible for the latter to emulate some of the good practices of the former (this is particularly important in view of the problems or scandals associated with private sector organisations in recent years). For example, the single objective approach adopted by the Singapore government provides a useful operational scorecard for public sector managers to assess their successes (and failures). Second, arguments for privatisation of state owned enterprises should be reconsidered if the problems alluded above on private sector organisations are not adequately addressed. There are indeed state owned enterprises such as those in Singapore, Austria and South Korea that have bucked the common perception about ineffectiveness of public sector enterprises. For example, a number of government-linked companies in Singapore are well-known regionally (like Singapore Telecommunications and Development Bank of Singapore) and globally (like Singapore Airlines), while many others have potentials to become world class companies. Privatising state-owned enterprises for the sake of privatisation may not lead to improvements in economic standards and social welfare of the economies.

 

References

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Buchanan, James and Gordon Tullock, 1962, The Calculus of Consent, University of Michigan, Ann Arbor.

Chamber, John and Monica Ritcher, 2004, Public Sector Governance, in: George Dallas, ed., Governance and Risk: An Analytical Handbook for Investors, Managers, Directors and Stakeholders, McGraw-Hill, US.

Dixit, Avinash, 1997, Power of Incentives in Private versus Public Organizations, American Economic Review, 87(2), pp. 378-82. Also published in Readings in Political Economy (2003), edited by Kaushik Basu, Blackwell Publishers Ltd, US.

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