Micro foundations of public sector management 1

The Treasury has a recent working paper out on Contemporary Microeconomic Foundations for the Structure and Management of the Public Sector by Lewis Evans, Graeme Guthrie and Neil Quigley. All three authors are at Victoria University of Wellington. The abstract reads:

The new public management of the 1980s was based in part on a range of important new insights about the role of transaction and agency costs arising from contractual incompleteness in defining the boundaries of the firm and the governance relationships within it. In this paper, we consider the literature of the last 25 years which extends our understanding of allocations of ownership rights and the boundaries of the firm as responses to contractual incompleteness. From this perspective, ownership represents an allocation of control rights to those with the potential to make the most important (value-enhancing) relationship-specific investments. We provide an outline of this modern approach to contractual incompleteness, illustrate its application to a range of issues in public and private ownership, investment, governance and decision-making, and provide suggestions about the impact that this approach might have on the scope, structure and management of the public sector in the 21st century.

I have done a quick read of the first three chapters of the paper. They do managed to get the references to the chapters of the paper wrong in the Introduction. When they refer to Chapter 2 they mean Chapter 3 and when they refer to Chapter 3 they mean Chapter 4 and so on.

In Chapter 2 they review the microeconomic foundations of the state-sector reform in New Zealand after 1984. The chapter looks at the economic theories that were important in the formulation and implementation of New Zealand's public management framework after 1984. The major influences from economics were the new institutional economics, principal-agent theory, transaction costs and information economics. At one point Evans, Guthrie and Quigley write,

Since the issue was first raised by Ronald Coase in the 1930s, academic economists have developed increasingly sophisticated theories of why firms exist, why some economic activity is organised within the market and some is organised within firms, and how the efficient boundaries of firms are determined.

Some economists would date the start of the modern theory of the firm from Knight (1921) rather than Coase (1937). Demsetz (1988: 244) goes so far as to state,

"[ ... ] it can be said without hesitation that Knight launched the modern theory of the firm in 1921".

I do sometimes wonder just how sophisticated even the modern theories of the firm really are. As Oliver Hart has written,

"[a]n outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are the engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth. Most formal models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organizations we see in the world. Furthermore, theories that attempt to incorporate real world features of corporations, partnerships and the like often lack precision and rigor, and have therefore failed, by and large, to be accepted by the theoretical mainstream". (Hart 1989: 1757).

In 2008 Hart said of the 1989 quote

"[t]he language of 1989 is strong, and I'd probably tone it down a bit now. There's been a lot of work in the last twenty years, and some progress. However, we are still not at the point where we have good models of the internal organization of large firms".

In section 2.3 Evans, Guthrie and Quigley write,

"The Treasury (1987:37-39) set out a transaction-cost and incentive-based theory of the limitations of state ownership. It motivated the benefits of private ownership by drawing attention to the agency problems associated with information acquisition and performance management under state ownership given the complex objectives of state entities and the absence of market monitoring and competition."

The problem with the complete contracts approach to ownership was not shown until the late 1980s when the ownership neutrality theorems started to appear. These theorems give conditions, in particular complete contracts, under which private or public ownership of productive assets is irrelevant for the allocation of resources. As Hart (2003) sums it up,

"One of the insights of the recent literature on the firm is that, if the only imperfections are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights')."

In section 2.4 Evans, Guthrie and Quigley outline what they see as some of the unresolved issues with public management,

• The boundaries between the state and the private sector, including:
  • the case for public investment where the private sector is unwilling to invest, and
  • the allocation of ownership and service delivery between the private and public sectors.
• The place of competition in the public sector and, in particular:
  
  • the role of competition in promoting greater efficiency in the delivery of services and the management of assets within the public sector, and between the public and private sectors, and
  • the balance between competitive discovery of efficient solutions to operational and organisational problems, and single national approaches to investment and public-sector infrastructure.
• 
  The need for stronger individual and organisational incentives for performance, and more effective mechanisms for the measurement and monitoring of that performance. Gill and Hitchener (2010:498) argue that while the vertical structures of accountability created under the Public Finance Act and the State Sector Act were designed to allow greater scrutiny of performance of ministers, chief executives and their departments or agencies, in practice there is relatively little use of performance information by central agencies, other than as a measure of bottom-line performance when things go wrong, and that this has tended to reinforce rather than mitigate the “well known bureaucratic pathologies of public organisations, in particular risk-averse, rule-driven behaviour.”
• The effectiveness of the governance and management of the public sector as a whole, including the role of advisory and governance boards, the central monitoring agencies, and the challenge of producing more effective mechanisms for solving problems and developing innovative new approaches to policy where policy issues span the mandates of multiple teams and multiple government organisations. Scott et al (2010) point out that there have been consistent concerns about the ability of the public sector to deliver quality and innovative policy advice on the big issues that are of relevance to multiple departments and entities.

The rest of the paper looks at the recent academic literature to search for answers to these problems.

More on chapter 3 of the paper later.