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PUBLIC ECONOMICS AND PUBLIC ADMINISTRATION Public administration has always overlapped economics.

Efficiency was the holy grail of the progressive officials and academics who created the modern discipline of public administration. They sought to place public affairs "on a strict business basis," directed "not by partisans, either Republican or Democrat, but by men ... skilled in business management and economics." Consequently, they created a professional bureaucracy to manage "the increased importance of the public functions of the twentieth century city. Streets had to be paved for newly developed motor vehicles; harbors had to be deepened for big, new freighters. In addition, electric lighting systems, street railways, sewage disposal plants, water supplies, and fire departments had to be installed or drastically improved to meet the needs of inhabitants, human and commercial, of hundreds of rapidly growing industrial centers" [Weinstein, 1968: 93-95; see also Rubin, 1993]. Moreover, establishing a professional bureaucracy at the municipal level did lead directly to higher levels of investment in infrastructure and, thereby, to significant increases in economic growth [Rauch, 1994; see also Mauro, 1995]. Organizational efficiency once meant the Weberian bureaucratic paradigm, which was codified for the public sector in the Taft, Brownlow, and Hoover Commission reports [Barzelay, 1992; see, for example, Blau & Meyer, 1971]. In the years following publication of the first Hoover Commission report, public administration did not abandon the bureaucratic paradigm, but it drifted away from economics. Public administrationists discovered organizational psychology and behavior. Many in the field rejected the distinction between politics and administration, with its stress on neutral competence. Some were intimidated by the mathematics used by the rational choice disciplines. And a few rejected the traditional goals of economy and efficiency on ideological grounds Public administration's drift away from economics was not entirely one-sided. Fifty years ago, most English speaking economists accepted Pigouvian welfare economics and Keynesian macroeconomics. They generally believed that government should set goals and objectives for the economy as a whole. Many admired the system of detailed centralized planning and control used by Gosplan in the Soviet Union to implement its long-term policies and strategic plans, an adaption of the Kriegwirtschaftsplan, the planning and control system used to mobilize Germany's resources during World War I -- i.e., Weberian bureaucracy carried to its ultimate conclusion. Indeed, Gosplan's approach was not unlike the planning and control mechanisms used in the United States and the United Kingdom to fight World War II. Gradually, however, most economists came to appreciate the dysfunctions produced by state allocation of productive assets and central planning and control and to recognize the impossibility of a Pigouvian social welfare function. For many this

appreciation was reflected in a commitment to markets over almost any system of hierarchy or command. It is hardly surprising that this commitment was inimical to the idea and practice of bureaucracy -- or almost any other kind of organization or regulation, for that matter. Public Administration's drift away from economics was interrupted temporarily by the flurry of excitement generated during the 1960s and early 1970s by program budgeting and systems analysis, the former grounded primarily in applied economics and the latter in operations research and management science, both rational choice disciplines. This period witnessed the publication of the work of Charles Hitch and Roland McKean [Hitch & McKean, 1960; Hitch, 1965; McKean, 1968], Jesse Burkhead and Jerry Miner's landmark text, Public Expenditure [1971], which focused on the supply and demand for governmentally provided goods and services, and other significant works concerned primarily with questions of resource allocation in the public sector -- mostly defense [Novick, 1965; Enke, 1967; Niskanen, 1967; Quade & Boucher, 1968; Fisher, 1970], but other areas as well [Schultze, 1968; Haveman & Margolis, 1970; Hirsch, 1970; Margolis, 1970; Williamson, 1970; Merewitz & Sosnick, 1971; Rivlin, 1971 & 1972; Quade, 1975]. This body of literature represents a mother lode of scholarship that still has not been adequately incorporated into public administration. At the same time, the topics raised by Hitch and McKean and their contemporaries have since been largely abandoned by economists and now find only occasional mention in standard textbooks in public finance/economics. Arguably, the defining moment for the relationship between public administration and economics came at the Minnowbrook conference in 1970. The conference proceedings, which announced the New Public Administration [Marini, 1971], included a respectful comment on PPBS [Planning Programming Budgeting Systems - an arrangement combining program budgeting and systems analysis (Parker, 1971)], but the rational choice theorists in attendance were roughly treated by the assembly and some claim virtually expelled from it. Their comments and Steven Bram's invited paper were subsequently deleted from the conference proceedings [Marini, 1971: 5]. Ultimately, the gulf between public administration and economics created a niche that two distinct intellectual hybrids vied to fill. The first of these hybrids involved the creation in 1965 of what has since come to be known as the Public Choice Society. The participants at its first two meetings included James Buchanan, Gordon Tullock, John Rawls, William Riker, Vincent Ostrom, Toby Davis, James Coleman, and Charles Plott. Public choice involves the application of economic logic -methodological individualism and rational, self-interested decision making -- to questions and issues that had traditionally been the concern of political scientists and public administrationists; it has been one the great success stories of modern social and economic science.

The second of these hybrids involved the establishment of schools of public policy at some America most prestigious universities: Harvard, Chicago, UC Berkeley, Duke, Carnegie-Mellon, etc. These schools placed the rational choice disciplines of economics and operations research/management science at the center of their curricula. They continue to benefit from the halo effect produced by their location at elite universities, but most now acknowledge that their defining mission -- training policy analysts -- was fundamentally misconceived. On balance, they have not been intellectual successes and their faculty members have generally sought intellectual refuge in their home disciplines. Given this history of continental drift, it is surprising, indeed, to find Zhiyong Lan and David Rosenbloom asserting in a recent editorial published in Public Administration Review[1992] that the discipline of public administration is undergoing a paradigm shift and that a rational-choice, economics-based paradigm has emerged preeminent. PUBLIC ADMINISTRATION IS NOT ECONOMICS Of course, Lan and Rosenbloom are wrong. The discipline of public administration may be undergoing a paradigm shift, but a rational-choice, economics-based paradigm has not emerged preeminent, at least not so far. There are at least three reasons why public administration cannot be economics [Zorn, 1989]. Public Administration is Prescriptive First, there is the basic difference between engineering and science [Behn, 1996]. Public administration is concerned with prescription -- the identification of normative rules for decision makers that would lead them to make decisions that are optimal from the standpoint of the citizenry as a whole. Economics is concerned with prediction -- the identification of rules decision makers are likely to follow, given their incentives. Bluntly put, public administrators solve problems; economists explain choices. Economic theory is useful to public administrators when it provides them with concepts they can use to diagnose problems accurately and to prescribe effective solutions to those problems -- i.e., concepts like opportunity costs, incentives, or capitalization that can be profitably applied to an array of problems frequently encountered by public administrators. But real-world problem solving also frequently raises questions of value and of right and wrong. Economic logic recognizes no good but efficiency, no evil aside from inefficiency [Box, 1992; Hood, 1995]. Morality ought to play an important role in the conduct of the public's business; economists often have trouble accounting for this simple fact.

Public Administration Is Realistic, Empirically Grounded, and Practical Second, economics is an a priori, theoretical discipline; public administration is concerned with "pragmatic reform." Economists build elegant, logically consistent deductive models; public administrators deal with messy, real-world problems. Indeed, it can be argued that economists prefer rational choice theories to models that incorporate bounded rationality primarily because they are conclusive, not because they are right. Decision makers can be approximately rational in a nearly infinite number of ways; they can be rational in only one. This difference between economists and public administrators is illustrated by the way they deal with the problem of voluntary provision of collective goods. Economists define a collective [or public] good in terms of two properties: jointness of supply and impossibility of exclusion. This means that once a collective good is supplied by some of the members of a group, it may be enjoyed by all. From this premise they deduce that the decision of some of the members of a group to provide the good or some quantity of it for themselves presents each of the other members with an opportunity for strategic behavior. Since the other members of the group can profitably engage in strategic behavior, economists conclude that they will. If the other members of the group can share in the good regardless of their contributions, economists predict that they will withhold or reduce their own contributions to its provision. Hence, the decision by some of the members of a group to supply a quantity of a collective good leads other members to "free-ride" on their contributions -- which is to say that, if contributions are voluntary, collective goods will be under provided or, in the extreme, not be provided at all [see Breton, 1989]. Crime control aptly illustrates this situation. Citizens can affect the level of crime in their community in two ways: by limiting their exposure to risk and protecting their property, and by helping the police fight crime. If their possessions or personal security matter enough to them, individuals may see a direct material benefit from investing in locks, guns, guard dogs, or security systems. They may even see the benefit from participating in volunteer citizen block-watches or banding together to patrol their own streets or financing a private security force to do so. The authorities can encourage these kinds of activities by providing guidance and technical assistance, by passing out police whistles, by urging people to mark their property so that it can be more easily identified when stolen, by helping to organize block watches, by setting up emergency call systems tied to rapid response, and by positioning themselves to provide back-up to private efforts. However, self-defense alone will not control crime. Criminals must be identified, apprehended, and convicted. The police necessarily depend upon the citizenry to alert them to crime and to aid them in the conviction of criminals. Unfortunately, only

breathing humans. with living. and convict their assailants.. As the result of a careful study of beekeeping and apple-growing practices in Washington State. though of great value to their community. Hence. since the harm has already been done and the criminal justice system seldom provides restitution. In contrast. Cheung concluded that free riding may not be a serious problem among real apple growers and beekeepers [see also Ostrom. 1989]. beekeeping must be undersupplied. Breton. citizens rarely individually benefit from helping the police identify.where their safety or that of their loved ones is at risk or where their property is threatened will private citizens realize a direct benefit from intervening to stop in crimes in progress. but they interpret this as problem to be solved rather than a necessary fact of life. 1990. 1989]. the propensity of economists to confuse a perfectly useful analytic construct. Cheung found a long history of contractual relationships between apple growers and beekeepers. in part. Cheung. the behavior expected of citizens.N. And even where they have been personally victimized. et al. public administrators recognize that citizens often free-ride on the efforts of their neighbors. Given the opportunity to ride free. individuals often shirk these onerous civic responsibilities. 1994. In these instances. Hence. in the presence of collective goods. he must be forced to do so.S. These contracts provided for beekeepers to be compensated for their contribution to the growers' apple crops. Apple growers who did not abide by the covenant were ostracized and treated to inconveniences by those who did. Economic man is a rational fool. economists taught that beekeeping is a collective good and that. This mind set reflects. then an assistant professor of economics at the University of Washington. citizens must be coerced to perform their civic responsibilities [Breton. economic man. since fruit growers can rely on their neighbors' bees to pollinate their blossoms. Many economists insist that. otherwise jointly provided services will necessarily be undersupplied. He also found that apple growers implicitly covenanted with their neighbors to keep the same ratio of bees to trees. S. . This mind set also reflects a propensity to overlook the vitality of human ingenuity in designing social arrangements and to ignore the availability of motivational alternatives to coercion. Beekeeping provides the classic example of the failure to distinguish between economic theory and reality. apprehend. is not personally rewarding in an obvious way. 1983]. he will. Ostrom. most growers will. trying to freeride on the efforts of their neighbors. Since economic man will not voluntarily cooperate with his neighbors to provide public or collective goods. Consequently. did something that was rather extraordinary: he left his armchair to find out whether beekeeping is actually undersupplied [Cheung. Once upon a time.

of course. public administration is preoccupied with identifying decision rules that citizens would unanimously support. or simply fixed rules of thumb for individual behavior. 1990]. must be charged with mobilizing the community on the behalf of the public good. the USDA provided growers with a powerful collective sanction against free riders in the form of marketing orders and quota. Furthermore.The primary point that Cheung was trying to make is that real people are not rational fools. This information gave apple growers a solid technical basis for group norms governing the behavior of individual growers. organizing provision of the good. and defectors sanctioned [see Heckathorn and Maser. In practice this means that. individual contributions established. A second lesson to be drawn from the fable of the bees is that neither community norms nor the collective enforcement of those norms just happened. In so doing. Moreover. it follows that someone. the last and most important lesson of the fable of the bees: voluntary provision can be organized and must be managed. 1989. These conventions can take the form of ethical precepts. Knowledge of what to do and how to do it was provided by field agents of the United States Department of Agriculture's [USDA] Extension Service. Moreover. regularities imposed by institutions. group norms can be collectively enforced through the ostracism of those who fail to contribute and praise for those who do. performance monitored. They often do contribute voluntarily to the provision of collective goods [Ostrom. 1994]. Free riders were not merely subject to social ostracism. Maser. the other growers could have actually denied them access to the most lucrative markets. Technical inefficiency means that managers fail to minimize cost or maximize output because they aren't . public administrators are usually more comfortable condemning technical than allocative efficiency. The point is that voluntary contributions to the provision of public goods don't just spontaneously occur. just as economists don't like to make value judgments. and supervising enforcement of community norms [Powers & Thompson. creating incentives. the field agents could identify shirkers and the subsequent shortfall in the provision of bees that had to be made good by the rest of the community. opportunities for collectively beneficial action must be identified. They also played a role in monitoring compliance with group norms and in passing that information along to growers. Public Administrators are Preoccupied with Technical Efficiency There is a third reason why public administration is not economics. Because management implies a manager. As a normative discipline. usually a public official. The field agents determined how many hives were needed and fairly apportioned responsibility for their provision. social conventions or group norms can discourage freeriding and reduce shirking. 1986]. This is.

the people who produce information do not process it. let alone repeated at every level of the organization. Processing is handled by financial management specialists from the bottom of the organization at the top. Ignorance is Protean. organization theorists. accounts for its purchases with how the Navy handles accounts payable illustrates technical inefficiency. there are only a few ways to do right. Computerization could eliminate more than half of the steps in the Navy's accounts payable process [Hemingway. maybe accountants. Instead. 1993: 25]. but they tend to explain it in terms of structural or other factors [e. While the efforts of economists to understand managerial failure has in recent years produced some powerful new theories and concepts that can that can help public administrators deal with a variety of problems [see below]. Even in peacetime their effectiveness in managing resources often has little or no bearing on the evaluation of their performance. Not so long ago. But why are fourteen. the Navy does not build financial control into its job designs. Finally. accounting records needed where Ford gets by with three? One answer is that Navy fails to capture information once and at the source. each step in the supply process -.. For example. 1990: 104.requisition. Until recently. Moreover.using the best available technology. According to the National Performance Review. it causes delays in obtaining repair parts that keep a high proportion of the Navy's cars and trucks out of commission and forces the taxpayer to fund ten percent more vehicles than the Navy really needs [Gore 1993: 12]. Naval officers have little discretion as to the mix or quantity of resources used by their commands.thirty-five steps in all -. it often leads to bad service and excessive investment in inventories. not merely in theory. In contrast. means in practice. 1993: 8-12]. certification of invoice. economists still tend to overlook the most common cause of technical inefficiency: ignorance. A comparison of how Ford Motor Co. there are an infinite number of ways to screw up. Technology means not only plant and equipment. it takes the Navy twenty-six manual accounting transactions and nine reconciliations -. but also the methods used to coordinate activities and to motivate performance. Ford cut the required number of manual accounting transactions to pay for goods from nine to three. As they say in the Navy. This system is not only time consuming. lack of competitive pressure] that are beyond the control of managers. the Navy's Byzantine system of accounting is arguably an unintended consequence of the Anti- . most economists assumed that technical efficiency was someone else's concern: engineers. Nowadays they understand that technical inefficiency is often far more important than allocative inefficiency. Best available.g. permitting a 75 percent staff reduction in its accounts payable department [Hammer. reconciliation. receipt. 107].to process and pay for things [Hemingway. or even public administrationists. and revision -.

for example. Economics teaches.769 accounting lines. In this case. also often results in allocative inefficiency. They give too much weight to current costs and benefits and too little to future ones. they often put off investment programs that would produce net benefits or they stretch out programs.C. Both over. John Mendeloff [1988] has shown how this propensity leads OSHA to over-regulate and how overregulation leads to underregulation." It is not hard to find instances of allocative inefficiency in government or to identify some fairly common pathologies that induce it. who object to private monopolies.S. Consequently. net benefits are forfeit [net benefits = willingness and ability to pay . Why is this is bad? It is bad. not because their prices are too high. OSHA overregulates exposures to harmful chemicals in the workplace because it . even where production is technically efficient. and 1. over the past two decades. the interest upon which is now running about six percent per year. for example. Economists refer to foregone net benefits as "deadweight loss. In several instances this has had the result of increasing the present value costs of the total production run by more than 100 percent.Deficiency Act [33 U. the federal government was willing to trade huge future liabilities for small current reductions in the growth of the national debt. especially administrative and economic feasibility. But governments often appear to be obsessed with the timing of outlays. be acknowledged that a preoccupation with technical efficiency leads public administration to slight allocative efficiency. At the same time it should. It is of special concern to economists. §1214. Hence.cost > 0]. in the presence of a capital market where funds can be obtained at a price. because consumers would willingly pay more for the things that aren't being produced than it would cost to make them. that. thereby increasing their costs. That authority is now divided into fifty separate accounts. For example. For example. Government's propensity to disregard questions of feasibility. in order to comply with arbitrary spending constraints. According to Mendeloff. perhaps. Allocative efficiency has to do with matching supply to demand. the welfare of the citizenry will be maximized by the implementation of all projects offering positive net present values. Why? To reduce the annual deficit. This means that the timing of benefit/cost flows usually does not matter so long as future benefits and costs are properly discounted. The system was designed to insure that neither local commanders nor higher level authorities exceeded the obligational authority granted them by Congress. 1257 (1905)]. the Department of Defense has reduced production rates for a variety of weapons systems below minimum optimal scale. but because they produce less than they would under competition.and underregulation are examples of allocative inefficiency. 557 management codes.

000 times greater than benefits. economics seems much more directly relevant to the concerns of public administration than in the recent past. This necessarily results in allocative inefficiency. In the case of its proposed formaldehyde standard. some people still have trouble seeing a relationship between low grazing fees on BLM land and overgrazing. The opportunity cost of overregulation can. economics-based paradigm has emerged preeminent in American political science. nearly all of OSHA's discretionary resources have been absorbed defending standards that govern a mere handful of hazardous substances. 155-185]. I will deal with the first of these two issues briefly. between low prices for agricultural water and wasteful farm irrigation practices or urban water scarcity. Fortunately. not too strong to say that a rational-choice. Morrall III [1986] estimates that as a consequence OSHA's proposed standards impose costs on industry that typically exceed benefits by a factor of ten. Public administrators ignore allocative efficiency at their peril. subfields that are closely related to public administration. or political measure that might conceivably prevent. many in the field now reject the traditional bureaucratic paradigm. administrative. A paradigm shift seems to be in the works. or between agricultural price supports and food surpluses. including bureaucracy and public policy. and advances in economic science." THE RENEWAL OF INTEREST IN ECONOMICS Of course. Not surprisingly. but it is no great honor either. costs were 25. The remainder of this essay will focus on the last. Government also has a propensity to disregard the incentive effects of the prices it sets. therefore. Consequently. Moreover. delay. between low timber harvest fees and overlogging. John F. An unbiased observer would have to acknowledge. be seen in the workers who are exposed to hundreds of underregulated substances because the resources needed to revise standards are simply not available. perhaps. or overturn promulgation of new standards. at least. A preoccupation with technical efficiency. this propensity seems to be waning. changes in the environment of public administration. Nevertheless. like poverty. Political Science It is. In my opinion this is a healthy turn of events.often sets standards without regard to the benefits and costs of reducing hazards to those levels [pp. There are three not entirely unrelated reasons for these changes: changing styles in political science. between the low landing fees charged private planes and airport overcrowding. these costs have inspired industry to embrace every legal. may be "no sin. . observers as perceptive as Lan and Rosenbloom could not have concluded that economics has emerged as public administration's preeminent paradigm unless their claim held a kernel of truth.

1995. not simply a shift towards less state. the use of quasi-markets and contracting out to foster competition. The efficacy of decentralized allocation of resources and after-the-fact control has . He stresses that many of the governments that have embraced the new public management are or were dominated by social democrats. 3. They come and they go. 1991. Barzelay. Reductions in information costs brought about by computers and computer networks and our increased capacity to use them have caused four major shifts in the comparative advantage of governance mechanisms and institutional arrangements. public administration more often than not catches a cold. forthcoming]: 1. Nevertheless. The efficacy of the market has increased relative to government provision and control. Osborne and Gaebler. for example. like most of the humanities and social sciences. and a style of management which emphasizes amongst other things. 1993]. Just as academics of past generations usually seem wrong-headed to us. the disaggregation of public bureaucracies into agencies which deal with each other on a user-pay basis." He attributes this shift to international market pressures. so too are we likely to appear to the next. The new public management emphasizes "performance appraisal and efficiency. The new public management is a worldwide movement [Rhodes. 2. but also a shift to a different kind of state. It is natural that we think of ourselves as the tip of progress's arrow. Arguably. output targets. claims that government is undergoing "a profound shift toward a new kind of regime . 1992]. monetary targets and incentives. but intellectual history demands a more humble interpretation. The efficacy of the market and other self-organizing systems has increased relative to hierarchically coordinated systems. limited term contracts. that political science. often leaving little or nothing behind in the way of accumulated knowledge. is prone to academic fads. is a prominent example [see below]..however. These are [see Reschenthaler and Thompson. 1991: 11. Schedler. 1994]. Political science has sneezed.. and freedom to manage" [Rhodes. it represents a paradigm shift in public administration. 1991. when political science sneezes. The driving force behind the new public management is technological change. which under Labour governments has gone further than any other country in its embrace of the new public management. Changes in the Environment of Public Administration Public administration in the United States has also been influenced by the "new public management" [Gore. see also Hood. cost-cutting. for good or ill.. 1992. Dunleavy & Hood. Herman Schwartz [1994]. New Zealand.

These changes are hardly surprising. The efficacy of process-oriented structures has increased relative to functional structures. allocated scarce resources to administrative units. after all.E. only very large organizations could take full advantage of the bureaucratic revolution. As late as 1892. Birdsall [1986: 235-37] explain. Only they could be completely vertically integrated or afford to devote substantial amounts of resources to gathering and processing quantities of data for top management to use to coordinate activities. Today. for example. allocate resources. most of the entrepreneurs of the Industrial Revolution were merchants and financiers -.these are. and direct employment could not have become a general practice until recruiting. the comparative advantage of any institutional arrangement boils down to a question of information or transaction costs. for example. "The organization of the work of large numbers of employees was a new management function. which broke tasks down into their simplest component parts and recombined them to produce complex goods and services. fixed costs. As Nathan Rosenberg and L." Of course.increased relative to centralized allocation and before-the-fact control. thereby.000] can have first-class administrative systems. over larger volumes of output.sequentially combining highly specialized functional units in multifarious ways to produce a variety of products.they knew little or nothing about production. hierarchy and bureaucracy were made possible by innovations in organizational design. Economies of scope are produced by exploiting the division of labor -. and marketing and. were once justified by economies of scale and scope. organizing. and established product-market strategies. Business did not learn how to organize and supervise large numbers of workers until the mid 19th century. ranging from purchasing and inventory control to human resources management to financial planning and capital . administrative controls. and 4. and set strategy -. Large organizations. especially investments in plant and equipment and the organization of production lines. 1962]. they contribute nothing directly to output. thereby reducing unit costs. Changes in information costs should and have dramatically altered the relative advantage of governance mechanisms and institutional arrangements. Carnegie Steel avoided the problem of organizing and managing the work of its production employees. Economies of scale are produced by spreading fixed expenses. and supervising factory workers been sorted out and fitted into a hierarchical scheme. In turn. and operational engineering [Chandler. the comparative advantage of hierarchy and bureaucracy. production. As will be explained below. Economies of scale and scope were made possible by hierarchy and bureaucracy. The computer is rapidly eroding economies of scale in administration. any organization that can afford a computer workstation and software [about $20.

and its customer relationships -.not output volume. including the costs of holding materials. [and] they are putting a computer on every desk and giving power to front-line workers. To create value from information. authority. Universal product codes and optical scanning devices permit continuous monitoring and. To control overheads. computerized production [which consists of machine tools or other equipment for fabrication. and operating as an integrated system under full programmable control] now permits organizations to produce customized services at mass-production prices.budgeting to marketing and logistics." As Shoshana Zuboff explains [1988: 204].." .concentrating on their core businesses and contracting everything else out. Large companies are "mimicking their smaller competitors by shrinking their head offices. removing layers of bureaucracy and breaking themselves up into constellations of profit centers. members of the organization must be given the opportunity to know more and do more. and finished goods inventories. therefore. direct manufacturing labor often accounts for less than 5 percent of costs. June 24. As a result of the declining importance of economies of scale in production. materials handling. and especially product designers and engineers on controlling overheads. In computerized production facilities. rate. marketing. they are 'sticking to their knitting' -. marketing and manufacturing teams. the average size of the workplace has been falling throughout the industrialized world for the last twenty years [Economist. Again.. this is feasible because technology generates information about underlying productive processes. assembly or treatment. or even mix. not surprisingly. Two tools have been critical to this effort: cycle-time burdening and transaction cost accounting [activitybased costing]. Twenty years ago these systems were available only to giant organizations. realtime reprogramming of the production process. Moreover. Most overheads are transaction or information costs. This means "dismantling the very same managerial hierarchy that once brought greatness. 1995: 4-6 Survey]. and responsibility. accounting. linked by a materials handling system to move parts from one work station to another.. They involve activities like purchasing. This leaves at least fifty-five percent for overheads. and asset utilization. efficient operations in the modern workplace call for a more equal distribution of knowledge. .. many organizations have adopted techniques like lean manufacturing and just-in-time delivery of parts and materials. overheads are more important than production volume. . They have also modified their managerial cost accounting systems to focus the attention of responsibility center managers. They are driven by an organization's policies. In these facilities. Computer-assisted-design programs also produce cycle-time and transactions costs estimates. its operating and administrative procedures. materials and purchased components typically account for thirty to forty percent more. parts.

and others. and budgeting]. Frederick Taylor." that bigger is better.K. Now changes are taking place in what managers do and how organizations are put together -. but because they face similar problems and the business-management literature is full of ideas that seem relevant to meeting these new challenges. Luther Gulick. public choice theory has given public . Alfred Chandler. Fitch. pragmatic disciplines [Hammond. Robert Kaplan and Robin Cooper. Moreover. Public choice theory has changed the way we think about government and how it works. and Peter M. We both taught that bureaucracy is the solution to the "problem of maximizing organizational efficiency. Besides. Advances in Economics While the business-management literature is central to the new public management. that organizations should be functionally differentiated and vertically integrated. C. two bodies of economic literature have also profoundly influenced its reception and its implementation: public choice theory and the new economics of organization.All of this looks like economics to many noneconomists. reporting. The intellectual justification for these changes comes primarily from management thinkers such as Peter Drucker. and most centralized resource allocation and staff services. and bureaucrats are likely to follow given their incentives. Robert Anthony. Senge. 1990]. organizing. Kenichi Ohmae. Sloan Management Review. and Management Accounting. 1990. and developing] and low level management tasks [controlling. Phillip Selznick. in explaining the rules that voters. Thomas Peters. Joseph Bower. Prahaladad and Gary Hamel. Mary Parker Follett. as well as a recent phenomenon for the discipline of public administration. Henri Fayol. large organizations in both the public and the private sectors were fundamentally alike. not the American Economic Review or even the Journal of Economic Behavior and Organization. operating. Many public administrators now read these journals and have tried to use the new tools in their organizations -. Henry Mintzberg. staffing. but it is really not. The new public managers are interested in the way business does things. business schools and schools of public administration once shared the same proverbs of administration. and that top management always knows best.hence the new public management. Borrowing from the business-management literature is an old custom. elected officials. Theodore Levitt.even in what they are. Moreover. most distinguished between high-level management tasks [planning. Most were hierarchies. just as we shared the Weberian bureaucratic paradigm and a common intellectual foundation in the works of Chester Barnard. The informational and organizational tools used in making these changes are described in the Harvard Business Review. not because it is better than government. Business administration and public administration are both prescriptive.

and incentive compatibility that are directly relevant to managerial problems. implicit contracts. Ron Wintrobe. develop budgets based upon results. The economics of organization has already influenced the design of a variety of institutional arrangements [ranging from emissions trading and "bubbles" to outright deregulation of the airlines and interstate trucking] in the United States and the privatization and securitization of an astonishing array of government-owned assets [and some liabilities] in Europe. and the size of the market for the good. Harold Demsetz. After all. asymmetric information -. and adverse selection. search and signaling theory. moral hazard. the theory of demand for a collectively provided good is identical to the theory of consumer demand for a private good. in many cases.including agency theory. a good normative model is merely a good positive model run backwards. In both instances. William Baumol. Nevertheless. It provides the new public management with the solid analytical foundation needed to understand how. incomplete contracts. externality. therefore. demand reflects individual willingness and ability to pay to consume a good or service. Albert Breton. Total demand for the service is. when. like the older normative theory of public finance from which it evolved. With two exceptions. assumed to be a decreasing function of the price of the good. when public administrators look to advances in economic science for help. It is partly because of this evidence that the ideas of the new public managers command the attention they do. expose operations to competition. contract theory. transaction costs. incentive contracts. Gordon Tullock and especially Ronald Coase and Oliver Williamson. or use quasimarkets and contracting out to foster competition. replace rules and regulations with incentives. Victor Goldberg. search for market rather than administrative solutions. starts with the demand for and the supply of collectively provided goods and services. the evidence is accumulating that these arrangements work. Michael Jensen. it is not primarily to the public choice literature that they turn to. but the new economics of organization. It is the legacy of economists like Kenneth Arrow. PUBLIC CHOICE THEORY Public choice theory. an increasing function of consumer income. The new economics of organization focuses on incentive and control structures and on the allocation of property rights and the ownership so as to minimize intraorganizational externalities or spillovers. The two differences between the theory of demand for a collectively provided good and the theory of consumer demand for a private good are that the quantity of service provided within a jurisdiction is determined by a .administrators some useful new normative information. and where to delegate authority. Paul Milgrom. Moreover. William Niskanen. It comprehends concepts like the Coase Theorem. team theory.

and population size [C]. and population served better explain cross-sectional variations in collectively supplied service levels that any other set of "determinants" [Oates. That is: intergovernmental grants appear to produce far larger increases in the output of government services than predicted by the income and price elasticities of the basic demand model. the quantity demanded of a collectively provided service will depend upon its price [P]. and is necessarily uniform throughout the jurisdiction. a = the income elasticity of demand for good i.. 1994. usually assumed to be some form of majority rule. the permanent income of the citizenry [Y]. Hence. and b = a value from 0 to 1. tax price. Rubinfeld.g. e. Inman. 1978. 1977. see also Bergstrom & Goodman. The one bug in the ointment is the "flypaper effect. Di should reflect the tastes and elasticities of the median voter [Bowen." so called because intergovernmental transfers tend to stick where they land [Oates. Ladd. Romer. & 1989. community size. 1992]. i. 1991. 1994. reflect existing political institutions as well as culturally mediated tastes and preferences [Breton. Romer & Rosenthal.e. 1986. 1994. 1989]. The Median Voter and Bowen Equilibrium In democracy. 1943] and would be in equilibrium where: Vm = Tm where: Vm = the marginal benefit of good or service i to the median voter m Tm = the marginal cost of good or service i to the median voter m . Duncombe. Of course these variables work best where service levels are determined by direct referenda [Holcombe. [This formulation is outlined in Borcherding. 1972]. 1982]. Cb] where: e = the price elasticity of demand for good i. 1977. of course. There is a fair amount of evidence that this model of voter demand for collectively provided goods works reasonably well in practice. The functional relationship that would obtain in any particular case would. Literally hundreds of studies have demonstrated that family/per capita income.political process. 1994]. Ya. representing the degree of publicness of good i.: Di = f [Pe.

however. reliance on the property tax reduces differences between the mean and the median voter even in the absence of Tiebout sorting. where the cost of the good is equally shared by all voters [n]. 1990]. The key point to be stressed here is. because. that. to the extant that service and tax levels are capitalized in real property values. federal levels of government. perhaps. and Helen F. where the sum of the marginal costs of providing the collective good equals the sum of marginal benefits to all contributors.e. Taylor. claims that the evidence from zoning and voting demonstrates that it is fairly complete. While most economists grant that Tiebout sorting takes place. is: it follows. claim that the evidence from tax-capitalization is equivocal. . perhaps. Deller. 1989. 1955]. willingness. 1956] in which voters move to the communities whose governments best satisfy their preferences for collectively provided goods and services [Zax. see. 195960]. collectively provided goods will tend to be undersupplied. Tiebout. and ability to pay of all the voters in a jurisdiction are practically identical. This is of course something of a "knife-edged condition.. William Fishel [1992]. the average voter's demand for collectively provided goods will normally exceed the preferred consumption level of the median voter. Bloom. Hoyt. the following condition would have to be satisfied: Consequently a Bowen equilibrium will be efficient if and only if marginal net benefits sum to zero at the output or supply level preferred by the median voter. Howard S. the marginal cost/benefit to the average voter would have to be equal to the marginal benefit/cost to the median voter. where costs are equally shared or. it follows that the marginal cost of the good to all voters is: Since the Samuelsonian efficiency condition [1954. Ladd [1988]. as Bowen explained [his conclusion was later popularized by Downs. John Yinger. 1990b. however. 1991. One mechanism that might lead to the satisfaction of this condition is Tiebout sorting [named after the late Charles M. i. at the local level. for example.Then. even where taxes are proportional to income. This is a significant claim. Axel Borsch-Supan. for a Bowen equilibrium to be efficient. there is little consensus as to its significance." except where the tastes. 1990a. Reliance on proportional or progressive income taxes probably has a similar effect at state and. This means that in a democracy.

This structure was intended to insure that the United States would have a government of law and that the law would change slowly and incrementally and only when the direction of change was endorsed by a large majority .. albeit not this formulation. This voting rule is seldom used. thereby. i will want.There is evidence that Bowen/Downs undersupply does occur. however. Lindahl equilibrium is defined as a vector of expenditure shares [S1. 1995] hypothesis that. the passions of minorities. and property from the overweening ambitions of a reckless and extravagant executive.e.e. Unanimity can be satisfied under Lindahl equilibrium [Feldman. James Buchanan and Gordon Tullock [1962] suggest that an optimal constitution would minimize the sum of the costs imposed upon dissatisfied minorities. Before Serrano. Silva and Sonstelie found that one-half of this decline could be attributed to Serrano.. the quantity of the good desired is D* [i. Indeed. in mind. the higher i's share Si. and the interests of narrow or temporary majorities. 1986]. demand for all i is presumed to be normal. an increasing of function. reducing Tiebout sorting and widening the gap between the preferences of the average and the median voter. ten percent below the average.. bargaining. a decreasing function of the size of required majorities.. Formally. Furthermore: Under this formulation. the lower the D. The founding fathers designed the federal Constitution to protect lives. the California Supreme Court in Serrano v. Hence. California ranked 11th among states in public school spending per pupil. Because of this fact. 13 percent above the average of all other states.S2. a special case of the Samuelsonian efficiency condition. the share of all other i would increase and D1 > D2. …Si = 1]. example. They attributed the remainder to rapid enrollment growth during the l980]. For. by requiring equal spending per pupil across all school districts in the state and. and monitoring costs [Heckathorn & Maser. Americans have tried to design a constitutional order with this goal. because i's expenditure or Ti is SiD*.. if the Lindahl equilibrium were D1 and one i reduced their contribution to the provision of the good. where i's expenditure share is Si. at least in theory: where decisions about collective provision are made unanimously. By 1990. i. Lindahl Equilibrium There is a second condition whereby the knife-edged condition described earlier might obtain.. California had fallen to 30th. Fabio Silva and Jon Sonstelie [1995] recently tested William Fischel's [1989. liberties. 1989. Priest caused a reduction in public spending to support elementary and secondary education. and transactions costs.Sn] and a level of provision [D*] such that for all i. because of the transactions costs associated with finding Lindahl equilibrium -. Maser.

] is one way to deal with this market failure. Unfortunately. Consider. Bell. in this case. M's export all theirs to N's. M. In this example the efficient solution is at xopt.except where prevented by restrictions on side payments. and xhi for N. Each represents a smog producing district.although. Legislative Decision Making Representation promotes efficiency in two other ways. . and N. 1979]. and N's keep all the smog they produce. This example also clearly illustrates the typical gap between xmed and xopt -. 1990. any decision rule will produce an efficient outcome -. & N must deal with is underinvestment in maintenance of automotive smog control devices. where benefits and costs are denominated in dollars and knowledge of the netbenefit schedule of each voter/legislator is equally available to all [Shepsle & Weingast. it transforms some public goods. or just plain ignorance [Dahlman. M. transactions costs. 1960]. The founding fathers relied upon partisanship. 1984]. efficiency should be easy to arrive at. plus that which they import from X's and M's constituents. xmed for M. however. option that equates T and V for the median voter in their constituencies: zero for X. the cost of maintaining this equipment is very low. Once the public goods problem is laid to rest. According to the Coase Theorem [Coase. into private goods. Vm and Vn equals MC. since individuals bear the cost of maintenance. they have no incentive to do so. But since each legislator prefers the I&M. option. Second. First of all it minimizes the transactions costs of political participation [economists see participation as cost. not a benefit]. X's constituents export all of their smog to M's. xmed is closer in xopt than zero [see also Nelson. for example. where we are dealing with private goods and decisions are made one good at a time. The problem that X. 1989]. Compulsory inspection and maintenance [I&M. but the benefit thereby produced accrues primarily to others. Figure 1 illustrates the political calculus associated with a typical compulsory I&M. where each individual voter's preferences are known only to himself or herself and costs are shared. This is a real market failure: smog control devices work properly only when they are properly maintained. 1979]. one of which is that it can be assumed to impose roughly equal costs on voters in each constituency. at least compared to other equally effective means of abating pollution. The result is underinvestment. where the vertical sum of Vx. and the particularities of committee interests to make the federal government an agent of negotiation and compromise that would reach its decisions through the discovery of a lowest common denominator [Thompson.of the citizenry. the following problem: there are three legislators: X. It is an attractive example for our purposes for a number of reasons. jealousy between the two chambers of Congress.

it is frequently far harder to design a practical program to implement one [e. What they want to do is explain what they observe: an excess of .[Figure 1 goes about here] What happens when this problem is approached in a Coasian manner. Simple human fallibility goes a long way toward explaining this fact. The Coase theorem merely states that. Of course. the solution they choose will be efficient. I&M.. but it may also be available to none. Hence. individually and. 1982]. Hahn and Noll. collectively. the situation outlined in Figure 2 would obtain. searching at the margin for Pareto superior moves? For example. Like the rest of us. Explaining Oversupply The basic model for a collectively provided good implies the likelihood of undersupply. To many public choice theorists this likelihood appears to fly in the face of reality. real legislators do not always behave like Coasian paragons. where decision makers are not constrained in their search for a solution.] [Figures 2 and 3 about here] Note that this solution has the attractive quality of making all three legislators better off than they would have been under the solution shown in Figure 1. it is not surprising that legislators fail to behave like Coasian paragons.g. [Figure 3 shows the same circumstances in preference space and demonstrates that the efficient solution obtained in Figure 2 is also the Bowen Equilibrium. These bribes could be financed by a property tax levied on N's district. but it is only one of possibly many Coasian solutions to the problem of underinvestment in the maintenance of smog control equipment. they make mistakes. consequently. Automobile operators could be bribed to have their vehicles inspected and to achieve high maintenance scores at inspection. It is easy to conceptualize a Coasian solution to a problem of market failure. Under these circumstances. Information on the incidence of benefits and costs of a proposal may be equally available to all. does not have to be compulsory to be effective.

Of course. Hird. the concentration of benefits produced by those policies. 1974. geographically-targeted benefits and predominantly federally-financed costs (Ferejohn. The theory predicts that politicians will use their power to transfer income from those with less political power to those with more: from the rich and the poor to the middle class and from disorganized. The economic theory of interest-group politics is largely the creation of the "Chicago school" of regulatory theorists: George Stigler [1971]. tariffs and import quotas. economists brought Mancur Olson's theory of collective action to bear upon the question of interest group influence on the public policy process. 1991]. These are the interest-group theory of politics and William Niskanen's theory of spending coalitions. that elected official are exclusively concerned with maximizing the probability of their reelection." This focused attention on public policies that could deny benefits to nonparticipants. 1965. and Sam Peltzman [1976]. most regulation of business. Two serious attempts to explain government excess have been mounted and. and members of groups. What was new about the economic theory of interest-group politics? First. 1974]. and the support thresholds required to claim those benefits. diffuse interests to well-organized concentrated interests [e. and the structure of the tax system] are the product of an exchange between elected officials. military procurement.g. . who receive votes and campaign contributions. Who gets what depends upon the costs and benefits to individual group members of participating in political processes and the ability of groups to influence policy makers. 1991)]. They argued that a variety of government programs [agricultural subsidies. voting. Shepsle & Weingast. Third. which introduced the notions of structurally induced equilibrium and agency theory to the study of politics and bureaucracy. Olson & Zeckhauser. who reap higher incomes from their political investment. political scientists have known about interest groups for generations..] imposed private costs upon the participant but tended to create benefits that were nonexclusive. economists based their theory on an assumption that is often wrong. Richard Posner [1971. 1981. which in turn led to free-riding and the "exploitation of great by the small. Olson demonstrated [Olson. which focused attention on the size of individual payoffs rather than the wealth of the player. etc. 1966] that political participation [interest-group activity. which is an increasing function of interest group support [since citizens won't even vote unless they are persuaded to do so by campaign advertising and workers]. while neither entirely succeeds.government [Coughlin. both have taught us something about government. but still might be of considerable utility in partial equilibrium analysis. Second. economists better understood the costs and benefits of government actions and their distributional consequences.

1991a&b. In a related vein. Indeed. for that matter. and Tullock. the inevitable result is a kind of policy gridlock. the rents created by government action are capitalized in asset prices. 198]. Tollison. maintenance.that doesn't seem to be the case [see Krueger 1974] -. Kalt & Zupan. tariffs. the rents created by government would be dissipated by the directly unproductive activities incurred to capture them. compared say to the presumption that legislators pursue their own notions of the common good [Peltzman. requires] so much more effort here than elsewhere. 1990. administrative. empirical tests of its basic assumptions and predictions seldom work very well. Gordon Tullock [1967] was probably the first scholar to think systematically about the consequences of rent-seeking.but that the creation. while it often tells a plausible story about existing public policies. What seems remarkable about the American political system is not that it produces more rents than in other countries -. especially real property values. if everyone could freely participate in the rush for the spoils. 1991. Both of which have been subsequently deregulated. an outsider cannot help but notice the amounts of money spent on campaigns for public office in this country or the resources employed to influence the legislative. each rent-seeker would expend the full amount of the potential transfer in its pursuit. if rents are extensive and efforts to retain them pervasive. and judicial processes. beyond some point. by diverting investment away from productive activities and inhibiting the process of creative destruction. or competed away. Indeed. Graddy.The biggest problem with the economic theory of interest-group politics is that. one should be mindful that the economic theory of interest-group politics was created primarily to explain government regulation of prices and entry in industries like trucking and airlines. Instead. of course. In which case. William Niskanen and the Budget Maximizing Bureaucrat . and distribution of rents attracts [or the gestation and implementation of any policy initiative.behavior aimed at getting or keeping rents. do not accrue to their nominal recipients [Buchanan. Mayer. import quota. 1984 & 1990. Tullock hypothesized that the waste involved in capturing rents could actually exceed the rent to be captured. Government created rents are often competed away because their existence leads to rent-seeking -. The one central claim of the economic theory of interest-group politics that has gone unchallenged is that many of the benefits of government action: tariffs. Mancur Olson [1982] argued that. pork barrel spending. which devours ever more resources in defense of the economic status quo. entirely wasteful. And. stultify change. reduces the rate of economic growth. in an implicit analogy to the effect of product differentiation in the economics of imperfect competition. and the like. and. He argued that. various types of price and entry control regulation. Most of these activities are directly unproductive and are. agricultural marketing orders.].

but insufficient condition for allocative inefficiency. 1990]. For example. 1984]. demonstrating. 1994 & 1995. demonstrated that the behavior of government officials. 1991] showed that a revenue-maximizing. are likely to be dominated by program advocates [for evidence on this point. Munger.e. 1993. Ferris & Graddy. Shepsle. 1979]. 1990. 1990]. 1976. There is now an extensive literature on structurally induced equilibrium [see Bendor. Blais & Dion. could be deduced from their tastes and opportunities and that this approach is more effective than assuming that they are merely well trained robots. among other things. Vm < Tm ]. 1991. Political scientists have embraced Niskanen's notion of structurally induced equilibrium.In a second attempt to explain government excess. Another widely-accepted conclusion is that an inability on the part of the legislature to achieve a stable . 1989. the effective legislative and budget agenda setters. the drafter can manipulate them to produce almost any outcome desired. anyone who leaps from the presumed monopoly power of bureaus to the allocative efficiency of government is undoubtedly over-reaching. if referenda are not carefully restricted to a single issue dimension. committees and subcommittees. Of course. Niskanen showed how the ability to control agendas presented to median voters could shift outcomes from their preferred positions. the median voter should prefer the higher spending level as long as total benefits exceeded total costs [ ÚVm > ÚTm]. Having said that. While there are. their agenda-setting powers are often limited. Niskanen's strictures against bureaucratic monopoly have probably had more influence on the theory and practice of public administration than any other idea drawn from the public choice literature [Ezzamel. McKelvey. see Shepsle. Miranda. perhaps [see Carroll. First of all he. William Niskanen. Finally. One conclusion that can be drawn from this literature is that. [1971. but Niskanen argued that in the American congressional system. single-product bureau with absolute monopoly and agenda-setting powers would be technically efficient but produce up to two times the optimal quantity of output. 1976. more than anyone else. like corporate bureaucrats. most use a variety of technologies to provide an array of services. 1993. too many monopoly bureaus. 1979. one must still recognize the remarkable scientific contribution made by Niskanen. and technical inefficiency is widespread. Chairman of the Cato Institute and former head of the President's Council of Economic Advisors. Mayston. Second. Niskanen adapted the structure-conductperformance paradigm from the industrial organization theory to the behavior of government bureaus. Rogerson. this same mechanism in the hands of a different agenda setter could lead to undersupply. primarily I think because it appeals to their concern with political institutions and their fascination with games of strategy. that monopoly supply is a necessary. confronted with a choice between nothing and a higher than preferred spending level [i. Hence. 1986.

see also Antoci. Schleifer. for examples. a while back L. 1986. has been largely superseded in the industrial-organization literature by a new technology of games under incomplete information [Tirole. 1977]. 1979]. the dichotomy between competitors and monopolists proposed by the structure-conduct-performance paradigm: price takers versus price setters. and reputation [Laffont & Tirole.even were there no problems measuring bureaucratic performance or designing incentive mechanisms [Hill. 1977]. Of course. however. control benefits and other nonpecuniary benefits. officials in central control agencies have taken the lead in promoting competition within government. Most. Knott & Miller. 1976. Both economists and political scientists have also recognized the decisive role played by individually motivated agents in the determination of bureaucratic outcomes. In both New Zealand and Australia. Contemporary models of bureaucracy stress the informational endowments of bureaucrats. 1993. Jones and I [Thompson & Jones. control benefits and other nonpecuniary benefits. But like the economic theory of interest-group politics. 1996. 1988]. with the central control office on one side and agencies on the other. 1974. they generally fail to yield successful empirical predictions beyond the ones for which they were custom tailored [see Conybeare. We assumed that budgeters were primarily interested in cutting budgets -. and reputation [see Thompson & Williams. In the meantime new theories have been developed that rely on a more careful or perhaps more imaginative description of bureaucratic tastes and opportunities. 1985. 1994. The typical outcomes of this model were less than optimal budgets and outputs and higher than minimum unit costs. .that is after all what they are paid to do -and that agency officials were motivated by a variety of considerations -. Santerre. McFadden. however. perquisite consumption. 1976. the implicit and explicit contracts that link their actions to rewards. 1991]. 1986] proposed a bilateral monopoly model of the budget process. De Fraja. perquisite consumption. McFadden. 1993.collective choice could be a source of considerable bureaucratic discretion -. If this model were generally valid. That does not always seem to be the case. Mehay. 1984]. 1990. McCubbins & Schwartz. question Niskanen's assumption that bureaucrats are revenue maximizers [Blais & Dion. Gemmell. 1995. 1985. The presumption that individuals within the State's administrative apparatus are single-mindedly driven to expand and protect existing programs and develop new programs of intervention has given way to the presumption that their utility functions might include some or more of the following arguments: effort and risk aversion. 1984. 1987]. For example. and their discretionary powers.task accomplishment. Whynes. Gonzalez & Mehay. The newer models of bureaucratic behavior often seem inherently plausible. Moreover. could is not the same as is [Langbein.R. both budgeteers and agency heads would consistently oppose competition whenever it raised its ugly head. Migue & Belanger. 1990. however. 1993.

and in ad hoc ways to protect or advance the interests of particular clients in particular matters. Government activities often are designed to interfere with efficient market solutions to resource allocation problems. Summing up Public choice theorists are often cynical about politics and pessimistic about the workings of government. instead. and clearly they are not small problems. [5] an environment pool that reflects the overall "quality" of the environment. if true. He claims that legislators shun serious policy control and. 1993]. Consequently. favor administrative controls that are ineffective by design. It is not a bad thing to look beneath the packaging [see Stanbury. if for no other reason than because it has been useful in promoting a healthy skepticism [not cynicism] about government and interest group demands. for example. Moreover. 1989]. than with what it buys for the public at large. and to tax reform can hardly be explained any other way. Moe argues that the rigidity characteristic of the American administrative process is largely the product of the efforts of temporary ruling coalitions to prevent future majorities from interfering with their handiwork [see also McCubbins. Noll. these policies show that ideas have force and that ". as Michael Trebilcock [1994] explains. especially legislators. 1990. except to the extent that self interest is defined to include an interest in the welfare of others [a tactic which has the effect of denying to public choice any Popperian bite whatsoever]. As Trebilcock puts it. Individuals and groups do often turn to government to obtain or preserve economic rents that would otherwise be unavailable to them. Cooley & Smith. inexpensively. [3] publicly owned natural resources. free riding. detailed object-of-expenditure budgets are the norm. and [6] the wealth of the . although the recent trend to privatization. They disallow any role for what Steve Kelman [1987] calls "public" or "civic" spirit. not including natural resources. Society has several common pools of wealth: [1] personal and business net assets... not for historical reasons." These problems aside. [4] the stock human capital. is partly about what are thought to be good ideas as well as what are thought to be politically salient interests. [2] government's net real and financial assets. seek "particularized" control because they "want to be able to intervene quickly. to an important extent. would render public choice an exercise in futility]. politics. & Weingast." Detailed rules that impose rigid limits on an agency's discretion and its procedures help to satisfy this appetite. what public choice theorists say about coalition formation. Moe [1990: 140. agenda setting. but because they are suited to the needs of temporary governing coalitions. 1989. 1989]. deregulation. public choice theorists implicitly reject the notion that ideas have power [which. Furthermore. see also Tabellini & Alesina. and bureaucracy is important. which are likely to be far more concerned with who gets public monies and where it goes. who argues that political authorities.Another example is due to Terry M.

Hence. individually and collectively.. externalities. Much the same logic applies to the choice between organizations and markets and the kinds of governance mechanisms used within organizations. for example -. for example. This situation is changing [e. the circumstances that create market failures: public goods.. the problems that justify government action in a capitalist economy. 1993. externalities could be eliminated by bargaining between self-interested individuals. of course. moral hazard and adverse selection. The wealth of future generations is. logically consistent deductive models created by the practitioners of the economics of organization is that many are neither empirically grounded nor very practical. Markets could deliver public goods. And. is merely a means by which stakeholder groups use the collective. Frant. when John Conybeare [1984] surveyed the literature on economic structure and performance in the public sector. but not very rapidly. and Barzel. One reason for this state of . without the intervention of government -.g. THE NEW ECONOMICS OF ORGANIZATION In a recent article. The problem with the elegant. 1982]. Moreover some groups are especially vulnerable to losses -. such as how public managers can break the micromanagement cycle of procedural rules and how they can measure the achievements of their agencies in ways that will help to increase those achievements. coercive power of government to tilt these pools in their direction. 1972. at its worst. Consumers and taxpayers. largely dependent upon the expansion of the first five pools. 1969. It seems likely that increased skepticism about existing institutional arrangements and governance mechanisms has encouraged experimentation with alternatives and increased receptivity to the lessons of the new economics of organizations and institutions.if information technology existed that would permit free-riders to be profitably excluded from enjoying them.if information costs were lower.if transactions costs were zero. The new economics of organization focuses on these vital questions.the young and a fortiori the unborn. are fundamentally information failures. must bear the consequences of the failure of current generations to expand these resource pools. Politics. Behn [1995] observed that public administration needs to focus on big questions. are similarly although not so completely disadvantaged in political arenas. see also Alchian & Demsetz. he found a single empirical study to cite. Monopolies could be compensated to behave like competitors -. natural monopolies. Until very recently the economics of organization was a classic example of theory without data. Robert D. for instance. forthcoming].future generations. This produces a lot of sloshing about and considerable leakage. etc. Its basic idea is that the comparative advantage of any institutional mechanism or governance arrangement boils down to a question of information or transaction costs "and to the ability and willingness of those affected by information costs to recognize and bear them" [Arrow. Ten years ago. but are largely excluded from political processes.

1988] or that the arrangements one observes are optimal. bringing their actions into line with the tastes of the citizenry. moral hazard. 1993. comparative. Moreover. in part because its practitioners are often more interested in saying what cannot be done. than what should be. perhaps most. 1993. although it is best to be agnostic on this point. Evidence that a potential problem is a real one requires information about magnitudes. moral hazard. 1989. and not just an existence proof. 1988]. they often shrink in size. 1991].affairs is that tinkering is required to make a satisfactory positive theory of public sector supply arrangements. 1990. In which case. than how one might go about minimizing them. De Fraja. see Ferris & Graddy. 1994. which usually leads to a substantial gap between what principals get and what they could get if they were better informed [Persky. 1994. The difference between potential and real agency problem is demonstrated by James Buchanan's conjecture that risk-averse public officials will exploit their superior understanding of the production of government services to extract higher budgets from the public [1969:98-102]. simply presume that arrangements have been selected because they minimize the sum of operating and transactions costs [Moe. Wallis. Buchanan's argument goes something like this: from the public official's standpoint. and adverse selection problems. 1989]. for example. Furthermore. Second. 1992. 1992. 1994]. Bates. De Groot. but as it turns out. De Groot. & Marino. . Many.either it is not a problem or is easily soluble [Choate and Thompson. Gibbons. Yet many businesses survive and prosper nonetheless. But intellectual interest ought not obscure reality. since the interests of corporate managers are also not necessarily identical to those of the stockholders [see. and adverse selection problems are common in corporate governance. 1993. 1993. asymmetric information problems have reasonably satisfactory solutions [Tirole. it may be more costly to finance public spending with taxes than with debt. Consider the typical approach to asymmetric information -. Economists seem to fix on problems in which there is high degree of conflict between principal and agent. these conflicts do not undermine completely the value of theories that ignore them. Baker. Agency. One cannot. 1991. Itoh. Campbell. & Murphy. 1988. careful. 1994]. 1989. for example. Mayston. 1993. borrowing would lead to higher than optimal levels of government spending and services. the risk-aversion problem that is at the heart of Buchanan's conjecture is strictly incentive compatible -. Consequently. best-practice research is needed. 1984. Pay-as-you go financing has much to recommend. Williamson. Hemmer. when economists look closely at agency problems. when they cannot be made to disappear altogether [Baker. Buchanan concludes that pay-as-you go financing serves as a check on public officials. see also Wittman. Chan. the new economics of organization can be Good. and in demonstrating that circumstances give rise to inefficiencies.

Mosher [1980: 545-47] not so long ago observed that government has experienced a sea change in its responsibilities and its tactics and concluded that these massive changes have rendered obsolete the traditional administrative controls we inherited from our forebears. and [4] flexible-price contracts. the specifications for the MIL-F-1499 [Fruitcake] are eighteen pages long. Schick concluded that we cannot afford to go on imposing direct controls over an ever widening sphere of activities -. Allen Schick [1978: 518] has noted with concern that recent changes in the reach and scale of government have been accompanied by massive growth in the scope and content of rule-bound governance mechanisms: reporting requirements have multiplied. chewing gum fifteen. auditors scrutinize more closely the accounts of federal agencies and contractors. He finished with a reminder that in many cases individuals can be more effectively influenced to serve the public interest "by inducements which allow them to pursue their own interests than by constraints which try to bar them from behaving as they want. to guarantee adequate shelf-life and resistance to handling. The late Frederick C. Plastic whistles take sixteen pages.that new solutions to the problem of administrative governance must be sought. Governance in General . nowhere more irresistible than where government procurement is concerned. [2] responsibility budgets. to make sure there really are some candied fruits and nuts in the fruitcake. and to insure palatability in all the far-flung places of the world where the American soldiers celebrate Christmas. and so on. what can one take from new economics of organization that is both useful and valid? The Control Problem The propensity to devise inflexible and comprehensive rules is. [3] fixed-price contracts. Given this assumption. perhaps." Perhaps the most useful contribution of the economics of organization is that it has made us cognizant of the alternative governance mechanisms that are available for influencing people to advance the policies and purposes of the institutions they serve: [1] outlay budgets. and the criteria to be used in choosing between them. olives seventeen. 250 tons of which are purchased by the Army each year. condoms thirteen. Consider the fruitcake. and direct controls in the form of rules and regulations have proliferated.In the remainder of this essay I assume that agency problems are not completely intractable and can usually be mitigated if not completely overcome. of the circumstances under which each has a comparative advantage. To preclude abuses on the part of unscrupulous bakers. In a similar vein.

when. 1989]. decides on and carries out a course of action and. monopolistic public bureaucracies and freely competing private firms [Hanke. In the abstract.e. may do. Because bad decisions cannot be undone after they are carried out. [1] The subject may be either an organization or an individual. or regulations that specify what the subject must do. therefore. departments and agencies. contractors.. however. after some of the consequences of the subject's decisions are known. a governance system designer has four sets of options. etc. Privatization The significance of these alternative designs is partially reflected in debates over the merits of privatizing the delivery of public services. it is difficult to see how privatization could be wrong. It is simplistic because many proponents of privatization implicitly assume . often over-regulated. see. The subjects of before-the-fact controls are held responsible for complying with these commands and the controller attempts to monitor and enforce compliance with them. Combining the choice of subject with that of timing. rules. The choice of what and where to control is reasonably self-evident. After-the-fact controls are executed after the subject. Consequently. Savas. we find that the governance system designer must choose among four distinct institutional alternatives: individual responsibility. Proponents of privatization imply that the choice is between rule-governed. Donahue. the efficiency with which they produce goods and services. But other things are not equal. and ultimately the efficiency with which they use the assets at their disposal.]. Management control should be primarily addressed to the behavior of service suppliers [i. and. either an organization or an individual. where. These controls necessarily take the form of authoritative mandates. provision by competing private firms will usually be more efficient than provision by a public monopoly. before-the-fact or after-the-fact. after-the-fact controls are intended to motivate subjects to make good decisions. or must not do. comprised of two choices of subject and two of timing. 1982. whom to control. The choice of whom to subject to controls and when to execute those controls is less self-evident. Other things equal. Before-the-fact controls are intended to prevent subjects from doing undesirable things or to compel them to do desirable thing. the distinction often drawn by proponents of privatization between public and private production is often overly simplistic. 1987. Hence subjects are made responsible for the consequences of their decisions.All governance system designers face the same key choices: what. before-the-fact or after-the-fact. since it resolves to a simple question of monopoly or competition. and the controller attempts to monitor those consequences and to see that subjects are rewarded or sanctioned accordingly. and organizational responsibility. and [2] Controls may be executed either before or after the subject acts. Were that the choice.

ultimately the public pays. The difference between holding individuals and organizations accountable or between direct. their capacity to influence directly the rewards and sanctions that accrue to those individuals. Unfortunately. If the item or service is to be made available at a later date.that governments are flawed but markets are perfect: that market participants are perfectly informed. although most goods and services are produced by organizations and not individuals. that is precisely what we must not do. but cannot punish the managers responsible for the failure -. bargaining. the purchaser must expend resources to insure that the supplier adheres to the terms of the bargain or contract. where the production of a good or service may be characterized by increasing returns to scale or scope. but only indirectly. and that they involve the exchange of a discrete product for cash. is grossly unsatisfactory. Take the following example: if the quality of services supplied by an agency. and the relationship is unsatisfactory. asset specificities. monitoring. Where the Department of Defense has an arm's length relationship with a service supplier. thereby. However. or the absence of close substitutes. the controller can recommend the dismissal of the agency director. the purchaser must expend resources shopping and bargaining over prices and terms. the Defense Logistics Agency for example. It does not matter whether they occur inside of government or out. any sole-source supplier] is like cutting . It also fails to reflect all of the factors that are relevant to the choice. when the choice of governance arrangements is at hand. the purchaser must incur search. These transaction or control costs are part of the cost of acquiring a a good or service. Consequently. the distinction between provision by a public agency and provision by a private entity fails to capture the full range of choices available to the governance system designer. and enforcement costs. to avoid costly mistakes. that market transactions are costless. The distinction drawn by the proponents of privatization between public and private provision ignores the capacity of controllers to hold managers of public organizations under their jurisdictions individually responsible for their behavior and. punishing a monopoly [that is. The controller can punish the supplying organization. a high degree of lumpiness in production [or consumption]. McDonnell-Douglas for example. all that the controller can do is recommend termination of the relationship. effective control ultimately presumes individual accountability. That is. such as salary and opportunities for advancement. First. The only way an organization can be rewarded [or punished] is by increasing [or reducing] its revenues. Controllers cannot possibly hold managers personally responsible where their relationship to the supplying organization is at arm's length and the structure of individual responsibility is veiled by the organizational form.although their actions might very well lead the organization's board of directors to to so. In the real world. personal influence and indirect influence is quite straightforward. An organization's revenues can affect an individual manager's welfare.

Prusa. Indeed.over additional output. Colbert & Spicer. the capacity to influence managers directly will have considerable utility. 1995]. their customers may threaten to switch suppliers to extract discounts from them. The new economics of organization tells us that vertical integration occurs because it permits transaction or control costs to be minimized. and Ferris and Graddy. where the supplying organization is a monopoly. where the relationship between the intermediate product supplier and his customer is at arm's length. In the language of transaction-cost economics. total production volume is your nose to spite your face. In that case.. investment in specialized resources is called asset specificity. the threat of opportunistic behavior may be sufficient to eliminate the incentive to make what would otherwise be cost-effective investments. Investment in specialized resources often inspires a process called vertical integration ["backward" if initiated by the consumer goods producer.. 1986. see Maser.e. Vertical integration is. in part through the substitution of direct supervision for indirect influence [see Williamson. 1988. most real natural monopolies make intermediate products. 1981 and Borcherding. 1988]. In the private sector. Schroeder. 1991. Young. Or. 1990. goods that are used to produce consumer goods or services. 1991. "forward" if initiated by the intermediate goods producer] [Joskow. For example. Hence. equipment. Vertical integration can eliminate this threat. 1994. -. once intermediate product producers have acquired specialized assets. An asset is said to be specific if it makes a necessary contribution to the provision of a good or service and has a much lower value in alternative uses. 1990]. outputs that are easily monitored]. Vining and Weimer. Some organizations invest in specialized resources and own design- . The corollary of asset specificity is bilateral monopoly. Consequently.technological know-how. of course. particularly where controllers can stimulate and exploit competition between alternative management teams. lumpy investments in specialized resources -. on the relevance of transaction cost economics to public administration. 1983. rewarding one is like eating an eclair to celebrate staying on a diet. a circumstance that provides an ideal environment for opportunistic behavior on the part of both supplier and customer. where the intermediate product producer provides homogeneous goods or services [i. 1991]. Natural monopoly [decreasing costs as output increases] can usually be attributed to spreading large. This claim can be verified by reference to the private sector. only one way to deal with asset specificity [Walker & Poppo. if demand for the final good increases greatly. vertical integration permits a bilateral monopoly to be governed satisfactorily by unbalanced or two-part transfer prices [Masten.e. product specific research and development. and technologies are mature. 1993. 1985. suppliers may find it necessary to write off large parts of their specialized investment. 1993. see also Friedman. the intermediate product supplier may be able to use its monopoly power to extort exorbitant prices from customers. i.

1982]. and in individuals if and only if the organization is part of the public sector. even 31 percent of all simple. Similarly. the recurring procurement fraud cases show that managers of private entities that supply services to the government can be held directly and personally responsible for their behavior when it violates federal law. of course. It is common in both the automobile and the aerospace industries. Finally. which implies that the .specific assets. many state legislatures base their relationships with public entities such as universities or hospitals on arm's length relationships that are guaranteed by self-denying ordinances. in one study of vertical integration in the U. regardless of its complexity. there was a 92 percent probability that it would be made internally. 1990]. 1993]. Where intermediate products were both complex and highly specialized [used only by the buyer]. The Department of Defense's decisions about base closure and realignment. for example. it is standard procedure for the Department of Defense to provide and own the equipment. specialized components were made internally. buyer-seller relationships tend to be based on mutual confidence [Ravenscroft.S. Other organizations that rely on a small number of suppliers or a small number of distributors write contracts that constrain the opportunistic behavior of those with whom they deal. and designs that defense firms use to supply it with weapons systems and the like [see Monteverde and Teece. most of the proponents of privatization implicitly presume that the services provided to or for government are homogeneous or fungible. forthcoming]. The proponents of privatization also err in their implicit claim that responsibility can be vested in organizations if and only if the organization is private. decreasing cost is basic to the make-or-buy decision. In other cases. aerospace industry. where one of the parties is inclined to exploit the other. for example. Nevertheless. exchange of debt or equity positions] or just plain old-fashioned trust based on long-term mutual dependence.. which they provide to their suppliers. dies. In Japan. surety bonds. public authorities are another good example [Frant. are exempted from direct congressional control by just such a self-denying ordinance [Twight.g. The absurdity of this claim becomes clear as soon as it is explicitly stated. For example. prohibitively costly to enforce] without incurring the very real costs of vertical integration. desired outcomes can be realized through alliances based on the exchange of hostages [e. It maintains tight working links between its manufacturing and engineering departments and its suppliers and explicitly eschews opportunistic behavior in the interest of maintaining long-term relationships. therefore. which exempt the managers of these public entities from detailed oversight and direct control. and. The probability dropped to less than 2 percent if the component was not specialized. Scott Masten [1984] unambiguously demonstrated that asset specificity and. This is called quasi-vertical integration. it is consistent with neither theory nor practice. Toyota relies on a few suppliers that it nurtures and supports. A well-executed contract can approximate the outcome from vertical integration [although such contracts are often very hard to write and.

from the "customer's" perspective. where they are not. control should focus on their content [inputs]. Furthermore. At the same time. the implication of this line of reasoning is that controllers should vest responsibility in organizations only where inter-organizational rivalry is practical and likely to be effective -. This choice should depend upon minimizing the sum of production costs and transactions costs [Williamson. At least two factors are relevant from a transactions-cost standpoint: the ease with which the consequences of operating decisions can be monitored and the desirability of inter-organizational competition. Choosing between Alternatives Proponents of privatization do make one significant. they frequently fail to carry this claim to its logical conclusion. unexceptionable claim: the choice of institutional design should depend on the cost and production behavior of the good or service in question. Good. These normative prescriptions are summarized in Figure 4. 1993. Because responsibility can be effectively vested in organizations only where customers or their agents are ultimately indifferent to the survival of one or more of the supplying organizations. Where economies of scale or scope cause costs to decrease when output is increased. 1992]. & Miller. 1993. Whynes. In fact. where it is not [Willig & Jatar. Brown. However. In contrast. 1992. Thornton. it follows that they should rely on before-the-fact controls where each item supplied is. an elementary control mechanism that reveals information about the "customer's" demand for the service. intrinsically unique. see also Kettl (1993)]. Buede. Macintosh. Most management control theorists believe that where consequences [that is. 1992]. FIGURE 4 GOES ABOUT HERE . it follows that controllers should rely on after-the-fact controls where homogeneous outputs are supplied. 1990]. many of the organizations supplying goods or services to or for government supply bundles of more or less heterogeneous products -. Aertsen. 1988. 1993. Ezzamel. Carlton & Perloff. monopoly supply is usually appropriate [Barzelay (1992) refers to entities that have this characteristic as "utilities". 1985].problem of identifying the most efficient supplying organization or management team resolves to a simple question of price search. 1993. Because consequences are easily monitored where entities produce homogeneous outputs or where a responsibility center within an entity performs fungible activities. this view has been reinforced by recent findings in organizational economics and agency theory [Mayston. industrial organization theory tells us that inter-organizational competition is desirable only where costs are constant or increasing as quantity of output [rate or volume] increases [Tirole. control should focus on the consequences of the subject's decisions. some prohibitively so. 1993.many of these products are hard to measure and costly to evaluate. an organization or responsibility center's outputs] are easily monitored.and in individuals.

My discussion will concentrate on the use of before-the-fact controls. Before-the-fact controls are like after-the-fact controls in that they ultimately rely on incentives and sanctions for their effectiveness. which explains why their incentive aspects are easily overlooked and. many of those who believe in the potency of before-the-fact controls fail to understand that moral authority is all too easily eroded by an oversupply of rules. what they are. not everyone is inclined to respect moral authority. to respect the law. On the contrary. but also. I must first show how these designs are used and explain the practical logic of their implementation. It is also necessary to specify the content of before-the-fact controls -. which is no easy matter. why they are not better understood. respect for the law. One possible explanation for the persistent faith in the efficacy of before-the-fact controls is that its devotees just don't understand how hard it is to execute them efficiently. The incentive aspects of before-the-fact controls are thus less clear than the incentive aspects of after-the-fact controls. that they are far too important to be frittered away where other mechanisms of social control will suffice. at least. they tend to believe the solution lies in still more or better rules. improve performance. they appear to believe that the subjects of before-the-fact controls will comply with them simply because they are morally obligated to do tell subjects what to do and what not to do in such a way as to find and enforce efficiency. But is each appropriately employed? Before this question can be answered. I concentrate on the use of before-the-fact controls because it seems to me that their implementation is not well understood. while beforethe-fact management controls are incentive or demand-concealing mechanisms. perhaps. Many participants in the policy process seem to believe that before-the-fact controls not only safeguard against abuse. Rather they ought to be carefully husbanded so that they will be available when and where they are really needed [see Tyler. especially by those who most rely on them. . This means that opacity is an essential characteristic of before-the-fact controls. by reducing costs. however. Moreover. Moral authority. or to obey rules. This does not mean that I particularly like them. I believe that controllers should resort to before-the-fact control designs only where production and transaction costs clearly renders their use the least objectionable alternative [Reid. 1990]. I will first try to show how demandrevealing mechanisms work or. This also means that their effectiveness is hostage to the skill with which they are executed.Execution of Alternative Governance System Designs These four basic sets of controls are all employed by government. It is necessary to monitor and enforce compliance with rules and to ferret out and punish noncompliance. If failure occurs nevertheless. In reality. the inclination to obey rules are of critical importance to the stability and the efficacy of social arrangements. The difference is that after-the-fact management controls are incentive or demand-revealing mechanisms. In order to show how demand-concealing mechanisms work. For example. 1990]. Obviously.

at the market price payable on delivery. In that case. Government relies on these kinds of spot markets when. In so doing customers reward the suppliers that are willing to do the most to satisfy their tastes and implicitly punish the rest.those that moves them farthest down their demand schedules. The classic demand-revealing mechanism is the competitive spot market. although not directly on the costs incurred by the suppliers. Thompson. and the structure of authority and responsibility within the supplying organization is purely an internal matter. Customers transparently reveal a demand schedule that fully expresses their wants and preferences to their suppliers. When many suppliers are disposed to satisfy customer wants. But all of these variations have one common attribute: rewards are provided after operating decisions have been made by the producer. There many variations on the basic theme of reliance on transparent rewards. such as enrolling a full-time equivalent student or treating a heart attack. 1986].After-the-Fact Governance System Designs By demand-revealing mechanisms. it purchases electrical components off the shelf. Customers would put no restrictions on producers. after assets have been acquired and used and outputs monitored. we refer to them as ex-post or after-the-fact controls. After-the-Fact Controls Transparently Reward Measured Performance or Results The spot market is by no means the only demand-revealing mechanism used to govern transactions between buyers and sellers. A close analog to a spot market is seen where government uses prospective price mechanisms to reimburse free-standing service providers. This means. Because they are executed after asset acquisition and use decisions have been made. For example. or activities. for example. customers probably won't even know who grew their grain. The system used by the Health Care Financing Administration to pay hospitals for treating patients is an example. all qualified organizations will be paid a stipulated per-unit price each time they perform a specified service. The government or its agent announces a price schedule and specifies minimum service quality standards [or a process whereby these standards are to be determined] and the time period in which the price schedule will be in effect. I mean those in which customers [or their agents] declare their willingness to pay for various quantities of goods. In fact. In both of these instances the subject is a freestanding organization. services. they might order wheat from a broker. The enrollment-driven funding formulas used by some states to compensate post-secondary institutions for teaching students is another [Jones. there would be no formal contract. Under prospective pricing. where customers buy from any number of anonymous firms. It depends on the price offered and the quantity of service actually provided [Liability = Price Quantity]. . Then they let suppliers figure out how best to satisfy those wants and preferences. among other things. customers simply choose the best price and quantity combinations offered -. that the government's financial liability is somewhat open ended. But wheat farmers are nevertheless rewarded for their contributions. and Zumeta.

The output of a mission center contributes directly to the organization's objectives. This control mechanism is.. Demand-Revealing Mechanisms in Vertically Integrated Organizations In some cases. sometimes as performance contracting [Islam.g. Fixed-price contracts also comprehend franchises to provide a specified services. i. 1988: 365-386. usually known as responsibility budgeting [Anthony and Young. a responsibility center can be either a mission center or a support center.. along with the profit motive. government relies upon interorganizational competition. under flexible-price contracts those costs are shared with the customer. Again. The fundamental construct of responsibility budgeting is an account [or control] structure that is oriented toward administrative units that have purposes or objectives and use inputs [resources] to produce outputs [goods or services]. The output of a support center is an input to another responsibility center in the organization. after-the-fact. This is done in businesses and businesslike public sector organizations by holding managers responsible for optimizing a single criterion value. organizations that don't make wise asset acquisition and use decisions fall by the wayside. Responsibility centers are classified according to two dimensions: [1] The integration dimension &endash.e. These price schedules can entail all sorts of complex arrangements.e. prices are fixed before hand and aren't affected by the supplier's subsequent costs. usually a measure of financial performance. or a profit or return-on-investment target] for each administrative unit. Ideally a responsibility budget contains a single number or financial performance target [e. measured in terms of the discretion to acquire and use assets. to motivate service suppliers to make wise asset acquisition and use decisions and to produce efficiently. the amount of authority delegated to the responsibility manager. In a pure fixed-price contract government usually buys from numerous suppliers held at arm's length. either another support center or a mission . therefore. If interorganizational competition is effective. including rate. and mix adjustments as well as inflation adjustments and sometimes default penalties. perhaps at specified locations. under fixed-price contracts. 1991]. Thompson. Under all of these demand-revealing mechanisms. the relationship between the responsibility center's objectives and the overall purposes and policies of the organization. subject to a set of specified constraints. where the customer assumes full responsibility for all legitimate. On the first dimension. i. for a fixed periods of time -.garbage collection at a military base. 1993]. a unit cost standard. The limit under flexible-price contracts is reached in the case of a cost-plus fixed-fee contract.Another close relative of the spot market is the fixed-price contract. demandrevealing mechanisms can still be effectively employed. volume. measured costs. even where the cost behavior of the service in question renders vertical integration and therefore monopoly supply appropriate. for example. Frequent bidding contests are held and orders are shifted among suppliers chosen simply on price. In contrast. [2] The decentralization dimension &endash.

On the decentralization dimension. transfer prices. transfer prices. support units can be made to compete within the context of a quasi-market dynamic with others supplying similar services inside and outside the organization and permitted to charge whatever the market will bear. Responsibility centers coordinate their activities via a process of exchange and mutual accommodation. This is often possible now. Loeb. equipment. 1994].including support center charges. Where bilateral relationships are concerned. which mimic the governmental norm. Such an account structure would look something like the following: 1. In most cases.including charges for the use of capital assets and inventory depletion -. 1988. [Unbalanced transfer prices are often easier to use than cost-based twopart tariffs. 1994]. where they occur within the organization. these relationships can be governed via buyer-seller arrangements and. 1989. All costs accrued by support centers -. All administrative units are be classified as either mission or support centers. and other issues that are significant to the long-run performance of the organization. by appropriate transfer prices. Responsibility budgeting is largely concerned with setting targets. 1992] or unbalanced transfer prices can be used to manage relationships and to provide the supplier with an incentive to make long term investments in plant. 4. see Tirole. A working capital fund provides short-term financing for support units. A capital asset fund provides long-term financing of capital assets and encourages . A support center may be either an expense center or a profit center. 1992. 1988. its profit is the differences between its expenses and "revenue" from "selling" its services to other responsibility centers [Halal. discretionary expense centers. Stark. Ronan & Balachandran. 1991]. and costing procedures is largely due to improvements in computer speed and software [Lapsey..g. 3. and investment centers are also free to make decisions about plant and hook-up plus usage charges for telephone services. Dorkey & Jarrell. where it wasn't really before. Mission centers are funded to cover their expected expenses -.are charged to the mission centers they serve. The increased sophistication of performance measures. since the latter must be very carefully calibrated to produce an efficient solution. and costing procedures] are now more sophisticated. 2. Both profit and investment centers are usually free to borrow. and rewarding managers accordingly. it is usually possible to set up some kind of transactional arrangement to eliminate or internalize spillovers [Ronan. but accountants don't like them very much] In other cases. or know-how. new products. two-part tariffs [e. are found at one extreme and profit and investment centers at the other. Cohen. 5. If the latter. Balachandran & Ronan. Where monopoly supply is appropriate. because the design of responsibility structures [the allocation of property rights and the ownership so as to minimize intraorganizational externalities or spillovers] and management information systems [performance measures. monitoring performance in terms of the targets specified.

and careful matching of spending authority and responsibility. [2] if support centers nominally charge all of their expenses against revenues earned delivering services. 1993. Modern transfer pricing could expand the scope of this device and enhance its effectiveness by establishing rules for setting prices prospectively rather than retrospectively and my emphasizing the notational nature of the exchange. the structure of authority and responsibility within the organization is of crucial interest to the controller. Industrial funds are used to purchase industrial or commercial services [e. transportation. Switzerland.i. most others either as cost or income centers [although in most cases their performance could be evaluated in terms of quasi-profitability -. Both kinds of funds are supposed to be financed by reimbursements from customers' appropriations [Juola. 1967: 343]. 1990. 1988. is essential to .] from production units within the government. 1994]. Examples of governments that have experimented with responsibility budgeting and accounting include New Zealand. etc. The effectiveness of responsibility budgets depends on the elaboration of well-defined objectives.. The principal formal device by which transactions are currently accomplished within government is the revolving fund. both of advice and delivery systems. Transfer prices encourage efficient choice on the part of support centers and the units that use their services. Goold.. the Province of Alberta. and [3] if support centers are treated as responsibility centers -. Chia. Their effectiveness also depends on the clarity and transparency with which individual reward schedules are communicated to responsibility-center managers and the degree of competition between alternative management teams [Govindarajan. 1991. The Navy had a revolving fund as early as 1878. Cothran. and many others [Schick.efficient management of their acquisition. Under responsibility budgeting/performance contracting. depot maintenance. 1995]. under the Defense Business Operating Fund. Modern day revolving funds date to the 1947 National Security Act and.their managers are authorized to incur expenses to deliver services and are held responsible for meeting the stated financial targets of their centers: the more highly capital intensive ones. Finland.e. These governments have rapidly downsized their public bureaucracies to more efficient types of organizations and replaced reliance on monopolistic agencies with policies favoring competition and contracting out on the assumption that competition. and disposition. accurate and timely reporting of performance in terms of those objectives. Schedler. Ezzamel. 1993: 43]. as investment centers. Australia. benchmark cost/price less actual cost][Bailey. only [1] if prices are set ahead of time. Canada. Two kinds of funds have been established under this authority: stock and industrial funds. Stock funds are used to purchase supplies in bulk from commercial sources and hold them in inventory until they are supplied to the customer -. use. have grown to $40 billion a year. These funds involve buyer-seller arrangements internal to federal government.g.usually a military unit or facility. 1993. Great Britain.

Under Mode B. however. Their distinguishing attribute is that they are executed before public money is spent. Appropriations pay for the outputs produced by the department and for any changes in the department's net assets. Parliament relies on the fact that managers' financial performance is one of the main bases upon which their performance is assessed to insure that their decisions will be sound [Gul." The residual "core" includes a mix of policy. they govern a service supplier's acquisition and use of both short-term and long-term assets. and the fund and account controls that regulate the rate. 1990]. 1995.these govern the kind of assets that can be acquired by governmental departments and agencies. apportionments. Under Mode A. departments are treated like quasi-profit or expense centers. timing. Under both Modes B and C. Most of the attention given to public administration in New Zealand has focused on its efforts to improve the quality of its financial reports and its performance measures. However. 1994]. Schick. Parliament changed the way it appropriates funds. Bushnell. which also monitors and assesses performance [hence. the changes made in the structure of its government are perhaps even more noteworthy [Scott. The basis of appropriation now depends on the department's ability to supply adequate information about its performance. and purpose of public spending [Pitsvada. 1964. Departmental heads are appointed for fixed terms. see World Bank. Parliament redefined its relationship with department heads. Halal. Readers will recognize the combination of before-the-fact controls and individual responsibility in traditional government budgets. departments are treated as discretionary cost centers and Parliament appropriates funds for the acquisition of inputs. 1994. 1994. Each works to a specific contract. New Zealand has carried these reforms furthest. 1976. Under Mode C. Kovacic. Islam. Third.efficient service provision. departments are treated like investment centers. As noted above. performance contacting. see. Most will also recognize the . Parliament privatized everything that was not part of the "core public sector. negotiated with the State Services Commission. with the possibility of reappointment. the majority have now progressed either to Mode B or C. Examples of before-the-fact management control include object-ofexpenditure appropriations and encumbrance accounts -. 1983. All departments started out in Mode A. which means that the controller retains the authority to preview these decisions. Second. It is the first country to publish a rational set of general purpose financial statements: including a balance sheet showing assets and liabilities and an accrual-based statement of income and expenses. 1978]. managers are free to make decisions [under C most] about investments in plant and equipment. Ball. 1993]. That is. & Sallee. Burke. and the similar rules and regulations that govern the behavior of private contractors [Goldberg. position controls. First. regulatory and operational functions. 1990. 1990]. Before-the-Fact Governance System Designs Before-the-fact management controls are demand-concealing mechanisms.

To distinguish them from responsibility budgets. They fully specify product or service characteristics and a usually a delivery schedule. must assume some responsibility for managing output levels and delivery schedules. agency. Flexible-price contracts comprehend a variety of incentive and cost-sharing contract designs other than the classic cost-plus contract. They usually receive the allotment regardless of the actual quantity or quality of services provided [which has the effect of treating every government department. This means that suppliers must be subjected to fairly extensive. supplying organizations are guaranteed reimbursement [complete or partial] for any legitimate expense incurred providing the service. under these control systems designs. program. for example." because I am concerned primarily with distinguishing these contracts from fixed-price contracts. Most governmental budgets are spending plans. An agency's outlay budget. Flexible-price contracts are basically production plans. should identify all the asset acquisitions that it is to execute during the year. Their attention to performance may be tacit. What is crucial is that. Controllers usually take account of information about the future consequences of a supplier's decisions as well as information on its current and past behavior. specify their magnitudes. and make it clear who is responsible for implementing each acquisition. the service provider." Under outlay budgets. the logic of demand-concealing oversight requires supplier discretion to be carefully restricted. supplying organizations are guaranteed an allotment of funds in return for providing a service for a stipulated period. But the consequences of asset acquisition decisions usually matter a great deal to controllers. In turn. whether a department or an outside contractor. I use the term "outlay budgets. attention to the performance consequences of spending decisions is necessarily prospective in nature. or zero-base budgets. I generally prefer the term "flexible-price contract" to "cost-plus contract. constraining managerial discretion is not the only function that before-the- . Of course. Under flexible-price contracts. rather than express. Nevertheless. the prices they are paid for providing services are determined retrospectively according to settled costaccounting standards and the specifics of their contracts. flexible-price contracts are included in the broader category of administered contracts [see Goldberg. or bureau as a discretionary cost center]. To say that controllers focus their attention primarily on a supplier's asset-acquisition decisions does not mean that they ignore performance in executing outlay budgets or price in executing flexible-contracts. fairly detailed before-the-fact controls. Even under these control systems designs. or price. Hence.combination of before-the-fact controls and organizational responsibility in the socalled cost-plus contract -. service quality. as in the execution of traditional line-item budgets. as I shall demonstrate. as in the execution of performance.the most notorious member of the administered or flexibleprice contract family. 1976]. Controllers will not reveal a demand schedule that fully expresses customer wants and preferences to suppliers or leave it to suppliers to figure out how best to satisfy those wants and preferences.

The difference is not that it takes place before the production of the service in question. or price [i.. Why. Under those circumstances. the refusal to take past performance into account discourages supplier loyalty and eliminates incentives to improve the quality of the product delivered [see Kelman. but once a contract is signed. von Ungern-Sternberg. 1993]. let alone to enforce efficiency [Cohen & Loeb. promised delivery schedules. Baron & Besanko. the supplier can no longer be fully trusted to make them [Thomas & Tung. I will outline in detail the logic of employing the two basic before-the-fact governance system designs: flexible-price contracts and outlay budgets. service quality attributes offered. 1989].fact controls perform. 1994]. Decisions that affect cost. Flexible Price Contracts There is a difference in the role that competition plays under fixed and flexible-price contracts. This conclusion holds especially where the customer ignores information regarding the performance of suppliers on earlier contracts or cannot [will not] award future contracts based on good performance. [Economists refer to such a competitive regime as competition for the market. 1992. Even where fixed-price contracts are concerned.garbage collection. the supplier is free to dip his hand into the customer's pocket. and bid price allow the customer to evaluate proposals satisfactorily. Regrettably. 1989. 1990. to distinguish it from competition in the market. all of these conditions are likely only where the service in question is fairly simple and relatively standard -. Because the supplier is spending somebody else's money. 1988.] The recipients of fixed-price contracts often receive exclusive franchises prior to the delivery of services. would a customer ever sign a flexible-price contract? Why not simply write fixed price contracts? The answer is that a fixed-price contract is the mechanism of choice where controllers know precisely what their principals want and there are several potential service suppliers who know how to meet those preferences. 1992]. let alone explain their widespread use. It is a simple fact of life that considerable experience is usually required to manage to a . To show how subjects can be told what to do in such a way as to enforce efficiency." Under flexible-price contracts. Technological Uncertainty and Financial Risk In other cases. service quality. 1994]. for example [von Ungern-Sternberg. neither the controller nor the service supplier may have enough knowledge of the value of product attributes or production processes prior to performance of the contract to employ a fixed-price contract [Macintosh. then. The difference between the role played by competition under fixed and flexible-price contracts can be summarized by the expression "moral hazard. it would be hard to claim that they ever represented a least-objectionable alternative. Once a flexible-price contract has been signed. Reichelstein. If it were. Rather. the normal incentives to cost effectiveness largely disappear.e. Keren. not an end in itself [Lewis & Sappington. asset acquisition and use decisions] must be made during performance of a contract. 1990]. competition cannot be relied upon to keep prices low. constraining managerial discretion is chiefly a means to an end.

In particular. but it cannot be eliminated. Flexible or retrospective pricing is one way for the government to assume this risk. 1989]. This process can be compared to a repeated prisoner's dilemma game. any organization that agreed to produce a unique service. Under a fixed-price contract. the risk is mostly unsystematic. and scheduled milestones. but can withhold full information as to his preference or demand schedule [Morgan. the preferences of the government may change during performance of a contract. Consequently. the indifference of the government to financial risk is easily exaggerated. Nevertheless. the cost to government will often be lower if it assumes a portion of the risk associated with acquisition of the service. Bargaining power in a prisoner's dilemma game depends on the information available to each party. and equipment to be used. input quality standards. 1989]. according to a specified schedule. This is the case because of the size of the assets government commands and its ability to pool risk. be diversified away. Kathawala. the customer's power is greatest where the customer [or his agent] knows the supplier's true cost schedule. . 1949]. 1967. In this game. in which both parties have a common interest in reaching agreement but also have antagonistic interests with respect to the content of agreements. no organization is likely to have the required experience. 1992. see also Breton. Cohen & Loeb. at a fixed price would incur a large financial risk. Government is not immune to financial risk. my point remains: customers should prefer flexible-price contracts to fixed-price contracts where it is cheaper for the customer to deal with uncertainty than it is for the contractor to do so or where the customer is more concerned with the ability of the contractor to provide a product that works than with price [see. Government. 1990. while it may be true that doing business with government is risky. and the supplier tries to get the highest possible price for providing the service [Hofstede. however. and may. 1990: 503]. 1989]. material. personnel. Moreover. This plan provides a basis for the enforcement of efficiency through bargaining and negotiations carried on during the performance of the contract [Reichelstein. it might not be possible to secure desired changes in service attributes if they involve increased costs for the vendor. The question is: can before-the-fact controls be used to insure that the seller retains an interest in cost effectiveness? Using Before-the-Fact Controls to Enforce Efficiency under Flexible-Price Contracts Execution of a flexible-price contract must begin with a fully specified project spending plan detailing work to be performed. Lewis & Sappington. Of course. Moreover. can often bear financial risks better than supplying organizations. therefore. otherwise it would never make economic sense for it to rely on outlay budgets [Carlton and Perloff. especially the federal government. the customers try to get as much of what they want as they can at a given price. This risk can be shifted.narrow range of outcomes. Consequently. where specialized or unique services are involved.

if the client will permit the altered welding maybe a deal can be struck" [Stark and Varley. The service supplier will also learn of the tradeoffs between cost. . Under a full set of before-the-fact controls. This fact will usually become evident to the service supplier during performance of the contract. But when flexible-price contracts are appropriately employed. such changes are contingent upon prior approval. About that time the client decides that some room on the ship should be larger. Thorton.purchasing agents in manufacturing plants. This can work to the advantage of the customer or the supplier. . As a result. the party suggesting or initiating a change must necessarily reveal valuable information to the other. Competition for the market provides an incentive to potential service suppliers to promise more than they can deliver. for example. . 1986]. under which changes can be made only with the prior approval of the other party or his agent. Consequently. . The contractor discovers he can do the welding of some plates less expensively by another means.. 1992. .. To secure approval service suppliers must reveal information about their capabilities and trade-off possibilities. are usually recruited from the ranks of industrial salesmen and process engineers and vice versa. It is also one of the purposes behind selecting agents who have walked in the other party's shoes [promoting trust is another] -. very few contract winners can make good on all their promises. Lewis & Sappington. there is every reason to believe that most change proposals will be initiated by the service supplier. Public choice theorists refer to this condition as agenda control [Hammond. 1989]. 1983: 132]. & Miller. Buede. one must know the other party's costs under a variety of contingencies].e.. especially where their managerial discretion is severely restricted by a full set of before-the-fact controls. and delivery schedule available to it and will eventually want to [or in some cases have to] change its promises or its plans. 1992. This is one purpose of "should-cost" models. however. To do so.but only if they know what they are doing and how to make it happen [Brown. a ship and agreed to. service quality. . since contracts are usually awarded to the service suppliers who promise the most. or both. one must be able to put oneself squarely in the other party's shoes [i. Given comprehensive before-the-fact controls. For example. [The federal government's revolving-door laws enjoin this kind of personnel exchange. power to enforce the preferences of the government passed to purchasing officers -.This is simply a more formal way of saying that strategic advantage accrues to the party that can best look ahead and reason back. consider the following situation: ". These laws probably increase the government's power to set an agenda but undoubtedly reduce its ability to understand or use the information that that power confers.] In a repeated game the information available to the customer [or his agent] will depend upon his ability to control the sequence of moves and countermoves that comprise the game. Reichelstein. A practical example of this process can be seen in the development and production of the Army's multiple launch rocket .. contracts and specifications are drawn for . The contractor can plead that he cannot easily change the room size: however. .

if they play their cards right. controllers retain authority to screen [or preaudit] all significant operating decisions. client. But wishes are not horses. responsibility center managers must have an interest in increasing their budgets. At a minimum this means that controllers must specify when. the faster its movement. controllers must usually settle for a practical approximation of this ideal. That is. they would like to know as much as possible about alternative choices and their consequences before managers of administrative units decide or acts.system. 1987]. how.even if they know what they are [and in most cases. their principals' preferences may be approximated. And.under decreasing costs to scale over an array of specialized or unique services [the following is based on Thompson. a full set of before-the-fact controls must be in place. over time. That is. lumpy investments in specialized resources are needed in order to provide services. or task performed is in some sense unique. Many organizational units in the government have these attributes. Here too. they would like service suppliers to reveal comprehensive menus of all possible actions and price lists identifying the minimum cost of performing each action under every possible contingency. The more pressured the unit. their authority provides a basis for the enforcement of efficiency through bargaining carried on during the execution of the budget. where each problem. of course there are no guarantees in budget augmentation alone. they won't][Brown. they may be able to compel supplying organizations to address the "most important" problems and to address these problems at a reasonable cost. The performance of such bureaus can only be improved by budget augmentation. Outlay Budgets A similar logic [Wildavsky and Hammond. here too as with flexiblecontracts. Presumably. where the relative expertise of the program manager permitted not only a confident source-selection decision but also highly effective contract management [Kennedy School. As a consequence." Under outlay budgets. Consequently. If controllers are skillful. But. & Miller. 1992]. Otherwise they will be indifferent to circumstances in which low priority problems drain resources from problems that are of greater importance to their superiors or legislative sponsors. That is. They supply outputs that are heterogeneous. 1993]. Thorton. hard to define. There is no way to compel managers within an organization to reveal their units' true production functions -. "such bureaus seem always to be near the beginning or end of a comprehensive dismantling and restructuring since there is usually a sense that performance is not all that it might be. Outlay budgets can help to keep prices low and to encourage efficiency where large. the impetus for change must come from the operating manager. and where . 1965] applies where outlay budgets have a comparative advantage -. and nearly impossible to measure. Buede. And here too. if not fully satisfied. and where the most serious problems are supposed to be dealt with first.

Breton and R. and the controllers must be confident that their monitoring procedures. Money lost in failed attempts to improve operations must be found elsewhere. Where these conditions obtain. if the price of such relief is a change in business as usual].which should go a long way toward insuring that managerial behavior corresponds to the customer preferences. They are also necessary to force the operating manager to seek authorization to make changes in spending plans and. including post-audit. thereby creating a precedent for higher levels of support in the lower priority area. the controller can enforce efficiency during the budget period by requiring affirmative answers to the following questions: Will a proposed change permit the same activity to be carried out at lower cost? Will higher priority activities be carried out at the same cost? Will the proposed asset acquisitions or reallocations of savings support activities that have lower priority than those presently carried out? When operating managers know and understand these criteria. to reveal hidden preferences. where a budget maximizer is subject to tight beforethe-fact controls. and trade-off possibilities. for example. McMaster. does not mean that the controller must administer before-the-fact controls directly. For example. therefore. This is obviously also the case where flexible-price contracts are appropriate. In addition. may have nothing to gain from relief from before-the-fact controls. 1989. Wintrobe [1982.assets are to be employed and how much the subordinate can pay for them. transfer funds. Paradoxically. As A. 1994] . trust can be substituted for bargaining and enforcement costs and authority to spend money. money saved during the budget period from substituting less costly or more productive assets for more costly or less productive assets must revert to the treasury. the Department of Defense has a program that designates exemplary contractors and exempts them from direct oversight. the gain to the operating manager from delegation must more than offset the associated sacrifice in bargaining power [the manager of an aging agency in the stable backwaters of public policy. The necessary conditions for relying on trust are: reimposition of controls must be a credible threat. Under certain conditions. controllers will approve most changes in spending plans that the managers propose -. capabilities. and fill positions can be safely delegated to operating managers. will identify violations of trust. These constraints are necessary because they prevent the operating manager from overstating asset requirements in high priority areas to get resources for use elsewhere. and new initiatives requiring the acquisition of additional assets or reallocation of existing assets must be justified accordingly. The threat that direct controls might be reimposed can be sufficient to insure that the operating managers ask the right questions of themselves and get the right answers to those questions before they take action -.because managers will propose only mutually advantageous changes. see also Gormley. to say that before-the-fact controls are needed to reinforce the controller's bargaining power where outlay budgets are called for.

1989: 28]. Trust requires mutual respect and understanding and a common sense of commitment to a joint enterprise. they are often overlooked. Kelly Johnson. It usually takes years of training and practical experience. there are fourteen rules for running a successful systems-development project. Effective execution of demand-concealing governance system designs -. by an excess of zeal or an overtly adversarial or confrontational approach. At the very least. Consequently. Trust in a bargaining relationship can be poisoned by a single lapse of honesty or fair dealing. more familiarly. by contempt on the part of one of the parties for the abilities. its corollary is a willingness on the part of both the controller and the operating manager to eschew opportunistic behavior that would be costly to the long-term well-being of either the operating unit or the organization as a whole.requires a great deal of savvy on the part of the controller. adoption of one of these governance system designs means that controllers must take steps to ensure that . but the most important is: "mutual trust between the . The skills required to execute demand-concealing governance system designs properly are certainly far rarer than are those needed to design and execute after-the-fact controls.or.flexible-price contracts as well as outlay budgets -. combined with a lot of common sense. the kind of trust that is needed to realize the best possible outcomes under a spending budget. In this context. can be threatened by the very same conditions that threaten a business partnership -.. and minimal inspections and reports.explain. specifications agreed to in advance. External observers fail to understand how they work. including complete control of the program. All long-term buyer-seller relationships ultimately rely on incentives. the incentives are deeply embedded in the process of budget or contract execution. small military project offices. these conditions also apply where contractual relationships are concerned. The Costs of Over-Control All long-term buyer-seller relationships rely to a degree on standards and rules. or by a simple lack of communication. or ethical standards of the other. to manage the complexities of bargaining in this context. Of course. for which a modicum of technical expertise will suffice. Even where the government uses prospective price mechanisms to reimburse free-standing service providers. As we have seen. or under a flexible-price contract for that matter. But demand-concealing governance system designs require considerably higher levels of reliance on before-the-fact controls and also on monitoring and enforcing compliance with them than do demand-revealing designs. project officer and the contractor" [Kitfield. judgment.. the difference is that when these governance system designs are employed. In other words. quality standards must often be specified and enforced. including a willingness to forego opportunities to exploit events for personal advantage. timely funding. a marriage. even those governed by outlay budgets and flexible-price contracts. According the original manager of Lockheed's Skunk Works. they also fail to understand how hard it is to make them work well. the sufficient condition is simply that the controller and the operating manager trust each other.

As I have noted. the federal acquisition regulations state: "Although the government does not expect to participate in every management decision. This. to approve subcontractors and suppliers. not what might have happened. in turn. it may reserve the right to review the contractor's management effortsŠ" In fact. but the supplier cannot be trusted to make them efficiently. 1975. Economic theory tells us that this optimum is to be found where the marginal costs of controls equal their marginal benefits. and report their expenses. To what extent should the government replace or duplicate the supplier's managerial efforts? It is necessary to pose this question because before-the-fact controls are costly. operational. and planning systems. The answer to this fundamental question is obvious: the minimum necessary. 1990. let alone those that should have been considered but were not [Cohen & Loeb. But accurate accounts will not guarantee efficiency. where government decides which costs are allowable under the terms of a contract and which are not. The problem of figuring out how much constraint is necessary is. to use the language of public discourse. direct costing procedures. best expressed in terms of minimizing the sum of the costs that arise out of opportunistic behavior on the part of suppliers [that is. and abuse] and the costs of control. under outlay budgets and flexible-price contracts. as shown in Figure 5. suppliers must be denied some discretion to make managerial decisions. requires careful definition of costs and specification of appropriate account structures.the service supplier's financial and operational accounts completely and accurately present every relevant fact about the operating decisions made by its managers. cost accounting. . 1994]-. is unlikely to be the case [Sourwine 1993. 1989]. given the motivations of service suppliers and the incentives confronting them. How much depends on circumstance and the controller's skill in exploiting the opportunities that are created by the supplier's response to institutional constraints. [from Breton and Wintrobe. to specify internal financial reporting. they will not provide a basis for evaluating the soundness of those decisions. Furthermore. A fundamental question is how far should this participation go. Even if -. federal contracts typically assign to government the right to review make-or-buy decisions.suppliers fairly and accurately recognize. wage rates. bookkeeping practices and internal controls. Consequently. fraud. "the minimum necessary" is a great deal indeed. Government or its agents will very seldom be more competent to make asset acquisition decisions than suppliers. perhaps. and the criteria to be used in handling overheads. both direct and indirect. Sometimes. They cannot show the range of asset acquisition choices and tradeoffs the supplier considered. This is because cost accounts can show only what happened. it has the power to determine which activities and what items of expenditure the source will undertake. both in terms of outof-pocket monitoring and reporting costs and in terms of benefits lost owing to the customer's inability to exploit fully the supplier's managerial expertise. record. etc. Hence. asset acquisition decisions must be made.

including those outlined here. FIGURE 5 GOES ABOUT HERE The figure indicates that it almost never makes sense to try to eliminate abuse altogether. But it must be recognized that controls are themselves very costly [e. Harr. and abuse avoided should be executed first. it seems to me that the indirect costs of control -. In contrast. Harr and Godfrey. the total cost of controls is depicted by the triangle marked with diagonal lines in 5. the costs of control [the sum of direct and indirect cost of their execution] are characterized by increasing marginal costs. Nevertheless. I would like to distinguish the costs of mismatching controls from the costs of over-control or micromanagement. some abuse must remain simply because it would be dreadfully uneconomical to eliminate it. If the sum of the costs of opportunistic behavior on the part of suppliers plus the direct and indirect costs of controlling their behavior is minimized.Masten. most don't show how the choice of mechanism affects costs. do increase at an increasing rate as the quantity of controls is increased. 1994]. But most empirical studies overlook the distinction between the subject and the timing of controls. might be more reasonable to presume constant marginal costs.the outof-pocket search. 1991. Hence. my reading of the evidence suggests that mismatched controls may add . Moreover. fraud. WHAT DIFFERENCE DOES IT MAKE? How much more efficient would the government be if governance system designs were carefully tailored to circumstances? Unfortunately. and abuse. 1990. and Snyder.. To the extent that they do what they are supposed to do. however. their singular purpose lies in helping us to avoid waste. and duplicative effort [Marcus. of course. The consequences of micromanagement are far more frequently denounced than measured. These consist of avoided waste. debatable. This assertion is. and enforcement costs that they impose on buyer and seller alike -. This is simply an abstract way of saying that controls that produce the greatest payoffs in terms of waste. bargaining. Hence. 1993. Controls contribute nothing of positive value. fraud.see also Williamson. Masten. 1985 -. dulled incentives. 1991. Reid. The darker triangle shows the waste remaining. Meehan.Williamson largely ignores. I don't have an unambiguous answer for this question.g. they can generate substantial savings. the particular institutional designs. see Vena. The benefits produced by administrative controls are characterized by diminishing marginal returns. that actually drive costs -. 1988]. To the extent that we are talking about the direct cost of controls -.stifled initiative. 1990]. The lightly shaded triangle represents the total benefits from controls. However. The theory outlined here states that both the ease with which the consequences of operating decisions can be monitored and the desirability of interorganizational competition matter.

security services. In another relevant study. the operation of day-care centers. and Edward Snyder [1991] carefully analyzed the determinants of control/transaction costs. Making the right decisions resulted in control costs that were a third less than if all components had been made internally and half what they would have been if all components had been contracted out. in the construction of the SSN-21 Seawolf. James Meehan. Scott Masten. classified using benchmarks similar to those outlined here -. Gallais-Hamonno. most have direct commercial counterparts -. ship and aircraft maintenance. Haskel & Szymanski. the substitution of after-the-fact for before-the-fact controls produces similar productivity gains. water supply. including custodial services and building maintenance. lumpy investments in extraordinary assets -.five to twenty percent to the real cost of supplying services. fire protection services. 1994]. where appropriate. hospitals and health care services.they are appropriate candidates for a combination of organizational responsibility and after-the-fact control.the greater the number of competitors. 1990: 36. 1991: 68-9]. over-control can add far more. Because these are common.indeed. which was carried out under the auspices of the Defense Enterprise Program. In his evaluation of the navy's commercial activities program. Szymanski & Wilkins.they determined that intraorganizational control costs represented about fourteen percent of total costs -.41 "make" items and 31 "buy" items. achieving productivity improvements of thirteen percent on average. In these latter instances. Looking at 74 components -. David J. Ehrlich. & Lutter. and weather forecasting. Not surprisingly. homogeneous services that do not require large. for example. refuse collection. Liu. the greater the average savings. found that the introduction of competition reduced service cost in eighty percent of the cases studied. 1992. postal services. Carrick also found that navy teams won over one third of the competitions carried out under OMB Circular A-76. Harr and Godfrey. Paul Carrick [1988] of the Naval Postgraduate School. the only significant change in governance relations was the shift from a demand-concealing to a demand-revealing governance system design. They also determined that the proper choice of governance mechanism permitted control costs to be substantially reduced. for example. Some of this evidence goes to the efficiency of privatizing various services. Other analysts who have . reports that replacing standard outlay budgets with responsibility budgets in Defense Logistics Agency depots was associated with efficiency increases of ten to 25 percent [Harr. Several analysts have found that. with average savings of nearly forty percent -. since most winning in-house teams were the incumbent suppliers. 1995. see also Parker & Martin. Harr. 1995.about thirteen percent for make components and seventeen percent for buy components. 1993. the evidence shows that shifting from individual responsibility and before-the-fact controls to organizational responsibility and after-the-fact controls does reduce the cost of deliveringtheseservices [Domberger & Li. housing. holding production costs constant. waste water treatment.

William Turcotte's classic matched comparison of two state liquor agencies reports even larger productivity differences caused by the substitution of after-the-fact for before-the-fact controls [Turcotte. both Anthony and Turcotte appear to conflate the choice of governance designs with their intensity. Furthermore.treating outlets as a profit centers. and inventory costs 400 percent higher. and granting them the operational discretion needed to meet those targets. straightforward responsibility budget to govern local retail sales outlets. Gordon Chase. the introduction of an effective monitoring system will yield a fifty percent improvement in the product in the short run" [Allison. but absolutely far greater in state A than in state B. One of the states [Turcotte refers to it as state B] did in fact adopt this approach to governance -. which leads to more controls. The organizations studied by Turcotte ran sizable statewide programs featuring large numbers of local retail sales outlets.excess controls cause failures. However. Unworthy Candidates for After-the-Fact Controls The evidence also shows that instances in which a single supplier could more . holding outlet's mangers responsible for meeting profit targets.from a high of 143 percent in the machine repair center to a low of nineteen percent in the motor room [Anthony and Young. Turcotte reports that one consequence of the difference in the control strategies used by the two states is that direct control costs were twenty times higher in state A than in state B. One of the more melancholy properties of before-the-fact controls is their propensity to proliferate -. 1974]. The indirect costs of control were somewhat less disproportionate. Productivity increases of this size are not. Operating expenses for each dollar of sales in state A were 150 percent higher than in state B. which replaced its standard municipal outlay budget with a well designed responsibility budget. I would not be surprised if two-thirds of the productivity differences reported here were due to over-control. both defined their missions in identical terms -.maximization of profits from the sale of alcoholic beverages to the public. 1988: 356-7].looked at the issue outside the defense arena make even stronger claims about the significance of the nature and timing of controls. administrative expenses were 300 percent higher. this situation called for the use of a rather simple. According to the theory outlined here. asserts that "wherever the product of a public organization has not been monitored in a way that ties performance to reward. 1982: 16]. Furthermore. in fact. and then more failure. New York's garages and State A's liquor stores were subject not only to the wrong kinds of controls but probably also to an excess of controls. for example. individual stores in state B were twice as productive as stores in state A. Robert Anthony claims that this reform increased productivity by nearly seventy percent -. unheard of. The other state [Turcotte refers to it as state A] relied on outlay budgets and a comprehensive set of before-thefact controls. One frequently cited example of such an increase is the central repair garage of the New York Sanitation Department.

and win the contract.. the next highest bid. if not. Consider what can happen when rival companies are invited to bid on a fixed-price. the customer may have to step in to rescue the project and. therefore. since the bidder with the most optimistic view of a project's feasibility will usually win the contract. Lockheed's default on the C-5A program and the subsequent Department of Defense bailout. It will often be the low bidder. even if Lockheed had known what it was doing. But this likelihood is crucial where bidders lack the experience needed to manage to a narrow range of outcomes -. they were in too deep to get out. the advantage will usually be borderline. 1990]. It is generally acknowledged that the worst defense procurement fiasco in recent memory. Unfortunately. as it mostly will. Indeed. when the A-12 development team got into trouble. a more interesting case -. even worse. highly risky technologies are concerned. This likelihood probably doesn't matter very much where all of the bidders have the experience needed to manage to a narrow range of outcomes [i. Lockheed submitted a bid on a fixed-price. sole-source contract to supply an advanced and. the most optimistic [or most desperate] bidder is unlikely to best understand the contract's technical feasibility. If it is not very lucky. the company as well. however. Consequently. which as it turned out it didn't. they will bid high to protect themselves against the risk of failure. it may overestimate its feasibility precisely because of its incompetence to carry it out. In that case. thereby .as will usually be the case where advanced and. 2. If they bid at all. either comparative advantage will trump optimism or. Evidently. Department of Defense decided the A-12 was expendable and canceled the contract. The case that has been given the greatest amount of attention by industrialorganization economists is where customers artificially maintain rival suppliers [Anton and Yao. One or more of the bidders will underestimate the difficulty of the contract [or overestimate his capacity to meet its terms]. in some cases.e. this means that the price of the service to the customer will be excessively high. of course. total package procurement contract to design and deliver 150 C-5s that was fifty percent less than Boeing's. The same thing happened more recently with the Navy's A-12 medium bomber program. its bid would have been half-again too low. Alas. By the time the Department of Defense and Lockheed discovered magnitude of their error. there are a number of firms already supplying the market]. therefore. open-bidding contests tend to select suppliers for their optimism [or their desperation]. Fortunately. They will likely respond to such an invitation in one of two ways: 1. highly risky or uncertain technology. occurred because Lockheed misread the difficulty of designing and building the C-5A. or threatens to slide into bankruptcy. There is.where design error produces a search failure [the technical term for this phenomenon is adverse selection]. When it fails to deliver.efficiently supply the entire market are unworthy candidates for after-the-fact controls. or. it will then be cursed by its victory.

Firms tend to rely on experience and reputation to pick suppliers. Indeed. this was evidently a near run thing. The formality with which proposals are evaluated also serves to insulate them from the consequences of choice and. there is a tendency for RFPs to swell out of control. a single organization will often be uniquely qualified to supply it. One lesson suggested by the example of the C5-A is that the costs arising from mismatched controls are asymmetrical in their composition: if other things were . A decision to invite a proposal is usually tantamount to an offer to do business. One must sympathize with procedures that work to minimize unjust criticism and keep hard-working contract officers out of trouble. these search processes have similar aims and. particularly where major projects are concerned. fortunately for Boeing and ultimately for the taxpayer. This is clearly wasteful. Unfortunately. Potential suppliers must appear on a list of qualified vendors. Nevertheless. the process is more formal. as happens in the best of circumstance. more often than not produce similar outcomes. I believe. The point is that. In the mid-1980s. therefore. therefore. These RFPs tend to be very detailed. Customers must usually request proposals from more than one organization. with each section of a proposal assigned an explicit numerical score and its overall evaluation based upon the weighted sum of these scores. Identifying the right supplier is. purchasing officers probably have a pretty good idea of the identity of the most qualified suppliers. Boeing took a bath on a series of fixed-price contracts that it sought and won despite lack of expertise. Only after evaluators have identified the best proposal will the government's representatives engage in ex parte conversations with the vendor to work out contractual details and nail down a best and final offer. where a single supplier has an acknowledged technological lead. Requests for proposals [RFP] are supposed to provide detailed explanations of what proposals should include and how they will be evaluated. Evaluations tend to be highly ritualized. Even where that is not the case. and armies of evaluators are needed to score them. Where the program manager is authorized to issue an RFP rather than an invitation to bid. RFPs cannot but reflect purchasing officers' subjective judgments about the importance of various product attributes and the competence of alternative vendors to deliver on their promises. In the private sector the search process is often fairly informal. Boeing's civilian profits were sufficient to make good its military losses. in response. to protect them from the complaints of rebuffed vendors. proposals expand to carload size. although probably less wasteful than when the contract is awarded solely on the basis of price and the winning contractor turns out to be incompetent. the formality described here is probably more apparent than real. This is especially important when. things go wrong. In the public sector. the law permits the request of a single proposal and a sole-source contract.avoiding the worst aspects of the C-5A case. Proposals are more often than not jointly developed. where a unique product or service is involved. the key to getting the best product. Nevertheless. and at a reasonable price. Again. on time.

for example. tends to result in organizational rigidity and ultimately total ineffectiveness. which may make subordinates even more unwilling to trust or cooperate with management. rather than measured performance. Meehan. more failure. Michael Crozier [1964] argues that failures to meet expectations almost inevitably produce a cycle of rule-making." and a rule is promulgated to avoid the abuse in the future. produce certain equally predictable consequences. it would be far more prohibitive to rely on after-the-fact controls where beforethe-fact controls are called for than vice versa -. in turn." Jack H. Khandwalla [1978]. but that they also exacerbate the factors that cause organizational failure. Furthermore. No one who has the power to rescind the rule may ever consider "whether the likelihood and seriousness of error is great enough to warrant continuation of the rule. see also Marcus. 262-5] observe that stricter rules and tighter oversight often produces positive short-term results.nearly two hundred percent.equal. Where the purchaser relies on demand-revealing controls. extra supervisors giving more orders and monitoring effort more closely may make subordinates "even more resentful of their status than before. but such rules often continue after the need for them has passed. William Kovacic [1990: 112] provides an example here of the cyclical process by which before-the-fact . observes that threatening situations always generate pressures for direct controls: standardization of procedures. Miller [1987: 108. Before-the-fact controls often produce positive feedback that leads to their multiplication. Which leads to more stringent rules. greater reliance on hierarchy. institution of rules and regulations. and Snyder's [1991] finding that. 1988] concludes that reliance on rules and regulations reflects a concern with error prevention and that an emphasis on error prevention.evidently because moral hazard is easier to fix than adverse selection. although making "buy" components would have caused internal control costs to be about seventy percent higher than they actually were. the inclination to respond to abuses with calls for more and better rules is normal. Anthony and Young [1988: 562] claim that detailed rules result from encrustation: an abuse occurs. 257. Pradip N. This lesson is reinforced by Masten. Knott and Gary J. and centralization of authority. and more hostility on the part of subordinates and on and on.and that these responses. contracting out "make" items would have caused control costs to increase even more . In other words. and then more rules. from thirteen percent of the total value of the items to over thirty percent. they are also self-limiting. Carrying Legitimate and Necessary Controls to Self-Defeating Extremes Organization theorists have long understood that failure induces certain predictable responses -. greater oversight and closer supervision. Not only are after-the-fact controls easier to use. someone decides that "there ought to be a law." Robert Merton [1957. over-control produces negative feedback in the form of higher prices or reduced output that causes controls to be cut back. But other things are not all equal. as is responding to failure with ever more inflexible and comprehensive rules.

Applying function-point analysis to thousands of software projects selected from around the world. Kovacic [1990: 112-13] further observes that: "[t]his strategy has enormous costs. The same study showed that the United States is in first place in the production of management-information systems and runs a strong second to Japan in large-scale systems software projects. "Because DOD's contracting personnel are overmatched by their industry counterparts. the United Kingdom. files. it is a simple matter to calculate its cost per function point. Software Productivity Research found that American military software productivity lags behind France. The problem is not that American software engineers are inherently unproductive. and military systems. but contributes no function points to . This study was conducted by Software Productivity Research of Burlington. Preparation of this paperwork takes a lot of engineering time." Excess Controls One critical piece of evidence on the burden of procurement controls in the United States was provided recently by a study described in the Economist [Anon. Authority is dispersed so widely among a large collection of program managers. outputs. Function-point analysis is widely used in the software business because it can be applied to any piece of software written in any computer language. contract officers. Korea. On the contrary. senior [government] executives. inquiries. Germany. By having large numbers of less talented eyes look long enough at a given problem.controls induce failure and thereby additional controls in the Department of Defense.. Programs proceed at a glacial pace as contractors and government purchasing personnel carry out required review and auditing procedures. it is assumed that DOD can prevent Contractors from picking its pocket. a standard measure of productivity. Government payrolls expand. and used a method called function-point analysis to estimate the productivity and cost-effectiveness of three kinds of software projects: small management-information systems. Congress and DOD have sought to rebalance the playing field by mandating layers of procedural safeguards and intricate review processes. and inspectors that accountability vanishes. asymmetries in human capital between government and its suppliers help to explain the size and content of the existing control regime. and the number of function points produced per systems engineer. weighted according to the complexity of the codes needed to provide them. Sweden. Software Productivity Research also discovered that differences in cost per function point are due primarily to the amount of paperwork generated per point. Massachusetts. and even Italy. large-scale systems. Once a software project's function points have been measured. procurement organizations. and interfaces. 1993]. Israel." In other words. Both Texas Instruments and Unysis sell computer-aided engineering programs that automatically compute five things in terms of a measure called "function points": inputs. the standard measure of cost effectiveness used in the industry. auditors.. and contractors hire legions of contract administrators to respond to the requirements of large multitiered .

costs are typically 200 to 500 percent higher. federal procurement procedures may account for more than half their cost. because of the costs of complying with cumbersome procurement regulations. But for high-tech products. and that on average defense goods cost 30 to 50 percent more than their commercial equivalents. Gansler [1995: 123-124] found that the typical defense plant spends about four times as much to administer contracts as its commercial counterpart and employs four times as many administrators. software can be reproduced innumerable times at almost no cost. There is a second reason for emphasizing this evidence. as we noted earlier. Petroleum products are at one end of the spectrum and software engineering the other. design. 1983: 146. There are other estimates. Raw materials and processing costs account for nearly all oil company expenses. This leaves at least fifty percent for overheads. documentation. This comparison is particularly telling. but the identification of allowable/disallowable costs. direct manufacturing labor accounts for only ten to twenty percent of costs. of course. Software production is mostly overhead -. Indeed. The Grace Commission estimated that complying with procurement regulations accounted for at least ten percent of the cost of the Pentagon's purchases. no materials. One was provided by the Grace Commission [President's Private Sector Survey on Cost Control [Grace Commission]. 1988]. for activities like software engineering. However. see also MacManus. which are arguably comparable to military software projects.the finished product. This one of a very small number of studies that that directly estimates the cost burden imposed by federal acquisition procedures.product development. The Grace Commission based its estimate on the observation that oil companies give substantial discounts to most bulk purchasers -. And that's the typical defense firm. the Department of Defense pays market prices for about eighty percent of the gas and oil that it buys. They are six times as costly per function point as big systems software projects. no production labor. materials and purchased components typically account for thirty to forty percent more.up to fifteen percent in some cases. 1991. What this comparison suggests is that. and administrative support. no capital. American military projects generate five times as much paper and cost twelve times as much per point as management-information systems projects. Consequently. overheads for nearly all software company expenses. Accounting for Transaction Costs In the typical defense plant. These studies also show why it is that good estimates of the costs of before-the-fact controls are lacking: the accounting standards established by the federal government that tell contractors how to measure costs simply do not provide this information. many suppliers refuse to offer similar discounts to the Department of Defense. Lamm. direct labor costs are practically irrelevant in . Once codes have been written and documentation prepared. the main objective of these procedures is not cost finding. about $12 billion a year. Based on a survey of 206 firms.

Trailers are technologically unsophisticated and their manufacture appears to be a pretty straightforward exercise in metal bashing.the increasing number of firms that rely on flexible computer-aided design and manufacturing. The company in question established a second production line at a new location for its military business. On its military increase that should properly be attributed to the policies that caused it and not to the trailers themselves. Its inventories have been cut to the bone. The software productivity study is useful precisely because it took this approach -paperwork was identified as a cost driver as well as a source of unproductive expense. and manufacturing-cycle time -. total inventories were once twenty-five times higher. which allows the firm to apply just-in-time inventory control to the production of finished goods as well as to raw materials. On its commercial side. it is unrealistic today and has probably always had the effect of diverting attention from costs that arise out of the procurement process. Of course. components purchased elsewhere.the time from the start of production to shipment of the finished product -. because that was the easiest way to comply with federal costaccounting standards and other government reporting requirements. Figuring out what drives overheads. But increased red tape is just the tip of the iceberg. Until government accounting standards are changed to focus on overhead and transaction costs. The studies reported by Gansler all took this approach as well. utilities. and depreciation. identifying cost drivers that do not add value to end products. This doubled the company's working capital requirements and increased rents. They call for overheads to be assigned to products on the basis of standard labor hours or machine time. This firm tries to practice the principles of lean management and just-in-time inventory control. and changing them. when efficient use of direct labor was the key to manufacturing productivity. Most of the cost of procurement controls result from their effect on operating processes and the use of assets. ought to be the purpose of cost analysis. This was forcefully brought home to me by an experience working with a firm that makes trailers for the Army.that's the gist of both the Software Productivity Research study and the Grace Commission's opportunity-cost analysis. we won't know how much federal controls really increase costs. this is not government's typical approach to cost measurement. For example. and work-in-progress inventories. since they also varied directly with inventory usually less than thirty-six hours. Unfortunately. Products are shipped to customers as soon as they are finished. it has succeeded fairly well. duplication of facilities increases the average cost of the firm's trailers -. insurance. everyone believes that procurement regulation increases paperwork burdens -. Inventory size was higher on the military-production line because cycle time was . Its accounting standards require suppliers to focus on direct labor and materials costs and to treat most other costs as fixed. While this approach may have made sense thirty years ago.

as an example. Consequently.50 a pound for its fruitcake -. although direct labor costs per trailer were not significantly higher.higher. it cost on average more than $1 to save $1. The same thing happened with management time. even if one allows for the source of the claims. for example. it is not hard to find evidence that the marginal benefits produced by some before-the-fact controls are actually negative. but where a plethora of rules deny the program managers the authority to trade off costs. excessive reliance on rules often produces organizations that are simultaneously over controlled and out of control. schedules. Anecdotal evidence suggests that this is often the case where defense procurement is concerned. I must nevertheless acknowledge that the Department of Defense pays only $1. but. and performance. Looking beyond government. even . the rule of thumb is that monitoring and enforcing regulations imposes private costs of about $10 for every dollar spent by the government [Weidenbaum and DeFina. found that the managers of retail stores in state A were subject to more rules and far stricter executive and legislative oversight than their counterparts in state B. Evidence that marginal costs are greater than marginal benefits. overhead costs per trailer were more than twice as high on the military line as on the commercial line. cycle time was higher because the Army required inspection at each stage of manufacture and because the Army preferred to take delivery in large batches. in the first instance. Marcus. Finally. together with greater oversight and closer supervision. earlier I used fruitcakes to illustrate the ludicrous extent of federal procurement controls. which increased each trailer's capital cost. the Defense Contract Audit Agency proudly claims that it saved the American taxpayer about $7 billion in 1988 and cost only $1 billion. This sounds like a pretty good deal. Since these costs are ultimately borne primarily by the firm's customers and since in this instance the customer is the government. is prima facie evidence of over-control. Increased cycle time also meant less intensive use of the firm's plant and equipment. let alone four times greater. What about Benefits? To say that controls have high costs does not necessarily mean that they cost too much. Turcotte [1974: 69]. Evidence of over-control requires information on the benefits as well as the costs of control.about half the price in civilian markets. actually had the effect of degrading reactor safety [Marcus. For example. 1978]. shows that increasing the number of safety rules governing the operation of nuclear power plants. Are the benefits of control generally proportionate to their costs? One agency. Its criminal investigations generated an additional $300 million in fines and penalties and cost only $84 million . and $1 billion to save $300 million in the second -. 1988]. especially where demand-concealing governance mechanisms are called for. Alfred A. this multiplier implies that Defense Contract Audit Agency regulation imposed costs of $10 billion to save $7 billion. for example. which is consistent with marginal costs of $2 and $ other words. However.

000 currently performing activities with private sector counterparts [Carrick. the degree of incentive is supposed to be calibrated to the project's riskiness. there are very few it should perform for itself. 1988: 521]. Yet the mismatches are. the Department of Defense simply doesn't have the unit cost information it needs to implement the A-76 program.the big ticket projects that account for eighty percent of federal procurement spending. there are fewer critical ones. Most of the rest of the Department of Defense's employees are effectively exempted from competitive challenge by the absence of cost information. Many of these services do not require large. only 58. for example. as second sourcing permits renewed competition at each renegotiation of production contracts. How Well Are Designs Matched to Circumstances? The match between the governance mechanisms used by government and the cost behavior of the goods and services it produces and acquires is frequently imperfect. there are clear opportunities for subjecting many of the common. government policy calls for the maintenance of long-term contractual relations with two or more producers. Moreover. the federal government was under excessive pressure to sign to fixed-price contracts awarded by competitive bidding on major systems development projects -. however. about one-tenth of the 540. Congress has formally exempted 250. therefore. not as pervasive as one might fear. much of this pressure it was a consequence of the . is supposed to be constructed under a cost-plus contract. Government policy currently restricts the use of flexible-price contracts to situations characterized by considerable procurement risk. to assume a greater share of the risk burden. over-control led straightaway to loss of control. At the same time. And while there are many minor services that the Government performs for itself that should probably be let to contract. perhaps. On the face of it. In many cases. were far less responsive to the wishes of their political masters. The first ship in a multi-ship construction it seems that the government generally makes the proper transition from cost-plus to award-fee contracts as it moves from design to prototype development. In other contracts. Where production volume is sufficient. Consequently. these look like sound policies. lumpy investments in extraordinary assets and some already have direct commercial counterparts. During the mid to late 1980s.000 Department of Defense employees are subject to A-76 competitions under the government's commercial activities program. on the assumption that experience permits the service supplier to manage to a narrower range of cost outcomes and. Among the services that the Government now contracts out.000 Department of Defense employees from the commercial activities program. Evidently the managers of retail stores in state A were subject to so many rules that none of them mattered very much. For example. everyday services used and/or produced by government to competition. while later editions are required to be built under under incentive and eventually fixed-price contracts.

are essentially unproductive and could be eliminated. the field is changing. and the lack of a sound responsibility budgeting system is by far the greatest mismatch between governance system design and circumstances in government. in our research. Obviously. many remain equivocal. incentives in the form of loans and taxes. Rather. One of the biggest needs of government is a modern activity-based costing system. but that is not the most important use for such a system. understand a wide variety of institutional arrangements: regulation. This was excessive. 1989]. Despite their efforts. adequate cost accounts are needed to implement a sound responsibility budgeting system. and quasi-governmental enterprises. and our teaching. better cost information is necessary to carry out make-or-buy decisions. we have failed to show the need for alternative institutional designs and governance mechanisms. But Kelman's diagnosis is also an indictment of many in public administration. inward less -. CONCLUSION Steven Kelman [1991: 196] argues that one reason for government's excessive reliance on before-the-fact controls is an intellectual failure to understand their high costs. especially overhead and supply activities. multiple sources are required to exploit competition and that runs counter to the current need for a drastic culling of defense firms. 1989: 3-7]. And the simple fact is that governance mechanisms have not been developed match contemporary government's tactics and responsibilities. our literature. contracting. then the situation is happy indeed. Public administration has accepted Mosher's challenge to look outward more. the answer must lie in an inability to look beyond superficial institutional dissimilarities to common structural elements inability to . Some of the adverse effects of favoring fixed-price contracts and competitive bidding regardless of circumstances have been mitigated by governmentsponsored changes in production technology and by its imaginative use of quasivertical integration. Intellectual failures are fairly easy to fix. Its intensity was reflected in the decline in flexibleprice contracts from sixty percent of the Department of Defense's major purchases in 1978 to twenty percent in 1988 [Pilling. Fortunately.Competition in Contracting Act. Why? Since the new economics of organization provides a satisfactory framework for analysis. It is not unlikely that such a system would show that many of the activities performed by government. It implies that. especially the cost they exact in terms of mission performance. Many do not even understand that this task should be central to the enterprise of public administration. If Kelman is correct. They have not been eliminated altogether [Pilling. Besides.especially innovative administrative controls -.

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