The incentives and constraints matter. The incentives and constraints that people face influence their behavior. As consumers and producers, we pay a great deal of attention to the personal gains that we hope to obtain in different ways of action. The analysis of people's behavior must therefore begin with the careful study of the incentives and constraints that they face. The logical conclusions that we reach this way have a vast explaining power because they can be applied to the probable behavior of the people in different time and places.
Managers
Managers are professionals employed by business owners so as to represent the best they can the business owners' interests. The aim of the business owners is usually higher profits and the rise of their shares prices. Stockholders can have as well other purposes such as the development of the community in which they do business, workers' appreciation, refraining from projects that involve damaging the environment and an honest business conduct (e.g. without paying bribes in exchange for contracts). The variety of the shareholders' objectives does not diminish the importance of considering the profit motivation for two reasons. First, in order to become a task for managers, a business objective must be agreed upon by the majority of shareholders. If a group of shareholders thinks that following a different objective would be a good idea, they have to convince other shareholders so their proposal is adopted. Second, although at a first glance an objective may seem to have nothing to do with aiming higher profits, a closer analysis proves that following that specific objective would ultimately lead to increased profits. Many measures that private firms enact under the umbrella of the social responsibility of corporations fall in this category. The apparently altruistic expenditures made by business people with "social concerns" may bring higher profits in the future if they are properly delivered to a gullible public.
Modern corporations have many shareholders. The decision regarding the appointment of managers is shareholders' collective decision. The phrase collective decision is an imprecise one. Only individuals are rational and can decide. In other words, in order for a participatory body to work, rules to govern the aggregation of individual decisions into a collective decision are needed. In the case of the modern corporation, these rules are described in the statute. The analysis of the incentives and constraints that a shareholder face in trying to dismiss an incompetent manager may reveal a possible weakness in the operation of corporations. To cause a change to be made, a single shareholder must convince other shareholders that changing the current manager could lead to an increased profitability. His efforts of monitoring the current situation and of convincing other shareholders are activities that incur costs. In case of success, the benefits in the form of increased profits must be shared with other shareholders. Hence, the incentives that an individual shareholder have in trying to monitor the management are weak.
Managers act as agents of the shareholders. If they are successful in accomplishing the goals that the shareholders established, they have personal benefits. A manager will soon realize that he can gain even if he does not dedicate his entire energy to increasing the company's profits.
We can now see a problem that might appear when the shareholders do not run the business themselves: to what extent will the managers follow the shareholders' interests? In other words, what incentives and constraints do managers face in their attempt to achieve higher profits?
Although there are no perfect solutions, free markets led to several methods to diminish the managers' temptation to diverge from the following of the profit.
Managers are able to offer useful services as a result to their talents and abilities that they have gained in time, because of investment made in professional training and experience. These services are subject to exchange on the market. We may call this market "the managers market". The evaluation that a manager receives on this market is strictly related to the profitability of the firm that he runs. In the event of changing his actual job, a manager may expect a rise or fall in his income according to the value that his services have on this market. Because the managers have an advantage over the shareholders regarding the access to information, they may the trust that the shareholders invested in them. The position that the managers occupy on the market relates to another important element: the reputation that they have built. Following his own interests, the manager has a strong incentive to promote the interests of the shareholders.
Another method that shareholders may use in making sure that the managers act in their behalf, using the managers profit participation. An increased salary for the manager in case of good performance may be a part of the contract that the shareholders and managers negotiate.
The stock market may generate another incentive for managers to be efficient. If a corporation is poorly managed, the price of its stock will have a tendency to fall. If speculators believe that the company's profitability can be improved by changing the existing managerial team, they will make a takeover bid. As they gain the majority of votes, new shareholders will let off the manager. Due to the prospect of losing his job, a manager has a strong incentive to be efficient.
Free markets may lead to the discovery of new institutional mechanisms to ensure that the managerial team follows the shareholders interests. We can imagine the situation in which the problems depicted above were considered irresolvable in a free economy, and a centrally planned economy was put in its place. The people would have never had the opportunity to discover solutions through private efforts and state borders would have replaced the free markets.
Bureaucrats
The incentives and constraints that bureaucrats face in their activity are nothing like the ones of privately owned companies. The analysis of these will lead us to a different conclusion about the bureaucrats' behavior.
The bureaucrats work for the government administration and for various regulation agencies. The official denomination is public servants, but in economic theory, bureaucrats and bureaucracy are the usual terms used.
The bureaucrat does not enjoy a bright image in the eyes of the public. He is thought to be lazy, apathetic, lacking initiative and ever ready to take bribes. In the analysis of the bureaucrat's behavior, we will employ the following hypothesis: he is no different then the business people or managers. One does not need special characteristics in order to become a public servant. In fact, there are numerous cases in which, tying to improve its efficiency, politicians employ reputable managers to run a government bureau. The opposite case is also common, but as well more controversial: a bureau chief may become a manager. The bureaucrats are no better or worse than their equivalent working for private corporations. If the analysis of the bureaucrat's behavior leads us to the conclusion that he acts differently than the manager, this fact cannot be the result of different characteristics of the two.
Unlike a private company, a government bureau does not seek profits. The aim of the bureau is to supply a service in exchange for a budget that it receives periodically from the state. The consumers do not buy the goods or services that the bureau supplies in the regular sense, so the extent to which that consumers value those goods or services cannot be determined. That does not mean that the goods or services are worthless. It merely means that the value of the good or service cannot be known. It is possible that producing that good or service will incur costs that are greater than the benefits to the consumers. There are many reasons (described below) to believe that these cases are not rare at all.
Some bureaus may charge consumers a user fee in exchange for the service supplied, but usually this does not cover the costs incurred. The bureau cannot keep the money that it receives as user fees. It must either turn it to the government or use it in accordance with rules that are set by the legislature. The profit motive is the essential difference between a private firm and a government bureau and the main reason for the divergence between the behavior of the manager and the one of the bureaucrat.
In the case of bureaus, since there is no profit motivation, efficiency is a meaningless term. The efficiency of privately owned firms is the result of voluntary actions of many individuals that decide how to spend their money in order to get as much satisfaction as they can. Any government bureau's activity is based on state financing, which means that it obtains its revenue through coercive means. However, the idea of efficiency cannot exist in lack of voluntary behavior. The consequence is that there is no precise instrument that can be used to assess the degree to which a bureau reaches its targets. A bureau cannot be assessed as being more efficient than other that supplies the same service in a different area. Accordingly, bureaucrats cannot be rewarded with higher payments for their success nor can they be penalized for failure.
The politician that supervises his activity can reward a bureau chief with a higher pay, with promotion to a better position (in another government agency or even in the government), or with the prospect of employment as a manager of a privately owned firm. The reward that the bureau chief receives is in no relation with consumers' satisfaction. Most likely it is due to the success of the bureau in using the bureau's resources to help politician accomplishing his goals.
Given that obtaining profit is not an objective for a bureau chief, he must obey to precise rules and regulations. In the case of a privately owned firm, since obtaining profit is due to consumers' satisfaction, the main goal of its manager is identifying and satisfying consumers' wants. The chief of a government bureau does not need to worry about the degree to which the consumers of the service that he provides are satisfied. Moreover, even if he was interested in discovering consumers' wishes, he has no means to measure consumers' satisfaction. The aim of the bureau chief will be obeying the rules. A politician would assess the activity of the bureau chief according to the degree to which he obeyed the rules. There is no doubt that the politician will be interested in the consumer's appreciation, but he has a strong incentive to use the resources of the bureau for winning the next elections. Another characteristic of the management of government bureaus is the hierarchical enforcement of rules. An additional difference between a privately owned firm and the government bureau is that in the case of the later the connection between consumers' satisfaction and the appraisal (therefore his income) that a bureau chief gets.
The relationship between a bureau chief and the politician whose job is to monitor it is different from the relationship between shareholders and managers of a privately owned firm. The politician has weak incentives to monitor carefully the bureaus and to improve their activity. The instruments that he can use are most of the times inefficient. In addition, civil service laws protect the bureaucrat against being punished unjustly or severely by politicians. They cannot be fired unless they committed a crime.
The very different incentives and constraints that the two categories face is also the explanation for the very different kinds of personality that most probably would be successful. The free markets award managers that proved to be inventive and willing to take risks in introducing new products or technologies. Bureaucrats tend to be conservative: they gain if the environment in which they act remains more or less the same. Introducing new management methods is likely to be regarded with distrust. They tend to favor redistributive policies and interventionist governments.
Conclusion
The well-being of a manager depends upon his success in ensuring the profitability of his enterprise. He has a strong reason to follow the interests of the shareholders. The consumers are the ones to decide the future of a manager and their interests will be accurately followed. A government bureau chief is interested in applying the rules that the politician in charge with supervising his activity gives him. His well-being does not depend upon consumers' satisfaction, but the politicians' satisfaction.