Monthly Archives: February 2015


Consumers’ utility equals the quality of the good plus net income (gross income minus price of the good). Consumers, then, are willing to pay q+Q1-mE for the good, where E is the anticipated level of unverifiable effort, and q is a constant. After the entrepreneur chooses E and Q1, he delivers the good to the consumer at time three.

The total cash profits of the firm are P- C(Q1)+K(E). If the firm is for-profit, these profits are realized as income to the entrepreneur. If the firm is not-for-profit, the entrepreneur is forced to spend these revenues on perquisites, denoted by Z. Entrepreneurs maximize a quasi-linear utility function:

We begin with the entrepreneur’s decision about his effort level, E. Price P is fixed when the entrepreneur chooses effort. Total utility of a for-profit entrepreneur is P-C(Q1)+K(E)-E. In choosing the optimal effort level, he sets K'(E)=1. Define Ef as the effort level that satisfies this first order condition.
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Although our basic results are driven by the effect of the non-profit status on incentives, and do not rely on entrpreneurial altruism, most founders of non-profits — such as Dunant or Muir — have a strong interest in their causes. We show in an extended model that entrepreneurs with a strong taste for quality would opt for non-profit status. When this taste for quality is unobservable, nonprofit status serves as a signal of such taste.
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Finally, we examine general (non-targeted) donations from charitable donors who wish to improve product quality. Donations to for-profit firms do not to a first approximation change the marginal conditions for production of quality. However, donations to non-profit firms lower the marginal utility of revenues and lead to even softer incentives. Through this channel, unverifiable quality in non-profits may improve. In the same spirit, we examine the role of governing boards of non-profit firms, which are often structured to have very low benefits of perquisites, and also staffed by donors.


Finally, unlike much of the recent literature (Hart and Moore 1997, Kremer 1997), we focus on non-profit entrepreneurs rather than on cooperatives. The cooperatives literature focuses on the consequences of collective decision making. Many non-profits are started by entrepreneurs, and hence do not face this particular problem.

Our basic model examines a firm that sells a commodity to a single consumer. The quality of this commodity has both verifiable (contractible) and non-verifiable components. After the sale, the entrepreneur can exert effort to reduce costs. As in Hart, Shleifer and Vishny (1997), cost-reducing effort may also reduce the non-verifiable component of consumer quality. Consumers are willing to pay higher initial prices if the firm can commit to making less of such cost-cutting, quality-reducing effort. As a means of such a commitment, non-profit status ensures higher prices. Entrepreneurs choose the non-profit status if the benefits of committing to higher quality outweigh the costs of having to take their net revenues in the form of perquisites rather than cash.
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We present a model that attempts to capture this idea. Some of the literature on non-profit firms, such as Drucker (1990) and Rose-Ackerman (1996), stresses the altruistic motives of its management. We agree that many founders of non-profit firms are motivated by public spirit and altruism, rather than just profits. At the same time, we believe that one can explain many crucial aspects of non-profit behavior, including which markets they operate in, without relying on the assumption of altruism. Even with the altruism assumption, the question of why an altruistic entrepreneur chooses the non-profit organizational form remains pertinent.

The basic idea of our model is well-known from the theoretical literature on incomplete contracts, including Klein, Crawford, and Alchian (1978), Holmstrom (1982), Grout (1984), Grossman and Hart (1986), and Holmstrom and Milgrom (1991, 1994). In some situations, particularly strong incentives lead to inefficient behavior and cannot be controlled by an explicit contract. Such incentives should be moderated by other means.