Monthly Archives: March 2015


Part (a) suggests that tax deductible donations will be higher among donors who face a higher marginal tax rate. More importantly, part (b) implies that, as the firm acquires alternative sources of revenue, donations dry up. When firms are already rich, donors expect their donations to have less of a marginal impact on quality-related incentives and contribute less. Segal and Weisbrod (1998) find some evidence that donations and sales revenues are indeed substitutes for non-profit firms.

This result may explain why state-supported institutions receive few donations. State funding reduces private donations because private donors do not expect to have much of an impact on quality. In practice, there does appear to be a strong substitution between private charity and state funding. City Year, the national service organization founded by Brown and Khazei (discussed in the introduction), originally faced tremendous difficulties finding private donors to fund its programs, evidently because it already received sizable public funds. State universities in the United States have traditionally been less successful in fundraising than private schools. Indeed, both Yale and Harvard received most of their funding from state governments until the first quarter of the 19th century.


Moreover, in many non-profit institutions, funds are substantially fungible, and even specifically targeted gifts can be used for general purposes. To understand the role of general gifts to a non-profit institution, we must return to the previous model and explicitly incorporate an altruistic donor. Furthermore, we now assume that V(Z) is not linear, but an increasing, strictly concave function.

The timing of the model must be adjusted to include a donor. In period zero, the entrepreneur decides on the not-for-profit or the for-profit status. In period one, a donor decides on a level of general donations, denoted by D. The donor correctly anticipates the effect of his donation on the future price and the non-contractible quality level. In period two, the entrepreneur sells the good to the consumer at a price P and a contractible quality level Qx. As in the previous section, we assume that there is only one possible level of contractible quality. In period three, the entrepreneur chooses his effort level E, which in turn determines non-contractible quality.


When non-profit status attracts more altruistic producers, prices in non-profit firms need not always be higher than prices in for-profit firms, despite the fact that non-profits have higher unverifiable quality. If altruists care about offering low prices, which many at least claim to, then the altruistic producers in the non-profit sectors may set prices below those in the for-profit sector. Of course, there would then be queues in the non-profit sector. Thus Harvard and other top universities ration the slots in their entering classes, as do some of the non-profit long term care facilities. An alternative view is that low prices make administration easier, since there is less need for advertising and management (since there is always a queue of customers) and that non-profits set lower prices to avoid effort.


These examples raise the obvious question: what are the markets in which reputation and/or competition suffice for quality assurance by for-profit firms, and what are the markets where the not-for-profit status is necessary? Non-profit status is usually only necessary when the potential expropriation problem — and the disutility to consumers or donors from reduced quality — are very large. In the case of donations in particular, where the donor cannot take the money back or switch, the non-profit status might be essential. This logic might explain why we see non-profit hospitals (they deal with life and death and rely on donations) but not non-profit doctors (it is easier to switch or get a second opinion, and there are no donations). This logic might also explain why universities are non-profit (rely on donations) while vocational schools are not (no donations). Finally, this logic might explain why, for most goods where quality matters, market mechanisms are good enough for assuring quality production by for-profit firms.


One potentially interesting dimension of heterogeneity among consumers is the difference in the ability to monitor suppliers. Consumers who are bad at monitoring would then select non-profit firms to deal with. If governments are particularly weak at monitoring contracts (because of their own well known incentive problems), they will specialize in dealing with non-profit firms.

Examples and Discussion

Not for profit status is not the only means of softening incentives. Other institutional arrangements may supplement (or replace) it. For example, entrepreneurs with a particularly low known taste for perquisites, or whose consumption of perquisites can be restricted by a higher authority, might make particularly effective operators of non-profit firms. This may be the reason why so many non-profits such as schools and hospitals are operated by or affiliated with particular religions that restrict consumption.


Market Equilibrium

When consumer tastes and the producer technology are homogeneous, inequality (3) either holds or fails for all possible entrepreneurs. As a consequence, all firms in an industry choose the same status. Indeed for profit firms almost completely dominate some industries (automobile manufacture), while non-profits dominate others (child care). On the other hand, in some industries, such as healthcare and theatres, for-profit and non-profit firms coexist.

One possible reason for such coexistence is heterogeneity of consumer tastes. Assume, as an illustration, that (3) holds for most consumers and most firms choose non-profit status. If a small fraction of consumers receive no utility from non-contractible product quality, then for-profit firms would enter and supply just these consumers. Two types of firms then coexist in equilibrium: for-profits and non-profits, with the latter catering to consumers who demand high quality.


What legal status does the entrepreneur choose? The entrepreneur chooses not-for-profit status if:
The left hand side of inequality (3) represents the benefits that a for-profit firm would obtain by committing to the non-profit firm’s lower level of non-verifiable cost-reducing effort. The right hand side represents the loss imposed on a non-profit firm by the necessity to enjoy profits only as perquisites. This comparison represents the fundamental tradeoff between non-profit and for-profit status. The following proposition describes conditions determining the entrepreneur’s choice of status: