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.

The two schools only focused on private donations after the states cut them off for refusing to cater to the prevailing religious winds (Hansmann 1990). More recently, some state universities, in California, also turned to private donors after state funding became scarcer. In European countries, which have a long tradition of government funding of artistic, educational and medical institutions, there is much less of a tradition of private giving to such firms (until government funds dry up, as they did for British universities in the 1980s and Finnish musical institutions in the 1990s). Since the government has already created soft incentives for state-supported firms, private donors are not needed to further soften their incentives.
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Proposition 5 also suggests that institutions will put themselves into situations where donations have a real effect on their incentives. For example, they may overcommit their resources so as to become cash poor. Or, like Harvard, they may restrict the discretion in using their resources as much as possible and attempt to appear unable to finance worthwhile new ventures without new donations. This implication explains why some institutions with extremely lush endowments still work hard to stay poor on the cash flow basis.


Not-for-profit firms are often controlled by entrepreneurs, and not by their employees or customers. The decision of entrepreneurs to establish such firms can be understood as an attempt to commit themselves to softer incentives. Soft incentives protect customers, volunteers, donors and employees of the firm against ex post expropriation. Donors in particular would favor non-profits with unrestricted donations even if such donations had no tax advantages because the risk of diversion of funds is much smaller. While sufficient reputation or competition may substitute for the non-profit status, in many cases we still expect entrepreneurs to seek the non-profit status, even if they are completely self-interested.

This basic framework yields several empirical predictions about non-profit firms. To begin, according to the theory, we expect to find non-profit firms in activities where:

1) there exist substantial opportunities for reductions of the quality of the good after it is purchased, or for other forms of expropriation of consumers;

2) the activity is not too profitable, or — more importantly — relies on charitable donations;

3) altruism or public spiritedness are important motivators of entrepreneurs;

4) it is costly for consumers or employees to change firms they deal with.

The need for donations to assure the survival of a business is probably the most important determinant of the preference for non-profit status, because it is difficult to imagine a market mechanism that would support donations to for-profit firms.
Furthermore, in the activities where for-profit and non-profit firms coexist, we expect the latter to deliver higher quality to consumers. At the same time, we expect it to be difficult to detect such higher quality empirically, because easy to detect quality differences should be equalized through contracts. Finally, we expect to find higher levels of perquisites in non-profit firms, which may show up as better working conditions, wages, and benefits for the employees. Many of these implications appear to be consistent with the available evidence, while others are at least potentially testable.