NOT-FOR-PROFIT ENTREPRENEURS: The Basic Model 3

What legal status does the entrepreneur choose? The entrepreneur chooses not-for-profit status if:
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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:

Proposition 2: There exists a unique cutoff level of consumer taste for non-contractible quality, denoted m*, below which all entrepreneurs choose the for-profit status and above which they all select the non-profit status.
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This proposition illustrates the crucial point that markets for goods where consumers do not value non-contractible quality would be dominated by for-profit firms, but markets where consumers do value such quality — by the non-profits. When consumers care deeply about non-verifiable quality, entrepreneurs prefer non-profit status because it allows commitment to soft incentives and brings higher prices ex ante. The more valuable such quality, the more valuable is the ability to commit.

The next proposition derives further conditions on what makes an industry more likely to be dominated by non-profit firms.

Proposition 3:

(a) As the profitability of the entrepreneur or of the industry rises, the non-profit status becomes less desirable. More precisely, suppose K(E)=k+ K (E) an C(Q1)=c+ C (Q1). Then, as q or k rises or as c falls, m* rises.

(b) If d is sufficiently low, then the for-profit status dominates the non-profit status.

According to part (a), when net revenues are high, entrepreneurs prefer for-profit status because spending these revenues on perquisites is too unattractive. With heterogeneity in costs among producers, the lower cost ones choose for-profit and the higher cost the non-profit status.

One implication of parts (a) and (b) together is that a very profitable firm, for which the marginal benefit of perquisites to an entrepreneur is trivial, is unlikely to be a non-profit.

The critical theoretical assumptions of our model are that ex post expropriation (1) hurts the purchaser (or employee or donor), (2) yields financial returns, and (3) has non-financial costs such as effort. Since non-profit status reduces the financial returns, but does not affect the non-financial costs, it softens incentives and entails less ex post expropriation in any setting that has these three features.