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.

Co-existence of the two types of firms in equilibrium can also arise because of heterogeneity of employment relationships. For example, repertory theaters might need the non-profit status to commit to good treatment of actors who make large investments in their jobs, whereas more conventinal theatres do not rely on such investments, and hence can be for-profit. Hospitals to a significant extent cater to the interests of the doctors who treat patients there (Pauly and Ledish 1973, Herzlinger and Krasker 1987). If hospitals are organized as for-profit institutions, doctors may be concerned that the profits would be expropriated by the owners, whereas the non-profit status may serve as a commitment to spend the profits on wages and perquisities for doctors, including research.
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This argument would suggest that doctors who care the most about perquisites would gravitate toward non-profit hospitals. This argument would also suggest that, as profitability and hence the perquisite potential of hospitals declines, the attractiveness of the non-profit status declines as well. Consistent with this view, a significant number of non-profit hospitals have recently converted to a for-profit status under revenue pressure from managed care providers (Cutler and Horwitz 1997). The more general message here is that the analysis of the quality of hospitals for the doctors may be as important as that for the patients.

Even when markets are divided between for-profit and non-profit firms, it will be difficult to distinguish empirically between the quality of their output. The reason is that both types of firms would produce output of the same contractible quality, but non-profit firms would choose higher non-contractible quality. To the extent that non-contractible quality is hard to put in a contract and verify in court, it may also be difficult for an econometrician to measure. This may explain why some comparative studies of quality across for-profit and non-profit firms such as hospitals had trouble identifying any differences in observable quality (Norton and Staiger 1984).