The following post comes to us from Albert Choi, Professor of Law, University of Virginia School of Law, and is based on his recent paper, “Relational Sanctions against Non-Profit Organizations: Why a Selfish Entrepreneur would Organize a Non-Profit Enterprise.” The full paper is available here.

One of the most influential theories on the purpose and functions of non-profit organizations is that the non-profit status works as a signal of, or commitment to provide, better quality product or service when quality is difficult or impossible to verify.  Simply stated, when the person who controls a non-profit organization is constrained from distributing its profits to herself, she is more likely to invest in offering product or service that is of higher quality.  One important piece of the puzzle that has been under-examined in the literature, however, is whether market-based (including reputational or relational) sanctions can alleviate the quality provision problem in the absence of a more formal incentive scheme.  After all, strong market-based sanctions, at least in theory, should be able to provide sufficient incentive to produce high quality product or service regardless of the organizational choice.

This paper attempts to fill this gap.  The paper analyzes a game theoretic model in which an entrepreneur, who may be motivated solely by the returns she derives from the organization, can set up either a for-profit or a non-profit organization in selling product or service to customers.  While the entrepreneur can distribute all the profits from a for-profit organization to herself, she faces a non-distribution constraint with respect to a non-profit organization and, to generate a return, has to convert a non-profit firm’s profits into private benefits (such as perquisites).  Because realized quality is not verifiable and is subject to error, customers impose relational sanctions (such as boycott or reduced demand) against the firm to solve the incentive problem.

The paper finds that with sufficient relational sanctions, for-profit and non-profit firms provide the same (expected) level of quality to the consumers.  The size of the relational sanctions and the entrepreneur’s preference over the organizational form differ, however.  When converting profit into private benefits becomes more difficult at the margin, i.e., conversion exhibits decreasing returns to scale, because temptation to shirk from investing in quality gets weaker (but still positive), a non-profit organization is subject to shorter (less severe) relational sanctions.  Shorter relational sanctions, in turn, can make a non-profit organization’s long-run return to the entrepreneur (in terms of private benefits) higher than that from a for-profit organization (in terms of distributed profits).  Hence, even if the entrepreneur has no altruistic motive and cares only about the returns she derives from the organization, she may still choose a non-profit form.  The entrepreneur is more likely to organize a non-profit firm (1) as the correlation between investment and quality gets weaker; (2) as the non-distribution constraint gets stronger at the margin; (3) when a for-profit firm is subject to tax; or (4) and as the profit margin gets smaller due, for instance, to stronger competition in the market.