Relational Sanctions against Non-Profit Organizations: Why a Selfish Entrepreneur Would Organize a Non-Profit Enterprise
Albert H. Choi
University of Virginia School of Law
July 21, 2014
Virginia Law and Economics Research Paper No. 2014-07
Virginia Public Law and Legal Theory Research Paper No. 2014-19
This paper examines how relational sanctions can affect organizational choice. An entrepreneur 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 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, in equilibrium, impose relational sanctions against the firm when low quality product or service is delivered. With the relational sanctions, for-profit and non-profit firms provide the same (expected) level of quality to the consumers in equilibrium. 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 income tax or a non-profit firm is subject to tax subsidy; or (4) and as the profit margin gets smaller due, for instance, to a stronger bargaining leverage of the buyers.
Number of Pages in PDF File: 23working papers series
Date posted: March 10, 2014 ; Last revised: July 24, 2014
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