Non-Profit Status and Relational Sanctions: Commitment to Quality through Repeat Interactions and Organizational Choice
Albert H. Choi
University of Virginia School of Law
February 18, 2015
Virginia Law and Economics Research Paper No. 2014-07
Virginia Public Law and Legal Theory Research Paper No. 2014-19
This paper examines how market-based sanctions facilitate commitment to quality and how such sanctions affect organizational choice. An entrepreneur can organize either a for-profit or a non-profit firm, and while she 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 its profits into private benefits for herself. Because realized quality is not verifiable and is subject to error, customers impose relational sanctions against the firm when low quality product or service is delivered. With relational sanctions, both types of firms provide the same (expected) quality, but the size of the relational sanctions and the entrepreneur’s organizational preferences differ. When converting profit into private benefits becomes more difficult at the margin, because temptation to shirk from investing in quality gets weaker, a non-profit organization is subject to shorter relational sanctions and, this, in turn, can make a non-profit form more attractive for the entrepreneur. The entrepreneur is more likely to organize a non-profit (1) as quality becomes a noisier signal of investment; (2) as the non-distribution constraint gets stronger at the margin; (3) when a for-profit firm is subject to profit tax or a non-profit firm is subject to production subsidy; or (4) as the profit margin shrinks due, for instance, to a stronger competition in the market. The paper also shows how ex ante identical entrepreneurs can choose different organizational forms when legal enforcement of non-distribution constraint gets weaker as the number of non-profit firms in the market increases.
Number of Pages in PDF File: 28
Date posted: March 10, 2014 ; Last revised: March 3, 2015
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