Non-Profit Status and Relational Sanctions: Commitment to Quality through Repeat Interactions and Organizational Choice
Albert H. Choi
University of Virginia School of Law
April 30, 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 in selling product or service. While the entrepreneur can distribute all the profits from a for-profit firm to herself, she faces a non-distribution constraint with respect to a non-profit firm and has to convert its profits into private benefits (such as perquisites), which entails a deadweight loss. 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 firm 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 firm is subject to shorter relational sanctions and, this, in turn, can make a non-profit status 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 levied profit tax or a non-profit firm receives production subsidy; or (4) as the profit margin shrinks due, for instance, to a stronger competition in the market. The paper also shows how properly tailored profit tax can improve welfare and 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: 32
Date posted: March 10, 2014 ; Last revised: May 5, 2015
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