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Tuesday, August 26, 2008

Why are non-profits, well, not for profit?

I've started a few blog posts on non-profits and politics, but it's hard to get far into that swamp before you end up asking the question, "Hey, what's the point of having these non-profits around, anyway?"  So maybe it makes more sense to start at that end.  The classic economic account, per Henry Hansmann, is that some firms must find a device for credibly signaling that they will not shirk.  For example, since no one can tell easily whether health care is of high or low quality, customers will be reluctant to pay for it unless they have some guarantee the hospital won't cut corners in order to maximize revenues.  So non-profit status is a commitment device for providers of credence goods.  Since the pledge makes it hard to raise capital, these goods can only be provided if they come with a subsidy.

Recently, Malani and Posner have cast some doubt on Hansmann's story by pointing out that many non-profits seem uninterested in advertising their non-profit status.  They then leverage this insight into a claim that the subsidy for charitable works should be open to for-profit firms.  One could quibble with Malani & Posner's premise here.  For example, their big example is hospitals, but it may be that hospitals were overwhelmingly non-profit for so long that customers now assume they are for-profit, or that hospitals choose names, like "City Hospital" or "University Hospital" or "St. Jude's" that themselves signal a commitment to health care over profit. 

In any event, there are a couple of other strong economic justifications for the non-profit sector, and I think they both demand that subsidy recipients be non-profits.  Neither would be undermined by the Posner/Malani claim that non-profits do not signal their status.  Both are, like Hansmann, market failure stories.  The first is a coordination problem. 

What do I mean, coordination problem?  Well, as Acemoglu et al. point out in their neat LEO piece from last year, "Incentives in Markets, Firms, and Governments," there are times that a firm would actually prefer that the incentives it offers its employees be low-powered -- that is, produce only weak motivation.  Their key example is the Freakonomics tale of teacher testing -- give teachers strong reasons to improve test scores, and they teach to the test or cheat.   This "bad" effort in response to incentives may crowd out or swamp any beneficial effects from increasing "good" effort.   

Here's the problem (as I see it; Acemoglu et al. are a little sketchy on this part).  It's hard for a firm acting alone to offer only low-powered incentives.  If my rivals can offer a share of profits, I'm likely to be outbid for the best talent; high performers will want to get large rewards for doing better than others, so that my low-powered compensation scheme selects for workers who see themselves as less able.   In order for anyone in the industry to offer low-powered incentives, they all have to commit to that compensation scheme. 

The U.S. scheme for subsidizing and regulating the non-profit sector could be a way of getting to that result: a whole industry committed to low-powered (e.g., not profit-based) compensation.  And, as it turns out, the sectors where this tactic is necessary look a lot like Hansmann's description of what should be a non-profit, because a key component of the "bad" incentives dilemma is that we're trying to produce goods where the quality is hard to measure, so we have to use imperfect incentive schemes.

Is this making sense to anyone so far?

Posted by BDG on August 26, 2008 at 03:05 PM in Corporate | Permalink


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Be careful who you call non-profit. The NGO/non-profit sector is a thriving economic force. Non-profits do make money through grants, charity and loans, and many have huge operating budgets. A quick review of the AARP's finances will force one to ask "Can a non-profit own and manage numeorus parking garages and buldings for profit and still be "non-profit?" Perhaps some non-profits also exist precisely because there are such high barriers to entry to provide certain services and make a traditional "for-profit sector" profit. Looking at it from an employee incentive perspective only would miss this. Take your average think-tank, or development consultant advising an African government on how to build sanitation services or schools. The larger profit from that would come from either having the capacity to deliver those physical services, or managing them. Non-profits however earn revenue by charging for advice or strategies. And, they earn plenty of money to keep Phd's in Agronomy on the payroll. The non-profit status enables them to supplement income by constantly applying for government and private sector grants, and working jointly with for-profit partners who can then deduct that from their taxes. Non-profits play a complex role in the economy which varies by sector. I just wanted to point out that non-profits are a competitive business with more than sufficient financial motivation to compete. I wish you all the best in your analysis of the health care sector. Cheers

Posted by: Damian Zimmerman | Sep 9, 2008 6:07:46 PM

Right, sometimes it is. But is it easy to straightforwardly decide that? Academic medicine (to which I happen to belong) struggles with this; if our incentives are too skewed toward direct rewards for patient care, we become production machines but intellectually lazy and unproductive as teachers and researchers. Whereas if we neglect patient care too much our departments are poor in clinical dollars and unable to hire clinical faculty (at an acceptable discount to the private practice market). Academic departments in medical schools are struggling to develop incentive schemes that will increase clinical revenue without stifling research and teaching. It is not so clear how that might best be done.

Can your train of thought here be brought to a drawing of any general policy conclusions beyond the obvious thought that one cannot serve God and mammon? It seems clear that there is a universe of cut and dried “bottom line” sorts of incentives for which a for-profit orientation is useful for maximal outcomes; on the other hand, it is hard to produce academic distinction or real clinical excellence or a host of other worthy goals if one attempts to do so purely through paying people more for…what exactly? The problem is not simply that achievement of such goals is difficult to assess through measurement. One can, after all, come up with surrogate measures for many such goals. But such goals resist capture in terms of monetary profit and loss.

Just wondering whether you’ve taken this further…

Posted by: Tom H | Aug 27, 2008 9:51:22 PM

That's right, Tom. But sometimes the low-powered bundle of tradeoffs is a better deal.

Posted by: BDG | Aug 27, 2008 2:27:59 PM

So the public school system fits your bill as a fairly monolithic system in which low power incentives prevail, having the good effect of generally avoiding "teaching to the test". But such incentives perhaps have downsides in regard to attracting talent and motivating hard work, also (we tend to think) features of the public school system. Is the trade off worth it? Is there a way to have one's cake and eat it here? I wonder...

Private for-profit health insurance companies have an incentive to manage their health care providers more tightly than do not-for-profit companies (or at least so I would suppose); but they also have more incentive to deny claims without justification (cf Michael Moore's Sicko). It begins to look as though the choice of low vs high power incentives is inevitably going to be a mixed bag of good and bad effects whichever one chooses..

Posted by: Tom H | Aug 27, 2008 1:10:32 PM

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