Nonprofits and The Power of Weak Incentives

By Patrick L. Warren

A key feature of non-profits, emphasized by Glaeser and Shleifer (2001), is that the non-distribution constraint allows the firm to commit to weak incentives. Put simply, if I cannot take profits home with me, I have to do something else with them and those alternative uses are of lower value and, perhaps, suffer more dramatically from diminishing marginal returns. So if I am trading profits off against something else, I will make that tradeoff differently than how a for-profit firm does.

Glaeser and Shleifer’s goal is to explain the existence of non-profit firms. For students of organizational and institutional economics, their central point should be clear. The non-profit institution arises in equilibrium when the higher economic costs induced by weak incentives for cost minimization can be outweighed by the lower economic induced by weak incentives for rent-seeking in noncontractible quality shading (or, alternatively, fewer resources expended in costly quality verification).

But a good model explains much more than the point it was originally built to illustrate, and the commitment to weak incentives turns out to have implications for a wide variety of nonprofit behaviors. To me, it illuminates so many features of non-profit behavior that it has become my stock model whenever I first try to think about some novel non-profit behavior. I will illustrate this model’s wide applicability with a brief non-exhaustive catalogue of facts about non-profit behavior that all seem to reflect this basic insight.

1. CEOs of nonprofits have much lower-powered incentive contracts. Ballou and Weisbrod compare the compensation contracts of CEOs of for-profit, non-profit, and government hospitals. They find that non-profit and public managers face much weaker incentives than those in for-profit firms, in the sense that their compensation is skewed toward salary and away from bonuses or performance-based rewards. Their explanation: “our analysis of differences in compensation …provides some evidence on the importance of nondistribution constraints relative to other influences in determining differences in managerial reward structures across organizational forms.”

2. Non-profit financial institutions offer lower-powered credit contracts.  Bubb and Kaufman (working paper version) compare the credit-card contracts offered by non-profit credit unions to those offered by for-profit banks.  They build a model where the firm can use penalty fees to exploit naïve consumers for increased profits, but there are non-monetary psychic or reputational costs from this behavior. They find, as predicted, that credit unions charge lower penalties and higher up-front prices, such as introductory interest rates, than do for-profit firms. Their explanation: “By eliminating an outside residual claimant with control over the firm, these alternatives to investor ownership reduce the incentive of the firm to offer contractual terms that exploit the mistakes consumers make.”

3. Nonprofits are less likely to outsource sensitive tasks. In a paper with Christina Marsh Dalton, I find that non-profit hospitals outsource medical services much less intensely than similarly-situated for-profit hospitals do. We think about outsourcing as a cost-versus-control tradeoff. Low cost production is valuable, and so is control of the details of service provision, but since lower costs (higher profits) are less valuable to the nonprofits, they make the tradeoff differently than for-profits do.

4. Nonprofits offer a different mix of services. Jill Horwitz  finds that non-profit hospitals are much more likely to offer consistently unprofitable services, like emergency psychiatric care, and less likely to offer consistently profitable services, like open-heart surgery, than for-profit hospitals are. Services that are profitable for a span of time (like home health service in the mid-nineties), are offered by for-profit hospitals at high rates (higher than nonprofits) during the times that they are profitable and low rates (lower than nonprofits) at times when they are not. Her explanation: “Profit-making is likely lower on the list of objectives for nonprofit than for-profit hospitals.”

5. Nonprofits come to look more like for-profit firms as they move closer their (quasi-) profits decline. A number of the papers above, as well as several papers that investigate other aspects of non-profit behavior (see, in particular, Duggan (2002)), investigate how the "gap" between forprofits and nonprofits responds to various economic shocks. The particulars differ with context, but the general conclusion is that nonprofits come to look more like forprofits as their economic situation worsens. This is exactly what we would expect if the first few dollars of profit (those that keep the firm above the shut-down constraint) are nearly as valuable to the non-profit firm as they is to the for-profit firm, perhaps because the first few dollars in profit will be spend on identical goods in both ownership regimes.

In this post, I’ve focused on one important difference between non-profit and for-profit firms (non-distribution) and argued that a parsimonious model based entirely on that difference can explain a wide variety of nonprofit behavior. Surely there are important features of nonprofit behavior that this model fails to explain, but I think you will often find it a useful start. I certainly have.