Monday, 14 November 2011

Not-for-profits have owners

One of the most common features associated with not-for-profit firms is that they don't have owners. Or do they? In a 2001 article Jennifer Kuan writes,
So, for example. when a nonprofit hospital is sold to a for-profit firm, proceeds from the sale go into a public trust. In fact, Hansmann (1996) goes so far as to state that nonprofits do not have owners.
Hansmann's claim always seemed odd to me since if we follow Grossman-Hart-Moore and see ownership in terms of control rights rather than income rights then clearly someone has the control rights over the nonprofit, for if they did not how could they sell it?

Kuan paper, "The Phantom Profits of the Opera: Nonprofit Ownership in the Arts as a Make‐Buy Decision", backs up my intuition in that she models the nonprofit firm and shows that they do indeed have owners.

Her model looks at a performing arts firm which has two consumers, a high-type consumer and a low-type consumer. These two consumers comprise the market for an indivisible good and each would like to consume exactly one unit of the good. In the classical performing arts industry we know that both types of consumers want to consume the good, tickets are indivisible, and consumers are unlikely to consume the same concert more than once. Next Kuan introduces a profit-maximizing entrepreneur. The entrepreneur is assumed to be able to produce the good profitably, so that a good can be produced at a cost that is lower than a consumer's willingness to pay for that good. Not the high-type has a higher willingness to pay than the low-type. Kuan shows that nonprofits can arise even when a good can be marketed profitably.

In her model Kuan assumes that has a make-or-buy decision. That is, he an either buy the good from the entrepreneur or make the good himself. Making will amount to a nonprofit firm.
It is obvious that the high-type consumer would choose to make the good himself, rather than buy it from an entrepreneur, because the consumer surplus is highest in the make case. Notice that when the consumer chooses to make, he achieves first best and the quality level and total surplus are higher than in either the pooling or separating case.
So the high-type makes the good, but why is this a nonprofit firm?

Now the high-type can charge the low-type an amount, say t, to consume the good. Le t be the ticket price. The high-type also pays t so revenues for the firm are 2t. Let c(x) be the costs of producing the good by the high-type. If c(x)>2t then a "donation" (of c(x)-2t) from the high-type will be needed to keep the firm afloat. The high-type is willing to pay this since he is consuming a good worth this maximum willingness to pay to him which is greater and he only paid c(x)-t and he is getting a surplus greater than that he would have gotten by buying the good from the entrepreneur.
So even though the firm generates a surplus, that surplus is consumed and unobservable. Meanwhile, the firm itself appears lo be always just "breaking even" or on the brink of disaster, and why these firms seem to be dependent on charity.
So the high-type produces the good himself, making him the owner of the nonprofit firm.

Note also that as modelled by Kuan, nonprofits are economically efficient. And just as nonprolits have owners. they also have well-defined  utility maximizing objectives rather than some exotic, unpredictable optimization. Having a framework which identifies a well-behaved objective function for nonprofits enables economists to better deal with issues like the behaviour of nonprofits relative to for-profits, and to understand why nonprofits pursue profit-motivated activities.

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