The following four subsections offer a short discussion of non-profit enterprise in particular areas from the perspective of the theory of contract failure.
In the United States, two thirds of employment in the short term and general hospital sector is in non-profit enterprises. As we have seen, discussion of hospitals has formed a major part of the debate over the rationale and efficiency of non-profit firms. On the one hand, the dominance of non-profit hospitals can be seen as an efficient response to consumer ignorance by providing a form of quality assurance. Alternatively, it can be argued that the services provided by hospitals are purchased by medical practitioners on behalf of their patients and that these expert intermediaries are well able to assess hospital quality. Non-profit status might even result in quality which is excessive and which reflects the desire for professional standing of the medical staff.
Newhouse’s model of the non-profit hospital is in this tradition. In Figure 11.1, the constraint qq’ represents combinations of quantity and quality of service that can be offered while permitting the hospital to break even. At low levels of quality, demand for the hospital’s services is oq’. Higher quality raises costs, but it also results in a rise in quantity demanded over a certain range. An administrator wishing to maximise demand for the hospital’s services would pick point n on the constraint. Beyond this point, further increases in quality cause quantity demanded to fall. Higher quality is assumed to increase demand, but this effect is outweighed by the consequential rise in prices. If medical staff trade off quality against quantity in the way indicated in Figure 11.1 they will choose a point such as m.
The model implies, like all theory in the ‘managerial’ tradition (see again Chapter 4), that the hospital can exploit a degree of monopoly power. This is not entirely unreasonable because medical staff will have an incentive to lobby to restrict new entry. Wendling and Werner (1980), for example, study the use of ‘certificate of need’ regulation in some states in the USA. If new hospitals have to convince a regulatory agency that there is a ‘health need’ in the area before new capacity can be built, existing hospitals have an incentive to organise themselves politically to fight these proposals. With completely ‘free entry’ by proprietary as well as non-profit hospitals, staff in the non-profit hospital sector will themselves have to pay (perhaps be accepting lower remuneration) for increasing quality to levels in excess of those desired by patients. We would then observe the different types of hospital concentrating in different parts of the market. Non-profit hospitals would provide services of ‘over-high quality’ partly financed by their staff, while proprietary hospitals would provide the mainstream services.13
Assuming, for present purposes, that the unobservability of hospital quality is not a crucial problem for contracting, the dominance of the nonprofit form of enterprise still requires an explanation. Hansmann (1980 and 1987) speculates that a historical lag is involved. In the nineteenth century, hospitals were less commercial and more donative in their financial structures. Redistribution was as important as the provision of technical services. As hospitals become more commercially oriented over time, they will find themselves, according to this view, increasingly threatened by proprietary organisations.
Another possibility is that there are public benefits associated with the activities of hospitals, even in the modern world, which attract voluntary donations and which therefore require non-profit status. A philanthropic concern for the medical care of poor people would certainly be included here, but, in addition, economists have isolated some other important issues. Medical facilities cannot be created quickly, for example, and some excess capacity can be seen as a form of insurance against the occurrence of serious disasters such as accidents or epidemics. The methods used to cope with similar problems in other markets (such as the laying down of electricity generation capacity to cope with a freak winter) involve the charging of higher prices, when this capacity is used in order to recoup the capital costs. In medical markets, however, the probability attached to future freak demands would seem even more difficult to assess, while the prospect of raising prices at a time of strain on resources might appear unacceptable. In these circumstances, donors can be seen as paying for excess capacity and thereby correcting for another form of contract failure.14 Non-profit status provides assurance that funds are indeed used to produce additional medical capacity and are not distributed as profits.15
2. The University
The non-profit status of universities provides a similar type of puzzle to that discussed above. To the extent that universities exist to teach students, the contract failure approach to the non-profit enterprise would seem unlikely to apply. Students in higher education are able to judge the quality of their teachers and are intelligent and articulate enough to complain in terms at least as colourful as those used by Fielding’s diners in the quote which opens this chapter. Adam Smith robustly supported the system of direct payment of lecturers by their students in order to provide clear incentives to the staff to maintain quality.16
Research activity at universities presents a more promising area for the discovery of contract failure. The results of research activity do not necessarily lead to easily appropriable and marketable ‘discoveries’. They may simply contribute to a general climate of scholarship. This can be seen as having a value in itself. It can also be seen as providing the background of work and ideas which may ‘pay off at some future point, even if no one has yet quite perceived the ways in which this will happen. Research of this type is a form of public good, and its finance raises all the usual free-rider problems in addition to intractable problems of valuation. Given that individuals are prepared to donate resources for ‘pure research’, a good reputation for high-quality results and non-profit status would appear necessary to reassure benefactors.
Where research work is commercially oriented, however, some form of professional partnership would be predicted to be the preferred institutional form. Steinberg (1987, Table 7.1) reports that in ‘basic research’, 67 per cent of expenditures in the United States are accounted for by nonprofit institutions. In ‘research and development’, 72 per cent of expenditures occur in the for-profit sector. From this evidence, we might be tempted to deduce that universities which concentrate on teaching and on commercial research have little to gain from non-profit status and that pure research provides the only serious source of contract failure.
Once again, however, Hansmann in his extensive (1980) survey of the role of non-profit enterprise suggests another interpretation. He notes that many colleges in the United States do little research of the public good variety but that donations are still very significant. These donations come largely from the alumni of the colleges. They enable colleges to educate students at lower fee levels than would otherwise be possible. In effect, the colleges can be seen implicitly as running a voluntary and spontaneous student loans system. Students receive, through below-cost fees, an implicit loan which many of them repay much later in their lives by donating funds to their old college. The reasons for voluntary compliance with this system are the same as those mentioned in section 3(2). This explanation for nonprofit status is in the contract-failure tradition because it is a response to the hazards that otherwise beset the financing of human capital. Commercial loans are difficult to raise for educational purposes. The lender cannot establish control over human capital assets in the event of default by the borrower. Student loans schemes which use private sources of finance in ‘the open market’, therefore, usually require the state to act as a guarantor. Individual non-profit colleges, on the other hand, can be seen as creating the conditions required for voluntary compliance on a much smaller scale.
3. The Arts
Why are many performing arts groups organised along non-profit lines? Arguments for state subsidies have been developed based upon the public benefits thought to be associated with a lively performing arts sector. A paternalistic desire to encourage people who are ignorant of the arts to sample them and develop their taste has also played a part. Charitable objectives such as bringing ‘high’ culture within the price range of the relatively poor are frequently voiced. The relevance of these aims to the institutional structures adopted by the suppliers is not obvious, however. They might all be pursued within the context of profit-making, cooperative, or non-profit arts organisations.
As with hospitals and universities, the ability to attract private donations for the various charitable or public purposes mentioned above could be affected by whether or not a theatre or other group of performers is allowed to distribute its surpluses. However, the idea that private donations have much to do with redistributional or educational objectives is difficult to accept. Audiences are still made up of relatively affluent people, even after private donations have reduced the price of tickets. Indeed, many of the affluent people attending performances will be those who have also donated funds.
An alternative explanation of donations in the contract-failure tradition draws upon the cost characteristics of theatre and opera productions.17 The overhead costs of mounting a theatre production will often be large, while the marginal costs of serving an extra member of the audience at a point short of the full capacity of the house may be close to zero. Average costs per attender will therefore decline as audience size rises. It is possible, however, that there is no single price for tickets that will permit the theatre company to cover its costs. This could be so even if the sum total of willingnesses to pay by all the members of the audience were more than sufficient to justify the performance.
A method of increasing revenue from the sale of tickets is for the theatre to introduce a system of price discrimination. More comfortable or conveniently located seats may carry higher prices in the hope that those members of the audience with the greatest willingness to pay will be induced to choose them even though their valuation of the extra comfort may fall short of the price differential. Considerations of social status may also enable the theatre to charge differential prices for seats in different parts of the house. The situation is illustrated in Figure 11.2. Curve cc’ traces the average cost per member of the audience for a theatre performance. Curve dd is the market demand for the performance. It requires differential pricing of p’ and p” for the company to break even. No single price will suffice.
Supposing, however, that the company finds it impossible, even by introducing gradations of comfort and social status, to discriminate sufficiently between people to cover its costs; voluntary donations might still enable a production to take place. Donations, in other words, function as a voluntary system of price discrimination. By revealing their high willingness to pay for live theatre performances, donors help to finance the overhead costs which are strictly joint to all the audience members. Non-profit status encourages such donations because it ensures that money is used to lower seat prices or finance the costs of performance and is not distributed as profit.
In circumstances where demand for live performances is sufficiently great so that a theatre can operate at close to full capacity over a long run of performances, donations and voluntary price discrimination schemes will be unnecessary. Thus, in the United States and the United Kingdom, there is a large for-profit theatre sector which produces popular plays and musical shows. It is in the ‘higher culture’ sector where audiences are smaller that donations become a significant part of theatre finance and non-profit status is more common. Modern and experimental artistic work is also likely to be pursued within a non-profit institutional framework.
The role of the state as a major ‘donor’ to non-profit enterprises in the arts is also of great significance. It is perhaps no surprise that the analysis of non-profit institutions in the performing arts reported above was developed in the United States. There, public support comes indirectly via tax deductions for donations. In continental Europe, direct government support is much higher. Frey and Pommerehne (1989, p. 22) report that ‘in the case of theatres, governments typically provide more than 80 per cent of the cost, and in France more than 90 per cent’. In the United States, the figure for direct government support is five per cent. The United Kingdom is located somewhere in between these positions. The overwhelming level of state support in continental Europe is also reflected in the structure of theatre companies. ‘The system of state opera and state theatre is not restricted to such famous institutions as La Scala of Milan, the Paris Opera and the Vienna Burgtheater, but applies equally to hundreds of theatres and operas in the capitals and provinces’ (Frey and Pommerehne, p. 41). In other words, the performing arts sector in some countries is effectively part of the public administration. The supplying institutions are nearer to bureaucracies than to commercial or even donative non-profit enterprises. Bureaucratic supply will be discussed briefly in section 5.
4. The Club
Clubs form to provide collective goods for their membership. In circumstances where it is possible to exclude non-payers, goods consumed jointly by groups of people can be produced by competing clubs. Buchanan (1965), for example, investigates a situation in which some excludable public good can be produced within a club. For a given size of club, the members will have to agree about how much of the jointly consumed good to finance. If they agree to share the cost equally between them, and if the members have similar tastes and incomes, they will all agree to improve club facilities up to the point at which the marginal private benefit to each member equals the extra club fee that is implied. Conversely, for each level of service provision in the club, there will be an optimal membership size.
New members will benefit existing ones by contributing a share towards the cost of club facilities. On the other hand, if facilities are subject to ‘crowding’, new members will, after a certain point, reduce the service flow experienced by the established group. The club will expand to the point at which these additional ‘crowding costs’just equal the benefits from lower fees.
Figure 11.3 summarises the above argument. Curve SS’ traces the chosen level of service provision at each club size. Curve MM’ traces the chosen club size for each level of service provision. If existing members do not wish to change the level of provision or the membership size, the club is operating at its optimal point. This is point a in Figure 11.3, with membership M* and service level S*. As we saw with worker-owned firms, decision-making costs will be much lower if the club has a fairly homogeneous membership. Further, there will be a tendency for clubs to cater for particular income levels. Rich people will be dissatisfied with the level of service provision if other club members are much poorer, whilst the poorer members will chafe at the fees imposed in rich clubs.18
Buchanan’s analysis does not, however, explicitly address the question of why provision of club services should be organised in non-profit ventures. Proprietary organisations, it might be argued, could provide a range of services for different classes of consumer. In principle, there is no reason why tennis or other sports facilities, for example, should not be produced by for-
profit organisations. High-service-level, high-fee, low-crowding institutions would compete in the market with other firms offering different attributes. Health clubs are often profit-making entities. Arguments for non-profit status based upon consumer ignorance or the attraction of charitable donations would appear somewhat forced. Club-type facilities which require investment in large amounts of capital equipment would seem to favour for-profit enterprise unless (as in the theatre argument) viability requires a system of voluntary price discrimination and the market is not large enough to permit the formation of many institutions catering for particular client groups.
An exception to this reasoning occurs when clubs form not merely to finance an output of joint benefit but actually to produce the output. A social club, for example, produces an output which derives from the activities and interaction of the members themselves. As a group they produce a ‘social milieu’ which confers satisfaction on each person. Such clubs will be non-profit enterprises. If social clubs were run along proprietary lines, the members would be vulnerable to ‘hold-up’. The benefit that they receive from club membership is a form of rent which derives from the special conditions which the club creates. A proprietor, having established these conditions, would be tempted to increase the membership fee so as to appropriate some of the value of the social environment which is actually created by the members. Even allowing trade in membership rights might be resisted on the grounds that the acceptability of a new member will not necessarily be simply related to his or her willingness to pay.
Club goods of the social variety take us to the very margins of the subject matter of this book. Nevertheless, it is important to appreciate the great range of institutions within which ‘business’, broadly defined, is conducted. The social club has a place in a spectrum of institutions, which ranges from the private firm at one end to what sociologists call ‘intentional communities’ out in the furthest reaches at the other. Hechter (1987, p. 148) defines ‘intentional communities’ as ‘obligatory groups whose members seek to produce joint goods – like a sense of community, friendship, love, and the feeling of security – all of which flow from the existence of social harmony’. People who form groups to produce joint goods take their ‘profit’ in the form of the subjective net benefits which accompany membership. Profits do not take a monetary form and cannot by definition be distributed to outsiders. The very nature of the institution enforces the non-distribution constraint.
It would be a mistake to assume that obligatory groups are of no economic importance. There is an element of the ‘intentional community’ in many contexts. A university, for example, may be seen as creating a ‘scholarly atmosphere’ which appeals to its staff members and represents a joint ‘club-like’ good. No doubt, this is a somewhat feeble echo from the past under modern conditions, but from a historical point of view the communal side of university life could be a significant explanation of its non-profit structure. It is also worth noting that incentive and control problems afflict ‘intentional communities’ as much as the other institutional forms we have been studying. Such communities will often expect a great deal from their members and will enforce compliance by ensuring that members are dependent on the group and have a great deal to lose from expulsion. Hechter shows, for example, that successful groups (as measured by the duration of their survival) are characterised by hierarchy (monitoring), cultural homogeneity, limits on privacy, group rewards, and public sanctions. He comments that commitment to the group is not a matter of socialisation or identification. Rather, the structure of a communal institution ‘may reveal its doubts that such identification is likely to develop at all’ (p. 165).
Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.