Nonprofit Status and Relational Sanctions: Commitment to Quality through Repeat Interactions and Organizational Choice

An entrepreneur can organize either a for-profit or a nonprofit firm to sell products or services to consumers in the long run. Because quality is nonverifiable and unobservable, investment can still produce low quality; in equilibrium, consumers impose relational sanctions when low quality is delivered. With sufficient relational sanctions, both types of firms produce the same expected quality. However, because the nondistribution constraint reduces the temptation to shirk from investment, the nonprofit firm is subject to shorter relational sanctions, which can make nonprofit status attractive even for the entrepreneur who cares only about the return obtained from the firm. Nonprofit status is preferred as the relationship between investment and quality gets weaker or as stronger market competition reduces the profit margin. The paper also shows how both types of firms can coexist in a market when the legal enforcement against nonprofit status weakens as the number of nonprofit firms increases.