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Organizational form, prosocial motivation and provision of public services Vlassopoulos, Michael 2007

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Organizational Form, Prosocial Motivation and Provision of Public Services  by Michael Vlassopoulos  B . A . , A t h e n s U n i v e r s i t y of E c o n o m i c s a n d Business, 1998 M . A . , M c G i l l U n i v e r s i t y , 2000  A THESIS S U B M I T T E D IN P A R T I A L F U L F I L M E N T O F THE REQUIREMENTS FOR THE DEGREE OF  DOCTOR OF PHILOSOPHY in  T H E F A C U L T Y OF G R A D U A T E STUDIES  (Economics)  T H E UNIVERSITY OF BRITISH C O L U M B I A S e p t e m b e r 2007 © M i c h a e l V l a s s o p o u l o s , 2007  Abstract T h i s thesis is a collection of three essays that are concerned w i t h the role of organizational form and intrinsic motivation i n the delivery of public services. T h e first essay revisits one of the most influential among the economic theories of nonprofit organizations, the "contractual failures" theory, which argues that consumers perceive nonprofit status - because of the constraint in the distribution of surpluses - as a commitment device, which ensures them against opportunistic behaviour i n markets that are characterized by contractual incompleteness i n the producer/consumer relationship. T h i s paper questions the robustness of this theory by taking into account the role of reputation. T h e main result is that when reputations can be sustained, then for-profit status is the preferred organizational form and high quality services are ensured. T h e second essay provides an explanation for the fact that nonprofit employers are uniquely able to attract volunteers w i t h social concerns and career aspirations and for the related observation that nonprofits figure prominently i n mission-related activities.  Our  theory is predicated on that nonprofit incorporation relaxes the incentive constraint that employers face when implicitly contracting w i t h volunteers. T h e not-for-profit commitment is shown to be effective only i n activities where producers, who can choose to be for-profit or nonprofit, care about the level or quality of the service being provided. Thus, in the equilibrium of the model developed here nonprofit entry i n sectors where missions play a defining role and the hiring of volunteers arise endogenously due to economic forces. T h i s equilibrium outcome has some desirable welfare properties. T h e third essay, co-authored w i t h Patrick Francois, provides a selective overview highlighting some major themes of the recent literature on the role of intrinsic motivation i n the context of the provision of social services. We focus on how the presence of intrinsic motivation affects the design of optimal incentives, the selection of motivated agents, and how prosociality interacts w i t h monetary rewards and organizational form. We also discuss some of the recent literature that addresses issues of organizational design for the provision of public services.  Table of Contents Abstract  ii  Table of Contents  iii  List of Tables  vi  List of Figures  vii  Acknowledgements  viii  Co-Authorship Statement  ix  1  Introduction  1  2  Quality, Reputation and the Choice of Organizational F o r m  6  2.1  Introduction  6  2.2  The One-Shot Game  9  2.3  The Repeated Game  11  2.4  2.3.1  For Profit Status  11  2.3.2  Nonprofit Status  13  O p t i m a l Choice of Organizational F o r m  14  2.4.1  Overview  14  2.4.2  O p t i m a l Choice when (5 e [P (2m*),  1)  17  2.4.3  O p t i m a l Choice when P G (±,0 (2m*))  17  2.4.4  O p t i m a l Choice when f3 6 (0, ^)  18  2.4.5  Discussion  20  f  f  2.5  Relating the M o d e l to E m p i r i c a l Evidence and Policy Implications  21  2.6  Conclusion  22  Bibliography 3  24  Volunteer H i r i n g , Organizational F o r m and the  Provision of Mission-  Oriented Goods  26  3.1  Introduction  26  3.2  Related Literature  31  3.3  The M o d e l  32  3.3.1  32  Primitives iii  3.4  3.3.2  T h e Employment Relational Contracts  37  3.3.3  Selection of Relational Contract and Organizational F o r m  44  Market E q u i l i b r i u m  48  3.4.1  A 'Sorting' E q u i l i b r i u m  49  3.4.2  Welfare Analysis  54  3.5  Discussion  57  3.6  Conclusion  58  Bibliography 4  Prosocial M o t i v a t i o n and the Delivery of Social Services (with Patrick Francois)  63  4.1  Introduction  63  4.2  Modelling prosociality  65  4.2.1  Impure or Action-Oriented A l t r u i s m  67  4.2.2  Output-Oriented A l t r u i s m  72  4.3  4.4  5  60  Implications for Government Provision  78  4.3.1  Insights from Standard Agency Models  78  4.3.2  Contrasting Implications from Prosocial Motivation Approaches  4.3.3  E m p i r i c a l Evidence  . .  82 83  Conclusions  ^  85  Bibliography  87  Concluding Remarks  92  Appendices  95  A  O m i t t e d Proofs: Chapter 2  95  B  E q u i l i b r i u m Strategies Supporting the Relational Contracts in 3  Chapter 98  B.l  Information Sets  98  B.2  Strategy Space  99  B.3  E q u i l i b r i u m Strategies Supporting the Volunteering Structure  99  B.4  E q u i l i b r i u m Strategies Supporting the Internship Structure  101  C  O m i t t e d Proofs: Chapter 3  103  D  A Parametric E x a m p l e of a 'Sorting' E q u i l i b r i u m in Chapter 3  109  D.l  Parameter Values  109  D.2  C o m p u t i n g E q u i l i b r i u m i n the Mission Sector  D.3 C o m p u t i n g E q u i l i b r i u m in the Profit Sector iv  110 Ill  D.4  Checking the Sorting Constraint for Workers  D.5  Checking the Sorting Constraint for Managers  v  List of Tables Table 2.1: Summary of O p t i m a l Choice of F i r m Status and Quality by Region Table D . l : Parameter Values  .  19 110  vi  List of Figures 2.1  p {m)  2.2  S u m m a r y of O p t i m a l C h o i c e of O r g a n i z a t i o n a l F o r m  19  3.1  T i m i n g of Events  39  3.2  Volunteering E q u i l i b r i u m i n M i s s i o n Sector  52  3.3  Volunteering E q u i l i b r i u m (point V) vs Efficiency Wage E q u i l i b r i u m (point B)  54  3.4  Welfare A n a l y s i s  55  3.5  Volunteering E q u i l i b r i u m (point V ) vs E q u i l i b r i u m w i t h Internships (point I)  57  4.1  P r e d i c t i o n s of C o n t r a c t u a l F a i l u r e A p p r o a c h  80  4.2  A d d i n g "Care" D i m e n s i o n  83  4.3  P r e d i c t i o n s of P r o s o c i a l M o t i v a t i o n Approaches  84  f  (solid) and (3 {m) (dash)  17  n  vii  Acknowledgement s F i r s t a n d foremost, I w o u l d like to t h a n k m y supervisor P a t r i c k Francois. H e never failed to astonish me and uplift me w i t h his energy, enthusiasm, patience, generosity a n d perspective on life. T h e ideas developed i n this thesis grew out of the numerous discussions we h a d and bear his intellectual i m p r i n t . M y i n t e r a c t i o n w i t h P a t r i c k has been the most gratifying experience of m y life as a P h . D . student, a n d I w i l l always be indebted to h i m for a l l his help a n d guidance. I a m also very grateful to the other members of m y thesis committee, M u k e s h E s w a r a n and R a l p h W i n t e r , for encouragement and insightful comments and suggestions that substantially i m p r o v e d this thesis. T h a n k s also to D a v i d G r e e n for helpful advice throughout m y P h . D . studies and for p r o v i d i n g me w i t h financial assistance t h r o u g h T A R G E T . A l s o . I w o u l d like to acknowledge m y classmates and officemates for their friendship a n d for sharing the challenges and anxieties of graduate school. I a m very fortunate to have been blessed w i t h the u n c o n d i t i o n a l love and unwavering support of m y parents throughout m y academic career. I w o u l d not have embarked on this endeavour - let alone complete it - i f it h a d not been for t h e m .  I also owe a lot to m y  brothers, T h o m a s a n d Costis, who have always been there for me. L a s t , but certainly not least, I w i s h to t h a n k m y wife, A n n a , for p u t t i n g up w i t h me a n d helping me t h r o u g h the ups and downs of w r i t i n g this thesis.  viii  Co-Authorship Statement C h a p t e r 4 ( P r o s o c i a l M o t i v a t i o n a n d the P r o v i s i o n of Social Services) was co-written w i t h Professor P a t r i c k Francois ( U B C ) . M y c o n t r i b u t i o n to the p r o d u c t i o n of this piece of research is outlined below. • Identification of research p r o g r a m - Shared responsibility w i t h co-author. • Design of research p r o g r a m - Shared responsibility w i t h co-author. • Performing the research - Shared responsibility w i t h co-author. • M a n u s c r i p t preparation - Shared responsibility w i t h co-author.  ix  Chapter 1  Introduction T h e starting point and overarching m o t i v a t i o n of this thesis emanates from an interest to understand the relative merits of alternative i n s t i t u t i o n a l arrangements - government agencies, nonprofit organizations, for-profit firms - i n the delivery of p u b l i c goods and services. W i t h i n this broader research agenda, this thesis attempts to contribute to our understanding of what determines the scope of nonprofit organizations and the a l l o c a t i o n of economic a c t i v i t y between the for-profit and nonprofit sector.  T h e m o t i v a t i o n for an investigation  into the economic forces that account for the existence of nonprofit organizations stems, partly, from the realization that these organizations are a large a n d growing part of most m o d e r n economies a n d yet they r e m a i n relatively under-researched.  1  A s the relative size  of the private nonprofit sector increases and its c o n t r i b u t i o n to G D P a n d t o t a l employment rises, it seems increasingly appropriate to seek to understand the factors that shape the d i s t r i b u t i o n of a c t i v i t y between the two sectors across countries a n d across t i m e , the differences between the q u a l i t y of services p r o v i d e d i n c o m m e r c i a l firms versus nonprofit organizations, and the social benefits a n d losses involved i n favouring one i n s t i t u t i o n a l form over the other. E v e n a casual observation of the sectoral concentration of nonprofit organizations i n most developed countries suggests a salient p a t t e r n according to w h i c h this type of organizations tend to engage p r e d o m i n a n t l y i n the p r o v i s i o n of healthcare, education, social a n d other mission-oriented services. T r a d i t i o n a l l y , i n m a n y countries, the government has been the key player i n these sectors while the b o u n d a r y line between the nonprofit and the p u b l i c sector i n some cases can be h a r d to draw, as some nonprofit institutions are strongly influenced b y governments. Nevertheless, since the dominant p a t t e r n is for the government involvement as a direct service provider to wane, interest lies i n developing a theoretical framework F o r example, i n Canada the G D P of the nonprofit sector was estimated at $61.8 billion i n 1999, accounting for. 6.8% of the total economy. If the contribution of volunteers is also taken into account then the nonprofit sector's share of G D P increases to 8.5%. Equally impressive is the nonprofit sector's role as an employer, representing 13% of the country's nonagricultural employment. 1  1  that helps us appraise how should the responsibility for the ebbing government a c t i v i t y be replaced and d i v i d e d a m o n g private alternatives (for-profit and nonprofit). T h o u g h it m a y be c o m p a r a t i v e l y easy to e x p l a i n w h y some activities are associated w i t h one and only one type of provider, the coexistence of organizations t h a t appear to engage i n similar activities yet operate under different ownership form is m u c h harder to explain. F o r example, i n the U n i t e d States, the ownership of hospitals, schools, day care centres, nursing homes, museums a n d theatrical companies is shared between the nonprofit and for-profit sector. T h e persistent m i x of ownership types across m a n y industries poses a serious challenge to some of the existing theories of the neoclassical p r o f i t - m a x i m i z i n g firm. In p a r t i c u l a r , a valuable insight, emphasized b y the p r o p e r t y rights theory of the firm, is the i m p o r t a n c e of the residual claimant i n m o n i t o r i n g inputs and organizing p r o d u c t i o n efficiently.  2  T h e most distinctive feature of nonprofit organizations, is that they operate  under a strict n o n d i s t r i b u t i o n c o n s t r a i n t ,  3  w h i c h stipulates that t h o u g h the organization  may earn surpluses no person has legal rights over them, instead any residuals have to be used for the advancement of the organization's mission or kept as endowment.  While  nonprofits do not have owners w i t h residual rights, they do have boards of trustees or directors, w h i c h exercise control rights. A d d i t i o n a l l y , nonprofits face a set of state i m p o s e d legal and r e p o r t i n g constraints that m a i n t a i n oversight over the n o n d i s t r i b u t i o n constraint - ensure that its managers a n d employees are not p a i d excessively.  4  Nonprofit firms are often considered to be wasteful because presumably they face no pressure to m a x i m i z e profits - i n view of the lack of an owner w i t h residual c l a i m on profits. T h e y are expected to exhibit higher costs and grant managerial perks. T h e presence of the n o n d i s t r i b u t i o n constraint is remarkable, given the i m p o r t a n c e a t t r i b u t e d to the residual claimant i n the literature on the property rights theory of the firm, and p r o m p t s the following questions for economic theory: A r e there circumstances where the c o m m i t m e n t to not h a v i n g a residual claimant conveys a comparative i n s t i t u t i o n a l advantage for nonprofit provision of certain goods and services? W h y w o u l d a n entrepreneur c o n t e m p l a t i n g entry i n one of the m i x e d sectors, where for-profits can break even, found a nonprofit if the for-profit status were more cost efficient? There have been some attempts to address such questions, i n the economics literature, w h i c h have largely focused on justifying the existence of the nonprofit sector by reference to instances of failures of markets a n d governments.  5  One of the most influential a m o n g  the economic theories of nonprofit organizations, the "contractual failures" theory, argues See Alchian and Demsetz (1972) and Holmstrom and M i l g r o m (1994) for early and more recent statements respectively of this theory. T h e first paper to emphasize this aspect of nonprofits is Hansmann (1980). T l i e effectiveness of oversight mechanisms in nonprofits varies. See Glaeser (2003), for a discussion of governance problems in nonprofits and a model of nonprofit capture by its elite workers. Hansmann(1987) and Weisbrod (1988) survey early economic theories of nonprofit organizations while the articles i n Anheier and Ben-Ner (2003) revisit older theories and introduce some more recent ones. 2  3  4  5  2  that consumers perceive nonprofit status - because of the constraint i n the a p p r o p r i a t i o n of surpluses - as a c o m m i t m e n t device, w h i c h ensures t h e m against o p p o r t u n i s t i c behaviour i n markets that are characterized by c o n t r a c t u a l incompleteness i n the p r o d u c e r / c o n s u m e r relationship. I n these markets, profit-taking firms have an incentive to s k i m p on q u a l i t y i n order to reduce costs and improve profitability. B y r e m o v i n g or attenuating the profit incentive, nonprofit status is a signal that a firm w i l l provide the non-contractible q u a l i t y it promises, a n d thus i n such circumstances consumers perceive t h e m as more trustworthy. T h e second chapter of this thesis t i t l e d " Q u a l i t y , R e p u t a t i o n a n d the C h o i c e of O r g a n i z a t i o n a l F o r m " , revisits this theory, to question its robustness by t a k i n g into account the role of reputation. If for-profit firms can establish a reputation of not e x p l o i t i n g consumers as they do i n m a n y service sectors where q u a l i t y is unverifiable - then it is not clear whether nonprofit status is the most efficient protection mechanism against consumer e x p l o i t a t i o n . T o investigate this possibility, the paper analyzes an entrepreneur's o p t i m a l choice of organizational form and service quality, w h e n q u a l i t y is noncontractible, i n a repeated i n t e r a c t i o n framework.  F o u r possible combinations of firm status (for-profit, nonprofit) and service  quality (one-shot, reputation) can arise i n e q u i l i b r i u m . T h e m a i n result is that w h e n reputations can be sustained, then for-profit status is the preferred organizational form and high quality services are ensured. T h i s finding challenges the adequacy of the contractual failure hypothesis as an e x p l a n a t i o n of nonprofit organizations that generate most of their revenue from the sale of goods and services. T h e next chapter of this thesis t i t l e d "Volunteer H i r i n g , O r g a n i z a t i o n a l F o r m a n d the P r o v i s i o n of M i s s i o n - O r i e n t e d G o o d s " , is m o t i v a t e d by the observation t h a t volunteering constitutes a considerably large and increasing share of the nonprofit sector's c o n t r i b u t i o n to economic activity, i n most advanced economies. F o r example, i n 1997 the value of volunteer work amounted to roughly one-quarter of the t o t a l value of labour services p r o v i d e d to the nonprofit sector i n C a n a d a , while i n the U . S . it reached one-third of t o t a l earnings i n the sector.  6  Besides volunteering for altruistic reasons - a desire to help others or contribute  to a n i m p o r t a n t cause - there is a widespread belief t h a t volunteering c a n be a stage i n professional development b y \ p r o v i d i n g work experience a n d a chance to develop skills that strengthen employability. V o l u n t e e r i n g offers some of the benefits that are often also associated w i t h u n p a i d internships i n for-profit firms or the government:  opportunities  to receive valuable on-the-job t r a i n i n g , discover h i d d e n talents and interests, learn about possible career tracks, e x p a n d networks of contacts, a n d enrich one's resume. I n m a n y cases the p o t e n t i a l is high for the t r a n s i t i o n to a p a i d p o s i t i o n , especially i n the nonprofit sector where volunteering experience appears to be a prerequisite for any type of career. For those i n d i v i d u a l s whose m o t i v a t i o n for volunteering includes the desire to acquire T h e estimate for Canada is taken from the Satellite Account of Nonprofit Institutions and Volunteering of Statistics Canada, which is available at http://www.statcan.ca/english/freepub/13-015-XIE/13-015XIE2004000.htm. For the U . S . , see the New Nonprofit Almanac and Desk Reference, Table 1.7, pg 22-23. 8  3  professional skills that improve future earning capacity, it is not clear w h y they do not associate more often w i t h for-profit employers. T h i s chapter provides an e x p l a n a t i o n for the fact that nonprofit employers are uniquely able to attract volunteers w i t h social concerns a n d career aspirations and for the related observation that nonprofits figure p r o m i n e n t l y i n mission-related activities. O u r theory is predicated on t h a t - by c o m m i t t i n g to not dist r i b u t i n g profits - nonprofit i n c o r p o r a t i o n relaxes the incentive constraint that employers face when i m p l i c i t l y contracting w i t h volunteers, w i t h o u t r e l y i n g on ex ante differences i n workers' preferences over the employer's identity or inherent asymmetries between nonprofit and for-profit providers. T h e not-for-profit c o m m i t m e n t is shown to be effective o n l y i n activities where producers, who can choose to be for-profit or nonprofit, care about the level or quality of the service being provided. T h u s , i n the e q u i l i b r i u m of the m o d e l developed here nonprofit entry i n sectors where missions p l a y a defining role and the h i r i n g of volunteers arise endogenously due to economic forces. T h e welfare analysis of the e q u i l i b r i u m suggests that it has some desirable properties. T h e fourth chapter t i t l e d " P r o s o c i a l M o t i v a t i o n a n d the D e l i v e r y of Social Services", co-authored w i t h P a t r i c k Francois, provides a synthetic overview t h a t highlights the major themes of the recent literature on the role of intrinsic m o t i v a t i o n i n the context of the prov i si on of social services. W e focus on the insights obtained from the two alternative ways of modelling pro-social m o t i v a t i o n , action-oriented a n d output-oriented a l t r u i s m , concerning the design of o p t i m a l incentives, the selection of m o t i v a t e d agents, a n d its interaction w i t h monetary rewards and organizational form. W e also discuss the i m p l i c a t i o n s for government provision of social services from the perspective of the literature that emphasizes the noncontractible nature of output a n d contrast it w i t h the i m p l i c a t i o n s derived from the literature that emphasizes the role of intrinsic m o t i v a t i o n . I n a d d i t i o n to t a k i n g stock of what has been learnt so far we suggest a few directions for future work. C h a p t e r 5 provides a brief s u m m a r y and offers some c o n c l u d i n g remarks.  4  Bibliography [1] A l c h i a n , A . A . , and H . Demsetz (1972): " P r o d u c t i o n , Information Costs, a n d E c o n o m i c O r g a n i z a t i o n , " American  Economic  Review, 62(5), 777-795.  [2] A n h e i e r , H . , and A . B e n - N e r (2003):  The Study of the Nonprofit  Enterprise.  Kluwer  A c a d e m i c / P l e n u m Publishers, N e w Y o r k . [3] Glaeser, E . (2003): "Introduction," i n The Governance  of Not-for-Profit  Organizations,  ed. by E . Glaeser. T h e U n i v e r s i t y of C h i c a g o Press. [4] H a l l , M . H . , C . B a r r , M . E a s w a r a m o o r t h y , S. W . Sokolowski, and L . M . S a l a m o n (2005): T h e C a n a d i a n Nonprofit and V o l u n t a r y Sector i n C o m p a r a t i v e Perspective, Imagine C a n a d a , Toronto. [5] H a n s m a n n , H . (1980): " T h e R o l e of Nonprofit Enterprise," Yale Law Journal,  89, 835-  901. [6] H a n s m a n n , H . (1987): " E c o n o m i c Theories of Nonprofit O r g a n i z a t i o n , " i n The Sector: A Research  Handbook,  ed. by W . Powell. Y a l e U n i v e r s i t y Press, N e w H a v e n .  [7] H o l m s t r o m , B . , and P . M i l g r o m (1994): " T h e F i r m as a n Incentive System," Economic  Nonprofit  American  Review, 84(4), 972-91.  [8] Shleifer, A . (1998): "State versus P r i v a t e O w n e r s h i p , " Journal  of Economic  Perspec-  tives, 12(4), 133-150. [9] W e i s b r o d , B . (1988) The Nonprofit  Economy.  H a r v a r d U n i v e r s i t y Press, C a m b r i d g e ,  MA. [10] W e i t z m a n , M . C . a n d J a l a n d o n i , N . T . (2002) The New Nonprofit Reference. Independent Sector, Jossey-Bass, N e w Y o r k .  5  Almanac  and Desk  Chapter 2  Quality, Reputation and the Choice of Organizational Form* 2.1  Introduction  T h e i m p o r t a n c e of the provision of h i g h q u a l i t y p u b l i c services such as health, education, child care and care for the aged cannot be overstated.  1  Clearly, voters a n d consequently  their elected representatives place a h i g h value o n these and improvements i n these areas are given h i g h p r i o r i t y i n the social agenda of any m o d e r n society. However, several potent i a l pathologies associated w i t h the provision of such services have been recognized i n the economics literature. In p a r t i c u l a r , one k i n d of market failure that has received considerable attention is the one induced by the h i g h degree of i n f o r m a t i o n asymmetries between providers a n d consumers over the q u a l i t y of these services. T h e p r o b l e m arises w h e n consumers are not as well informed about the q u a l i t y of the service or w h e n the q u a l i t y of the service is difficult to measure and verify by t h i r d parties.  I n such circumstances, it  is argued, service providers have a n incentive to act o p p o r t u n i s t i c a l l y and take advantage of the ill-informed consumer.  These i n f o r m a t i o n a l problems are exacerbated by the fact  that often the person t h a t is c o n s u m i n g these services is not the person t h a t is choosing t h e m . A n example from education w o u l d be that of the parent who chooses and pays for her child's schooling but is not the recipient of the services; moreover, the quality of the provided service m a y be h a r d to assess i m m e d i a t e l y because the p o t e n t i a l deficiencies m a y only manifest themselves as the child grows u p .  2  * A version of this chapter has been submitted for publication. These services are often more accurately characterized as quasi-public goods, in that they yield both public and private benefits. Besides, the mere fact that the private sector is partly involved in the provision of these services, indicates that they fail to satisfy (or do not satisfy fully) one or both of the principal properties associated with pure public goods: non-rivalry and non-excludability. T h i s type of goods which are evaluated by experience, are commonly referred to as experience goods (see Nelson 1970). 1  2  6  In response to these i n f o r m a t i o n a l problems, w h i c h following the literature we w i l l refer to as "contractual failures", it has been suggested by some authors, starting w i t h H a n s m a n n (1980), that nonprofit organizations are an effective solution because the low-powered i n 3  centives that permeate the structure of these organizations provide insurance to the consumer that she is not going to be exploited. In other words, what this theory argues is that nonprofit organizations act as a c o m m i t m e n t mechanism for the provision of q u a l i t y services i n circumstances where q u a l i t y is too costly to monitor. Interestingly, H a r t , Shleifer and V i s h n y (1997) use a similar rationale i n an influential paper t h a t analyzed the choice between in-house government p r o v i s i o n of services a n d cont r a c t i n g out to private suppliers, w h e n the q u a l i t y of service the government requires cannot be fully specified. T h e conclusion that emerges from their analysis is that private provision is generally more cost efficient but m a y result i n lower q u a l i t y service because private s u p p l i ers have a stronger incentive to undertake cost reduction that adversely affects quality. I n a recent formalization of the "contractual failure" idea, Glaeser and Shleifer (2001) a p p l y the incomplete contracts framework of H a r t et al. (1997) to s t u d y the choice of a n entrepreneur between setting up a for-profit firm and a nonprofit organization. T h e p r e d i c t i o n of their model is that when the benefit of c o m m i t m e n t is high, that is, w h e n consumers value quali t y h i g h l y and are w i l l i n g to pay higher prices a n t i c i p a t i n g better quality, then nonprofit status is preferable, despite the fact t h a t the entrepreneur is not the full claimant of profits, because it ensures softer incentives to s k i m p o n quality. T h i s paper is m o t i v a t e d by the fact that i n spite of its i n t u i t i v e appeal, the c o n t r a c t u a l failure approach seems to have overlooked a p o t e n t i a l l y i m p o r t a n t issue, namely, that the relationship between purchaser and supplier is, i n m a n y cases, a n on-going one. T h e ongoing aspect of the relationship should allow r e p u t a t i o n to emerge as another mechanism for m a i n t a i n i n g high unverifiable q u a l i t y .  4  Therefore, a p o t e n t i a l l i m i t a t i o n of the c o n t r a c t u a l  failure argument is that it fails to take into account the interaction between  reputations  and the choice of organizational form or treats the two as orthogonal. However, markets that involve unverifiable q u a l i t y are e x a c t l y the ones that we w o u l d expect long-term relationships to predominate and reputation effects to matter. Specifically, the repeated feature of the interaction between producer a n d consumer seems p a r t i c u l a r l y relevant i n the case of p u b l i c services, where the arrangement of services is of a c o n t i n u i n g nature a n d it rarely entails a one-time exchange.  A related shortcoming of this theory  arises when one considers a salient pattern i n the sectoral concentration of nonprofits. In particular, contractual failures cannot be reconciled w i t h the observation that nonprofit O t h e r early studies of nonprofit organizations that emphasize the role of asymmetric information between producers and consumers are Easly and O ' H a r a (1983) and Weisbrod (1988). W o r d of mouth is also a means of learning about the quality of the services of various providers. Therefore, reputation is not only valuable because of the multiple purchases by the same person, but also through the impact of this person's experience on his friends and family. 3  4  7  organizations t e n d to engage p r e d o m i n a n t l y i n the p r o v i s i o n of health, education, social a n d other mission-oriented services and not other services where q u a l i t y is equally unobservable and i n f o r m a t i o n a l problems are acute - for example business, professional, legal services etc. - yet, only for-profit firms appear to have established themselves as q u a l i t y providers of services i n the latter.  T h u s , two related questions c a n be raised: (a) Is it possible for  reputation mechanisms to work equally well i n the provision of p u b l i c services and ensure the s u p p l y of q u a l i t y services by for-profit firms? ( b ) W h a t factors determine w h e n r e p u t a t i o n is a sufficient consumer protection mechanism and w h e n not, i n w h i c h case nonprofit status is necessary to resolve failures associated w i t h i n f o r m a t i o n a l imperfections? T h e purpose of this paper is to e x p l i c i t l y address these questions by s t u d y i n g the o p t i m a l choice of organizational status allowing r e p u t a t i o n to act as a n alternative c o m m i t m e n t mechanism to nonprofit status for the provision of h i g h q u a l i t y services.  5  O u r analysis  builds on the Glaeser and Shleifer (2001) m o d e l because it captures the essence of the theory i n a concise and formal way. A repeated game is the n a t u r a l environment to s t u d y reputation effects.  Therefore, we extend the one-shot framework to a setting of repeated  interaction between the consumer and the provider of the service a n d establish conditions under w h i c h reputation is a sufficient mechanism for the provision of q u a l i t y services b y for-profit firms. T h e i n t u i t i o n is that the loss of r e p u t a t i o n associated w i t h delivering b a d quality service implies a substantial loss of future profits for the for-profit firm and therefore when the entrepreneur is sufficiently forward-looking then the fear of foregoing future profits disciplines h i m to deliver high q u a l i t y services. T h e idea that repeated purchases are a means of d i s c i p l i n i n g the producer to deliver h i g h q u a l i t y has been previously explored i n the Industrial Organization literature.  6  T h e difference i n our approach is that, besides quality,  the choice of organizational form is endogenous a n d the interest is on what c o m b i n a t i o n of type of firm and quality level w i l l be o p t i m a l l y chosen i n a d y n a m i c set-up. T h e m a i n finding of this paper is t h a t w h e n reputations can be established, then forprofit status is the o p t i m a l choice of organization form and firms have an incentive to s u p p l y h i g h q u a l i t y services. Therefore, we believe that w i t h o u t dismissing the contractual failure hypothesis, the repeated-interaction version of the m o d e l restricts its explanatory power. Furthermore, we argue i n section five that the m o d e l can be useful i n e x p l a i n i n g some empirical evidence from the U . S . a n d C a n a d a on the q u a l i t y differences between c o m m e r c i a l a n d nonprofit child care centres. F i n a l l y , we believe the paper has some n o r m a t i v e i m p l i c a t i o n s , i n particular, on the debate over the soundness of policies that favour nonprofit organizations on the grounds that c o m m e r c i a l firms cannot be trusted to deliver h i g h q u a l i t y service L i c e n s i n g is an alternative means of controlling the quality of the service which is arguably imperfect, because it sets only a m i n i m u m standard on the inputs used to provide the service and does not directly affect quality. For details on the impact of occupational licensing and certification on consumer welfare, see Shapiro (1986). See for example K l e i n and Leffler (1981), Shapiro (1983), Tirole (1988) and more recently Horner (2002). 5  6  8  because of their interest to earn profits.  T h e r e may be a number of good reasons  why  governments should subsidize nonprofits but our analysis suggests that, i n many sectors, overcoming contractual failures is not one of them. T h e rest of the paper is organized as follows. T h e next section sets-up the basic onep e r i o d m o d e l of Glaeser a n d Shleifer and section three extends it to a m u l t i - p e r i o d setting. T h e fourth section analyzes the o p t i m a l choice of firm status i n the repeated game. Section five discusses the predictions of the m o d e l and attempts to relate t h e m to e m p i r i c a l evidence on the quality of child care centres across c o m m e r c i a l and nonprofit providers i n the U . S . a n d C a n a d a . F i n a l l y , section six offers some c o n c l u d i n g remarks.  2.2  The One-Shot Game  In order to set a benchmark as well as establish some n o t a t i o n we introduce here the basic setup of the one-period Glaeser-Shleifer m o d e l . T h e m o d e l analyzes the o p t i m a l choice of organization from the perspective of a r a t i o n a l entrepreneur who contemplates entering a n i n d u s t r y and decides on firm type i n order to m a x i m i z e utility. T h e t i m i n g of events is as follows: F i r s t , the entrepreneur sells one unit of the good to a competitive market of consumers at price P, w h i c h is p a i d upfront. Consumers are w i l l i n g to pay P  e  = z — m(q — q ) for one unit of the good of expected unverifiable quality q , where e  e  [q — qj i f the firm is for-profit and q = q e  e  n  if nonprofit), m is a parameter c a p t u r i n g the  c o n s u m e r s taste for unverifiable quality, a n d z, q are constants. T h e n , the entrepreneur chooses what level of unverifiable q u a l i t y q to produce a n d delivers it. T h e t o t a l cost of p r o d u c i n g one unit of quality q is c(q), where c(.) satisfies the s t a n d a r d regularity conditions: it is twice differentiable w i t h c'(q) > 0, c"(q) > 0, c(0) = 0, c'(0) = 0, c'(oo) = oo. T h e key assumption is that while q may be observable b y the consumer, the final q u a l i t y of the good cannot be verified by a t h i r d party and therefore the transaction is subject to contractual incompleteness. Before any transactions take place, the entrepreneur decides whether to organize the firm as for-profit or nonprofit, denoted by / a n d n respectively, i n order to m a x i m i z e utility. Specifically, entrepreneurs m a x i m i z e a quasilinear u t i l i t y function: U% = I — b(q — qi), i € n} where / is income, a n d b is a parameter measuring entrepreneurs' altruistic preferences or intrinsic care for quality, w h i c h is independent of the firm's legal status.  W h e n the  entrepreneur is for-profit then income is equal to the profits the firm makes, while when he is nonprofit then he is subject to a n o n d i s t r i b u t i o n constraint, w h i c h implies t h a t he cannot • A m o n g the social benefits of nonprofit provision of public services one can single out the positive externalities associated with the acquisition of services such as education and childcare. Another important reason that a government may want to subsidize nonprofits is that they offer supplemental services to the ones that are publicly provided, which are tailored to the needs of consumers who are not satisfied w i t h the quality of service that the government offers. 7  9  {/,  directly draw o n the firm's profits. However, a fraction 5, S < 1, of the profits can accrue t o the entrepreneur i n the form of benefits such as less work hours, better w o r k i n g conditions etc.  8  Entrepreneurs m a x i m i z e u t i l i t y by choosing q u a l i t y  while the price Pi is predeter-  m i n e d b y consumer's expectation of quality. T h u s , i f they choose for-profit status their objective is: max if  U = P - c{q ) - b(q- q ) f  f  f  (2.1)  f  while i f they choose nonprofit status: max  U = 5 (P - c(q )) - b(q- q ) n  n  n  (2.2)  n  w i t h 5 < 1. T h e o p t i m a l q u a l i t y level of a for-profit entrepreneur is given b y c!{q ^) = b, s  while a nonprofit entrepreneur chooses c'(q^) = | . A s a n immediate consequence of the convexity of c(.) it follows that q^ > q j, a nonprofit entrepreneur c o m m i t s to higher quality, s  and  consumers correctly a n t i c i p a t i n g this are w i l l i n g to p a y the associated higher price  ( ^ n > Pf).  Hence, the entrepreneur chooses nonprofit status i f U > Uj, or: n  5 (z - m{q-  q ) - c(q )) - b(q - q ) > z - m{qs  s  n  s  n  n  q ) - c(q ) - b(q- q ) s  s  f  s  f  f  (2.3)  T h i s inequality implies that there exists a cut-off level of consumer taste for non-contractible quality m*, w i t h „ _ (1 ~ S)z - (c(gj) - 5c(q )) - b(q - qj) s  s  n  ( ! - * ) « +  n  1  ]  below w h i c h a l l entrepreneurs choose for-profit status a n d above w h i c h they a l l choose nonprofit status.  9  T h u s , the one-shot analysis of the game predicts that markets for services where u n verifiable q u a l i t y is not valued by consumers w i l l be d o m i n a t e d b y for-profit firms, while nonprofit firms w i l l provide services whose unverifiable q u a l i t y is i m p o r t a n t for consumers. In what follows we extend the static m o d e l t o a m u l t i - p e r i o d setting where consumers a n d entrepreneurs interact repeatedly. One can think of the nondistribution constraint as a discount on the cash value of the entrepreneur's profits. T h a t is, from the entrepreneur's perspective the restriction that residual earnings can only be consumed in kind, makes those earnings less valuable under not-for-profit status than they would have been under for-profit status. Moreover, this discount may vary with the constraints that the state imposes on the kind of perks nonprofits can grant to their managers. 8  9  N o t e that for m > m = - ~ - n - (Q-'! ) 6<  z  c<  q  >  h  n  ^ [ jj s  n  =Q  s  o  the range of m over which nonprofit status  is preferable is bounded by m. To rule out the degenerate case where nonprofit status is never optimal, we assume throughout that m * < m.  10  2.3  The Repeated Game  N o w suppose that there is infinitely repeated interaction between the consumer and the entrepreneur. firm's  10  In the d y n a m i c game, the consumer bases her purchasing decision o n the  past behaviour, that is, based on the firm's "reputation".  If the firm has b u i l t a  r e p u t a t i o n for p r o d u c i n g h i g h q u a l i t y then the consumer w i l l be w i l l i n g to pay the associated price as long as the entrepreneur's past actions live up to his reputation.  T h u s , the  entrepreneur c a n choose q u a l i t y to m a x i m i z e one-period u t i l i t y i n t e r n a l i z i n g the adverse effect that his choice of q u a l i t y has on the price t h a t the consumer is w i l l i n g to pay, namely, he can choose  first-best  quality.  However, the entrepreneur's promise of h i g h q u a l i t y is  credible provided it is incentive c o m p a t i b l e for h i m to c o m m i t to p r o v i d i n g better quality. T h a t is, the entrepreneur w i l l choose to b u i l d a n d m a i n t a i n a r e p u t a t i o n for h i g h q u a l i t y if this strategy generates a discounted stream of payoffs that exceed the one-shot gains of cheating a n d being punished i n future transactions. A s might be expected, i f entrepreneurs are sufficiently patient then the first-best outcome can be achieved under any ownership. I n what follows we focus o n (a) establishing a n d c o m p a r i n g the level of incentive c o m p a t i b l e per-period payoffs, that can be supported using punishment strategies that entail reversion to the outcome of the one-shot game, under the two alternative organizational forms, a n d (b) on e x a m i n i n g the possible configurations of firm status (for-profit, nonprofit) a n d quality (one-shot, reputation) that can occur i n the infinite repetition of the stage game, for the different values of the discount factor j3 a n d the consumer taste for q u a l i t y parameter m.  2.3.1  For Profit Status  In each p e r i o d the structure of the interaction is as follows.  T h e entrepreneur chooses  organizational form a n d the consumer pays upfront for the service. T h e n the entrepreneur makes his quality choice and delivers the service. T h e consumer observes the q u a l i t y chosen by the entrepreneur and forms her beliefs about future quality. If the producer deviates from delivering promised q u a l i t y he is punished i n future interactions by the consumer agreeing to pay upfront o n l y for one-shot quality. A s a first step we must now determine the  first-best  u t i l i t y that can be sustained i n the repeated game.  level of q u a l i t y and the resulting  F o r m a l l y , each p e r i o d the for-profit  entrepreneur maximizes the following objective: m a x U (q ) if f  f  =z-  m(q-  q ) - c(q ) f  f  - b(q-  q) f  (2.5)  T h e assumption that the firm is infinitely lived is important here. Behaviour that would be compatible with (ICF) cannot arise if there is a final period to the firm's life because the unique subgame Nash equilibrium of that game would be for the firm to cheat. So, backward induction rules out behaviour that satisfies {ICF) i n a finitely repeated version of the game. In other words, {ICF) can only be satisfied if at any period t, there is a positive probability that the game will continue into period t + 1. 1 0  11  Therefore, the u t i l i t y m a x i m i z i n g choice of q u a l i t y q*f{m), satisfies: c'(q* (m)) = b + m=$> q}(m) f  and  = c  + m)  (2.6)  1 1  — / / ( » ( ) ) > 0. Moreover, per-period u t i l i t y i n this case is given by: c  g  m  U (q}(m)) f  = z - m(q-  q}(m)) - c(q}(m)) - b(q-  q}(m))  (2.7)  N o t e that the convexity of c(.) implies that q*f{rn) > q p t h a t is, the entrepreneur  has  s  an incentive to increase the q u a l i t y of the good relative to what he offers i n the one-shot game - indeed, qj(m)  m a x i m i z e s t o t a l surplus - since he can extract a l l the surplus that is  generated. However, the first-best choice of q u a l i t y ^q*f(m)J  w i l l be supported i n e q u i l i b r i u m i f  and only i f the discounted stream u t i l i t y from adhering to honest behaviour exceeds the payoff stream from the d e v i a t i n g p a t h . T h a t is, incentive c o m p a t i b i l i t y for the for-profit entrepreneur m a y be w r i t t e n as: jhpU (q* (m))  > U [m) +  U (m)  if  YrpUfiqjim))  > U {m) +  U°(m)  i f m*  f  f  c  f  c  f  s  f  where (3 G (0,1) is the discount factor a n d Uj(m)  0 < m < m* <m<m  (IC ) F  = z—m(q—qj(m))—c(q j-)—b(q—q jr), s  s  (2.8)  is the  u t i l i t y the entrepreneur can a t t a i n i f he deviates from offering the anticipated first-best level of q u a l i t y a n d instead chooses the most profitable d e v i a t i o n w h i c h is to produce the one-shot u t i l i t y m a x i m i z i n g choice of q u a l i t y qj  (i.e. qj satisfies c'(qj) = b). Moreover, w h e n the  entrepreneur deviates he loses reputation, so i n subsequent periods the consumer punishes h i m by reverting to the N a s h e q u i l i b r i u m of the stage game. G i v e n the strategy adopted by consumers, the entrepreneur's best-response after a d e v i a t i o n i n w h i c h he cheated by p r o v i d i n g one-shot level of q u a l i t y is to continue p r o v i d i n g low q u a l i t y from t h e n on. I n particular, for m higher t h a n the cut-off level m*, the entrepreneur chooses to come back as a nonprofit firm a n d make one-shot level of u t i l i t y : U^(m)  = 5 (z — m(q — q^) — c(q^)) —  b(q — q^), every p e r i o d thereafter. If, instead, m is less t h a n ra*, then it is more profitable for the entrepreneur to m a i n t a i n her for-profit legal status b u t is punished for h a v i n g s k i m p e d on q u a l i t y a n d therefore his u t i l i t y is reduced to the one-shot level of profit: Uj(m)  —  z — m{q — q^) — c(qj) — b(q — qj), every p e r i o d after the d e v i a t i o n . c' is continuous and strictly increasing as a consequence of the continuity of c'(.) and that it is strictly increasing. 1 1  12  2.3.2  Nonprofit  Status  If the entrepreneur is nonprofit, then his p r o b l e m is to choose q  n  utility  to m a x i m i z e one-period  U (q ): n  n  m a x U (q ) n  = 5 {z - m(q-  n  q ) - c(q )) - b(qn  q)  n  (2.9)  n  T h e u t i l i t y m a x i m i z i n g choice of quality ^ ( m ) satisfies:  S  with  =  M  b  +  S  ~  m  ^  =  c  -  >  [  —  )  (2.10)  _ L _ > o, and q*(m) > q . U t i l i t y is given by s  =  n  U (q*(m)) n  =5{z-  m(q-  q*(m)) - c(q* (m))) - b(qn  q* (m))  (2.11)  n  N o t i c e that (2.6) and (2.10) i m p l y t h a t q £ ( m ) > q*f{m), first-best q u a l i t y under nonprofit status is greater t h a n under for-profit status. L e m m a 1 There exists m G (0, m*), such that U (q^(m)) n  P r o o f . I n the A p p e n d i x .  is = L7|(m) / o r m = m .  •  L e m m a 1 suggests that for low m, m 6 ( 0 , m ) , nonprofit status is not desirable even if a r e p u t a t i o n for q u a l i t y c a n be established. T h e i n t u i t i o n is t h a t when m is s m a l l , the price p r e m i u m that the consumer is w i l l i n g to pay a nonprofit firm for higher q u a l i t y is not enough to compensate the entrepreneur for the loss of income due to the l i m i t e d access to profits. A s i n the case of a for-profit entrepreneur, the first-best choice of q u a l i t y (q*(m)) w i l l be supported i n e q u i l i b r i u m i f a n d only if the discounted stream of u t i l i t y from adhering to honest behaviour exceeds the payoff stream from the d e v i a t i n g p a t h . T h a t is, incentive c o m p a t i b i l i t y for a nonprofit entrepreneur m a y be w r i t t e n as: f  T^U (q*(m*))>U^m)  + j ^  n  { ^U (q*(m*)) n  where U^(m)  > U {m) + ^ c  n  Uf(m)  if  m < m < m*  U^m)  if m * < m < m  = 5 (z — m(q — g*(m)) — c(q£)) — b(q — q^)  N  is the u t i l i t y the  >  entrepreneur  can a t t a i n i f he deviates from offering the anticipated first-best level of q u a l i t y and instead produces the one-shot u t i l i t y m a x i m i z i n g choice of q u a l i t y q^, i.e. q^ satisfies Sc'(q^) — b. T h e arguments regarding the choice of legal status a n d the corresponding payoff after the deviation are analogous to the ones we made above for the for-profit case. T h e difference here is that, as L e m m a 1 suggests, for m < m , it is Uj(m)  13  > U (q^(m*)), n  so ( / C A T ) cannot  be satisfied, w h i c h implies that a nonprofit entrepreneur cannot c o m m i t to p r o v i d i n g firstbest q u a l i t y (g*(m)) to the low m segment of the market.  2.4 2.4.1  Optimal Choice of Organizational Form Overview  In the m u l t i - p e r i o d formulation, the entrepreneur has two distinct decisions to make: what organizational type to choose a n d whether to establish r e p u t a t i o n for q u a l i t y or not. C o n sequently, four possible combinations of firm-status (for-profit, nonprofit) a n d q u a l i t y (firstbest, one-shot) m a y arise. T h e o p t i m a l choice of firm status and q u a l i t y can be analyzed w i t h reference to the two c r i t i c a l exogenous parameters: the firm's discount factor (5 a n d consumer's sensitivity to unverifiable q u a l i t y m. T o this end, it is useful to rearrange and (ICN)  {ICF)  as follows: uW-UfWm))  <m<m*  0  (2.13) p  >  P >  TTC,—\  U  ^^  U  „.—\  i  q  ^  it  )  }  %{ )-utlrn) m  m  <  m  <  m  ^  m<m<m*  l f  rn*<m<m  T h e right-hand-side of (2.13) a n d (2.14) define c r i t i c a l values for the discount factor /?, w h i c h we shall denote f3f(m) and / 3 ( m ) , respectively, above w h i c h delivery of first-best q u a l i t y n  can be sustained. T h a t is, for m such t h a t j3 > Pj(m),  {ICF)  is satisfied and the for-profit  entrepreneur delivers first-best q u a l i t y qj{m). Likewise, for m such that fi > / 3 ( m ) , n  is satisfied and the nonprofit entrepreneur chooses the  first-best  (ICN)  level q u a l i t y g*(m).  Our  a i m is to establish, first, w h i c h organizational form is preferable when reputations can be established, and second, w h i c h organizational form can support first best quality for the widest range of discount factors, namely, we shall be interested i n c o m p a r i n g Pf(m)  to  P (m). n  T o compare u t i l i t y across organizational forms, note that the relative benefit of being for-profit when {ICF)  a n d {ICN)  are slack is given by:  G{m) = [{m + b)q}{m) - c{q}{m))} - [{5m + b)q*{m) - 5c{q}{m))]+{l-5){z-mq)  (2.15)  T h e following l e m m a applies: L e m m a 2 When the entrepreneur g*(m), then for-profit  can commit to the first-best level of quality q^{m)  status is more attractive  14  at any level of m,  i.e.  G{m)  and  > 0 V m G  ( 0 , m ) . 12 P r o o f . I n the A p p e n d i x .  •  T h i s result suggests that r e p u t a t i o n forces favour for-profit status.  T h e i n t u i t i o n for  this is that as m increases the for-profit firm can now anticipate the price r e d u c t i o n that w i l l occur if it does not offer better quality, a n d adjusts the o p t i m a l q u a l i t y offered q*f{m) upwards, thus r e m a i n i n g more attractive t h a n the nonprofit firm for any m.  T h i s is the  power of the r e p u t a t i o n mechanism, it allows for-profit firms to c r e d i b l y c o m m i t to delivering the h i g h q u a l i t y service because it is more valuable to t h e m to do so. N e x t , i n order to compare (3f(m) to d {m), n  notice that, after s u b s t i t u t i o n a n d the  appropriate simplifications, (2.13) a n d (2.14) i m p l y that: (bqj-c(qj))  £ / (  m  ) H  - {bq* (m)-c{q*  (m))  f  )  if  {bq} - c(^T) - ( m f - c f a (m)))  .. if  (l-6)(z~mq)+mq* (m)-c{q )+bq -6viq?,+5c(q? )-bq?, s  f  s  f  f  0 < m < m* . m* < m  ( 2  <m  1 6  )  l  and (bq°-Sc(q°))-(bq*(m)-c(q*(m))) 0  ( )=  )  m  n K  '  m  |  if  m < m < m*  if  7B* < TO < m  "  -a-S)(z-™fi+trnq^m)-6c(q^)+bq^- q}+c(q})-bq}  (ftqg-fe(g|))-(6<?n(m)-c( »(m))) g  A n a l y z i n g the m o n o t o n i c i t y a n d the relative p o s i t i o n of Pf(m)  iii  »* ~-  a n d f3 (m) is very subtle. n  T o gain some i n t u i t i o n for this, notice that (3f(m) a n d /3 (m) can be r e w r i t t e n as follows: n  " B, Ht(m) " t/.»}  ft(  i)=  f0read  (2.18)  £  (m  where Bi{m) Ui(q*(m))  = Uf{m) — Ui{q*{m)) denotes the one-time benefit from cheating, a n d L j ( m ) =  — Uf(m)  denotes the absolute value of the future loss i n d u c e d by the punishment.  F r o m (2.18), it follows that:  < w i w ™ > ~ f ^ i £ $ T h i s last c o n d i t i o n suggests that c o m p a r i n g Pf{m)  <»»>  to (5 {m) amounts to c o m p a r i n g the n  ratio of benefits a n d losses associated w i t h a deviation, across organizational forms a n d for different values of m.  Intuitively, one might t h i n k that under nonprofit status the  manager's incentive to cheat is attenuated, because he can o n l y p a r t i a l l y enjoy the e x t r a profits generated due to cheating, so we might expect B (m) n  to be smaller t h a n  Bf(m).  I t follows, a fortiori, that for profit status is more attractive when the entrepreneur can choose first-best quality q}{m) when for-profit, but {ICN) is not satisfied. That is, Uf{q}{m)) > U {q {m)) implies that 12  n  Uf{q}{m)) > U {m) V m 6 (0,m). . n  15  n  O n the other hand, though, the value of the punishment inflicted i n the event of cheating is also smaller - the expression i n the denominator, so it is not i m m e d i a t e l y clear how (3f(m) compares to  (3 (m). n  In particular, closer inspection of (2.16) a n d (2.17) suggests that the value a n d the m o n o t o n i c i t y of these expressions depend o n relative changes of terms i n v o l v i n g c(.), w h i c h renders the p r o b l e m intractable. Therefore, i n order to proceed to a full characterization of the properties of Pf(m)  and P {m) n  and therefore of the o p t i m a l choice of firm, we need  to place some structure on the cost function c(q). After performing the analysis p o s i t i n g a specific cost function, we r e t u r n to discuss what part of the results obtained we t h i n k w o u l d hold under more general conditions. A s s u m p t i o n 1 c(q) =  \q 2  Vi  T h e following l e m m a describes the properties of [if (m) a n d f3 ( T O ) . n  = ^ for m G [TO*, TO).  L e m m a 3 (i) (3f(m) — \ for m G (0,m*], and P {m) n  (ii) P (m)  > (3f(m) form  n  (Hi) P (m)  G (0,m*), and Pf(m)  is decreasing, form  n  (iv) j3f{m) reaches a maximum P r o o f . I n the A p p e n d i x .  G  > P [m) n  form  G  (TO*,TO).  (0,TO*).  at m — 2m*.  •  T h e analysis is significantly aided by reference to F i g u r e 2.1, w h i c h L e m m a 3 helps us construct, a n d w h i c h illustrates Pf(m)  and P (m) n  i n (m,P)  space.  N o t e t h a t for TO  such that the punishment p a t h after cheating does not include conversion of legal status, Pf(m)  and P (m) n  r e m a i n flat a n d equal. T h i s , however, is not true i n the subintervals of  T (O, m ) where the punishment phase entails change of the firm's legal status prescribed b y entrepreneur's o p t i m a l behaviour i n the one-shot game. I n this case, there are two opposite effects governing the m o n o t o n i c i t y of Pf{m)  a n d P (m). n  O n one h a n d , the first p e r i o d  benefit of cheating increases w i t h m, w h i c h implies t h a t incentive c o m p a t i b i l i t y becomes stricter.  O n the other h a n d , the benefit of c o m m i t t i n g to h i g h quality, relative to b e i n g  a one-shot firm, increases w i t h m for periods two onwards as the r e p u t a t i o n firm  adjusts  o p t i m a l quality upwards while the one-shot firm adheres to the stage game quality. F o r m G (0, m*\, the second effect dominates the first effect we described above so the overall tendency is for (ICjv) to become increasingly easier to satisfy and hence P {m) n  For m G (m*, TO), Pj T (O)  is decreasing.  is n o n m o n o t o n i c because i n i t i a l l y the first effect dominates while  for higher m the second effect takes over. W e can now determine the entrepreneur's  choice of firm status for P l y i n g i n three  different subintervals of (0,1) b y referring to figure 1. 1 3  N o t e that this specification satisfies the regularity conditions imposed on c(.).  16  3/M  F i g u r e 2.1: Pj(m)  2.4.2  (solid) and P (m)  (dash)  n  O p t i m a l Choice when /5 e [/? (2m*), 1) /  T h e following p r o p o s i t i o n applies: P r o p o s i t i o n 1 / / the entrepreneur (ICF)  never binds and for-profit  of m.  Furthermore,  Proof.  is sufficiently  patient  status is the preferred  (i.e.  (3 > (3f(2m*)),  choice of organization,  then the  for any level  the first-best level of quality (q*j(m)) can be sustained.  Follows directly from L e m m a 2 a n d the fact t h a t (3f(2m*) is the m a x i m u m  value that (3j(m) takes i n ( 0 , m ) . Therefore, for f3 > Pj(2m*),  (ICF)  is always satisfied, so  it follows from L e m m a 2 that for-profit status is the o p t i m a l choice of legal status and that first best quality (qj(m))  2.4.3  is provided.  O p t i m a l Choice when )3 e  •  (\,p (2m*)) }  T o analyze the o p t i m a l choice of organizational form when /? lies i n the interval (\,  f3f(2m*)),  it is useful to divide the relevant (/?, m) space into the following two m u t u a l l y exclusive a n d exhaustive regions, also illustrated i n F i g u r e 2.2: D e f i n i t i o n 1 a) Region A consists of (3 6 {(3j(m), (3j(2m*)) and m £ ( 0 , m ) such that (3 > f3 (m). f  17  b) Region B consists of (3 G (\,(3j(m)) The  and m G (m*,m)  such that P (m) n  <  f3f(m).  following p r o p o s i t i o n summarizes the o p t i m a l choice of o r g a n i z a t i o n a l form a n d  quality for j3 G (\, p (2m*)): f  P r o p o s i t i o n 2 a) In Region A the entrepreneur best quality  chooses for-profit  first-  qj(m).  b) In Region B the entrepreneur  chooses nonprofit  a) N o t e that i n region A it is /3 > Pf(m)  Proof,  status and delivers  status and delivers  so (ICF)  first-best  quality  is satisfied, thus it follows  from L e m m a 2 that for-profit status is the o p t i m a l choice of legal status a n d that first best quality (qj(m))  is provided.  b) In region B it is P (m)  < P < Pf(m),  n  i m p l y i n g that only (ICN)  is satisfied w h i c h  means that nonprofit status offering first best q u a l i t y (g*(m)) w i l l be chosen. Moreover, whether (ICF)  •  is satisfied or not, for m G (m*,fn) depends o n parameters  such as the consumer's willingness to pay for the service (z) a n d the entrepreneur's altruistic taste b. R e m a r k 1 Differentiation  of f3f(m) form  G ( m * , m ) yields:  T h u s , the higher the profitability of the i n d u s t r y or the firm the larger area A becomes, w h i c h implies that the greater is the likelihood that (ICF) w i l l be satisfied a n d entrepreneurs are going to choose for-profit status as the preferred form of o r g a n i z a t i o n . O n the other hand, the more a n entrepreneur is i n t r i n s i c a l l y concerned about quality, the larger area B becomes, w h i c h means that it is harder to m a i n t a i n first-best q u a l i t y under for-profit status.  2.4.4  O p t i m a l Choice when j3 e (0, \ )  T h e following p r o p o s i t i o n applies: P r o p o s i t i o n 3 If P < \ , reputations  cannot  then (ICF)  be sustained  and (ICN)  regardless  The optimal choice of organizational  are never satisfied for any level of m and  of what legal status the entrepreneur  chooses.  type is the one described in the one-shot game.  P r o o f . It is i m m e d i a t e l y clear from L e m m a 3 a n d figure 2.1 that for (3 < \ . (3 < /3f(m) and f3 < P (m), n  so b o t h (ICF)  a n d (ICN)  fail.  •  For reference, the various possible outcomes of the repeated game are also illustrated i n F i g u r e 2.2 a n d s u m m a r i z e d i n Table 2.1. 18  •  For Profit, first-best quality  \ \ \  Area A  \  \  fi/im)  \  0/(277.') 1  -  "  Area B One-Shot Analysis  2m*  m  F i g u r e 2.2: S u m m a r y of O p t i m a l C h o i c e of O r g a n i z a t i o n a l F o r m  Table Summary  of Optimal  Choice of Firm Status and Quality  Region (0,m) x A:  F i r m Status  [8 (2m*),l) f  ( 0 , m ) x (8 (m),  8 (2m*))  f  B : (rn*,m) x  1.1  f  q*  FP  q}  One — Shot  (0,m) x (0,1)  Quality  FP  NFP  (\,3f(m))  by Region  f  q*  n  Analysis  T h e foregoing analysis suggests that i f we imagine that there is a d i s t r i b u t i o n of 8's in the p o p u l a t i o n of entrepreneurs,  then those that have sufficiently h i g h 0 w i l l choose  for-profit status and w i l l deliver h i g h q u a l i t y service. T h e r e is an intermediate range of 8's where the choice of firm status varies w i t h m. F i n a l l y , for very low 8, reputations are not going to be established and the one-shot analysis of Glaeser a n d Shleifer w i l l a p p l y .  14  T h e value of 8 need not be interpreted literally as a discount factor. T h e r e are plenty of reasons that one would expect v a r i a t i o n i n managerial outlook of future profitability that are not directly related to one's personal rate of time preference. For example, some markets T h e r e may also be ideological or religious motivations that make nonprofit status attractive for some people and therefore affect the supply of nonprofit activity. M u c h like most of the literature that relies on contractual failures, we have abstracted from these considerations here. 14  19  may have higher d e m a n d g r o w t h t h a n others w h i c h means that the potential future losses from s h i r k i n g on q u a l i t y a n d losing r e p u t a t i o n i n these markets are higher. T h i s k i n d of differences i n market-specific or sector-specific conditions can be regarded as  determinants  of the effective discount factors that have to be applied by potential entrants when deciding w h i c h firm status to choose and what level of q u a l i t y to offer. It is noteworthy that i f we were to adopt the view t h a t the o p t i m a l organizational form is the one that m i n i m i z e s the discount factor that is necessary to sustain first-best quality, then the outcome of the repeated game matches w i t h that of the static game. T h a t is, there exists a threshold value for consumer preference for quality m*, above w h i c h nonprofit status is o p t i m a l and below w h i c h for-profit status dominates. T h i s way of r a n k i n g organizations m a y be relevant if, for instance, we believe that free-entry c o m p e t i t i o n a m o n g firms w i l l ensure that the incentive compatible constraints (ICF)  a n d (ICN)  b i n d . T h e n , we should  expect the organizational form w i t h the lower c r i t i c a l value for the discount factor to drive the other one out of the market.  2.4.5  Discussion  T h e analysis of the o p t i m a l choice of firm status was considerably simplified b y i n t r o d u c i n g an explicit functional form for the cost function, since a general characterization is not possible. Here we point out where the difficulties i n o b t a i n i n g general results lie and elaborate on what parts of the analysis are likely to generalize under more general conditions. F i r s t , we examine whether the result that for profit status is o p t i m a l for m £ i.e. Pf(m)  < P (m),  (m,m*},  is general. U s i n g (2.19) and simplifying one can o b t a i n the following  n  necessary and sufficient c o n d i t i o n for this to be true: U (q}(m))  (U (m) c  f  n  - U (m))-U (m) s  s  f  f  (U (m)  - U (ql(m)))  c  n  n  > Uf(m)  (U (q* (m)) n  -  n  Uf(m)) (2.20)  where the left-hand-side is positive because Uf(qj(m))  > Uj(m)  and U (q^(m))  >  n  U j(m). s  In a d d i t i o n , recall that L e m m a 1 suggests t h a t the t e r m on the right-hand-side is zero, for m i n the v i c i n i t y of m, and increasing i n m.  T h i s suggests that inequality (2.20) holds  for m = m; whether it becomes easier or harder to satisfy as m increases depends on the relative changes of the terms on the left a n d right-hand-side of the inequality, w h i c h cannot be assessed generally. N e x t , we examine whether the p r e d i c t i o n that nonprofit status is o p t i m a l for m > m*, i.e. (3f(m) > (3 (m). n  W e use (2.19) again to derive the following necessary and sufficient  c o n d i t i o n for this to be generally true: U (m) (U (q* (m)) c  f  n  n  - U (m))+U^(m) s  n  (U^m)  + U (q}(m)) f  - U (q* (m))) n  n  >  U (q}(m))U (m) c  f  n  (2.21)  20  where a l l of the above terms are positive. T h u s , whether inequality (2.21) holds or not depends on the relative magnitude of these terms, w h i c h cannot be ascertained some structure is imposed on the cost function.  unless  T h e p a r t i c u l a r formulation we used is  convenient for d e r i v i n g simple a n a l y t i c a l results but numerical examples using higher-order power functions suggest that the insights obtained are robust to alternative specifications of the cost function.  2.5  Relating the Model to Empirical Evidence and Policy Implications  W e believe that the predictions obtained from the d y n a m i c framework can help us understand some facts concerning q u a l i t y differentials i n m i x e d sectors w h i c h the one-shot m o d e l falls short of explaining. F o r instance, consider the market for c h i l d care, w h i c h features a considerable nonprofit presence, m a k i n g it appropriate for d r a w i n g comparisons between the quality offered by for-profit and nonprofit p r o v i d e r s .  15  Furthermore, the q u a l i t y d i -  mension i n child care is arguably h a r d to measure a n d verify, w h i c h makes it amenable to the incomplete contracts framework we have l a i d out above. O u r reading of the e m p i r i c a l evidence on the between-sector differences i n q u a l i t y from the U . S . and C a n a d a ,  1 6  is t h a t  although most studies find that nonprofit centres as a group o b t a i n higher scores on observational measures of overall q u a l i t y developed by c h i l d development e x p e r t s ,  17  this  finding  cannot be interpreted as a direct confirmation of the contractual failure theory. F i r s t , the differences on average q u a l i t y between the two groups are not overwhelming, a n d there is v a r i a t i o n i n q u a l i t y w i t h i n each category of auspice. T h a t is, there are c o m m e r c i a l centres that offer high q u a l i t y and nonprofit centres that offer low quality. T h i s possibility t h o u g h is i n contradiction w i t h the strong form of the c o n t r a c t u a l failure view of the w o r l d w h i c h predicts that o n l y nonprofits w i l l occupy the upper part of the quality d i s t r i b u t i o n . Second, it seems very likely that the greater access to government funding a n d subsidies nonprofits enjoy i n certain jurisdictions, could at least p a r t l y account for the reported difference i n average quality between the nonprofit and c o m m e r c i a l c h i l d care sectors. F i n a l l y , it is possible that the v a r i a t i o n i n q u a l i t y m a y s i m p l y reflect choice of market niche and be unrelated to informational asymmetries of any sort.  F o r example, for-profit child care centres m a y  choose to substitute lower q u a l i t y care, for more convenient arrangements offered to the parents (convenient l o c a t i o n , longer hours etc.). S t u d i e s that examine the relative performance of nonprofits are too many to list here, see Rose-Ackerman (1996) for a comprehensive review of the literature. O r t m a n n and Schlesinger (2003) review the empirical work on ownership-related differences i n quality from various mixed industries. F o r evidence from the U . S . child care sector, see the survey by B l a u and Currie (2005) and the references therein. For evidence from Canada, see Krashinsky (1998) and Doherty et al (2002). I t is important that these instruments of child care quality refer to non-contractible quality, and is distinct from structural measures of quality, such as the child-teacher ratio, which are contractible. 15  1 6  1 7  21  Yet another explanation of the apparent between-sector q u a l i t y differential, a n d indeed one that the analysis of the repeated version of the m o d e l points to, is that because for-profit status dominates the lower part of the q u a l i t y d i s t r i b u t i o n (m < m*), even t h o u g h there are some h i g h q u a l i t y for-profit centres (in area A a n d for 0 E [0f(2m*),  1), o n average the  quality p r o v i d e d by the commercial sector is lower t h a n the nonprofit w h i c h has a higher quality t h r e s h o l d .  18  Furthermore, i n markets where nonprofits have lower costs (c(g)),  because of access to free space and utilities, the m o d e l suggests t h a t more entrepreneurs w i l l choose nonprofit status, w h i c h w o u l d increase the average q u a l i t y care i n the nonprofit sector a n d lower that one i n the c o m m e r c i a l sector. In light of this interpretation of the q u a l i t y differential, it is interesting to revisit the ongoing debate over the effectiveness of subsidy policies that discriminate against for-profit child care centres, on the basis t h a t they are untrustworthy to provide h i g h q u a l i t y care. W e argued above that the existing e m p i r i c a l evidence o n the i m p a c t of centre ownership o n care quality is scant and does not allow for sweeping conclusions, w h i l e the m o d e l considered here demonstrates that reputations can provide enough incentives for p r o f i t - m a x i m i z i n g entrepreneurs to offer h i g h q u a l i t y services w h e n the p l a y i n g field is levelled. Perhaps future e m p i r i c a l work may be able to settle the debate by identifying the extent to w h i c h q u a l i t y differences between sectors echo contractual failures or unequal funding opportunities.  2.6  Conclusion  T h e idea that nonprofit organizations can solve market imperfections a t t r i b u t a b l e to asymmetric i n f o r m a t i o n between consumers a n d producers, regarding h a r d to verify q u a l i t y of certain services, has been a p a r t i c u l a r l y influential e x p l a n a t i o n of the emergence and expansion of the nonprofit sector. O u r task i n this paper has been to perform a robustness check of this theory by allowing reputations to serve as a c o m p e t i n g mechanism that can ensure quality. T h e analysis of the m o d e l of repeated interaction between consumers a n d firms yields some interesting new outcomes while it encompasses the one-shot case originally examined by Glaeser a n d Shleifer. I n this sense, it may be argued that the predictions of the contractual failure hypothesis a p p l y i n the special case where the long-run r e p u t a t i o n mechanism cannot be sustained because interaction is not repeated or because of frictions i n the flow of information. In more general circumstances, nonprofit status does not appear to be a necessary mechanism to overcome o p p o r t u n i s t i c behaviour that arises because q u a l i t y is unverifiable. A l s o , the m u l t i - p e r i o d version considered i n this paper provides an explanation for the differences and v a r i a b i l i t y i n non-contractible q u a l i t y across organizational types that have been identified i n e m p i r i c a l studies of the child care sector. T h e goal of this paper has not been to u t t e r l y dismiss the c o n t r a c t u a l failure hypothesis, 18  R e c a l l that nonprofit status is chosen only for m > m*.  22  only to challenge its scope as an e x p l a n a t i o n for the widespread presence of nonprofit organizations. T h e key i m p l i c a t i o n of our analysis is that, i n m a n y sectors, the existence of a large number of nonprofit firms cannot be explained w i t h reference to their unique a b i l i t y to mitigate problems of a s y m m e t r i c i n f o r m a t i o n .  In p a r t i c u l a r , we shouldn't expect it to  be an i m p o r t a n t factor i n industries where income from sales of services constitutes the largest source of revenue a n d where there is repeated interaction between consumers a n d providers - such as the child care sector discussed i n the previous section a n d other social services. T h i s does not preclude the theory to play a n i m p o r t a n t role i n charitable services where donations are a significant source of revenues. A l s o , our analysis does not rule out the e x p r o p r i a t i o n p r o b l e m h a v i n g significant i m p l i c a t i o n s on the relationship between the organization a n d various other economic actors such as its employees, volunteers, donors and the different government agencies. F u r t h e r research i n these areas m a y prove fruitful i n advancing our understanding of the role, advantages a n d evolution of the nonprofit sector.  23  Bibliography [1] B l a u , D . , and J . C u r r i e (2006):  " W h o ' s M i n d i n g the K i d s ? :  and After School Care," i n The Handbook  of the Economics  Preschool, D a y C a r e , of Education,  ed. by E .  Hanushek and F . W e l c h . N o r t h H o l l a n d , N e w Y o r k . [2] Doherty, G . , M . Friendly, and B . Forer (2002):  " C h i l d C a r e by Default or Design?  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K l u w e r A c a d e m i c / P l e n u m Publishers, N e w Y o r k . [13] R o s e - A c k e r m a n , S. (1996): " A l t r u i s m , Nonprofits and E c o n o m i c Theory," Journal Economic  Literature,  of  34(4), 701-28.  [14] Shapiro, C . (1983): " P r e m i u m s for H i g h Q u a l i t y P r o d u c t s as Rents to R e p u t a t i o n , " Quarterly  Journal  of Economics,  98(4), 659-680.  [15] Shapiro, C . (1986): "Investment, M o r a l H a z a r d , a n d O c c u p a t i o n a l L i c e n s i n g , " of Economic  Review  Studies, 53(5), 843-862.  [16] T i r o l e , J . (1988): The Theory of Industrial [17] W e i s b r o d , B . (1988): The Nonprofit  Organization.  Economy.  MA.  25  M I T Press, C a m b r i d g e , M A .  H a r v a r d U n i v e r s i t y Press, C a m b r i d g e ,  Chapter 3  Volunteer Hiring, Organizational Form and the Provision of Mission-Oriented Goods* 3.1  Introduction  Volunteering constitutes a considerably large and increasing share of the nonprofit sector's c o n t r i b u t i o n to economic activity, i n most advanced economies. So m u c h so, that i n fact it is not u n c o m m o n for nonprofit organizations to be referred to as "voluntary organizations" to emphasize their reliance on v o l u n t a r y employment.  F o r example, i n 1997 the value  of volunteer work amounted to roughly one-quarter of the t o t a l value of labour services provided to the nonprofit sector i n C a n a d a , w h i l e i n the U . S . it reached one-third of t o t a l earnings i n the sector.  1  Besides volunteering for altruistic reasons - a desire to help others  or contribute to a n i m p o r t a n t cause - there is a widespread belief t h a t volunteering c a n be a stage i n professional development by p r o v i d i n g work experience and a chance to develop skills that strengthen employ ability. V o l u n t e e r i n g offers some of the benefits that are often also associated w i t h u n p a i d internships i n for-profit firms or the government:  opportunities  to receive valuable on-the-job t r a i n i n g , discover h i d d e n talents a n d interests, learn about possible career tracks, expand networks of contacts, a n d enrich one's resume. I n m a n y cases the potential is high for the t r a n s i t i o n to a p a i d position, especially i n the nonprofit sector where volunteering experience appears to be a prerequisite for any type of career. P r e v i o u s research w h i c h studied factors that determine the decision to s u p p l y volunteer time, such as M e n c h i k and W e i s b r o d (1987), D a y a n d D e v l i n (1998), Segal and W e i s b r o d * A version of this chapter will be submitted for publication. The estimate for Canada is taken from the Satellite Account of Nonprofit Institutions and Volunteering of Statistics Canada, which is available at http://www.statcan.ca/english/freepub/13-015-XIE/13-015XIE2004000.htm. For the U . S . , see the New Nonprofit Almanac and Desk Reference, Table 1.7, pg 22-23. 1  26  (2002), G u n d e r s o n and G o m e z (2003) has found evidence suggesting that besides purely altruistic motives people may engage i n volunteering activities to improve their employment opportunities.  F o r instance, D a y a n d D e v l i n (1998) report evidence of a 6-7% r e t u r n of  volunteering i n annual earnings for C a n a d i a n workers.  Surveys also support this.  For  example, the N a t i o n a l Survey of G i v i n g , Volunteering, a n d P a r t i c i p a t i n g (2000), w h i c h provides a snapshot of the state of v o l u n t a r y a n d civic action i n C a n a d a , reveals t h a t almost a quarter (23%) of volunteers agreed that i m p r o v i n g j o b opportunities was a reason for volunteering, w i t h younger volunteers more likely (55%) to indicate this as a reason. Furthermore, 14% of volunteers reported that volunteering h a d at some point helped t h e m to o b t a i n employment, w i t h again a greater p r o p o r t i o n of younger volunteers (24%) c l a i m i n g likewise.  2  These findings confirm the c o m m o n w i s d o m that volunteering for some i n d i v i d u a l s  is viewed as a means to help others while at the same t i m e increase the chances of success i n the labour market, a n d i n p a r t i c u l a r i n the nonprofit sector. T h i s paper takes the altruistic motivations and the career concerns of volunteers as a point of departure and provides a n e x p l a n a t i o n for the following salient patterns (1) nonprofit organizations attract the overwhelming share of volunteers  3  that meet this pro-  file and (2) volunteer-hiring nonprofits are concentrated i n mission-oriented sectors, where the goods and services produced c a n be conceived as h a v i n g a p u b l i c (or collective) g o o d component  4  - c o m m o n l y thought to lead to the market u n d e r p r o v i d i n g t h e m - a n d w h i c h  generate nonpeeuniary benefits to those involved i n their delivery. E d u c a t i o n , healthcare, childcare, international aid, the arts, religious and p h i l a n t h r o p i c foundations, a n d the vast social services are examples of mission-oriented fields.  5  These contrast w i t h most other  activities, regularly p r o v i d e d by profit t a k i n g firms, where non-pecuniary motivations are less of a consideration. T h e challenge we pose i n this paper is to e x p l a i n the above set of observations as an e q u i l i b r i u m outcome w i t h o u t p o s i t i n g t h a t workers m o t i v a t e d by concerns for social outcomes have an exogenous disposition for w o r k i n g at nonprofit establishments or assuming that nonprofit and for-profit producers have respective ex ante advantages i n the delivery of goods and services of different character. W e e x p o u n d our theory by developing a m o d e l w i t h two sectors (a mission sector and a non-mission sector), where heterogeneous (some mission m o t i v a t e d and some not) managers (principals) and workers (agents) are matched, choosing organizational form (for-profit, nonprofit), employment contract and sector.  To  See H a l l et al. (2001), figure 2.2, pg 35. I n 1998, the distribution of full-time volunteers by sector in the U . S . was 68.5 percent nonprofit, 26 percent; government and 5.5 percent; for-profit; sector. See the New Nonprofit Almanac and Desk Reference, Figure 1.7, pg 24. E v e n though these goods do not necessarily feature both properties shared by public goods - nonrivalry and nonexcludability - they are associated with external benefits. For example, a person may benefit from high quality healthcare coverage of others, not only because it reduces the chances that she may be infected by a contagious disease, but also because of ethical concerns for the standards of human well-being i n society. See Rose-Ackerman (1996) for cross-country documentation of the composition of the nonprofit sector. 2  3  4  5  27  address the previously mentioned challenge we start from a p o s i t i o n of ex-ante s y m m e t r y : (a) the intrinsic benefit that caring managers and workers derive i n the mission sector is attached to the j o b that they do, not the identity of the o r g a n i z a t i o n (nonprofit or forprofit) i n w h i c h they do i t ;  6  (b) workers are equally p r o d u c t i v e w o r k i n g for either type of  employer; a n d (c) managers have access to a c o m m o n p r o d u c t i o n technology regardless of the organizational form they select. Therefore, besides the restriction i n the a p p r o p r i a t i o n of profits there are no ex ante s t r u c t u r a l differences between for-profit and nonprofit status. We then proceed to demonstrate how the observed configuration (nonprofit firms h i r i n g volunteers i n the mission sector) arises endogenously i n the e q u i l i b r i u m of the m o d e l , a m o n g the host of ex ante possible (firm-type/employment structure/sector)  combinations, and  that this p a r t i c u l a r e q u i l i b r i u m has some desirable welfare properties. A n example from healthcare illustrates the reasons why. C o n s i d e r the case of a h o s p i t a l or a long-term care facility, w h i c h recruits volunteers to support direct patient care. T h e given hospital can benefit b y refusing to recognize the volunteering experience of i n d i v i d u a l s at other firms while at the same t i m e t a k i n g advantage of the fact that its volunteers w i l l be acknowledged elsewhere. S u c h a d e v i a t i n g firm w i l l like to p e r p e t u a l l y fill positions w i t h u n p a i d volunteers who are denied p r o m o t i o n to p a i d positions and are replaced by new volunteers, w h e n they turnover to seek employment at another employer. S u c h behaviour w i l l eventually be detected and punished by future workers who w i l l pass up volunteer opportunities at a h o s p i t a l w h i c h h a d previously cheated on its volunteers. F o r nonprofit organizations, the incentive to exploit volunteers is weaker, because of the weaker incentives to pursue profits and the greater concern about the social mission, w h i c h allows t h e m to m a i n t a i n an incentive compatible scheme.  T h e i r c o m m i t m e n t to not d i s t r i b u t i n g profits  conveys a comparative advantage i n mission-oriented sectors by g i v i n g t h e m exclusive access to the volunteer pool. A n i m p o r t a n t feature of the analysis is t h a t workers' effort and output are unverifiable by t h i r d parties and as a result performance-contingent remuneration is infeasible; element is present i n b o t h sectors a n d for a l l types of  firm.  7  this  O n e s t a n d a r d solution to  this incentive p r o b l e m is the use of i m p l i c i t contracts that are self-enforcing a n d that take advantage of the long-term aspect of the employment relationship: a worker receives a fixed payment that exceeds o p p o r t u n i t y costs as long as performance has been satisfactory a n d is dismissed otherwise.  8  T h i s type of compensation, namely a wage set above the market  clearing rate (efficiency wage), is k n o w n to induce i m p o r t a n t l a b o u r market inefficiencies T h i s is not to deny that individuals might receive direct benefits from founding or working for a nonprofit firm. Here we wish to explore whether we can explain the observed patterns of nonprofit activity without assuming such direct rewards. T h e notion that workers' performance is observed by the firm but cannot be verified in court is borrowed from the incomplete contracts literature and has been widely applied to agency models of employment, see Malcomson (1999). I n the context of the provision of public services, this avenue has been pursued in Francois (2003). 6  7  8  28  - s u b - o p t i m a l employment levels. Here, m o t i v a t e d by the observation that some workers (interns and volunteers) are induced to undertake u n p a i d or very low pay work by the possibility of rewards i n the form of future employment by the same or some other employer, we recognize that this two-tier employment structure provides a more efficient s o l u t i o n to the p r o b l e m of incomplete employment contracts:  it allows firms to extract some of the  rents that workers have to be offered later on as p a i d workers i n order to s u p p l y effort, thus d a m p e n i n g the d i s t o r t i n g effect arising from p r o v i d i n g incentives w i t h payments above o p p o r t u n i t y cost.  9  W e consider two alternative incentive structures, w h i c h i n the interest of f a c i l i t a t i n g exposition we refer to as: - Volunteering:  A worker is hired as a n u n p a i d volunteer a n d is subsequently transferred  to a p a i d p o s i t i o n not necessarily at the firm where he has volunteered (incentives are sector-wide). - Internship:  A worker is hired as an u n p a i d intern a n d is subsequently p r o m o t e d w i t h i n  the firm he has interned, when a vacancy is created (incentives are  firm-specific).  T h e key difference between volunteering and internship is t h a t time spent volunteering elsewhere is treated "as i f it were volunteered at the firm - m u c h like actual volunteering occurs i n reality - whereas interns are p r o m o t e d at the firm where they intern. I n b o t h structures a worker is w i l l i n g to w o r k for a p e r i o d w i t h no pay i f he anticipates t h a t he w i l l be subsequently promoted to a wage p o s i t i o n , y i e l d i n g an expected lifetime u t i l i t y no less t h a n his outside o p t i o n .  B u t notice that the h i r i n g of volunteers (or interns) intro-  duces a two-sided m o r a l h a z a r d p r o b l e m , as firms have incentive to recruit u n p a i d workers, p r o m i s i n g t h e m p r o m o t i o n to p a i d positions, a n d then renege on the promise. It is well k n o w n from the theory of repeated games that repeated interaction c a n help overcome these problems (reputation mechanism), i f the discounted stream of payoffs associated w i t h h i r i n g volunteers exceeds the payoffs from cheating and then b e i n g punished b y h a v i n g to resort to h i r i n g o n l y p a i d workers. T h e d y n a m i c interaction between m u l t i p l e firms and workers is formally studied as a repeated game and a characterization of the e q u i l i b r i u m strategies s u p p o r t i n g 'volunteering' and the 'internship' structure is provided. A n a d d i t i o n a l component of the present setting is that managers a n d workers can be intrinsically m o t i v a t e d and derive nonpeeuniary benefits from c o n t r i b u t i n g to the product i o n of mission goods (e.g. nurses, teachers, aid workers). M o t i v a t e d agents are t y p i c a l l y heterogeneous i n terms of mission preferences - what a c t i v i t y to pursue and how to pursue it - and usually some hands-on experience is required before a n i n d i v i d u a l can learn enough about the different causes to be able to identify a preferred mission. F o r example, T h e possibility that employers use deferred payments as a means of providing incentives has been studied, in a different context, by Lazear (1981) and by Akerlof and K a t z (1989). 9  29  the manager of an international a i d agency or an a i d worker m a y prefer w o r k i n g for a n organization w i t h a p a r t i c u l a r religious outlook, or they may develop t h r o u g h experience a preference over the targeted group of beneficiaries (which group is more needy).  Because  the m a i n parties involved m a y have different views about how the project should be carried out, preference alignment is an i m p o r t a n t determinant of the q u a l i t y of the m i s s i o n good.  1 0  V o l u n t e e r i n g facilitates the m a t c h i n g of like-minded organizations a n d workers,  w h i c h improves the q u a l i t y / i m p a c t of the mission a c t i v i t y as well-matched pairs are more productive: a volunteer works for a p e r i o d of ' e x p l o r a t i o n ' , then as his mission preferences become k n o w n he can transfer to a m a t c h i n g firm, when a vacancy is created. B y contrast, internships m a t c h workers and organizations randomly, as when an intern joins the  firm  his mission preferences have not been determined. Therefore, from employers' perspective volunteer h i r i n g is the preferred h i r i n g practice i n the m i s s i o n sector because it c a n generate more efficient m a t c h i n g . T h e workings of the m a t c h i n g process we envisage between mission-motivated principals and agents resemble that of the entry-level m e d i c a l labour market. There it was recognized that mismatches occurred because c o m p e t i t i o n led hospitals to sign up interns early on, years ahead of graduation, before their skills a n d interests were developed. T h e p r o b l e m was that w h e n a hospital and a n intern reached an early deal they d i d not take into account the externality imposed on other hospitals a n d interns ( R o t h 1984). Some rules were eventually designed to move the dates of appointment  later into the senior year of m e d i c a l school  w h e n more information about students' abilities and preferences was available and as a result more efficient matches between interns and hospitals were identified. W e believe t h a t the process of volunteer h i r i n g we described above alleviates a s i m i l a r p r o b l e m - albeit i n a less structured fashion t h a n the labour market for m e d i c a l residents - t h a t w o u l d arise if mission-oriented organizations hired workers too soon (as w o u l d be the case w i t h internships), before their mission preferences have been revealed. N o t h i n g i n the structure of the m o d e l we have sketched suggests t h a t a r a t i o n a l manager w o u l d choose nonprofit over for-profit status, since the only effect of this choice is that the manager's pecuniary payoff from operating the firm is reduced. A possible reason w o u l d be that nonprofits are at an advantage i n terms of being able to sustain volunteer h i r i n g . B u t does the nonprofit i n c o r p o r a t i o n relax the incentive c o m p a t i b i l i t y constraint t h a t makes c o m m i t m e n t to h i r i n g volunteers credible? O u r analysis suggests t h a t the answer to this hinges on the type of a c t i v i t y (mission-oriented or not) that is undertaken. I n particular, i f volunteering o n l y raises profits then a nonprofit firm does not have a p a r t i c u l a r advantage T h e role of matching i n principal-agent pairs w i t h heterogeneous preferences is explored i n Besley and Ghatak (2005), who show that better matching leads to higher effort and productivity. Here we take as given the proposition that better matched pairs are more productive in order to focus on how the interaction between the choice of organizational form (for profit or nonprofit) and incentive structure (volunteering or internship) can lead to more efficient matching. 1 0  30  over for-profit firms (true i n the non-mission sector). T h i s is because while for a nonprofit manager the benefit from cheating is weaker - under nonprofit status profits are less valuable for managers because they can only be enjoyed as perks - so is the reward for honest behaviour. Therefore, i n this case a nonprofit manager's promise of honest behaviour is not more credible t h a n the one of a for-profit manager. O n the other h a n d , i f volunteering also enhances the quality of the service p r o v i d e d - because of better m a t c h i n g - a n d managers care about quality, then nonprofit status is helpful i n solving employers' m o r a l h a z a r d p r o b l e m (true i n the mission sector). T h e i n t u i t i o n is that a nonprofit manager w i l l discount more heavily the fact that i f she cheats on volunteers q u a l i t y w i l l suffer and hence a smaller profit (reputational rent) is needed to m a i n t a i n incentive c o m p a t i b i l i t y . W i t h free-entry the incentive c o m p a t i b i l i t y constraint for nonprofit firms binds, w h i c h means that the one for for-profit firms fails, so they cannot use the volunteer h i r i n g structure. T h u s , the m o d e l accounts for the observed patterns of entry by sector: nonprofits engage i n the provision of goods a n d services where better m a t c h i n g on mission preferences improves quality, while i n sectors where missions play no role, nonprofit i n c o r p o r a t i o n is not essential and for-profit status w i l l be preferred. I n a d d i t i o n , our analysis explains w h y otherwise similar nonprofit and for-profit organizations w i l l select different incentive structures to motivate their workers. In e q u i l i b r i u m , nonprofit organizations select the volunteering organizational structure while for-profit organizations utilize the internship. These features are i n tune w i t h the patterns of employment structure, work force characteristics and firmtype entry across sectors that we observe i n m a n y m o d e r n economies. F i n a l l y , we show t h a t this e q u i l i b r i u m has some desirable welfare properties as it generates more employment and output t h a n a benchmark e q u i l i b r i u m where only p a i d workers are employed, or one where firms hire interns. T h e rest of the paper is organized as follows. T h e next section briefly discusses strands of the literature that are relevant to this paper.  Section 3 introduces the environment of  the m o d e l , characterizes the two types of relational employment contract for a n exogenously matched organization-worker pair, a n d analyzes the choice of o r g a n i z a t i o n a l form a n d employment relational contract i n each sector. Section 4 turns to market e q u i l i b r i u m , characterizing a steady-state ' s o r t i n g ' e q u i l i b r i u m i n the two sectors and presents a welfare analysis of the e q u i l i b r i u m . Section 5 contains a brief discussion of some anecdotal accounts a n d case studies that lend support to some of the arguments made i n this paper a n d Section 6 concludes.  3.2  Related Literature  T h i s paper is related to the literature that has identified circumstances where nonprofit status m a y be a valuable c o m m i t m e n t against o p p o r t u n i s t i c behaviour t h a t arises because  31  of various forms of c o n t r a c t u a l incompleteness.  F o r instance, Glaeser and Shleifer (2001)  argue that nonprofit i n c o r p o r a t i o n is a valuable mechanism for an entrepreneur because, by weakening incentives to m a x i m i z e profits, it c r e d i b l y commits to customers that noncontractible q u a l i t y w i l l be higher, while i n R o w a t and Seabright (2006), nonprofit status is a valuable signal for aid agencies because it reassures donors t h a t their funds w i l l be indeed directed to unverifiable development projects and not be s k i m m e d off.  Francois (2001)  establishes conditions under w h i c h a nonprofit entrepreneur, b y relinquishing residual claims to profits, faces weaker incentives to adjust p r o d u c t i o n after a worker has shirked. W h e n workers care about the level of the p u b l i c g o o d produced this c o m m i t m e n t is shown to be valuable i n that it reduces the wage that has to be offered to induce workers' non-contractible effort. T h i s paper is also related to a literature ( W e i s b r o d (1988), T i r o l e (1994), R o s e - A c k e r m a n (1996), Francois (2000, 2001, 2003), D i x i t (2002)) w h i c h emphasizes the n o t i o n t h a t organizations p r o d u c i n g p u b l i c goods and services pursue missions that depart from strict profitm a x i m i z a t i o n , and underlines the significance of the fact that workers i n these sectors are intrinsically m o t i v a t e d by the a c t i o n of p a r t i c i p a t i n g i n the p r o v i s i o n of these collective goods. Several recent papers study the provision of incentives a n d the screening of i n t r i n s i cally m o t i v a t e d workers, a m o n g others H a n d y a n d K a t z (1998), M u r d o c k (2002), Francois (2007), Delfgaauw and D u r (2007). O u r paper builds o n the contributions by Besley a n d G h a t a k (2005, 2006a), w h o study incentive design issues i n a n environment w i t h missionm o t i v a t e d principals a n d agents. T h e i r emphasis is on the role of m a t c h i n g of principals and agents on mission preferences and the effects of c o m p e t i t i o n on p r o d u c t i v i t y a n d the power of incentives, but they abstract from issues concerning organizational form w h i c h are central i n our m o d e l . Specifically, the c o n t r i b u t i o n of the present paper is that it presents a plausible avenue (volunteer h i r i n g a n d sorting) w h i c h interacting w i t h the endogenously chosen organizational status allows mission-driven entrepreneurs to m a t c h w i t h l i k e - m i n d e d workers and therefore play the efficiency enhancing role emphasized by Besley a n d G h a t a k (2005). A l s o , one of our aims (and indeed the one that might be relevant for policy-makers) is to compare welfare outcomes between an e q u i l i b r i u m where the volunteering structure is sustained, a n d hence the m a t c h i n g is facilitated, to one where it fails.  3.3 3.3.1  The Model Primitives  W e consider an economy w i t h discrete t i m e and infinite time h o r i z o n consisting of two sectors:  a mission-oriented and a non-mission-oriented sector w h i c h serves as a bench-  mark, denoted by m and b respectively. T w o groups of agents exist i n the economy: m a n -  32  agers/entrepreneurs and w o r k e r s .  11  Agents r e m a i n alive for another p e r i o d w i t h p r o b a b i l i t y  0 G (0,1), while w i t h the complementary probability, (1 — 0), they die a n d are replaced by identical a g e n t s .  There is heterogeneity i n mission preferences i n b o t h groups.  12  Specifi-  cally, we consider three types of workers, indexed by i, a n d managers, indexed by j, w i t h h 3 £ {, u  m  ii  2}-  T y p e u managers and workers are m o t i v a t e d exclusively by monetary  m  rewards. W e refer to type u agents as unmotivated. mission-motivated  T y p e s m i a n d m,2 are referred to as  i n light of the fact that, besides the usual pecuniary motivations, they  are d r i v e n by a concern about the missions pursued by the organizations they j o i n . allow for a d i s t i n c t i o n between m i a n d mi  w h i c h has one of two possible  We  interpretations.  It can either reflect the differences i n focus among the variety of subfields of p u b l i c g o o d a c t i v i t y (e.g. a d v o c a c y / a c t i v i s t versus direct care provider), or it can reflect differences i n some a t t r i b u t e (e.g. religious affiliation versus secular) w i t h i n some specific subfield (e.g. education) of the mission sector. W e assume that the s u p p l y of managers is infinitely elastic. A measure L  u  vated workers and a measure L  m  of u n m o t i -  of mission-motivated workers are alive every period, half  of w h i c h are of type mi and half of type m.2, that is (L  mi  — % ) . T h e fraction 0 of  = L  1  m2  workers that dies every p e r i o d is i m m e d i a t e l y replaced by identical workers, who enter the labour market as unemployed, so that the size and the c o m p o s i t i o n of the workforce r e m a i n intact and stationary. There are three goods i n the model: two produced goods g  m  and  corresponding to  the mission and the non-mission sector respectively, a n d a non-produced numeraire g o o d y. P r o d u c t i o n of g  m  and g^ is undertaken by organizations - established as either for-profit  or nonprofit - w h i c h consist of a manager (founder) e m p l o y i n g two workers. Details about the differences between the two types of institutions are provided further on. Workers do not care directly about the type of organization they work for a n d are equally p r o d u c t i v e w o r k i n g for either type of provider.  A l l organizations i n each sector, have access to a  c o m m o n sector-specific p r o d u c t i o n technology, g (e\,e2), s  where s G { m , b} a n d  G  {e ,e }, l  h  w h i c h describes how the combined effort choices of the two workers and the entrepreneurial input of the manager translate into the p r o d u c t i o n of the organization's service, g  or gf,.  13  m  W e assume that each worker can choose between two effort levels: h i g h effort (e = e ) w i t h h  corresponding o u t p u t g (e\, e\) — g%, a n d low effort (e — e — 0) w h i c h yields a n o r m a l i z e d l  s  o u t p u t g (e[,e ) l  s  2  — 0. W h e n o n l y one of the workers shirks p r o d u c t i o n level falls but not  all the way to zero: ^ ( e ^ e ^ ) = ^ ( e ^ e ^ ) = 7, where 0 < 7 < g%. W o r k e r s ' effort, e, need not admit a one-dimensional interpretation; one can imagine that workers' effort is applied For clarity, we shall refer to managers using feminine pronouns and to workers using masculine. F o r convenience, we subsume the discounting factor of agents in (3. F o r simplicity, we abstract from non-labour inputs. One possible interpretation of the difference between a manager and a worker is that performing the entrepreneurial and supervisory duties of a manager requires an investment in human capital. Thus, a wealthy fraction of workers who have incurred the fixed cost of acquiring the human capital have become managers. We do not model this investment decision here. 1 1  1 2  1 3  33  along a vector of qualitative a n d / o r quantitative dimensions of o u t p u t t h a t managers care about. In the mission sector, if, i n a d d i t i o n to h i g h effort, workers' type matches the type of the organization we assume that preference congruence has a beneficial impact on p r o d u c t i v i t y . W h e n workers' are called to carry out a mission w i t h w h i c h they identify, they are more motivated, and hence p r o v i s i o n of g  is increased to g  m  > g^.  14  m  T o be concrete, we  imagine that there are two sets of actions that workers c a n take: one set is costly to t h e m to provide, and s h i r k i n g on this dimension w i l l eventually be detected by the manager of the organization.  These actions, denoted by (e) i n the m o d e l , are responsible for the  organization delivering g!^ when effort is h i g h . I n a d d i t i o n , there is another  unobservable  set of actions, not e x p l i c i t l y modeled, that workers w i l l o n l y undertake i f they b u y into the mission of the organization. It is this set of actions that we view as accounting for the higher level of mission good provision, g , m  matching.  that the organization can achieve w i t h better  15  In order to focus o n incentive issues we assume t h a t workers are risk neutral a n d have a w i t h i n p e r i o d u t i l i t y function, separable i n income (y) and effort (e). W e summarize the per-period utility,  (y, 6ij, e), attained by worker of type i w h e n w o r k i n g for employer of  type j as follows:  (3.1) T h e parameter 9{j represents the intrinsic payoff of a mission-motivated worker, w h i c h accrues to the worker independently of the legal status of the organization (for-profit or nonprofit).  16  If employed by one of the organizations, a worker receives an endogenous  wage w, while i f not employed workers are able to find work elsewhere at an exogenously given reservation wage w, w h i c h does not require high effort. we assume that p s ^ e ^ , e^) — 2e  h  > 2w, where p  s  17  T o rule out t r i v i a l outcomes,  is the market price for good g , so it is s  Tn reality, the difference between and g would most likely correspond to differences in the quality of the service being produced. Our model is consistent with this view, if we interpret output as being weighted by quality. O u r logic is similar to that in Akerlof and K r a n t o n (2005), who emphasize the notion of workers' identity and argue that when workers identify w i t h the goals of the organizations they are employed they might be willing to put in high effort w i t h little wage variation. Here we take the view that workers' sense of identity stems from the particular mission the organization is committed to. T h e way we specified preferences implies that workers receive a "warm glow" effect; that is, the benefit they receive is action-determined not output-determined, as in Besley and Ghatak (2005). If instead we allowed workers to be motivated by the effects of their actions on the quantity of output, then the benefit generated would entail a public good component and hence a standard free-riding problem would ensue. T h e implications of this type of preferences on organizational incentives are pursued in Francois (2003, 2006). 14  m  1 5  1 6  ^ A l t e r n a t i v e l y , w may be thought of as the value of home production.  34  p r o d u c t i v e l y efficient for workers to be employed by a firm and to choose high effort. U n m o t i v a t e d managers, type u, care only about personal c o n s u m p t i o n of the numeraire good y. O n the other h a n d , mission-motivated managers have preferences given by Uj (y, 4  for j £ { m i , 7 7 1 2 } .  g ), m  T h a t is, we allow mission-motivated managers, as we d i d above w i t h  mission-motivated workers, to derive personal nonpecuniary benefits from being involved i n the delivery of collective goods. N o t e , however, t h a t managers' altruistic motivations are outcome-oriented as they care about the scale of the mission good (g ) m  p r o d u c e d by the  organization they set up and not merely about their p a r t i c i p a t i o n i n the p r o d u c t i o n of the collective good. A s i n the case of workers, intrinsic motivations are present whether the manager sets up a nonprofit or a for-profit organization. W e identify the mission of the organization w i t h the manager's type. Furthermore, we assume t h a t the manager's type and the organization's form are c o m m o n knowledge a n d so is the worker's type - whether he is mission-motivated or not; however, if he is, his precise mission type ( m i or m^) is revealed to h i m and becomes p u b l i c i n f o r m a t i o n only after w o r k i n g for one p e r i o d . Before entering a sector, a manager c a n choose whether to establish the organization as for-profit or nonprofit.  T h u s , a brief description of the differences between the two  organizational forms is i n order.  T h e objective of the manager (residual claimant) of a  private enterprise is p r i m a r i l y to m a x i m i z e profits (n) for the organization. T h i s a s s u m p t i o n is s t a n d a r d i n neoclassical economic analysis and does not warrant further justification. O n the other h a n d , when an organization is nonprofit, it is not obvious what the objective of its manager is.  Nevertheless, a defining characteristic of nonprofits is that they are  subject to a nondistribution  constraint,  w h i c h stipulates that the manager of a nonprofit is  banned from a p p r o p r i a t i n g any net earnings from the organization's o p e r a t i o n s .  18  W e follow  Glaeser and Shleifer (2001) i n assuming that the effect of this is that a fraction of the  firm's  profits can i n d i r e c t l y accrue to her i n the form of perquisites such as less w o r k hours, better w o r k i n g conditions e t c .  19  T h i s way of m o d e l i n g the objectives of nonprofit managers makes  operational the n o t i o n that these organizations c a n be i n s t i t u t e d to have weaker incentives to pursue p r o f i t s .  20  T h o u g h it is true that for-profit firms m a y also be m o t i v a t e d to serve  other goals, we m a i n t a i n t h a t they must be consistent w i t h their p r i m a r y responsibility w h i c h is to generate sufficient rewards to s h a r e h o l d e r s .  21  T h u s , we take the view that, as a  I t is important to note that such a constraint does not preclude the possibility that a nonprofit organization may be actually earning positive profits. I n addition to the nondistribution constraint, nonprofit, organizations do not have access to the equity capital market and may be also subject to regulations requiring that they engage in specific charitable, religious, educational or scientific activities in order to receive preferential tax treatment. We abstract from these issues here. T t is beyond the scope of this paper to model explicitly the objectives and constraints of nonprofit managers. The approach taken here serves the purpose of focusing attention on whether volunteer hiring can be consistent with a firm objective that departs from strict profit-maximization. I n a recent paper, Besley and Ghatak (2006b) show that the pursuit of socially responsible practices by profit-maximizing firms is possible i n a competitive environment. They develop a model i n which some firms commit to producing a public good along with a private good and are able to finance its production 1 8  1 9  20  2 1  35  first a p p r o x i m a t i o n , for-profit managers w i l l face more high-powered incentives to m a x i m i z e t o t a l firm value t h a n their nonprofit  counterparts.  In keeping w i t h this discussion, we assume that the decision m a k i n g process w i t h i n nonprofit organizations - represented by the actions of the manager (founder) i n our analysis - balances the goals of m a x i m i z i n g profits a n d furthering the mission of the o r g a n i z a t i o n . We posit that the outcome of this c a n be represented by an induced  per-period quasi-linear  u t i l i t y function for a manager of type j w h o chooses o r g a n i z a t i o n a l form k, where k — f denotes a for-profit o r g a n i z a t i o n a n d k = n indicates a nonprofit organization, given by: v*(7r,g ) = tfn + 5 b(g ) s  js  (3.2)  s  where n stands for profits a n d &(.) is a s t r i c t l y increasing a n d concave function. T h e b i n a r y variable 5j  s  G {0,1} captures managers' "care intensity" or a l t r u i s m , w h i c h is only present  for m i s s i o n - m o t i v a t e d managers w h e n p r o d u c i n g a mission-oriented good (i.e. Sj  m  j G { m i , m 2 } , while 5^ — 0 for j G {u,m\,m.2}).  T h e parameter ^  = 1 for  G [0,1] reflects the  extent to w h i c h the organization's profits can be enjoyed as income by the manager — so the n o n d i s t r i b u t i o n constraint implies that <pf >  W e assume that differences i n m i s s i o n  preferences ( m i or m j ) are orthogonal to the degree to w h i c h the n o n d i s t r i b u t i o n constraint is enforced, a n d that a for-profit manager is the sole residual claimant, thus a l l profits TT accrue to h e r .  22  F r o m now o n we let  4>mi — ^ m 2 = ^  a  n  c  -  ^ 1  =  4>L  = 2  $1 = 1-  N o t e that w h e n p r o d u c t i o n is of the good w i t h o u t the m i s s i o n component  then  5jb = 0, so setting up a nonprofit firm i n the non-mission sector o n l y corresponds w i t h reducing the u t i l i t y a manager obtains from profit. E q u a t i o n (3.2) captures, i n a reducedform, the fundamental trade-off that the manager faces i n m a k i n g the i n c o r p o r a t i n g decision, highlighted by Glaeser a n d Shleifer (2001): c o m m i t m e n t to nonprofit status signals greater care for the ' q u a l i t y ' of the p u b l i c good, w h i c h , however, comes at the cost of restricted access to pecuniary rewards. A n i m p o r t a n t feature of the environment i n w h i c h p r o d u c t i o n is undertaken is t h a t t h o u g h the i n d i v i d u a l performance of the worker can be p o t e n t i a l l y assessed by the m a n ager or supervisor, it is unverifiable by t h i r d parties, a n d as a result, no s t a n d a r d c o n t r a c t u a l instruments can be used to induce workers' effort.  F o r example, an a i d worker's j o b de-  s c r i p t i o n t y p i c a l l y involves a variety of c o m p l e x tasks: from direct care p r o v i s i o n to drafting reports, fund-raising a n d l o b b y i n g . Performance related compensation i n this context is rare because (a) T h e m o n i t o r i n g a n d measurement of a worker's c o n t r i b u t i o n to these tasks is very costly (and certainly difficult to verify by a t h i r d party, such as the courts) or (b) it by charging caring consumers a premium for the private good. These firms can be viewed as exercising corporate socially responsibility ( C S R ) . F o r simplicity, we make no distinction between the owner and the manager of the firm, so that agency problems between ownership and control are assumed away. 2 2  36  may be difficult to ascertain an i n d i v i d u a l worker's c o n t r i b u t i o n (due to the team character of production) or (c) it m a y induce effort distortions (due to m u l t i - t a s k i n g c o n s i d e r a t i o n s ) .  23  W e abstract from the u n d e r l y i n g details regarding the incentive provision p r o b l e m a n d simply assume that workers' i n p u t a n d the intrinsic reward they receive, t h o u g h p o t e n t i a l l y observable by the firm and the agent, are noncontractible.  A t the heart of the p r o b l e m is  not asymmetric information between p r i n c i p a l and agent but t h i r d party nonverifiability of the i n d i v i d u a l worker's effort and output. W h e n a n employer a n d a worker are engaged i n a repeated, on-going relationship, they may be able to sustain informal long-term relational contracts as a means to overcome the n o n c o n t r a c t i b i l i t y of worker's performance.  Specifically, M a c L e o d a n d M a l c o m s o n (1989)  (under s y m m e t r i c information) and L e v i n (2003) (under adverse selection and m o r a l hazard) have shown, i n a repeated game framework, the existence of an e q u i l i b r i u m outcome where firms can use i m p l i c i t self-enforcing contracts to motivate workers, p r o v i d e d there is sufficient rent for b o t h parties from the continuation of employment. O p t i m a l self-enforcing contracts can take the form of efficiency wages or performance bonuses depending on market conditions.  24  W e proceed to characterize first, the nature of the internship a n d volunteering  relational contract between a n exogenously given single manager-worker pair, and, subsequently, the market e q u i l i b r i u m i n section 3.  3.3.2  T h e E m p l o y m e n t Relational Contracts  T h e two alternative relational contracts that we consider here are (a) T h e internship contract, w h i c h entails the v e r t i c a l p r o m o t i o n of interns within  a n organization. U n d e r this  incentive structure, workers and managers are r a n d o m l y matched, contract, w h i c h involves the h o r i z o n t a l sorting sion preferences, after the u n p a i d stage.  (b) T h e volunteering  of workers to managers w i t h similar mis-  I n the mission sector, this incentive structure  w i l l be shown to generate assortative m a t c h i n g of organization-worker pairs. B o t h sorts of self-enforcing contracts give rise to actions that c o u l d not be supported i n a one-shot interaction, but w h i c h can be sustained when agents have a sufficiently h i g h v a l u a t i o n of the future. In the present m o d e l , a worker faces the following career choices: what sector to seek employment ( m or b), what type of employer (u, mi, 1712) to be matched w i t h and how m u c h effort to exert (e  h  or e ). l  T o fix ideas, we describe briefly the successive stages i n the career  p a t h of a t y p i c a l worker who w i l l enter into an i m p l i c i t contract w i t h a manager i n a c e r t a i n sector, assuming that such contracts exist i n e q u i l i b r i u m , abstracting m o m e n t a r i l y from T h i s insight is emphasized in the multi-tasking literature, see for example Holmstrom and M i l g r o m (1991). I n particular, M a c L e o d and Malcomson (1998) have shown that efficiency wages are likely to arise in markets where there is excess supply of workers, while performance-related bonus payments in markets with excess demand for workers. 2 3  2 4  37  issues of sector selection and m a t c h i n g w h i c h are considered subsequently. T h e given worker moves sequentially t h r o u g h three states: the general p o o l of workers, u n p a i d employment and p a i d employment (i.e. deferred wage position). I n particular, the worker is b o r n into the general p o o l where he receives an exogenous compensation w every period. A t the end of each p e r i o d there is a n endogenous p r o b a b i l i t y p that the worker w i l l exit the general p o o l and w i l l find an u n p a i d employment p o s i t i o n . Suppose that this occurs i n p e r i o d t — 1; then the worker works for no pay d u r i n g p e r i o d t and at the end of the p e r i o d he transitions to a wage p o s i t i o n w i t h p r o b a b i l i t y (1 — 0); otherwise, he remains a n u n p a i d worker for another p e r i o d .  2 5  If the worker is hired into a p a i d p o s i t i o n he continues to work there u n t i l  he dies. We m o d e l the self-enforcing contracts as e q u i l i b r i u m strategies of a d y n a m i c game between managers and workers. T h e first step of the analysis is to specify precisely the i n c o m plete contract environment i n w h i c h the repeated game is conducted. Information Structure and W i t h i n Period T i m i n g Our specification of the i n f o r m a t i o n structure of the repeated game between workers a n d organizations, at any t i m e t, can be s u m m a r i z e d as f o l l o w s :  26  P u b l i c I n f o r m a t i o n . T h e identity of a l l previous employment pairs a n d the wage payment histories are c o m m o n knowledge since they are verifiable pieces of information. I n p a r t i c u l a r , all workers and managers k n o w whether a separation has occurred but do not k n o w whether the worker quit or was fired, since this i n f o r m a t i o n is unverifiable. A separation that has taken place because of a death of one of the parties is distinguishable from separations due to the other causes i n v o l v i n g one of the parties v i o l a t i n g a promise. A l s o , i f a separation occurs because a volunteer transfers to a p a i d p o s i t i o n w i t h a different employer this is also distinguishable from a separation due to malfeasance.  27  N o t e that a manager's p u b l i c  history includes the event of mistreatment of volunteers. B y this we refer to the event where an organization w h i c h has been h i r i n g volunteers into u n p a i d positions refuses to reciprocate by p r o m o t i n g workers from the volunteering p o o l into its o w n p a i d work vacancies. assume that such practice becomes p u b l i c i n f o r m a t i o n .  We  28  A t this point the employer must decide whether to honour the promise to promote the worker or cheat by hiring another intern to fill the vacancy. We examine the conditions that ensure employers' incentive compatible behaviour in the next section. F o r a similar treatment of the information structure in a dynamic game between workers and firms, see M a c L e o d and Malcomson (1989). F o r example, a letter of confirmation/recommendation from the employer outlining a volunteer's experience may be provided at the end of the assignment. W h e n an organization cheats on the promise to promote a volunteer into its paid position, it hires instead an unpaid intern directly from the general pool and therefore ceases to employ a paid worker. We assume that this practice can be detected by labour market participants by observing the composition of the organization's workforce. Essentially what we assume is that whether the organization is employing paid 2 5  2 6  2 7  2 8  38  W o r k e r ' s P r i v a t e I n f o r m a t i o n . A worker knows his o w n performance a n d whether the organization where he was employed i n previous periods honoured any promises made to him. M a n a g e r ' s P r i v a t e I n f o r m a t i o n . A manager knows the history of effort contributions of a l l her workers up to time t and whether she has delivered on promises made to her workers. T h e sequencing of decisions within a p e r i o d i n the c o n t r a c t i n g game between a m a t c h e d manager and worker is: • T h e manager makes the h i r i n g decision (if there is a vacancy). • T h e manager decides whether to make a payment or not. • T h e worker makes the effort decision. • T h e manager observes imperfectly worker's effort c o n t r i b u t i o n . • T h e worker observes manager's h i r i n g decision. • B o t h parties decide whether to continue the employment relationship or not. • T h e p e r i o d ends and b o t h players continue to the next p e r i o d w i t h p r o b a b i l i t y /3.  Period Starts  Manager makes payment (if any)  Manager makes promotion decision (if any)  Manager observes (imperfectly) worker's effort  Worker chooses effort  Manager and Worker Period Ends make separation decisions  Worker observes Manager's promotion decision  F i g u r e 3.1: T i m i n g of Events  T h e 'Internship' Incentive C o m p a t i b l e W a g e W e now focus on the d e t e r m i n a t i o n of the incentive compatible wage that induces a n intern's effort. W e consider a stationary environment, w i t h employers offering the same wage  w  1  every p e r i o d a n d the expected u t i l i t y a worker gains from r e m a i n i n g i n the general p o o l workers or not is public information, which is verifiable information since wage payments are verifiable.  39  being constant. L e t t i n g V/j  t  represent the expected lifetime u t i l i t y of a worker of type i  who accepts an u n p a i d p o s i t i o n (internship) at a n organization of type j at t i m e t, a n d suppressing the time subscripts we write: Vi = - e  h  + p[(l-P)Vr /3Vi\  (3.3)  j+  In this expression, (1 — /3) denotes the p r o b a b i l i t y that there w i l l be a p a i d p o s i t i o n vacancy a n d thus that the intern w i l l be h i r e d into a p a i d j o b . V[- designates the expected lifetime u t i l i t y of a p a i d worker who decides to deliver h i g h effort. A n intern receives no compensation and provides h i g h effort i n the current p e r i o d but expects to be h i r e d into a p a i d j o b w i t h p r o b a b i l i t y (1 — (3). T h u s , (1 — 0) acts as a quasi-discount factor on the value of becoming a p a i d worker. Similarly, V[- is defined below: V? = w  1  + dij - e  + P m a x ( V ^ , V$)  h  (3.4)  where Vfj represents the expected u t i l i t y of a worker w h o decides to shirk. supplies h i g h effort then he attains u t i l i t y w  + 9{j — e  1  period, where w  1  h  If a worker  d u r i n g the course of the current  is the wage associated w i t h the p o s i t i o n i n an organization of type j a n d 9{j  is the intrinsic reward for i n d i v i d u a l of type i associated w i t h a p o s i t i o n i n a n organization of type j . If the job is continued, then the worker decides whether to furnish h i g h effort next p e r i o d or not, if doing so yields greater u t i l i t y to h i m t h a n s h i r k i n g . W h e n a worker shirks, he receives the wage w  1  does not undergo the d i s u t i l i t y of s u p p l y i n g effort.  and the nonpecuniary benefit 9ij but A s h i r k i n g worker is detected w i t h a  constant exogenous p r o b a b i l i t y /J, E (0,1), i n w h i c h case he loses the j o b at the end of the period, and goes undetected w i t h p r o b a b i l i t y (1 — fi) i n w h i c h case he makes the effort decision again next p e r i o d .  2 9  V$ =w'  W e write the value function of a shirker as: + On + {3  [IJLV*  + (1 - n) m a x ( V £ , ^ ) ]  (3.5)  F i n a l l y , the value function of being i n the outside general p o o l is: V9 = w + 0[pVl  + (l-p)V°]  where w is the general p o o l compensation and p is the endogenous,  (3.6) in equilibrium, job  acquisition rate. Let us now consider the incentives that employers face i n designing the relational conT h e assumption of a less than perfect monitoring technology can be justified by the costs associated with supervision. Tn addition, we assume that inference of effort v i a observing output is impossible because of noise and the difficulties of identifying individual contributions due to the team character of production. 2 9  40  tract. T h e i r strategy is to m i n i m i z e labour costs subject to being able to attract interns and induce t h e m to provide high effort.  Consequently, they w i l l choose w  1  such that the  prospective worker is no worse-off from becoming an intern a n d not r e m a i n i n g i n the general p o o l , i.e. the following p a r t i c i p a t i o n constraint must be satisfied: vi If V/j > V ,  > V  (PC)  9  then it is i n the firm's best interest to adjust the features of the package a n d  g  transfer the surplus from the worker to itself such that internships are no more attractive t h a n the outside option. T h e o n l y means of adjusting the package, since the p r o b a b i l i t y of t r a n s i t i o n i n g from u n p a i d to p a i d work (1 — (3) is exogenous, is to reduce the wage associated w i t h a p a i d position. L e t the wage solving ( P C ) w i t h equality be w . P C  S u b s t i t u t i n g from  (3.3), (3.6) and (3.4) it can be shown that:  w where 6  r  r  (e  h  0  ,  -  + w)-9  (3.7)  r  is the expected intrinsic payoff when workers and firms are r a n d o m l y matched.  (6 < 0 < 0 ). l  l + 0,„h  _  PC  h  A l s o , to deter s h i r k i n g by the worker, the wage offered to the worker must  satisfy the following incentive c o m p a t i b i l i t y (no-shirking) constraint: Vfj > V*  (3.8)  this c o n d i t i o n implies: L e m m a 4 If the probability  of detection of a shirking worker is sufficiently  low, p < ^\ ^ w+e  ,  e  h  then the relational  contract  (w ,e ) 1  between an intern/worker  h  and a firm, consists of a, wage  satisfying:  =  +  (l +  2  P  dp  a_r  8  0p(l+0 -8 ) with  (i-* )  +  (ici)  0 -0 ) 2  P  > 0.  P r o o f . P r o o f is i n A p p e n d i x B . N o t e that the assumption on the p r i m i t i v e s I p, < ^_ ^ \ w+e e  h  the wage i n (ICI)  ) is needed to ensure t h a t J  is at least as h i g h as the wage i n (3.7), w h i c h is necessary to induce  p a r t i c i p a t i o n by workers i n the general p o o l .  T h e incentive compatible wage i n  admits a standard efficiency wage type of interpretation.  T h a t is, to induce effort  (ICI) the  organization has to pay the worker a p r e m i u m over his market alternative. Intuitively, the relational contract defined above allows the organization to elicit effort from the worker 41  while l i m i t i n g the rent offered to h i m . T h i s is accomplished because while the worker gets a wage p r e m i u m while o c c u p y i n g an efficiency wage p o s i t i o n , the rent is p a r t i a l l y t a x e d back by m a k i n g the worker pay an "entrance fee" i n the form of the uncompensated effort he has to s u p p l y as an i n t e r n .  3 0  T h i s arrangement encourages interns to stay w i t h the firm and  s u p p l y high effort throughout their career i n order to benefit from the higher wages t h a t come w i t h seniority. For the relational contract i n (ICI)  to be s u p p o r t e d i n e q u i l i b r i u m , a sufficient rent has  to be generated from employment. T h e rent is the difference between the returns to the current arrangement a n d those t h a t the two parties c o u l d achieve i n their outside options. In this m o d e l , the surplus is d i v i d e d between employers a n d workers.  T o see this note  that an intern prefers his current status t h a n staying i n the outside p o o l (V/j > V ). 9  For  employers, profits from h i r i n g interns are t r i v i a l l y greater t h a n profits from h i r i n g straight from the outside p o o l , w h i c h w o u l d be the alternative way of filling a vacancy, because an intern generates as m u c h lifetime expected profits as an outside worker when i n a p a i d position, but also makes an uncompensated c o n t r i b u t i o n to the firm's profits as an i n t e r n . N o t e that we have ruled out the possibility that workers c a n post a performance b o n d (in the form of a negative h i r i n g wage) d u r i n g the internship stage of employment. If this were possible, then firms could use this instrument to b i n d the p a r t i c i p a t i o n constraint of workers (V/j = V ), 9  thereby e x t r a c t i n g the entire surplus from the employment relationship a n d  clearing the l a b o u r market. I n reality, however, performance bonds are rarely observed. O n e possible e x p l a n a t i o n for this absence is credit market imperfections t h a t make it impossible for workers to raise the money for the b o n d .  M o r e generally, the possibility of p o s t i n g  performance bonds raises a host of issues, as it induces employers to cheat workers i n various ways, so we proceed by assuming that firms leave some rents to workers.  T h e 'Volunteering'  Incentive C o m p a t i b l e  Wage  T h e volunteering employment structure resembles the internship structure except t h a t volunteering is an i m p l i c i t contract offered j o i n t l y by a l l p a r t i c i p a t i n g organizations and not by one specific employer. I n p a r t i c u l a r , the volunteer is i n i t i a l l y r a n d o m l y matched w i t h an organization and supplies high effort for that employer w i t h no compensation; subsequently, the volunteer learns his type and w h e n a p a i d p o s i t i o n i n an organization of the same type is vacated he transitions to that p o s i t i o n even if this means transferring to a different organization. W e examine managers' incentives to sustain this structure i n the next subsection. In a d d i t i o n to p r o v i d i n g incentives, since volunteering is recognized by other firms, it Essentially, our version of the shirking model allows an entrance fee to emerge which reduces the rent that the employer needs to concede in order to motivate the worker. T h e suppression of this mechanism in the original Shapiro and Stiglitz (1984) formulation-by assuming that the principal pays the same wage at every period-was considered a theoretical weakness of the efficiency wage theory (see Carmichael 1989). 30  42  plays the role of facilitating m a t c h i n g between mission-motivated workers a n d organizations.  31  W e posit a frictionless m a t c h i n g process: the m a t c h i n g is instantaneous and cost-  less. W e look for allocations of workers to organizations t h a t are v o l u n t a r y and stable, i n the sense that there is no pair that could negotiate a n agreement that w o u l d make b o t h parties better off t h a n they are i n their current matches. T h e following l e m m a characterizes the nature of stable m a t c h i n g i n the mission sector. L e m m a 5 Any stable matching tively  equilibrium  must have organizations  and workers  assorta-  matched.  P r o o f . P r o o f is i n A p p e n d i x B .  •  W e now t u r n to the d e t e r m i n a t i o n of the incentive compatible wage for an organization h i r i n g volunteers. T h e value functions of b e i n g i n any of the three possible states, employed and p a i d , employed and u n p a i d (volunteer) and unemployed are identical to the ones i n (3.3), (3.6), (3.4) and (3.5).  Therefore, m a i n t a i n i n g the n o t a t i o n we established i n the  previous section, incentive compatible wages that support assortative m a t c h i n g have to satisfy the following two conditions: V[ > V*  (3.9)  3  and ivY + 6  h  > wYj + 0  (3.10)  r  T h e first c o n d i t i o n is standard and ensures that the worker supplies h i g h effort. T h e second c o n d i t i o n ensures that the payoff to a worker when w o r k i n g for an organization of the same type is at least as high as when w o r k i n g for an organization of a different type. L e m m a 6 The relational of a wage  contract  (w ,e ) v  h  between a volunteer/worker  satisfying:  *IP)  W  =  fi-m+pp-w-M*  +  Pn{i + p -P )  <±z£)  w  [i + p -p )  2  2  P  with  and a firm consists  _ *  ( I C  y  v) 1  P  > o.  P r o o f . P r o o f is i n A p p e n d i x B .  •  T h e interpretation of the incentive c o m p a t i b i l i t y wage for volunteering is analogous to that offered above for internship: a worker receives a p r e m i u m for . T h e analysis of the two alternative self-enforcing mechanisms can be s u m m a r i z e d i n the following proposition:  I n equilibrium, volunteering only occurs in the mission sector, this w i l l be proved later, but for now we take it as given. 3 1  43  Proposition 4 Conditional patible wages in the mission a 'Volunteering'  on a common job acquisition  rate (p), binding incentive  sector are higher under an 'Internship'  relational  contract  (w (p) >  Proof. Follows d i r e c t l y from (ICI),  1  relational  contract  comthan  w (p)). v  (ICV) a n d n o t i n g t h a t 6 > 6 . m h  r  T h e role that mission heterogeneity plays i n the m o d e l now becomes clear. A s i n Besley and G h a t a k (2005), selecting workers w i t h congruent preferences c a n be cost saving for organizations, as this allows t h e m t o induce h i g h effort at a lower wage. I n a d d i t i o n , there are p r o d u c t i v i t y gains to be made since volunteering ensures the better m a t c h i n g w h i c h raises workers' o u t p u t . Consequently, those firms that c a n attract volunteers w i l l be at a n advantage. T h i s feature is absent i n the non-care sectors of the economy, so for employers a volunteering contract i n those sectors is not preferred to the internship contract we discussed above. It now remains to establish that the wages a n d employment patterns w h i c h have been c o m p u t e d for a single worker c a n constitute a n e q u i l i b r i u m of the multi-player game.  3.3.3  Selection of Relational Contract a n d Organizational F o r m  Mission Sector T h e purpose of this sub-section is to explore the role of the interaction between the choice of organizational form a n d the presence of mission preferences for the type of i m p l i c i t contract that managers w i l l use, i n e q u i l i b r i u m , t o overcome the n o n - c o n t r a c t i b i l i t y p r o b l e m of workers' effort. I n what follows, we analyze whether it is incentive compatible for managers to implement volunteer h i r i n g . I n p a r t i c u l a r , we shall show t h a t under the stated assumptions o n the preferences of the managers w h o control the organizations, a d e v i a t i o n from a volunteer structure is more valuable for for-profit firms, w h i c h i n e q u i l i b r i u m is going to lead to volunteering being o n l y available to nonprofit organizations. For a n organization that implements a volunteer h i r i n g structure the c o m p o s i t i o n of its workforce, at any t i m e t, is one wage worker plus one volunteer w h o awaits p r o m o t i o n t o a p a i d position next p e r i o d a n d is going to be replaced by a new volunteer. Profits equal ir  v  = pg— m  m  w , where p v  m  is the price of the final product w h i c h the firm takes as given.  Similarly, for a n organization w h i c h uses a n internship structure, its workforce consists of one wage worker plus one intern w h o w i l l be p r o m o t e d i f a wage p o s i t i o n is vacated next p e r i o d a n d w i l l be replaced b y a new intern. Profits equal ir = p 9m 1  m  ~  w  I  •> where g  m  g^, reflecting the fact that interns are r a n d o m l y m a t c h e d w i t h organizations. N o t e that the volunteer relational contract described above creates m o r a l h a z a r d o n the part of the employer. O r g a n i z a t i o n s have a n incentive not t o promote current  volunteers  to wage positions a n d to replace t h e m w i t h new volunteers from the general p o o l , thus a p p r o p r i a t i n g the u n p a i d labour c o n t r i b u t i o n made b y volunteers.  Workers a n t i c i p a t i n g  that they w i l l not receive the h i g h future payments have no incentive t o w o r k a n d thus 44  >  incentives are destroyed. T h u s , for volunteer h i r i n g to be sustainable it has to satisfy the manager's incentive c o m p a t i b i l i t y c o n d i t i o n . Consider what constitutes a d e v i a t i o n from the volunteering structure. Suppose that a p a i d position vacancy is created. T h e organization deviates by reneging on the promise t o hire an i n d i v i d u a l from the volunteering p o o l to fill its vacancy and instead hires a n u n p a i d intern straight from the general p o o l to fill this p o s i t i o n . B y doing this, the manager makes a one-period gain from not h a v i n g to pay the wage she w o u l d otherwise have to, if she continued to hire volunteers to p a i d positions, but has to resort to a n internship structure to get around workers' m o r a l h a z a r d i n future periods since workers w i l l refuse to volunteer for her anymore. T h a t is, organizations that cheat lose their reputations a n d are punished i n future labour market dealings by the workers' e q u i l i b r i u m strategies. P u n i s h m e n t here consists of future workers refusing to volunteer for organizations who have previously chosen not to promote volunteers into p a i d positions and to instead only accept internship contracts from such o r g a n i z a t i o n s .  32  T h i s k i n d of g r i m trigger strategy requires t h a t labour market  participants can observe whether a n organization is e m p l o y i n g a p a i d worker or not.  In  particular, w h e n a manager breaches the i m p l i c i t agreement to promote a volunteer into a p a i d position and hires another u n p a i d worker then d u r i n g the deviation she employs only u n p a i d workers; other potential workers c a n detect this - because wage payments are verifiable information - a n d so they r a t i o n a l l y avoid volunteering for the organization i n the future.  E q u i l i b r i u m strategies s u p p o r t i n g the volunteer-hiring relational contract  are  e x p l i c i t l y defined i n A p p e n d i x A . Specifically, i n the first p e r i o d of deviation the manager hires two interns to fill b o t h the vacant p a i d position a n d the u n p a i d position. Profits are it  Vd  — Pmg^.  The opportunistic  manager then loses the g o o d w i l l of being an honest employer so i n future periods workers only accept internship positions that are more costly for the firm because w  1  > w  v  - that  is, the wage p a i d to interns is greater t h a n the wage p a i d to volunteers. A l s o the m i s m a t c h induced because interns are r a n d o m l y matched w i t h organizations w i l l also have a n i m p a c t on the a b i l i t y of the organization to successfully fulfill its mission. T h a t is, following a deviation, the organization's mission good p r o d u c t i o n is compromised  {g ). m  Hence, volunteering is self-enforcing i f the present value of honouring is greater t h a n the present value of reneging. T h e manager's incentive c o m p a t i b i l i t y c o n d i t i o n may be w r i t t e n as:  Y=0*fr* >9m) V  * ^  V  d  M  + Y ^ j t f M  (3-H)  for each j E { m i , TO2}, and k E {/, n} G i v e n this strategy of workers, the best response for managers who have reneged in the past is to continue cheating on the promise to promote volunteers, so that workers' strategies are a best response. 3 2  45  where ir  > n  vd  v  > n  a n d the last i n e q u a l i t y follows from the fact that w  1  1  > w . v  The  left-hand side of (3.11) is a manager's discounted payoff from not cheating. T h e first t e r m on the right-hand side of (3.11) represents the u t i l i t y the manager c a n a t t a i n i f she cheats. N o t e that this w o u l d raise profits but hurt the q u a l i t y of the mission g o o d .  3 3  T h e second  t e r m captures the expected present value payoff from h i r i n g interns, w h i c h is the h i r i n g practice the manager implements along the punishment p a t h . O u r goal now is to determine for w h i c h o r g a n i z a t i o n a l form incentive c o m p a t i b i l i t y is easier to satisfy. S u b s t i t u t i n g from (3.2) into (3.11) yields: Lk„V 1-0  +  7T  jk Vd t> 7T  b(g ) > m  +1-0  L k  ^ + b{g  h m  w h i c h u p o n rearrangement a n d simplification implies that: 0)7r  / > ( i  Vd  Define the r i g h t - h a n d side of (ICM) P r o p o s i t i o n 5 In the mission compatibility  of managers  + PIT  K9m) -  1  (ICM)  Kg ) h  m  as 6(</> ). T h e following result holds: fc  sector, equilibrium  under a for-profit  level profits required to satisfy  incentive  status is higher than that under a  nonprofit  status. P r o o f . Because Q ( < p ) k  is increasing m (p , a n d <f) > <f) it follows that 0 ( ^ ) k  f  n  >  Q((j) ). n  T o gain some i n t u i t i o n for this result notice t h a t the way i n w h i c h the r e p u t a t i o n mecha n i s m i n f o r m a l l y enforces managers' incentive compatible behaviour is by offering to the p o t e n t i a l cheater a " p r e m i u m " : a stream of payoffs that exceed the p o t e n t i a l gain from cheating. T h i s p r e m i u m is given i n b o t h m o n e t a r y (i.e. higher profits) a n d i n t r i n s i c (i.e. better quality) terms. U n d e r nonprofit status profits are less valuable for a manager - because they can o n l y be enjoyed as perks - so a nonprofit manager places relatively more weight on the fact that i f she cheats on volunteers q u a l i t y w i l l suffer, a n d hence a smaller monetary  p r e m i u m is needed to m a i n t a i n incentive c o m p a t i b i l i t y . T h i s is further i l l u m i -  nated by inspecting (ICM):  the t e r m that is subtracted from the right-hand side captures  how heavily the loss of q u a l i t y - due to cheating - is discounted. T h u s , i f cheating d i d not affect q u a l i t y then this t e r m w o u l d be zero so the r i g h t - h a n d side of the inequality w o u l d be the same across firm types, a n d no o r g a n i z a t i o n a l form w o u l d find it easier to attract v o l unteers. But, to the extent that volunteering does affect the q u a l i t y of the service p r o v i d e d , the t e r m is positive, so nonprofit i n c o r p o r a t i o n relaxes the incentive c o m p a t i b i l i t y c o n d i t i o n N o t e that for cheating to be worthwhile it has to be that 4> (T\ — TX ) > b(g ) — b(g^). T h a t is, the monetary benefit from cheating (due to higher profits) has to be greater than the intrinsic loss a manager suffers (due to quality degradation). In what follows we assume that this is always true. 3 3  k  VD  v  m  46  that makes c o m m i t m e n t to h i r i n g volunteers credible. T h i s suggests that volunteer h i r i n g by nonprofits should occur o n l y i n fields where m a t c h i n g on mission heterogeneity has a noticeable effect on quality. P r o p o s i t i o n 5 has the following i m p o r t a n t i m p l i c a t i o n . C o r o l l a r y 2 For-profit firms will not be able to participate that is just incentive  compatible for nonprofit  in a volunteer hiring  structure  firms.  Free entry i n the mission sector w i l l ensure that the incentive c o m p a t i b i l i t y c o n d i t i o n of the nonprofit firm {ICM)  binds. However, w h e n this is the case, incentive c o m p a t i b i l -  ity for for-profit firms w i l l be v i o l a t e d w h i c h means that they cannot c r e d i b l y c o m m i t to h i r i n g volunteers. Furthermore, if a mission-motivated manager were to enter the m i s s i o n sector establishing a for-profit firm a n d implement an internship structure she w o u l d be outcompeted by existing not-for-profit firms r e c r u i t i n g volunteers because of their lower labour costs. T h u s , i n c o r p o r a t i o n as nonprofit is valuable for managers because it serves as a c o m m i t m e n t device that signals p o t e n t i a l volunteers t h a t they w i l l be fairly treated. T h e very factor that is u s u a l l y thought of as accounting for the efficiency supremacy of forprofit governance - high-powered incentives - can rule out p a r t i c i p a t i o n i n the volunteering incentive structure i n mission-oriented sectors. T h e model's p r e d i c t i o n that only nonprofit firms w i l l participate i n a volunteering structure a n d t h a t this w i l l occur i n mission-related activities is consistent w i t h even a casual observation of the p a t t e r n of sectoral d i s t r i b u t i o n of volunteer activity, according to w h i c h nonprofit agencies are the overwhelming recipients of volunteering services. T h i s is even true i n m i x e d ownership industries (childcare, nursing homes etc) where for-profit coexist and compete against nonprofits i n b o t h the service and labour markets. For a different perspective on the difficulties associated w i t h sustaining the volunteerh i r i n g structure notice that, because incentives are sector-wide and not employer-specific, their provision has the character of a p u b l i c good a n d is susceptible to a form of free-riding. T h a t is, each i n d i v i d u a l employer w o u l d like to o b t a i n labour donations from volunteers but refrain from reciprocating by subsequently h i r i n g t h e m into p a i d positions, thereby free-riding on other organizations' h i r i n g of volunteers. i.e.  W h e n the free r i d i n g is severe -  w h e n c o n d i t i o n (3.11) fails - it leads to the unraveling of the volunteering structure.  T h e i m p l i c a t i o n of Proposition  5 is that organizing the p r o d u c t i o n of collective goods by  nonprofit organizations is a less costly way to overcome this k i n d of free-riding p r o b l e m . N o n - m i s s i o n Sector In the non-mission sector mission m a t c h i n g plays no role. T h e following result holds: L e m m a 7 In the non-mission  sector managers 47  choose for-profit  status.  P r o o f . P r o o f is i n A p p e n d i x B  •  T h i s prediction of the m o d e l is also consistent w i t h the observation that nonprofit firms are absent from sectors of the economy w h i c h do not involve mission-oriented p r o d u c t i o n . Furthermore, since there is no issue of m a t c h i n g managers and workers i n this sector internships is the preferable h i r i n g policy.  However, when a n internship structure is  implemented there is still scope for o p p o r t u n i s t i c behaviour on the part of managers. I n particular, when a p a i d p o s i t i o n vacancy is created i n an organization w h i c h has been h i r i n g interns then its manager has an incentive not to honour the promise to hire the existing intern into the p a i d position, but to fill the p o s i t i o n w i t h a n u n p a i d worker from the general p o o l .  Such behaviour once detected by labour market participants results i n loss of  r e p u t a t i o n and is punished i n future labour market interactions by the workers' e q u i l i b r i u m strategies. T h a t is, i n future periods workers w i l l not be w i l l i n g to be recruited as u n p a i d interns and the manager w o u l d have to resort to p a y i n g b o t h of its workers a n up-front wage w  satisfying (ICI).  1  E q u i l i b r i u m strategies s u p p o r t i n g the internship h i r i n g structure  are defined i n A p p e n d i x A . T h e incentive c o m p a t i b i l i t y c o n d i t i o n of the manager may be w r i t t e n as follows:  or equivalently  TV**" TV  -  +  where ir , ir 1  Id  (3 12)  a n d 7r denote per-period profits under an internship structure, the deviation, e  and i n the periods after the d e v i a t i o n respectively, and 7r > ir d  Id  > 7r . F o r future reference, e  it is useful to rewrite (3.12) as: TT' > (1 - 0) n  I d  + 0ir  e  ~ K  (3.13)  T h i s incentive constraint must be satisfied for the internship structure to be a credible recruitment strategy. W i t h free entry into the non-mission sector, the level of profits t h a t a manager can enjoy i n e q u i l i b r i u m w i l l satisfy (3.13) as equality.  Notice that adding  heterogeneity among u n m o t i v a t e d agents w o u l d not lead to the i m p l i c a t i o n t h a t there is a nonprofit advantage i n the non-mission sector as well because of the absence of the nonpecuniary component i n managers' payoff.  3.4  Market Equilibrium  U p to this point we have discussed the design of incentive schemes between a given exogenously formed manager/worker pair. W e now t u r n attention to the steady-state analysis of  48  a market e q u i l i b r i u m where m u l t i p l e managers and workers interact, and consider the choice of organizational form (by managers) as well as the type of incentive relational contract t h a t w i l l be implemented by organizations i n the two sectors. W e characterize a n e q u i l i b r i u m w i t h sorting of agents into sectors by type. I n p a r t i c u l a r , mission-motivated managers a n d workers seek entrepreneurial and employment o p p o r t u n i ties only i n the mission sector and the same is true for their u n m o t i v a t e d i n the non-mission sector.  counterparts  I n a d d i t i o n , it w i l l be shown t h a t p r o d u c t i o n i n the mission-  oriented sector w i l l o n l y be undertaken by nonprofit organizations, and the employment structure w i l l take the form of the volunteering contracts derived above. Conversely, i n the non-mission-oriented sector, organizations w i l l o n l y be for-profit, a n d employment contracts w i l l take the form of internships.  3.4.1  A 'Sorting' E q u i l i b r i u m  T o close the model, since we d i d not e x p l i c i t l y include i n workers' preferences (3.1) the u t i l i t y benefits derived from c o n s u m p t i o n of the services (g ,9b)  produced, we assume that  m  the d e m a n d side of the m a r k e t  34  is described by a d o w n w a r d sloping d e m a n d schedule for  the t o t a l services produced i n the mission sector a n d the non-mission sector respectively: G  m  where  d D  ^  P m  ^  < 0 and  d  D  ^ ^ h  = D (p ) m  and  m  G =  D (p )  b  b  b  < 0, a n d aggregate service p r o v i s i o n is given by s i m p l y  adding up the i n d i v i d u a l o u t p u t of a l l p r o d u c i n g organizations: G  m  — ^2 g  m  and G = Y19bb  In the steady-state e q u i l i b r i u m , the same endogenous t o t a l number of jobs E  m  and  i n the mission a n d the non-mission sector respectively, are created i n every p e r i o d . assume that at full employment (E  m  +E  b  = L  u  + L) m  3 5  E, b  We  the revenue product of labour covers  the o p p o r t u n i t y cost of labour, that is, full employment is efficient. A t the b e g i n n i n g of each p e r i o d , workers i n the general p o o l are r a n d o m l y assigned to the unfilled vacancies created as some existing matches are dissolved w i t h exogenous p r o b a b i l i t y 1 — 0. Workers must be w i l l i n g to accept positions and s u p p l y high effort at the going wage, and managers must be w i l l i n g to create enough jobs to replace the workers who turnover because they die and must have a n incentive not to renege on the promise to promote u n p a i d workers into p a i d positions. Formally, a steady-state e q u i l i b r i u m is defined as follows: D e f i n i t i o n 2 Given the aggregate equilibrium G^,  wl,  consists  demand functions  of a set of wages, prices  pj^, G£) along with a stationary  non-mission)  and states (paid employment,  D (p ) m  m  and D (pb),  and allocations  allocation unpaid  b  a  of final services  of workers employment,  across sectors  steady-state (w^,  p^,  (mission,  general pool), such that  I n the case of mission goods, both the government and individual agents may be purchasers. E encompasses both paid workers (P) and unpaid workers (volunteers or interns) (U), i.e. E = P + U.  3 4  35  49  incentive  compatibility  is satisfied  for  both managers  entry, under any choice of organizational  form,  and workers.  must be  In addition,  no  new  attractive.  W e now focus on identifying the conditions under w h i c h a steady-state ' S o r t i n g ' equilibr i u m , that is consistent w i t h the above definition, exists. T h e e q u i l i b r i u m we are interested i n has the following characteristics:  the mission sector attracts mission-motivated m a n -  agers who establish nonprofit organizations that compete w i t h each other a n d hire missionm o t i v a t e d workers offering t h e m the volunteering relational contract derived above. In the non-mission sector, u n m o t i v a t e d managers establish for-profit organizations that compete w i t h each other and offer u n m o t i v a t e d workers the internship r e l a t i o n a l contract. T o establish conditions under w h i c h this type of ' S o r t i n g ' e q u i l i b r i u m we hypothesize exists, we check whether the prescribed self-selecting behaviour is incentive compatible once we take into account that workers are freely mobile between the two sectors, a n d t h a t managers are free to enter either sector.  T h a t is, for the sorting e q u i l i b r i u m to exist we  need to confirm that i n e q u i l i b r i u m the entry of mission-motivated workers into the mission sector and of u n m o t i v a t e d workers into the non-mission sector is o p t i m a l . L e t t i n g  Vf(s)  denote the discounted lifetime u t i l i t y of a worker i n the general p o o l of type i who wishes to enter sector s, the sorting constraint for mission-motivated workers may be w r i t t e n as: Vf(rn)  >Vf(b)  for i e { m i , m }  (SW1)  2  while the one for u n m o t i v a t e d workers is: V°(b)  > V°(m)  (SW2)  Similarly, the sorting constraint for mission-motivated managers is: v?(nV,g ) m  > I>/(TF£) for j E { m i , m } 2  (SMI)  and the one for u n m o t i v a t e d managers: 4(H)  > KA^m)  (SM2)  where (~) denotes t h a t the objects i n question are evaluated i n the sorting e q u i l i b r i u m . A l s o , note that i n the e q u i l i b r i u m we are interested i n , the p r o b a b i l i t y of finding a volunteering p o s i t i o n i n the mission sector (p )  for a mission-motivated worker i n the  m  general p o o l and for an u n m o t i v a t e d worker i n the general p o o l the p r o b a b i l i t y of finding an internship p o s i t i o n i n the non-mission sector (p ) is given respectively by: b  P (E ) m  m  =  and  50  p\E ) b  =  (3.14)  where p {E )  and p (E )  m  are increasing functions.  b  m  b  W e make the following assumptions on the parameters of the inverse d e m a n d functions: A s s u m p t i o n 2.  {p {Gm(E ))g m  m  — 6(</> )} takes at least one value i n the interval n  m  (w (0),w (L )). v  v  m  A s s u m p t i o n 3. [p (G (E ))g^ b  Because w (E )  b  — Kj  b  and w (E )  v  b  (L  1  are continuous and increasing i n E  1  m  takes at least one value i n the interval ( K / ( 0 ) , w and E  m  the above restrictions on the parameters of p ( G ) a n d p (G ) m  m  b  b  b  respectively,  ensure that the managers'  b  downward sloping incentive c o m p a t i b i l i t y conditions cross the workers' u p w a r d sloping incentive c o m p a t i b i l i t y conditions i n the relevant region, that is, for E  m  and  and managers  (C.5)  m  E  b  G (0, L )  G ( 0 , L ) . W e have: 6  P r o p o s i t i o n 6 / / the conditions  for self-selection  hold, there exists a steady-state  'Sorting'  of workers  equilibrium  (w , v  (C.4)  p, m  G  m  with the following  sector features a 'Volunteering'  sort into the mission  sector and establish  workers,  The employment  respectively.  of each type: ^  each type (m\  p,  G (E ))  b  b  b  nonprofit  structure  volunteers  equilibrium:  type m\  organizations  hiring  and mi  managers  type m\  takes the form of volunteering.  and -^p wage workers  and ^  and m^ There are  organizations  of  andm^).  b) The non-mission into the non-mission ployment  ), w , 1  m  properties:  a) The mission  workers  (E  structure  interns and ^  sector features an 'Internship' sector and establish for-profit  takes the form  wage workers  of internships.  and ^  P r o o f . P r o o f is i n A p p e n d i x B .  equilibrium:  firms  type u managers  hiring type u workers.  There are ^  workers  sort  The  em-  of each type:  organizations. •  C o n d i t i o n s (C.4) a n d (C.5) i n the proposition, w h i c h are derived i n A p p e n d i x B , ensure that i n the ' S o r t i n g ' e q u i l i b r i u m no mission-motivated worker or manager has a n incentive to deviate from sorting into their designated sector.  I n particular, the c o n d i t i o n for self-  selection of workers (C.4) is not transparent a n d does not y i e l d a straightforward economic interpretation.  Nevertheless, what this c o n d i t i o n suggests is t h a t the higher 6  36  h  the more  attractive employment i n the mission sector becomes for m o t i v a t e d workers, w h i c h makes the self-selection c o n d i t i o n easier to satisfy. T h e sorting c o n d i t i o n for managers (C.5) suggests that m o t i v a t e d managers w i l l find entry into the mission sector preferable provided that they can extract sufficient economic rents (high cp ) from the operation of the nonprofit n  38  I d e a l l y we would like to recast condition (C.4) in terms of only the exogenous parameters of the model,  namely, /3, 0, e, w, fi, L ,  Lf etc. T h i s is possible if we postulate specific functional forms for the inverse  m  demand functions p (Gm(E )) m  m  and p (Gf(Ef)), !  in order to explicitly solve (C.7) and (C.9) for E  m  and  Ef. Because this does not yield any additional economic insight we chose to leave Em implicitly defined i n condition (C.4) and demonstrate existence w i t h a worked example in Appendix C .  51  organization a n d / o r they derive sufficiently strong intrinsic benefits (high b(g )) m  t r i b u t i n g to the p r o d u c t i o n of mission goods.  from con-  I n A p p e n d i x C we numerically compute a  simple parametric example w h i c h illustrates t h a t the sorting constraints for workers a n d managers i n the ' S o r t i n g ' e q u i l i b r i u m c a n h o l d i n n o n - t r i v i a l environments. O n the managers' side, free-entry ensures t h a t incentive c o m p a t i b i l i t y (ICM) O n the workers' side, incentive c o m p a t i b i l i t y requires t h a t c o n d i t i o n (ICV) T h e two constraints are illustrated i n figure 2. because the inverse d e m a n d function p (G ) m  N o t e that (ICM)  binds.  is satisfied.  is downward sloping  is decreasing i n the level of employment  m  E. m  Workers' incentive c o m p a t i b i l i t y implies that e q u i l i b r i u m must lie on the u p w a r d sloping curve defined by (ICV),  w h i c h is increasing because  Qp ^  dW  P  > 0 a n d p is increasing i n E.  E q u i l i b r i u m occurs at the intersection of the two conditions.  F i g u r e 3.2: V o l u n t e e r i n g E q u i l i b r i u m i n M i s s i o n Sector  T h e comparative statics of the ' S o r t i n g ' e q u i l i b r i u m are as follows: C o r o l l a r y 3 A rise in the probability sic motivation  (6 ) h  of detection (p) or in the intensity  reduces the equilibrium  wage and increases  of workers'  the employment  level.  intrinThe  opposite is true when the benefits of being in the general pool (w) rise. On the other hand, positive demand shocks for the service produced G , m  and higher equilibrium  wage and employment  P r o o f . P r o o f is i n A p p e n d i x B .  G  b  lead to more entry of  organizations  level.  •  It is noteworthy, that i n b o t h sectors, workers i n the general p o o l w o u l d be w i l l i n g to work for less t h a n the wage received by a n identical p a i d worker, yet, organizations are not 52  w i l l i n g to hire t h e m k n o w i n g that if hired these workers w o u l d have incentive to shirk. I n this sense, unemployment i n the ' S o r t i n g ' e q u i l i b r i u m can be characterized as i n v o l u n t a r y the k i n d c o m m o n l y associated w i t h efficiency wage models, for example S h a p i r o a n d S t i g l i t z (1984). However, compared to a benchmark e q u i l i b r i u m where a l l workers are hired d i r e c t l y into efficiency wage positions we have the following result: P r o p o s i t i o n 7 Ifp (G ) m  m  >  e  employment  ^ I , for E  m  n  —  £ ( 0 , L ) , then in any 'Sorting' m  equilibrium,  9 r n  and output in both sectors are higher than those that would occur if  tions employed  only paid workers  and paid them efficiency  P r o o f . P r o o f is i n A p p e n d i x B .  organiza-  wages.  •  T h e restriction on the parameters of the inverse d e m a n d function p (Gm)  is a  m  sufficient  but not necessary c o n d i t i o n for this to be true. T h e i n t u i t i o n for the result i n the p r o p o s i t i o n is simple. T h e m o d e l predicts that workers' incentive c o m p a t i b l e wages, w h e n volunteer h i r i n g is implemented, are less sensitive to employment rates t h a n those w h e n workers are hired d i r e c t l y into p a i d positions. H a v i n g to go t h r o u g h an u n p a i d stage before h i r e d into a p a i d p o s i t i o n , if they are caught shirking, induces a harsher punishment so it reduces the wage p r e m i u m needed to motivate volunteers or interns, from that i n the b e n c h m a r k case where workers i n the general p o o l are d i r e c t l y hired into p a i d positions. A l s o , organizations' d e m a n d for l a b o u r is lower w h e n at any point i n t i m e b o t h workers need to be compensated, so managers' incentive c o m p a t i b i l i t y constraint is shifted d o w n and t i l t e d .  3 7  B o t h effects  result i n the employment level at the sorting e q u i l i b r i u m to be higher t h a n the b e n c h m a r k case.  T h i s is i l l u s t r a t e d i n figure 3, w h i c h depicts the e q u i l i b r i u m w i t h volunteer h i r i n g  (point V) and the e q u i l i b r i u m w i t h only p a i d workers (point  B).  T o summarize the key points made so far, s t a r t i n g from the premise that some i n d i v i d uals view volunteer experience as a stepping stone for a professional career, the ' S o r t i n g ' e q u i l i b r i u m described provides a plausible e x p l a n a t i o n for w h y v o l u n t a r y effort is almost exclusively elicited by not-for-profit organizations and w h y c o m p e t i n g for-profit corporations cannot duplicate the incentives needed to support a sector-wide volunteer-hiring structure. Furthermore, by r e l a x i n g the incentive c o m p a t i b i l i t y constraint of workers, employment a n d service provision i n the ' S o r t i n g ' e q u i l i b r i u m move closer to the full employment levels. A l i m i t a t i o n of the ' S o r t i n g ' e q u i l i b r i u m is the counterfactual p r e d i c t i o n that a l l h i r i n g by nonprofit organizations i n the mission sector is done from the volunteer p o o l . However, we believe that this s h o r t c o m i n g arises because of our stylized a s s u m p t i o n of a homogeneous (in ability) workforce. I n other words, what the m o d e l predicts is that if two otherwise identical workers a p p l y for a p a i d p o s i t i o n , t h e n the o r g a n i z a t i o n w i l l always choose the worker who has some volunteering experience over a person w h o has none, w h i c h seems to be a plausible description of the way nonprofit employers screen applicants. 3 7  T h e condition in the proposition ensures that this is true.  53  Eb  Ev  L  E  F i g u r e 3.3: V o l u n t e e r i n g E q u i l i b r i u m (point V") vs Efficiency Wage E q u i l i b r i u m (point B)  3.4.2  Welfare Analysis  O u r task i n this sub-section is to assess some welfare properties of the two-sector ' s o r t i n g ' e q u i l i b r i u m . In particular, we are interested i n gauging its performance against the efficient benchmark set by a social planner. It w i l l be demonstrated that the ' S o r t i n g ' e q u i l i b r i u m is constrained P a r e t o efficient, as a planner, m a x i m i z i n g a representative worker's expected u t i l i t y subject to the same i n f o r m a t i o n a l constraints faced by agents, w o u l d not be able to improve worker's welfare. In a d d i t i o n , we w i l l show that the ' S o r t i n g ' e q u i l i b r i u m has some desirable welfare properties as it generates more employment a n d o u t p u t t h a n a b e n c h m a r k e q u i l i b r i u m where only p a i d workers are employed, or one where firms hire interns. To begin notice that although b o t h the volunteering and the internship structures p a r t l y overcome workers' m o r a l hazard, they introduce another source of inefficiency because prod u c i n g organizations must earn a rent i n order to be deterred from behaving o p p o r t u n i s t i cally. A s a result, a wedge between m a r g i n a l p r o d u c t i o n cost a n d price is created, a n d the socially o p t i m a l amount of service is not produced. T o illustrate the welfare losses i n d u c e d by these two frictions, we decompose the departure from the first best allocation into two parts: one due to workers' m o r a l h a z a r d and one due to firms' m o r a l hazard. T h e analysis is significantly aided b y reference to figure (4). F i r s t , note that i n the absence of any inform a t i o n a l constraints the first best a l l o c a t i o n w o u l d correspond to full employment, point FB  i n figure (4). L e t us now introduce the two frictions successively: first, we seek the  point that m a x i m i z e s a representative worker's expected u t i l i t y subject to worker's incen-  54  tive c o m p a t i b i l i t y constraint (3.16) a n d the feasibility constraint (3.17) assuming away the c o m m i t m e n t p r o b l e m of firms: m a x (w + B - e )f + (-e )^ + w(L -E) w.E 2 2 h  h  (3.15)  h  m  subject to:  (l-/? )(l + / 5 f e ^ - / ? d - ^ ) ) \ , , r -e 2  w >  J  (1-/3 ) \  _  2  h  h  + -.  w  h h  - e  , ^ (3.16)  and w < Pm(G )g m  m  (3.17)  T h e s o l u t i o n to this p r o b l e m w o u l d be given by the intersection of the workers' incentive c o m p a t i b i l i t y c o n d i t i o n (3.16) a n d the b i n d i n g feasibility c o n d i t i o n (3.17), point P i n figure (4).  F i g u r e 3.4: Welfare A n a l y s i s  T h e planner w o u l d increase wages u n t i l there are zero profits. N o t e the first departure from first best: point P implies lower employment level a n d therefore service provision t h a n  55  the first best, point FB.  N e x t we a d d firms' b i n d i n g incentive c o m p a t i b i l i t y constraint:  Tr (p (G ),  E)  v  m  m  m  = p (G )g m  m  -w  m  = 0(0")  (3.18)  a n d let the planner choose the a l l o c a t i o n that w o u l d m a x i m i z e a representative worker's welfare. T h e planner w o u l d now choose point V, the volunteering e q u i l i b r i u m , w h i c h occurs at the intersection of (3.16) a n d (3.18). T h e fact that (3.16) is u p w a r d sloping a n d (3.18) is a parallel i n w a r d shift of the planner's feasibility c o n d i t i o n by the vertical distance Q(<fi ) n  implies that point V i n figure (4) w i l l occur at an even lower employment level i n t r o d u c i n g a second departure from first best. Therefore, the volunteering e q u i l i b r i u m is constrained P a r e t o efficient, since a social planner subject to the two i n f o r m a t i o n a l constraints could not increase the welfare of workers, b u t does not produce the first best amount of service g.  T h e same logic applies to the internship e q u i l i b r i u m i n the non-mission sector so we  m  do not repeat it here. T h e above argumentation is s u m m a r i z e d i n the following p r o p o s i t i o n : P r o p o s i t i o n 8 a) In the mission sector, the 'Volunteering' efficient  but fails to produce the optimal  b) In the non-mission  amount of  sector, the 'Internship'  but fails to produce the optimal  equilibrium  is constrained  Pareto  g. m  equilibrium  is constrained  Pareto  efficient  amount of g . b  W e next compare worker's welfare i n the mission sector w h e n the two alternative employment practices are implemented, that is, we compare the volunteering e q u i l i b r i u m to the e q u i l i b r i u m that w o u l d occur i n the same market i f organizations instead of horizontally sorting workers were using the next best alternative h i r i n g practice, the internal p r o m o t i o n of i n t e r n s .  38  P r o p o s i t i o n 9 In the mission equilibrium provision  sector, if p (G ) m  with a volunteer-hiring than an equilibrium  structure  with interns.  P r o o f . P r o o f is i n A p p e n d i x B  m  > ^}~ , &  K  h  for E  m  G (0,L ), m  always generates more employment Moreover,  workers'  then an and service  welfare is enhanced.  •  In the V o l u n t e e r i n g e q u i l i b r i u m , higher intrinsic m o t i v a t i o n p a r t l y substitutes the m o n etary compensation needed at each level of employment to sustain incentive c o m p a t i b l e behaviour of workers. Consequently, i n this s i t u a t i o n more matches c a n be supported a n d therefore employment a n d p r o d u c t i o n i n the mission sector is enhanced. T h e two types of e q u i l i b r i a are depicted i n figure 5. T h o u g h the m o d e l presented here is too stylized to be taken as a literal account of the functioning of the labour market for volunteers, we believe T h i s thought experiment would make no sense in the profit sector as i n that sector workers and organizations are homogeneous so the two hiring practices would yield identical equilibrium outcomes. 3 8  56  Ei  Ev  L  F i g u r e 3.5: V o l u n t e e r i n g E q u i l i b r i u m (point V ) vs E q u i l i b r i u m w i t h Internships (point I)  it is suggestive of the welfare benefits that the interaction between volunteering a c t i v i t y a n d nonprofit organizations can achieve.  3.5  Discussion  T h e r e is ample anecdotal evidence i n the literature of the selection a n d sorting of managers and workers across nonprofit organizations and proprietary firms modeled i n this paper. H a n s m a n n (1980) mentions the possibility t h a t the n o n d i s t r i b u t i o n constraint may act as a screening device that selects the type of entrepreneurs (managers) a n d workers who are more concerned about the q u a l i t y of the service being p r o v i d e d and less interested i n monetary rewards t h a n other individuals. W e i s b r o d (1988) suggests that this process is indeed t a k i n g place: 'Managers,  will, therefore,  sort themselves, each gravitating  that he or she finds least restrictive-most result, nonprofit  and proprietary  managers with systematically  compatible  organizations,  to the types of  with his or her preferences.  having different legal regulations,  different goals.'  organizations As a  will attract  (pg 32)  H e also reports case studies w h i c h find that business school and law school students w h o subsequently enter the nonprofit sector vary substantially i n terms of personality traits, values and behaviour from their colleagues preferring to pursue a career i n the for-profit sector.  57  Moreover, our m o d e l suggests t h a t those i n d i v i d u a l s w h o gravitate toward the mission sector are better-off t h a n i f they sought employment i n the non-mission sector — even i f they m a y have to suffer a wage penalty - because they derive intrinsic satisfaction from their work. In contrast, i n d i v i d u a l s w i t h strong monetary motivations are deterred from seeking employment i n the mission sector a n d opt for positions i n the non-mission sector.  This  may e x p l a i n the general perception that nonprofit workers, despite being relatively p o o r l y compensated, enjoy h i g h levels of j o b satisfaction. M i r v i s a n d H a c k e t t (1983), a n a l y z i n g the Q u a l i t y of E m p l o y m e n t Survey report that nonprofit workers m a y receive lower wages and benefits t h a n their for-profit counterparts, but are more likely to find the orientation of their work more i m p o r t a n t t h a n the money they earn a n d to receive intrinsic rewards from doing their jobs. I n a similar vein, F r a n k (1996) using a dataset of C o r n e l l graduates finds sizeable salary differentials between graduates employed i n the profit sector and the nonprofit sector, after c o n t r o l l i n g for a rich set of j o b and i n d i v i d u a l characteristics. T h o u g h these differences a d m i t other interpretations, they can be a t t r i b u t e d to the self-selection of intrinsically m o t i v a t e d i n d i v i d u a l s - who are w i l l i n g to accept a lower wage (compensating differential) for the possibility to contribute to a goal i n w h i c h they find intrinsic value — into the nonprofit sector.  3.6  Conclusion  T h i s paper helps us understand a number of related observations regarding volunteer act i v i t y and the sectoral concentration of nonprofit firms. B y c o m m i t t i n g not to distribute surpluses, the nonprofit status ensures that the social mission takes precedence over the financial remuneration of any interested parties. W e have shown how this c o m m i t m e n t allows nonprofit firms alone to sustain a sector-wide incentive structure - volunteer h i r i n g - w h i c h is capable of i n i t i a l l y e x t r a c t i n g labour donations from volunteers and subsequently c o m pensates t h e m w i t h higher wages as they t r a n s i t i o n to p a i d positions. I n a d d i t i o n , we argued that volunteering facilitates the m a t c h i n g of workers and organizations w i t h similar mission preferences. T h e tighter congruence of organizations' and workers' goals i n nonprofit organizations offers t h e m a competitive advantage i n mission-oriented sectors. I n the non-mission oriented sector of the economy there is no scope for nonprofit organizations to be founded since the for-profit structure is preferable i n that it allows the manager\owner to fully appropriate profits, whereas the nonprofit status rules out this possibility. Consequently, the simple framework developed here explains endogenously the observed d i c h o t o m y t h a t the mission-oriented sector is associated w i t h nonprofit organizations, w h i c h hire v o l u n teers and sort t h e m into p a i d positions based o n their intrinsic preferences, whereas  the  non-mission sector is occupied by profit t a k i n g firms w h i c h hire interns. I n a d d i t i o n , our analysis suggests that this arrangement  improves the provision of p u b l i c goods a n d ser-  58  vices and therefore highlights a welfare-enhancing i m p l i c a t i o n of the interaction between volunteer a c t i v i t y and the nonprofit i n s t i t u t i o n a l form. F i n a l l y , we s h o u l d a d d that b o t h the view that volunteering acts s i m p l y as a screening device a n d / o r as a form of investment i n h u m a n c a p i t a l , and the incentive provision (rent extraction) a n d m a t c h i n g theory we propose here lead to similar predictions regarding the process of volunteer engagement, w h i c h makes t h e m e m p i r i c a l l y indistinguishable. T h e r e is, however, a crucial piece of evidence w h i c h the volunteering as screening and h u m a n c a p i t a l investment views cannot be reconciled w i t h .  T h a t is, these alternative candidate  explanations w o u l d suggest that volunteer h i r i n g should be a widespread h i r i n g practice i n m i x e d sectors, whereas i n reality volunteering a c t i v i t y is restricted to nonprofit organizations while for-profit organizations seem to have very l i m i t e d a b i l i t y to recruit volunteers. 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Independent Sector, Jossey-Bass, N e w Y o r k .  62  Almanac  and Desk  Chapter 4  Prosocial Motivation and the Delivery of Social Services (with Patrick Francois)* 4.1  Introduction  W h i l e the presence of nonpeeuniary motivations is considered to be a n i m p o r t a n t component of h u m a n behaviour i n other social sciences, the use of models i n w h i c h agents display some type of other-regarding preferences is only recently b e c o m i n g c o m m o n i n the economics literature. T h i s development is, at least i n part, spurred by the m o u n t i n g experimental evidence attesting to the usefulness of this approach i n r a t i o n a l i z i n g m a n y social a n d economic interactions such as donations of time a n d money, private provision of p u b l i c goods, v o t i n g , intergenerational bequests and so on. T o be sure, i n their recent a n d comprehensive survey of the e x p e r i m e n t a l evidence, Fehr and S c h m i d t (2006) conclude that: 'Given  this evidence  other-regarding important  the real question  preferences,  economic  is no longer whether many people have  but under which conditions  these preferences  and social effects and what the best way to describe  model these preferences  have and  is'.  Here we w i l l argue that one area they do have i m p o r t a n t economic effects is i n the provision of social services, such as health care, education and research, child care, care for the elderly, c o m m u n i t y development, and international a i d . M a n y of these have been seen as part of the t r a d i t i o n a l role of government, but this view has been increasingly challenged. Governments i n m a n y countries have moved from provider to purchaser, and have sought out greater involvement i n direct provision from the private sector. T h e arguments u n d e r l y i n g * A version of this chapter will be submitted for publication.  63  this involvement are generally sound. T h e power of incentives created by residual c l a i m a n c y in private firms creates a better environment for timely, efficient and innovative service provision.  However, it w i l l be argued here that when prosocial m o t i v a t i o n is taken into  account, the recent literature l o o k i n g at its effect on private provision w i l l suggest t h a t governments (or more generally institutions w i t h o u t residual claimants, like nonprofit firms) continue to have an i m p o r t a n t role i n p r o v i d i n g such services. I n such environments, these may be the unique form of i n s t i t u t i o n capable of eliciting donations of effort that  are  engendered by prosocial motivations. To provide a bit of background on the motivations b e h i n d prosocial behaviour we draw on B e n a b o u and T i r o l e (2006). T h e y argue that prosocial behaviour reflects the m i x of three u n d e r l y i n g motivations: extrinsic,  intrinsic  a n d reputational.  E x t r i n s i c m o t i v a t i o n stems  from the standard pecuniary or other m a t e r i a l rewards t h a t a n i n d i v i d u a l m a y receive from outside. B r o a d l y speaking intrinsic m o t i v a t i o n refers to the case where a n i n d i v i d u a l pursues actions not because of external rewards but because the a c t i v i t y is valuable i n its own r i g h t .  1  Different conceptualizations of intrinsic m o t i v a t i o n are possible. In p a r t i c u l a r ,  a d i s t i n c t i o n can be made between (a) Impure or A c t i o n - O r i e n t e d A l t r u i s m : the i n d i v i d u a l receives a ' w a r m glow' from the a c t u a l act of c o n t r i b u t i n g to a p u b l i c good a n d (b) P u r e or O u t p u t - O r i e n t e d A l t r u i s m : the i n d i v i d u a l cares about the overall value of the p u b l i c g o o d to w h i c h he contributes.  I n reality, it is likely that a c o m b i n a t i o n of these two sources of  intrinsic m o t i v a t i o n is at play. F i n a l l y , intrinsic m o t i v a t i o n should be differentiated from an instrumental a l t r u i s m that arises because of the concern about developing a valuable reputation i n repeated interaction settings. We focus on the manifestation of prosocial behaviour i n workplace contexts that involve the provision of social services, like those above. G i v e n the nature of these services, workers engaged i n p r o v i d i n g t h e m often derive direct nonpecuniary benefits because they have a genuine concern, or care, about the recipients of the service - for example the welfare of the sick, the poor, or underprivileged children - a n d / o r by virtue of the social recognition they might receive for c o n t r i b u t i n g to a n i m p o r t a n t m i s s i o n .  2  Since such intrinsic motivations  seem relevant i n organizations t h a t provide social services, it is i m p o r t a n t to  understand  their interaction w i t h monetary incentives a n d what the i m p l i c a t i o n s are for the p r o v i s i o n of incentives and o p t i m a l organizational design. T h e classic agency-theoretic approach to addressing questions i n p u b l i c sector contracting and procurement is p r i m a r i l y concerned w i t h adverse selection and m o r a l h a z a r d problems that arise w h e n the government wants to procure a p u b l i c good or service from a A c c o r d i n g to Deci (1971), cited by Frey (1997), "one is said to be intrinsically motivated to perform an activity when one receives no apparent reward except the activity i t s e l f . Note that besides this kind of prosocial behaviour a worker may exhibit a whole class of other-regarding behaviour, such as altruistic feelings towards his employers or co-workers. For an excellent survey of the literature concerned with such motivations, see Rotemberg (2006). 1  2  64  private firm, or regulate a private firm that directly supplies a p u b l i c service to consumers on behalf of the government (see for example Laffont a n d T i r o l e 1993). T h e basic p r o b l e m is that the firm m a y have private i n f o r m a t i o n regarding the costs of p r o d u c t i o n a n d \ o r its cost reducing efforts, and so the government i n its a t t e m p t to elicit t r u t h f u l revelation of private information is faced w i t h a trade-off between provision of incentives and rent extraction. F r o m the perspective of t r a d i t i o n a l agency theory, p r o v i d i n g incentives for a p u b l i c agency or a privately regulated firm to deliver a service presents the government w i t h generally similar challenges. M o r e recently, attention has shifted from the distortions associated w i t h asymmetric information towards the effects of alternative ownership and o r g a n i z a t i o n a l structures. T h e core p r o b l e m i n h i b i t i n g private provision here is the n o n - c o n t r a c t i b i l i t y of the output, i n this case the service p r o v i d e d by the p u b l i c provider. I n an environment where the q u a l i t y of the service p r o v i d e d cannot be contracted u p o n , H a r t et a l . (1997) have offered insights into the specific trade-offs between government ownership and p r i v a t i zation. O u r focus i n the second part of this paper is on the lessons derived from this second wave of the literature on the i n s t i t u t i o n a l structure of p u b l i c services delivery. We w i l l argue, i n our very selective review of this literature, that this work suggests prosociality of employees has i m p o r t a n t i m p l i c a t i o n s for the delivery of p u b l i c services. P r o s o c i a l i t y amounts to a statement of what enters into agents' u t i l i t y functions, and it w i l l be seen that the i m p l i c a t i o n s for p u b l i c service delivery hinge on a subtle difference i n the way prosociality is modelled. Importantly, these i m p l i c a t i o n s w i l l contrast m a r k e d l y w i t h those derived from the literature that has e x a m i n e d the effects of ownership i n environments where the c o n t r a c t i b i l i t y of output is the core p r o b l e m . T h e rest of this paper is organized as follows. T h e next section introduces a n d discusses the two alternative ways of m o d e l l i n g prosocial m o t i v a t i o n : action-oriented a n d outputoriented a l t r u i s m . Section 3 is concerned w i t h the i m p l i c a t i o n s for government p r o v i s i o n of social services from the perspective of the literature that emphasizes the noncontractible nature of output and contrasts it w i t h the i m p l i c a t i o n s derived from the literature t h a t emphasizes the role of intrinsic m o t i v a t i o n . T h e last section offers some c o n c l u d i n g remarks.  4.2  Modelling prosociality  A t least implicitly, recent models e m p h a s i z i n g agent p r o s o c i a l i t y start from a p r o d u c t i o n function w h i c h converts inputs of either time, effort, or other resources into the p r o d u c t i o n of a good, service or a c t i v i t y about w h i c h some agents care. S o m e t h i n g of the form: g =  k(e.i....e-i,c)  65  where A; is an increasing function of efforts, ej is the effort of agent i, a n d also a function of c a vector of other p o t e n t i a l inputs into this process. T h e r e are s m a l l differences i n how this p r o d u c t i o n process m a y work t h a t have been the focus of some papers.  Output may  be m u l t i - d i m e n s i o n a l , i.e. depend on q u a l i t y w h i c h can be adversely affected by poor i n p u t choice, k  < 0, or multi-task a ( e j , e ) where e , for example, does not affect g. B u t these 2  c  2  w i l l not be the focus of this survey. T h e following quasi-linear u t i l i t y function for an agent i embeds, what we w i l l argue, are the m a i n contrasting ways i n w h i c h prosociality has been m o d e l l e d to affect service provision i n the literature. A g e n t i's utility, U~i, is increasing i n his own c o n s u m p t i o n c(yi) and decreasing i n the amount of effort he expends at work, ej. Some variant of this is c o m m o n to a l l papers i n this literature.  A u t h o r s , however, differ i n their inclusion of a  possible t h i r d a n d fourth t e r m i n this expression below.  Papers that have emphasized  i m p u r e l y altruistic, or action-oriented, m o t i v a t i o n include a t e r m like the t h i r d one: XJ = c ( ) %  yi  - <f> (ei) + In (e*) +  7  i  (g)  (4.1)  If the firm is p r o d u c i n g a good or service that the agent considers meritorious, then it is possible for the agent to o b t a i n a benefit from effort expended at the task.  T h i s is  represented by the t e r m h (ej) w i t h h! > 0, over some or a l l of the range. I n effect, workers c o n t r i b u t i n g effort at such firms m a y actually enjoy c o n t r i b u t i n g some of that effort, or dislike it less t h a n i f the same efforts were expended elsewhere. A recent example of such an approach is Besley and G h a t a k (2005), where the agent's identification w i t h a firm or principal's "mission", lowers the cost of agent effort. A l t e r n a t i v e approaches have started from the assumption t h a t a t e r m like the fourth one i n (4.1) plays a role. A c c o r d i n g to these papers, a recent example of w h i c h is Francois (2007), agents derive a benefit directly w h e n what they consider a socially worthwhile g o o d or service, g, is provided. T h e i r u t i l i t y is thus increasing i n the level of t h a t good, 7^ > 0. N o t e that this benefit is independent of whether agent i has a h a n d i n p r o d u c i n g the good or service or not; something w h i c h does not occur w i t h a c t i o n oriented motivations. Some of the i m p l i c a t i o n s of the two alternative conceptual views of intrinsic m o t i v a t i o n are not h a r d to see. F i r s t l y , free-riding. W h e n a l t r u i s m is impure, no free-riding p r o b l e m ensues as the i n d i v i d u a l worker's intrinsic reward hinges exclusively on his o w n c o n t r i b u t i o n to a project that has a social i m p a c t . T h i s c a n be conveniently used as a shortcut to s t u d y the structure of o p t i m a l incentive contracts. O n the other hand, w h e n a worker is purely altruistic she derives an i n t r i n s i c benefit from the project being successful regardless of whether she has been actively involved i n delivering it, and therefore the setting has a n endemic free-riding problem. Secondly, a n a d d i t i o n a l m o r a l - h a z a r d p r o b l e m may arise i n purely altruistic settings. W h e n workers care about the level of service provided, they w i l l want to ensure that their 66  efforts are c o n t r i b u t i n g to that service. T h e provider of the service, their p r i n c i p a l , boss, owner, manager, or employer w i l l thus be able to elicit this effort that is based on care, only w h e n they can ensure that such efforts w i l l contribute to the service of concern. M o r a l h a z a r d problems can arise w h e n the agent is unsure about how m u c h e x t r a effort c o n t r i b u t e d goes towards provision of their socially desired good. N o such p r o b l e m arises i n the case of i m p u r e a l t r u i s m . T h e worker knows the effort she provides, and is directly, intrinsically, rewarded for it.  4.2.1  Impure or A c t i o n - O r i e n t e d  Altruism  W e first consider i m p u r e a l t r u i s m . I n this case, the agent derives direct benefit from performing what he or she considers to be the meritorious task. T h o u g h it is presumably the effects of such actions that the agent u l t i m a t e l y cares about, i n this type of m o d e l l i n g , this is assumed to affect the agent directly by lowering the cost of performing the task.  The  agent does not deliberate regarding the i m p a c t of his actions, nor does he wonder w h a t w o u l d happen i f he were to act differently. A c c o r d i n g to this approach, the u t i l i t y function is of the following form: Ui = c(yi)  - 4>{ei) + hi (e,)  Besley and G h a t a k (2005) are concerned w i t h the i m p l i c a t i o n s of i m p u r e a l t r u i s m on the o p t i m a l incentive contract i n a m o r a l h a z a r d setting. T h i s paper studies the p r o v i s i o n of o p t i m a l incentives i n a principal-agent m o d e l w h e n some agents are d r i v e n by intrinsic motivations while others have conventional pecuniary motivations. I n particular, the two key i m p l i c a t i o n s of this framework are t h a t (1) A n altruistic worker w i l l provide more effort a n d (2) A n altruistic worker requires less monetary compensation. T h u s , intrinsic m o t i v a t i o n in this case is a k i n to a compensating differential. T h i s framework also emphasizes the role of endogenous m a t c h i n g of principals and agents w i t h similar a l t r u i s t i c preferences as this can raise p r o d u c t i v i t y and affect the structure of compensation. A n o t h e r paper i n this s t r a n d is the one by D i x i t (2005). T h i s paper features a m u l t i p l e task environment i n w h i c h p r o d u c t i o n entails two outcomes - a p r i m a r y and a b y - p r o d u c t b o t h of w h i c h generate nonpeeuniary rewards to the worker. T h e p r i n c i p a l can o n l y r e w a r d the agent for the p r i m a r y output since the secondary product might even be undesirable to her (for instance, the by-product might be p r o m o t i o n of a p a r t i c u l a r faith). T h e paper provides the properties of the o p t i m a l incentive scheme.  In a d d i t i o n to finding t h a t the  agent's intrinsic m o t i v a t i o n substitutes for pecuniary compensation that w o u l d have to be offered i n order to induce p a r t i c i p a t i o n , it is shown that when the p r i n c i p a l exhibits aversion to the by-product she offers weaker m a r g i n a l incentives. T h a t is, while worker's i n t r i n s i c m o t i v a t i o n may relax his p a r t i c i p a t i o n decision it does not affect the power of incentives. C o r n e o a n d R o b (2003) consider a setting where workers engage i n two tasks: an i n d i -  67  v i d u a l task and a cooperative task w h i c h furnishes personal benefits but w h i c h is difficult for the p r i n c i p a l to reward because of the collective nature of the o u t p u t workers contribute to. T h i s formulation is used to compare o p t i m a l incentives i n a p u b l i c firm that m a x i m i z e s social welfare (including workers' u t i l i t y ) a n d a p r o f i t - m a x i m i z i n g private firm. T h e analysis suggests t h a t incentives i n the private firms are stronger, but workers i n the p u b l i c firm provide more cooperative effort. C a n t o n (2005) presents a two-task two-output p r i n c i p a l agent m o d e l i n w h i c h one o u t p u t is observable while the other is not. Some agents are i n t r i n s i c a l l y m o t i v a t e d a n d some are not a n d the type is not observable by the p r i n c i p a l , so the m o d e l features a n element of adverse selection. I n c o m m o n w i t h the two other papers above, intrinsic m o t i v a t i o n reduces the fixed cost of meeting the agent's p a r t i c i p a t i o n constraint. I n a d d i t i o n , this paper finds that i n order for the intrinsically m o t i v a t e d workers to be induced to provide effort along the unobserved dimension, the power of incentives has to be moderate, a result w h i c h he interprets as high-powered incentives crowding-out intrinsic m o t i v a t i o n . A related paper that focuses on issues of worker selection and screening is Delfgaauw and D u r (2007).  T h i s paper addresses the question of how should a firm facing a p o o l  of workers that are heterogeneous i n terms of their intrinsic m o t i v a t i o n o p t i m a l l y set its compensation policy. In c o m m o n w i t h the papers mentioned above, i n their f o r m u l a t i o n intrinsic m o t i v a t i o n is also of the i m p u r e l y altruistic form as the way it enters is by affecting the cost of a worker's effort. T h i s allows t h e m to abstract from the free-riding p r o b l e m that w o u l d arise i f workers were purely a l t r u i s t i c . W h e n the level of intrinsic m o t i v a t i o n is private information of the worker, then the employer faces the following trade-off i n designing the o p t i m a l wage scheme: by increasing the wage she raises the p r o b a b i l i t y of filling the p o s i t i o n but attracts workers w i t h lower i n t r i n s i c m o t i v a t i o n . T h i s trade-off appears to be similar to the one i n Francois (2007) but i n the latter there is also m o r a l h a z a r d i n p r o d u c t i o n a n d this serves as a n a d d i t i o n a l inducement for m o t i v a t e d types to a p p l y for the j o b i n order to deter a shirker from filling the p o s i t i o n . In Francois (2007) a m a r g i n a l increase i n the wage induces more applications from b o t h shirkers and non-shirkers and whether increases or declines depends on the relative density of the two types of workers.  output  3  M u r d o c k (2002) studies the role of the agent's intrinsic m o t i v a t i o n for the investment decisions made by the firm. I n this paper, the agent's effort contributes to a project that generates a financial return valuable to the firm, and a n o n p e c u n i a r y r e t u r n valuable to the agent. S t a r t i n g from a p o s i t i o n where the expected intrinsic r e t u r n that the agent receives is zero, the author shows that the i n t r i n s i c m o t i v a t i o n affects incentive contracts o n l y by i n d u c i n g firms to undertake investment projects w i t h higher intrinsic payoffs. I n particular, the firm may i m p l i c i t l y agree to implement projects that have negative financial r e t u r n but generate positive intrinsic value to the worker, and i n exchange the worker provides higher 3  T h i s paper is covered in the next section.  68  ex-ante effort, thus increasing the firm's expected profits. Moreover, the firm's gains from i m p l e m e n t i n g such an i m p l i c i t contract are increasing i n the intensity of the agent's intrinsic motivation. T h e c o m m o n i m p l i c a t i o n of a l l of these treatments of i m p u r e a l t r u i s m is to lower the need for "power" i n incentives.  T h i s is a k i n to a compensating differential, and t h o u g h  it does suggest that such services may be cheaper to deliver w h e n people have prosocial motivations, this has relatively l i t t l e i m p a c t for the delivery of social services. Crowding  Out  T h e other i m p l i c a t i o n t h a t arises occurs w h e n service delivery happens i n m u l t i t a s k environments.  T h e usual m o d e l l i n g here treats one good as socially meritorious, a n d another  not, w i t h the socially meritorious one more difficult to contract over. T h e m a i n insight of these is that p a y i n g too m u c h for the good that can be d i r e c t l y rewarded may c r o w d out efforts devoted to the socially meritorious good. T h i s crowding out of a l t r u i s m c a n also occur w h e n the use of external incentives reduces or eliminates the effects of i n t r i n s i c motivations.  T h e r e is a large recent  experimental  literature documenting this phenomenon i n different contexts. T h i s literature is t h o r o u g h l y surveyed by F r e y (1997), a n d F r e y a n d Jegen (2001). Since these surveys there has been some interesting work by B e n a b o u and T i r o l e o n p r o v i d i n g a n information-based framework to formally t h i n k about the interplay between extrinsic a n d intrinsic motivations a n d the mechanism b e h i n d the notions of ' c r o w d i n g out' a n d ' c r o w d i n g i n ' .  4  In B e n a b o u and T i r o l e (2003) they consider an informed p r i n c i p a l setting where the p r i n c i p a l has private i n f o r m a t i o n over the characteristics of a task a n d / o r the agent's a b i l M a k r i s (2006) analyzes a principal-agent set-up that departs from the canonical adverse selection model in that the agent, besides the monetary payoff, derives direct utility from higher output and he is subject to an administrative constraint which gives rise to a limited liability condition. He finds that the agent's intrinsic motivation reduces the power of incentives, and that under certain conditions the principal may decide to distort the output of both the high and low-cost types, unlike the canonical model where only the high-cost's output is reduced from the efficient level. Huck et al. (2006) is concerned with the interaction between economic incentives and social norms and show that the choice of incentive structure can affect the impact that social norms have on team production. Tn this framework, social norms may be beneficial or detrimental to output depending on whether the type of compensation implemented induces positive externalities among workers (team-based incentives) or negative externalities (relative performance-based compensation), and it is possible that higher monetary incentives may reduce workers' effort. Vyrastekova et al. (2006) investigate the effect of power of incentives experimentally. In their experimental design, subjects repeatedly perform two tasks: one which improves their own output and another which increases the output of a teammate. Subjects are compensated based on both individual and team performance, and the power of incentives reflects the weight that the payment scheme puts on individual output. Subjects choose to join either a 'private' firm, which has a payment scheme with high weight on individual performance, or a 'public' firm which has a more low-powered incentive scheme. The experimental findings suggest that increasing the power of incentives has a negative effect on effort if the interdependency between workers is high. 4  69  ity to perform it, whereas the agent cares about the outcome of the task but has imperfect self-knowledge.  T h e p r i n c i p a l strategically chooses actions, rewards a n d punishments, i n  order to incentivize the agent a n d to enhance his self-confidence. T h e agent on his part, tries to extract i n f o r m a t i o n from the p r i n c i p a l ' s actions about himself and about the task. T h e y show that i n situations where the a s y m m e t r y of i n f o r m a t i o n is i m p o r t a n t , a n d under certain c o n d i t i o n s , extrinsic rewards may be d e t r i m e n t a l to the agent's intrinsic m o t i v a 5  t i o n , i n that they convey b a d news to the agent about the attractiveness of the task or about his own type. I n a c o m p a n i o n paper, B e n a b o u and T i r o l e (2006) describe a different mecha n i s m t h r o u g h w h i c h c r o w d i n g out m a y occur. T h e y argue that the presence of extrinsic incentives crowds out r e p u t a t i o n a l m o t i v a t i o n by creating doubt about the extent to w h i c h a person is u n d e r t a k i n g an action for the monetary rewards rather t h a n for themselves. A n argument i n the same vein can be found i n Seabright (2005); he develops a two-period m o d e l where agents undertake an altruistic action i n the first p e r i o d and are i n a second p e r i o d assortatively matched i n a m a t c h i n g market.  It is shown t h a t the signalling aspect t h a t  ensures an i n d i v i d u a l a more desirable m a t c h m a y induce a higher p r o p o r t i o n of i n d i v i d u a l s p a r t i c i p a t i n g w h e n rewards are zero t h a n w h e n rewards are positive but s m a l l . In workplace settings, the informed p r i n c i p a l mechanism of intrinsic m o t i v a t i o n c r o w d i n g out may be the most relevant. T h a t framework has a n a t u r a l manager-worker interpretation: the manager may be i n a better p o s i t i o n to judge the worker's a b i l i t y to perform well i n a certain task, or m a y be a better informed about how difficult a certain task w i l l t u r n out to be. T h e r e p u t a t i o n a l c r o w d i n g out, seems to a p p l y to activities such as d o n a t i n g b l o o d a n d volunteering where the social aspect is more pronounced, but m a y be also suitable here, since it is plausible that workers m a y undertake activities i n the workplace to g a i n social approval. I n reality of course b o t h considerations m a y be relevant. One of the defining characteristics of agencies p r o d u c i n g p u b l i c services is the m u l t i plicity of b o t h the tasks agents have to perform and the principals to w h i c h agents have to answer to (Burgess and R a t t o 2003, D i x i t 2002, W i l s o n 1989). A n interesting, i f challenging, extension w o u l d be to see whether the information-related crowding-out mechanisms work i n multiple-task a n d m u l t i p l e - p r i n c i p l e settings. T h e insights offered by the literature on c r o w d i n g out of intrinsic m o t i v a t i o n have i m p o r tant i m p l i c a t i o n s for the on-going debate regarding p u b l i c service reform, as they indicate that the u n c r i t i c a l i n t r o d u c t i o n of high-powered incentives, w h i c h have been proven to be effective i n the private sector, m a y backfire w h e n workers are altruistic. T h e key condition is a 'sorting condition', which suggests that a principal must be more willing to offer an agent rewards when he is less able or the task is more costly. 5  70  M o t i v a t e d B u r e a u c r a c i e s a n d the D e l i v e r y of S o c i a l Services A recent paper by Prendergast (2007) argues t h a t the fact of members of bureaucracies a n d government agencies b e i n g p u b l i c - s p i r i t e d has to be taken into account w h e n considering the various agency problems that arise i n such organizations.. T h a t paper takes the view that bureaucrats act as intermediaries between their principals and their clients. T h e issue that then arises is how to select bureaucrats such that an efficient outcome is generated. In particular, w h e n the objectives of the p r i n c i p a l a n d the client are aligned, as is the case for example i n healthcare, then efficiency requires that an altruistic bureaucrat is chosen, that is, one w h o cares about the welfare of the client. O n the other hand, i n bureaucratic settings where the p r i n c i p a l ' s interests are i n conflict w i t h the client's, for instance i n t a x authorities, then the o p t i m a l policy is to hire a bureaucrat who is biased against the client. T h i s explains w h y workers w i t h different attitudes are attracted to hospitals (client-friendly) t h a n t a x agencies (client-hostile). T h e next question that is addressed is whether, w h e n a bureaucrat's intrinsic m o t i v a t i o n is not observable, self-selection w i l l lead to the efficient outcome.  T h e analysis then suggests that this is not necessarily true, as b o t h the most  preferred and the least preferred types self-select, the latter attracted by the possibility to undermine the p r i n c i p a l ' s goals. F i n a l l y , another interesting i m p l i c a t i o n i n this m o d e l is a crowding out effect that emerges due to selection: higher wages induce more workers w i t h no intrinsic m o t i v a t i o n to apply, w h i c h adversely affects efficiency. Leaver (2004) is also concerned w i t h bureaucratic m o t i v a t i o n a n d behaviour. T h e paper draws attention to the fact that strong r e p u t a t i o n a l concerns i n the presence of informed interest groups may distort bureaucratic behaviour. A n o t h e r paper that is concerned w i t h the issue of worker selection i n the p u b l i c sector is Delfgaauw a n d D u r (2006). T h i s paper assumes that the presence of workers instilled w i t h a p u b l i c service m o t i v a t i o n gives monopsony power to p u b l i c sector employers. W h e n workers' effort is unverifiable the paper shows that u n m o t i v a t e d workers may be attracted a n d crowd-out the dedicated ones.  6  T h i s type of treatment of prosocial m o t i v a t i o n has profound i m p l i c a t i o n s for the design of o p t i m a l contracts, but says relatively l i t t l e about what sort of organization should be p r o v i d i n g the social service - a feature that w i l l be the focus of the next type of a l t r u i s m that we consider. A n o t h e r paper on public organizations is Dewatripont et al. (1999). Motivated by a number of observations regarding government agencies made in W i l s o n (1989), they introduce multiple tasks in a standard career concerns model. T h i s extension generates a set of interesting implications that are consistent with the motivating facts i n Wilson: increasing the number of tasks reduces effort because it hinders the market's ability to draw inferences about the agent's ability, while effort is also reduced when the market is uncertain about the nature of tasks undertaken. These results suggest that hiring specialists, and setting a well defined mission enhance the productivity of the organization. 6  71  4.2.2  Output-Oriented Altruism  O u t p u t oriented (or pure) a l t r u i s m has profound i m p l i c a t i o n s for organizational design. Papers that take a purely a l t r u i s t i c s t a r t i n g point are set up something like: Ui = c{yi) - 4> (e;) + 7 i (g)  g = k{ei....e-i,c)  (4.2)  T h e i m p l i c a t i o n s for organization design were analyzed by Francois (2000). Suppose t h a t a worker is m o t i v a t e d by a desire to advance a cause about w h i c h he is concerned, g, the function  7  i  c a p t u r i n g the i m p a c t of that. However, i n d i v i d u a l is not the only c o n t r i b u t o r to  p r o d u c t i o n of the good. T h e key element here is that the firm manager also controls other inputs that contribute to p r o d u c t i o n of the social good, as per equation (4.2). These c o u l d be the h i r i n g of other workers, the e _ i , or some other inputs like equipment or facilities. T h e manager observes the worker's effort before h a v i n g to decide on the final level of these other inputs. T h a t paper compares the behaviour of managers who are residual claimants i n the neo-classical firm a l a A l c h i a n and Demsetz (1972), and those managers w o r k i n g for a government. I n the private firm, the manager owns any accumulated surplus (negative or positive) from p r o d u c t i o n . I n the government, the manager has to respect a zero budget c o n d i t i o n i n p l a n n i n g his inputs, but has no claims o n accumulated surpluses. T h e question it asks is w h i c h type of organization has an advantage i n eliciting the worker's a l t r u i s t i c a l l y m o t i v a t e d contributions to the organization's output. T h e answer is that there exist conditions under w h i c h the worker is m o t i v a t e d to cont r i b u t e effort because of its effect on the social g o o d o n l y w h e n w o r k i n g for the government. T h a t is, the worker p a i d as a government employee can be p a i d less t h a n w o u l d have been required to compensate h i m for the d i s u t i l i t y of effort. O r , i n other words, the worker contributes more effort t h a n he w o u l d contribute i f he d i d not care about the good at a l l , i.e., if 7j (•) = 0. T h e reason is that he knows t h a t by c o n t r i b u t i n g this effort he is advancing the cause w h i c h he cares about, raising g and he takes account of this when deciding o n :  his effort level. W h y does this not h a p p e n when the same worker works for a private firm? P u r e l y altruistic people care about the o u t p u t of the good they produce.  T h e y are  not interested i n c o n t r i b u t i n g effort to such tasks o n l y to see t h a t their efforts i m p l y t h a t someone else who should, or could, be c o n t r i b u t i n g takes the o p p o r t u n i t y to do less. T h i s is the essence of the m o r a l h a z a r d p r o b l e m that arises when the firm is r u n by a residual claimant. T h e residual claimant may care as strongly about the o u t p u t of the organization as does the worker, but he also gains financially i f resources can be saved.  Consequently,  if he knows he has a worker w o r k i n g for h i m who is w i l l i n g to contribute e x t r a effort out  72  of a direct concern for the organization's mission, he c a n reduce the level of some other inputs that he controls. H i s incentive to do this w i l l be greater the higher the degree of s u b s t i t u t a b i l i t y between the inputs he controls and the efforts of the worker. I n terms of the p r o d u c t i o n function above, facing a higher level of ej reflecting the d o n a t i o n of a m o t i v a t e d worker, the m a r g i n a l c o n t r i b u t i o n of the inputs t h a t he controls, for example the c, w i l l be lower a n d the residual claimant w i l l o p t i m a l l y choose to lower these a n d pocket the savings provided that k  eiC  < 0. K n o w i n g this, the i n t r i n s i c a l l y m o t i v a t e d a n d purely altruistic worker  w i l l r a t i o n a l l y choose not to contribute e x t r a effort i n pursuit of the organization's m i s s i o n . He knows that d o i n g this merely crowds out the p r i n c i p a l ' s c o n t r i b u t i o n and therefore does not affect (or affects only weakly) the organization's output. T h e manager i n a government bureaucracy, i n contrast, has m u c h weaker incentive to reduce his inputs w h e n faced w i t h e x t r a contributions from a m o t i v a t e d worker. H e does not c l a i m any of the o u t s t a n d i n g residual from the department's operations. Consequently, w h e n faced w i t h the labour d o n a t i o n of a m o t i v a t e d worker, even t h o u g h the m a r g i n a l c o n t r i b u t i o n of the inputs he controls is reduced, he still has incentive to use these i n p r o d u c t i o n of the good about w h i c h he cares. Importantly, his level of direct concern for the firm's output need be no different t h a n that of a for-profit owner. It is s i m p l y that, due to the nature of government provision t h r o u g h bureaucracies, he is directly d i v o r c e d from a c l a i m on the operating profits of the p r o d u c t i o n u n i t . H e thus can c r e d i b l y c o m m i t to h a v i n g m u c h weaker incentives to reduce his o w n inputs ex post. So, the upshot of this story is that a government bureaucracy, w h i c h , i n contrast to the high powered incentives b u i l t i n by residual c l a i m a n c y i n a private firm, has lower powered incentives for operating managers, can o b t a i n l a b o u r donations due to the service m o t i v a t i o n of their employees i n some situations where a private firm could not. However, as always, this simple story becomes more c o m p l i c a t e d w h e n we consider its details more deeply. Specifically, we have assumed i n the discussion above t h a t only the relationship between the agent (worker i n the organization) a n d his boss, who is either the manager i n a government bureaucracy, or the residual claimant i n a private firm, is what matters. It has been i m p l i c i t l y assumed t h a t the o r g a n i z a t i o n is rewarded for changes in output by some sort of price for the service.  B u t overseeing this whole process is a  government, who chooses whether to contract this process of service provision out to the private firm, or to produce it i n house w i t h a bureaucracy.  It is not clear whether a  government purchasing the service could alter the price schedule faced by the private firm so as to help it overcome the credibility p r o b l e m t h a t it faces w i t h its employees. Francois (2000) shows that even allowing for the government to use any sort of unrestricted non-linear p r i c i n g schedule it wants, it w i l l not generally be able to undo the p r o b l e m of credibility faced by the residual claimant i n the private firm. T h e o p t i m a l p r i c i n g schedule for the service w i l l always allow greater p o t e n t i a l for l a b o u r donations by the m o t i v a t e d bureaucratic worker  73  t h a n it does by the worker i n a private for-profit enterprise p r o v i d i n g the same service. A n o t h e r p o t e n t i a l way for private firms to overcome this p r o b l e m is for t h e m to develop a r e p u t a t i o n for allowing their o w n workers' e x t r a contributions to have a n i m p a c t . If the problem that private firm owners face is that they have an incentive to distort downwards their input contributions i n light of e x t r a effort from their m o t i v a t e d workers, then a firm w o u l d have a financial incentive to develop a r e p u t a t i o n for not d o i n g this. T h i s is explored in Francois (2001). Such a r e p u t a t i o n w o u l d work as follows.  T h e firm is k n o w n to not  reduce inputs when workers contribute e x t r a to the firm's tasks.  Consequently, workers  know that when d o i n g so, they w i l l not be e x p r o p r i a t e d ex post by the firm reducing other inputs and thus keeping the service unadjusted. If the firm were to deviate from d o i n g this, its r e p u t a t i o n w o u l d be tarnished, and future workers w o u l d not donate effort to its service. Consequently, the q u a l i t y of its output w o u l d fall, a n d it w o u l d suffer a loss i n value. W i t h such a r e p u t a t i o n of non-interference i n place, the private firm w o u l d be able to elicit l a b o u r donations from workers, as the workers w o u l d not fear being expropriated ex post.  This  should i m p l y that any worker who was w i l l i n g to contribute e x t r a effort to the government bureaucracy should also be able to do the same to the private  firm.  T h o u g h the reasoning here is sound, this means of solving the c r e d i b i l i t y p r o b l e m requires some operating profit to accrue to the private  firm.  I n a repeated game context,  it is the operating profit that provides the private firm w i t h the incentive to not deviate and expropriate the workers' labour donations ex post. These profits must be positive for it to r e m a i n worthwhile for the firm to m a i n t a i n their r e p u t a t i o n of non-expropriation. I n contrast, the government bureaucracy can o b t a i n labour donations even w h e n its operating surplus is zero. O p e r a t i n g surpluses play no role i n d i s c i p l i n i n g the government bureaucrat. Consequently, i n this repeated game setting where reputations can be developed to m i t i g a t e m o r a l h a z a r d problems, t h o u g h b o t h a government bureaucracy and a private firm can operate i n a way that allows b o t h to equally o b t a i n l a b o u r donations due to purely m o t i v a t e d workers, the private firm has to also o b t a i n positive profit from per p e r i o d operations. T h e bureaucracy does not require this, a n d consequently, s h o u l d be able to produce at a cost w h i c h is lower t h a n the private firm. A g a i n , the bureaucracy, or equivalently a nonprofit entity w i l l perform better t h a n a n o r g a n i z a t i o n w i t h a residual claimant, i.e., the private firm. F i n a l l y , there is a free-riding p r o b l e m i m p l i c i t i n this discussion that has been s k i r t e d so far. If workers are concerned about the a c t u a l output of a n o r g a n i z a t i o n - irrespective of their own efforts - then the l a b o u r d o n a t i o n game resembles a s t a n d a r d private provision of p u b l i c good problem, w i t h free-riding a key c h a r a c t e r i s t i c . T h e worker benefits by d o n a t i n g 7  labour to a task about w h i c h she cares, however she w o u l d benefit s t i l l more if someone else L a b o u r donations i n this context refer to the circumstance where the worker contributes effort that is not fully compensated by the wage payments he receives. 7  74  were to undertake the d o n a t i o n for her. A first possibility of solving this p r o b l e m , identified by Francois (2000, 2003), is w h e n rents accrue to workers so that p a r t i c i p a t i o n constraints are not b i n d i n g . Such a s i t u a t i o n occurs i n the standard agency p r o b l e m w i t h private information. It also occurs w h e n firms use relational contracts to solve m o r a l h a z a r d problems. In that case, the firm implements an efficiency wage type of incentive structure that is able to b o t h overcome m o r a l h a z a r d i n p r o d u c t i o n as well as elicit labour donations. B y offering the worker a payment above opport u n i t y costs i n order to induce incentive compatible effort provision, workers' p a r t i c i p a t i o n is ensured a n d hence the free-riding p r o b l e m does not arise. T h i s way of overcoming the free-riding p r o b l e m applies whenever i n f o r m a t i o n a l rents i m p l y n o n - b i n d i n g p a r t i c i p a t i o n constraints; as often arise i n more standard agency problems w i t h heterogeneous types. A second way to overcome the free-riding p r o b l e m i n the labour donations game is explored i n Francois (2007). T h i s paper is concerned w i t h the p a r t i c i p a t i o n decision - not the incentive p r o b l e m - a n d so heterogeneity i n workers' evaluation of the p u b l i c g o o d is introduced. In particular, it is demonstrated that w h e n firms do not use performance-contingent compensation, a n d the possibility of workers' s h i r k i n g looms, those workers w i t h h i g h valuation of the p u b l i c g o o d may be m o t i v a t e d to donate labour effort to obviate the outcome where a low v a l u a t i o n type takes the j o b and shirks thereby adversely affecting output. Moreover, the elasticity of output w i t h respect to wages may be negative. T h i s result m a y be given a c r o w d i n g out of intrinsic m o t i v a t i o n interpretation: the use of monetary rewards contingent on performance accompanied by the use of direct supervision at the workplace may lead to c r o w d i n g out of labour donations. T h e logic of this argument is similar to the one made i n Engers and G a n s (1998), who also examine a purely altruistic setting where there are incentives to provide effort w h e n care for output is a central consideration. T h e outcome of interest i n their context is the quality of academic journals and their paper provides an e x p l a n a t i o n for w h y not p a y i n g referees may be editors' o p t i m a l response.  W h e n deciding whether to agree to review a  paper a referee compares the private cost that he w o u l d incur if he decided to referee the paper to the expected delay i m p o s e d o n the j o u r n a l i f he refused. W h i l e a d d i n g a monetary payoff w o u l d increase a referee's private gain from refereeing a paper it also reduces the cost of refusing because the monetary payoff w o u l d increase the acceptance rate. N o t e , however, that i n this setting the free-riding p r o b l e m is p a r t l y overcome by the editor sequentially soliciting referees' services whereas i n the context of labour markets workers usually a p p l y for positions voluntarily, so there is a n a d d i t i o n a l layer to the free-riding p r o b l e m . I n other words, i n labour markets the p o o l of applicants is endogenous, whereas i n the context of the refereeing process the p o o l of referees is fixed and the editor chooses sequentially a m o n g them. M a n y other papers have considered purely altruistic agents i n this context. G r o u t a n d  75  Schnedler (2006) extend the analysis i n Francois (2000) by i n t r o d u c i n g a t h i r d p a r t y - besides the worker and the manager - who has an interest i n the service being produced a n d who is w i l l i n g to contribute something (money or some other i n p u t ) t o w a r d its p r o v i s i o n . T h e y show that the worker's labour d o n a t i o n is sensitive to the other contributor's negot i a t i n g power a n d that this effect m a y be discontinuous - a slight increase i n power m a y crowd-out donated labour d r a m a t i c a l l y . T h i s suggests that i f the purchaser of the  final  service is for example a monopsonist, this m a y adversely affect the workers' willingness to donate labour as they recognize that were they to donate labour the monopsonist w o u l d adjust d o w n w a r d its own c o n t r i b u t i o n , i n a similar way as a for-profit employer adjusts i n Francois (2000). O t h e r papers that are concerned w i t h the role of firm c o m m i t m e n t i n i n d u c i n g donations are B i l o d e a u and S l i v i n s k i (1998) a n d G l a z e r (1998) - monetary donations i n the first case and labour donations i n the second. T h e first paper presents a multistage game i n w h i c h an entrepreneur first decides whether to set u p a for-profit or nonprofit firm i n order to produce a p u b l i c good and subsequently solicits v o l u n t a r y contributions by others.  It is  shown that by c o m m i t t i n g not to appropriate the funds donated by the community, the nonprofit entrepreneur attracts more contributions, a n d so the value of the p u b l i c good is enhanced. G l a z e r (2004) analyzes a setting i n w h i c h a good is p r o d u c e d using a technology that combines c a p i t a l p r o v i d e d b y an employer and a worker's labour effort.  Importantly,  the g o o d being p r o d u c e d is of intrinsic value for the worker. It is shown that if the employer can c o m m i t to a level of c a p i t a l and not adjust after observing worker's effort she can induce the worker to increase effort. T h i s result is given the interpretation that government provision of certain goods may be socially preferable because the p u b l i c sector is slower to react t h a n the private sector. T h e paper by R o w a t and Seabright (2006) is concerned w i t h a i d agencies and addresses the question of whether i n t r i n s i c a l l y m o t i v a t e d workers, w i l l i n g to take wage discounts i n order to contribute to a cause they care about, act as a signal to donors that their funds w i l l be devoted to the cause and not be appropriated.  In particular, the employment of  altruistic workers is viewed as a c o m m i t m e n t device against o p p o r t u n i s t i c behaviour by the managers of development agencies, because a m o t i v a t e d a i d worker w o u l d only accept a wage cut i f the o r g a n i z a t i o n were indeed u n d e r t a k i n g the promised a i d projects. Vlassopoulos (2006b) provides an e x p l a n a t i o n for the observation that nonprofit employers are uniquely able to attract volunteer workers who are b o t h i n t r i n s i c a l l y m o t i v a t e d and have career aspirations, and also accounts for the fact that nonprofits are concentrated i n mission-oriented sectors. T h a t paper shows that the choice of organizational form (for-profit or nonprofit) a n d sector (mission sector or non-mission sector) j o i n t l y i m p i n g e on the credibility of the promises that managers make w h e n i m p l i c i t l y contracting w i t h workers\volunteers. T o gain some i n t u i t i o n for this, consider the form that the relational  76  contract between employers and volunteers takes: a volunteer agrees to donate labour i n return for a promise of future compensation t h a t comes i n the form of p a i d employment - not necessarily at the employer where volunteering took place. So a firm t h a t wants to participate i n the volunteer-hiring structure has to c r e d i b l y c o m m i t to h a v i n g b o t h p a i d work and u n p a i d work positions a n d to fill p a i d work vacancies d r a w i n g from the p o o l of workers w i t h volunteer experience - m u c h like a c t u a l volunteering occurs i n the real w o r l d . Notice, that this structure induces a m o r a l h a z a r d p r o b l e m on the part of employers, as they have a n incentive to recruit u n p a i d workers, p r o m i s i n g t h e m p r o m o t i o n to p a i d positions, and then renege on the promise. T h e analysis suggests that whether nonprofit employers are at an advantage i n terms of being able to sustain volunteer h i r i n g hinges on the type of a c t i v i t y (mission-oriented or not) that is undertaken. I n particular, if volunteering enhances the q u a l i t y of the service provided and managers care about q u a l i t y - w h i c h c a n o n l y be true i n care-related activities, then nonprofit status is helpful i n solving employers' m o r a l hazard p r o b l e m . T h e i n t u i t i o n is that a nonprofit manager w i l l put relatively more weight on the fact that i f she cheats on volunteers q u a l i t y w i l l suffer and hence a smaller profit (reputational rent) is needed to m a i n t a i n incentive c o m p a t i b i l i t y . T h i s is true even t h o u g h the nonpeeuniary payoff a manager receives is the same regardless of firm type. Delfgaauw (2007) is a fascinating exploration of the i m p l i c a t i o n s of pure a l t r u i s m o n the delivery of m e d i c a l services. H e starts from the assumption that some physicians care to deliver m e d i c a l q u a l i t y p r o v i s i o n to patients. T h e y can choose between w o r k i n g i n the p u b l i c health p r o v i d i n g service, or private practice. I n private practice q u a l i t y can be contracted over and p a i d for. Patients differ i n their d e m a n d for quality, w i t h the rich, h a v i n g higher d e m a n d for quality, but due to quasi-concavity of preferences, lower v a l u a t i o n of m a r g i n a l increases i n quality. I n p u b l i c health provision, there is a lower level of q u a l i t y w h i c h must be provided, a n d for w h i c h physicians w i l l be p a i d . A n y e x t r a p r o v i s i o n of q u a l i t y above that is u n p a i d . T h e r e are two sorts of physicians - the pure altruists, w h o care about patient quality of service as well as their own income and effort, and purely selfish doctors who o n l y care about income and effort.  Since purely altruistic, the physicians care not just about  delivering services, but about what their efforts do to raise the level of provision above w h a t a patient w o u l d otherwise o b t a i n . I n general they w o u l d v o l u n t a r i l y provide more t h a n the non-altruistic physicians.  H e assumes that the number of places available i n the p u b l i c  service exceeds the number of altruistic physicians. Consequently, i n e q u i l i b r i u m , altruistic physicians correctly conjecture that i f they t u r n away a p u b l i c patient, or if they work i n the private sector, then one less patient w i l l receive the e x t r a treatment that a n altruist provides.  Consequently, the altruist's actions have i m p a c t , a n d this leads t h e m to want  to work i n the p u b l i c sector. T h i s ends up leading to selection of the altruistic physicians into the p u b l i c sector as well as the poor patients there. T h e richer ones select into the private sector and are treated by the doctors who o n l y care about money. Interestingly the  77  m i x e d e q u i l i b r i u m w i t h some p u b l i c a n d private provision P a r e t o dominates either a fully privatized or fully p u b l i c provision.  4.3  Implications for Government Provision  M a n y papers have explored i m p l i c a t i o n s for the o p t i m a l i n s t i t u t i o n a l arrangement for the provision of p u b l i c goods a n d services, w i t h o u t any reference to intrinsic m o t i v a t i o n . W e briefly survey that work h i g h l i g h t i n g its m a i n conclusions, a n d then contrast it w i t h the implications derived from the recent work emphasizing prosocial m o t i v a t i o n . M u c h of this recent work covers topics such as in-house government provision versus p r i v a t i z a t i o n or outsourcing, p u b l i c versus private ownership of p u b l i c goods, a n d comparative i n s t i t u t i o n a l analysis (for-profit vs. nonprofit, p u b l i c - p r i v a t e partnerships, corporate social responsibility).  4.3.1  Insights from Standard A g e n c y M o d e l s  A n a t u r a l point to start a n overview of this growing literature on these issues is the seminal paper by H a r t , Shleifer and V i s h n y (1997) (henceforth, H S V ) , w h i c h has spawned a lot of the recent research into this area. T h i s paper analyzes the relative merits of p r o v i d i n g a p u b l i c service in-house versus c o n t r a c t i n g out to the private sector, a d o p t i n g an incomplete contracts approach, following the earlier work by G r o s s m a n and H a r t (1986) and H a r t a n d M o o r e (1990) on the p r o p e r t y rights theory of the firm. T h e incomplete contracts framework seems appropriate i n the context of p u b l i c goods a n d services t h a t the government either produces or procures, since not a l l aspects of such services that a benevolent government m a y care about seem to be codifiable into a contract. In such an environment, the residual rights of control are c r u c i a l i n d e t e r m i n i n g agents' investment incentives, i n particular, their decisions to improve quality a n d reduce costs. T h e upshot of the analysis of the m o d e l is that private ownership leads to excessive investment i n cost r e d u c t i o n a n d insufficient i n vestment i n quality improvement, whereas, government provision leads to less t h a n efficient cost r e d u c t i o n and quality improvement. T h e i n t u i t i o n for this is that a private manager w i t h residuals rights has stronger incentives to reduce costs and improve quality, while a government employee faces weaker incentives as he benefits less from these improvements. T h u s , private provision is preferable the more i m p o r t a n t cost r e d u c t i o n is a n d the less i m p o r t a n t are the adverse effects on quality. O n the other hand, p u b l i c provision dominates w h e n q u a l i t y is a more i m p o r t a n t aspect t h a n cost considerations. T h i s insight is then used to guide a discussion of the w i s d o m of the p r i v a t i z a t i o n of various activities such as prisons, garbage collection, education and health. I n some cases, the authors are unequivocal about the superiority of the private sector (garbage collection, weapons procurement), or the government (foreign policy), whereas for a whole range of other activities (education,  78  healthcare) things are less clear-cut so they a d m i t that a more detailed cost-benefit analysis is required. H a r t (2003) uses the H S V framework to understand the benefits and costs of p u b l i c private partnerships ( P P P s ) , that have been widely used for p u b l i c service provision. T h e key characteristic of P P P s that this paper focuses o n is the b u n d l i n g of the b u i l d i n g a n d the r u n n i n g of the facility, as opposed to conventional procurement where the builder a n d the p a r t y who operates the facility are two separate entities.  T w o kinds of investment  can be undertaken b o t h of w h i c h reduce operating costs but only one of w h i c h generates social benefits.  T h e trade-off between u n b u n d l i n g a n d b u n d l i n g is the following:  under  u n b u n d l i n g , the builder does not undertake either type of investment, since he does not benefit from improvements that take effect at the operation stage.  I n contrast,  under  b u n d l i n g or P P P , the builder does some of the p r o d u c t i v e investment, a l t h o u g h s t i l l less t h a n the efficient level, but also more of the u n p r o d u c t i v e investment. T h e i m p l i c a t i o n of this is that b u n d l i n g of b u i l d i n g and management is preferable w h e n investment i n the p r o d u c t i v e component is a serious issue, or i n different terms, w h e n it is easier to w r i t e contracts on service provision t h a n on b u i l d i n g provision. T h e same question is also addressed by B e n n e t t a n d Iossa (2006) who extend the analysis i n H a r t (2003) assuming that there is renegotiation after investment decisions are sunk, so that ownership matters because it affects the disagreement payoffs of the parties and hence their shares of the surplus a n d investment incentives, and that there m a y be externalities, positive or negative, between the cost reducing activities undertaken at the b u i l d i n g stage and those at the a d m i n i s t r a t i o n stage.  N a t u r a l l y , w h e n there is a positive externality b u n d l i n g of the two activities is  preferred since it allows for the i n t e r n a l i z a t i o n of the externality. W i t h respect to ownership, B e n n e t t a n d Iossa (2006) find t h a t private ownership by a c o n s o r t i u m m a y or m a y not be o p t i m a l , for reasons similar to those identified i n H S V . In a related paper, B e n n e t t a n d Iossa (2005) s t u d y the desirability of for-profit versus nonprofit firms as contractors of p u b l i c services b o t h under P P P s a n d s t a n d a r d procurement. Besley and G h a t a k (2001) extend H S V into a setting where the service being p r o d u c e d has the features of a p u b l i c good. T h e i r analysis applies to the question of who s h o u l d be the owner of joint p u b l i c projects t h a t require investment contributions from b o t h the government and private organizations, such as N G O s .  T h e y show that ownership s h o u l d  reside w i t h the party that cares the most about the p u b l i c good, w h i c h is i n contrast w i t h the result i n H S V where the o p t i m a l ownership is d r i v e n by technological factors. Glaeser and Shleifer (2001) a p p l y the H S V framework to understand the entrepreneurial choice between setting up a p r o p r i e t a r y firm or a nonprofit organization. T h e approach is m o t i v a t e d by the c o n t r a c t u a l failures theory of H a n s m a n n (1980), who had earlier suggested that nonprofit organizations emerge as a remedy to i n f o r m a t i o n a l problems that pervade markets where q u a l i t y is h a r d to measure, so t h a t consumers are subject to producers'  79  m o r a l l y hazardous behaviour, as the c o m m i t m e n t not to pursue profits signals greater concern over quality.  In Glaeser and Shleifer's f o r m a l i z a t i o n of this idea, an entrepreneur  chooses organizational form (for-profit or nonprofit) to deliver a unit of quality is not contractible.  a good whose  B y choosing to incorporate as a nonprofit the entrepreneur's  incentives are blunted - because the n o n d i s t r i b u t i o n constraint permits only i n - k i n d cons u m p t i o n of residual earnings, m a k i n g those earnings less valuable to the entrepreneur t h a n they w o u l d be under for-profit status - and hence he commands a higher price i n the marketplace. T h u s , the trade-off associated w i t h the choice of organizational form is t h a t choosing to organize as nonprofit implies t h a t the entrepreneur can charge a higher price but on the other h a n d it gives h i m o n l y restricted access to the firm's profits. T h e m o d e l thus predicts that nonprofits w i l l dominate markets where the costs of m o n i t o r i n g q u a l i t y are high, w h i c h seems consistent, as nonprofits and governments are heavily involved i n the provision of services - and services are difficult to contract over. These models also predict government a n d nonprofit provision where consumers' taste for noncontractible q u a l i t y is high, so that the first effect w i l l dominate. T h u s , along the " C o n t r a c t i b i l i t y " dimension the predictions of contracting-based explanations do quite well as the figure below illustrates.  Location of Non-profits And Govt. Provision According to Contractual Failure Hypothesis  Low  Contractability  High  e-g. Services  F i g u r e 4.1: P r e d i c t i o n s of C o n t r a c t u a l Failure A p p r o a c h  80  B u t h a v i n g a firm w i t h o u t residual claimant is not the o n l y way to solve such problems. R e p u t a t i o n is an alternative mechanism t h a t c a n deter o p p o r t u n i s t i c behaviour that arises because quality is not-contractible. Vlassopoulos (2006a) asks the question of whether the predictions of the contractual failures hypothesis are robust i n a setting where firms a n d consumers interact repeatedly, i n order to s t u d y the effect of r e p u t a t i o n a l concerns.  The  analysis suggests that w h e n the manager can establish a credible r e p u t a t i o n for h i g h q u a l i t y then for-profit status is preferable for a l l levels of consumer sensitivity to quality, w h i c h may e x p l a i n w h y so m a n y fields that are subject to contractual difficulties (e.g. consulting, insurance, professional services etc.)  business  are d o m i n a t e d by for-profit firms w h i c h  have created and m a i n t a i n e d valuable reputations for h i g h q u a l i t y services. T h u s , this paper points to a p o t e n t i a l shortcoming of a r a t i o n a l i z a t i o n of nonprofit organizations based o n contractual failures i n the output market - it does not take into account the i n t e r a c t i o n between organizational form a n d reputations. O f independent  interest is the paper by A c e m o g l u et al.  (2006), w h i c h provides a  different, incentive-based perspective on the o p t i m a l a l l o c a t i o n of economic a c t i v i t y between markets, firms a n d governments. T h e y present a m u l t i t a s k career concerns m o d e l where a worker can choose two types of effort: one w h i c h is socially p r o d u c t i v e and one w h i c h is not. T h u s , i n this setting high-powered incentives have b o t h benefits and costs, and the relative i m p o r t a n c e of the two types of effort determines what is the o p t i m a l power of incentives a n d whether markets, firms or the government are the best way to organize the p r o d u c t i o n of a given activity. In particular, the analysis suggests that activities where p r o d u c t i v e effort is i m p o r t a n t should be left for market environments w h i c h breed high-powered incentives, whereas as the negative i m p a c t of the u n p r o d u c t i v e action becomes more severe, the a c t i v i t y should g r a d u a l l y shift t o w a r d firms, and the government, w h i c h entail progressively d u l l the power of incentives provided to workers. F i n a l l y , Besley and G h a t a k (2006) study the feasibility of corporate social responsibility ( C S R ) as a mechanism to deliver p u b l i c goods that are bundled w i t h p r o d u c t i o n of private goods - for example, fairtrade, i.e. goods that meet certain environmental or ethical standards. T h e economy consists of two sets of consumers: those who care about the p u b l i c g o o d a n d those who do not. I n the e q u i l i b r i u m characterized, consumers sort according to their preferences: the caring ones choose to patronage firms that promise to deliver a certain level of p u b l i c good alongside the private good - and pay a price p r e m i u m , while the non-caring ones purchase the private g o o d from firms p r o d u c i n g at m a r g i n a l cost. I n this framework, firms serving the caring consumers are interpreted as exercising C S R . T h e analysis then suggests that C S R can sustain a level of p u b l i c good p r o v i s i o n t h a t is equivalent to the private contributions game. Moreover, c o m p a r i n g p u b l i c good provision delivered t h r o u g h this mechanism w i t h that p r o v i d e d by nonprofit organizations reveals that C S R m a y be superior i n activities where the p u b l i c good is technologically b u n d l e d w i t h the p r o d u c t i o n  81  of a private good, but not more generally.  4.3.2  Contrasting Implications from Prosocial M o t i v a t i o n  Approaches  T h e c o n t r a c t i b i l i t y of output, w h i c h , we argued above, plays a key role i n the more s t a n d a r d agency based approaches to the issue of government provision, is not of direct i m p o r t a n c e i n the literature t h a t has emphasized prosocial motivations. T o be sure, n o n - c o n t r a c t i b i l i t y does p l a y some role, but it is not over output as m u c h as it is over agents' actions. Specifically, i f it is the case that a worker w i l l only contribute effort to a service when they are sure that their efforts d i r e c t l y i m p a c t t h a t service, then the worker effectively wants a guarantee that some other actions w h i c h the principle controls w i l l not be adjusted downwards i n the light of her e x t r a contributions. T h i s sort of guarantee w i l l be impossible for the p r i n c i p l e to provide whenever it is not possible to contract over inputs directly. B u t difficulty i n contracting over inputs is likely to be ubiquitous i n most p r o d u c t i o n processes, and so does not suggest where nonprofit or government provision should dominate. In understanding the d i s t i n c t i o n between explanations based o n prosocial m o t i v a t i o n a n d those based on t r a d i t i o n a l agency theory, it is useful to consider the differences suggested by the theories. A s explained above, t r a d i t i o n a l agency theory suggests that nonprofits a n d governments should have an advantage i n areas where output is difficult to contract over. It is the case that these organizations t y p i c a l l y provide services, w h i c h are difficult to contract over. However, there are m a n y services where provision is entirely by private firms: for example, management consultancy, cleaning, accounting, m a r k e t i n g . P r i v a t e firms a n d markets are somehow able to adequately provide these.  A n d , as V l a s s o p o u l o s (2006a) has argued,  there is no reason that s t a n d a r d r e p u t a t i o n based solutions cannot allow for-profit firms to dominate these sectors.  So, s t a n d a r d agency based explanations based on the non-  c o n t r a c t i b i l i t y of output have trouble explaining w h y n o n - c o n t r a c t i b i l i t y c a n be overcome for some services but not for those p r o v i d e d b y governments a n d nonprofits. Secondly, when one considers the types of services t h a t nonprofits do provide, a definite p a t t e r n emerges. Nonprofit firms are heavily over-represented i n sectors where t h i r d parties are likely to have some interest or concern over the q u a l i t y of service provided. C h i l d c a r e , for example, is t y p i c a l l y a t r a n s a c t i o n between childcare provider a n d parent, but even disinterested t h i r d parties who do not have direct acquaintance w i t h the child, m a y have a civic m i n d e d interest i n seeing that the care is p r o p e r l y provided. It is unlikely t h a t t h i r d parties w i l l take a similar interest i n the provision of services that are t y p i c a l l y transacted between firms a n d private providers — like, for example, management consultancy. T h i s reasoning suggests that there is another i m p o r t a n t dimension along w h i c h there seems to be a m a r k e d separation between for-profit firms on one h a n d a n d government and nonprofit providers on the other: the "care" dimension, that is, the degree to w h i c h  82  the provision of the service is associated w i t h external benefits to non-purchasers (workers, managers, donors, c o m m u n i t y ) .  A t the low-care end we find services such as business  consultancy, w h i c h do not generate external rewards to non-recipients of the service. A t the high-care end we find social and personal services such as c h i l d care, w h i c h do. W i t h respect to the "care" dimension then, the contractual failure approach does less well. N o n p r o f i t firms and the goverment seem to be concentrated at the high-care end while for-profit firms dominate the low-care end, a fact w h i c h this theory cannot e x p l a i n .  High e.g. Health, Childcare, aged care  Location of Non-profits And Govt. Provision  Care Related  Low e-gAccounting, consulting, managerial  According to Contractual Failure Hypothesis  Low e.g. Services  Contractability  High  F i g u r e 4.2: A d d i n g " C a r e " D i m e n s i o n  O n the contrary, the predictions of prosocial m o t i v a t i o n approaches seem to do better along this dimension, since they emphasize the care of a not d i r e c t l y concerned p a r t i c i p a n t , i.e., the provider, who w i l l most generally be a nonprofit or government employee, a n d therefore predict that governments and nonprofits should be over-represented i n care-based sectors, as the figure below illustrates.  4.3.3  Empirical Evidence  T h e r e is a relatively large b o d y of literature o n P u b l i c Service M o t i v a t i o n - its prevalence and effect - i n the p u b l i c sector. T h e first study emphasizing this seems to be P e r r y and W i s e (1990), and a number of authors have tested the i m p l i c a t i o n s of such a m o t i v a t i o n for performance i n the p u b l i c sector, see for example A l o n s o and Lewis (2001) a n d the references therein. M u r n i g h a n and K i m (1993) for a specific focus on non-economic factors m o t i v a t i n g 83  High e.g. Health, Childcare, aged care  Location of N P O and Govt. Provision according to labour donations hypothesis  Care Related  Low e-gAccounting, consulting, managerial  Low e-gServices  Contractability  High  F i g u r e 4.3: P r e d i c t i o n s of P r o s o c i a l M o t i v a t i o n A p p r o a c h e s  people to volunteer, and M e n c h i k and W e i s b r o d (1987) for an early economic analysis of v o l u n t a r i s m .  Segal and W e i s b r o d (2002) provide a recent investigation of volunteer  contributions a n d their v a r i a t i o n w i t h observable i n d i v i d u a l characteristics. Some suggestive evidence of the higher civic-mindness of nonprofit employees can be found i n R o t o l o and W i l s o n (2004). U s i n g d a t a from the C u r r e n t P o p u l a t i o n Survey, they report significant differences i n workers' propensity to undertake volunteer w o r k across sectors, w i t h workers i n the private sector being less likely to volunteer, and those who do volunteer contribute less hours t h a n workers i n the nonprofit sector and the government. M i r v i s a n d Hackett (1983), a n a l y z i n g the U S Q u a l i t y of E m p l o y m e n t Survey find that nonprofit workers report higher levels of intrinsic m o t i v a t i o n , feelings of accomplishment, and i m p o r t a n c e of work relative to money i n their occupations. A l s o , a B r o o k i n g s I n s t i t u t i o n Survey of over 1200 childcare, c h i l d welfare, y o u t h services, juvenile justice, a n d employment a n d t r a i n i n g workers found that the surveyed workers report that they took the work because they are d r i v e n by the desire to help the people i n need and serve the community, t h o u g h they are not satisfied w i t h the monetary rewards.  8  T h e r e is also some e m p i r i c a l evidence i n support of the idea that workers i n nonprofit firms should be w i l l i n g to donate effort while their for-profit counterparts should not. M o c a n and T e k i n (2000) provide a direct test of the labour donations hypothesis. U s i n g a n 8  See Table 4, pg 17 in Light (2003).  84  unusually detailed w o r k e r / f i r m m a t c h e d d a t a set for the U S childcare sector and controlling for the endogenous selection into sectors, found a significant nonprofit wage p r e m i u m . Workers were asked what the m a i n reason to choose employment i n child care was. O n e of the options was "this is a n i m p o r t a n t j o b t h a t someone needs to do", w h i c h is an i n d i c a t o r of the intrinsic value the worker derives from w o r k i n g i n the sector. T o be consistent w i t h labour donations workers who chose this o p t i o n s h o u l d receive lower wages. T h e authors report that this variable h a d a significant d o w n w a r d effect on wages i f w o r k i n g for a nonprofit firm. In contrast, workers i n for-profit firms who chose this o p t i o n h a d either no, or a positive wage p r e m i u m , suggesting no l a b o u r donations. T h e r e is also some evidence that incentives i n nonprofit organizations and the government are weak relative to those i n the private sector a n d that i n sectors where for-profit a n d nonprofit establishments co-exist the former tend to use more performance related compensation. Burgess and Metcalfe (1999) using B r i t i s h cross-sectional establishment d a t a from 1990 find that establishments i n the p u b l i c sector are less likely to operate an incentive scheme t h a n comparable ones i n the private sector, a n d that this difference arises o n l y amongst non-manual workers (workers more likely to be involved i n discretionary practices). R o o m k i n and W e i s b r o d (1999) find greater use of performance related compensation i n for-profit t h a n nonprofit hospitals amongst top managerial positions. F i n a l l y , D e V a r o a n d B r o o k s h i r e (2007) using a U S cross-sectional employer telephone survey (1992-1995) find evidence that, relative to for-profit employers, nonprofit employers are less likely to use p r o m o t i o n as incentive device, that promotions are less likely to be based on merit and j o b performance, and that nonprofits are less likely to use incentive c o n t r a c t i n g - output contingent payment or bonuses. These differences are most pronounced amongst the high skilled workers who are most likely to have significant effects on firms' missions.  4.4  Conclusions  T h i s survey has argued that prosocial m o t i v a t i o n has effects on the delivery of p u b l i c services. A slight difference i n the way the m o t i v a t i o n is modelled, whether as impurely, or purely altruistic, has large i m p l i c a t i o n s for service delivery. M o s t of the literature has m o d elled a type of i m p u r e a l t r u i s m w h i c h is action, not output, oriented. W h e n this is present, workers w i l l work for less t h a n otherwise, and w h e n workers have m u l t i p l e tasks, the presence of such motivations can make it better for firms to use low powered incentives. T h e r e are no i m p l i c a t i o n s for the type of o r g a n i z a t i o n that should be delivering the service. W h e n workers are m o t i v a t e d by pure a l t r u i s m , or direct output considerations, things are very different. T h e m a i n i m p l i c a t i o n is that it m a y be better to have the a c t u a l service delivery undertaken by a n o r g a n i z a t i o n that does not have a residual claimant.  A  government bureaucracy, or a nonprofit firm, can have a distinct advantage i n delivering  85  the service. Such an o r g a n i z a t i o n m a y be uniquely placed to o b t a i n donations of l a b o u r effort from output oriented employees because these employees w i l l not fear that their effort donations are expropriated by a residual c l a i m a n t . T h i s literature w o u l d seem p a r t i c u l a r l y i m p o r t a n t i n informing governments as to presently p o o r l y u n d e r s t o o d benefits of service provision b y governments in-house. I n m a n y countries, governments have moved away from their t r a d i t i o n a l l y direct role of providers of p u b l i c a n d socially meritorious services, to purchasing them. Some have suggested h a n d i n g over, en masse, bureaucratic service provision to contractors from the private sector i n a wide variety of sectors.  T h i s is for the well k n o w n incentive reasons t h a t such contractors have  as residual claimants. T h e present survey argues t h a t the government as a provider m a y still have an i m p o r t a n t role. T h i s w i l l be especially the case where the choice is between government bureaucratic provision a n d for-profit firms, i.e., where nonprofit firms are not able to play a part. B u t we are far from a good understanding of the e m p i r i c a l significance of these considerations. A s this survey has argued, subtle differences i n the w a y that prosocial m o t i v a t i o n arises c a n have profound i m p l i c a t i o n s for who should be p r o v i d i n g social services. D a t a are needed to d i r e c t l y test this. A t a theoretical level, the difference between government a n d nonprofits as providers of services is not well understood. T h e present survey has treated t h e m m u c h the same, as b o t h do not have residual claimants but there are clearly other differences w h i c h need to be better understood. O n e difference has to do w i t h preference heterogeneity. G o v e r n m e n t bureaucrats answer to elected politicians so they might take actions that appeal to voters, whereas the managers of nonprofit firms are appointed by the c o m m u n i t y so they might have more flexibility i n choosing the "mission" a n d p r o v i d i n g services tailored to the needs of the local c o m m u n i t y . If workers are also h o r i z o n t a l l y heterogeneous i n terms of their prosocial m o t i v a t i o n then there m a y also be p r o d u c t i v i t y gains from better m a t c h i n g i n nonprofits (a l a Besley a n d G h a t a k 2005) rather t h a n t h r o u g h a m o n o l i t h i c p u b l i c service.  There  may also be differences that are due to p o l i t i c a l economy a n d accountability. F o r instance, nonprofit managers m a y have more o p p o r t u n i t y to evade the n o n d i s t r i b u t i o n constraint t h a n do government bureaucrats. 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K o n i n g (2006):  " T e a m Incentives i n P u b l i c  Organisations: A n E x p e r i m e n t a l Study," C P B D i s c u s s i o n P a p e r s 60, C P B Netherlands B u r e a u for E c o n o m i c P o l i c y A n a l y s i s . [68] W i l s o n , J . (1989): Bureaucracy:  What Government  Basic Books, New York. 91  Agencies  Do and Why they Do it,  Chapter 5  Concluding Remarks T h e question of how to design effective provision of p u b l i c services, because of their significant i m p a c t on the q u a l i t y of life, is a key issue i n economic policy. T h i s thesis takes a few steps towards a better understanding of what i n s t i t u t i o n a l arrangements have a c o m p a r a tive advantage i n the provision of these services. O u r s t a r t i n g point is the r e a l i z a t i o n t h a t recent years have witnessed an expansion i n the involvement of the private nonprofit sector i n the delivery of p u b l i c services, i n b o t h advanced a n d developing countries. I n p a r t i c u l a r , nonprofit organizations are p l a y i n g an i m p o r t a n t role i n delivering p u b l i c services - often i n partnership w i t h the government - i n developed countries, whereas i n the developing w o r l d the recent t r e n d is for the state to delegate a large responsibility of c a r r y i n g out social a n d development projects to non-governmental organizations ( N G O s ) . Despite these developments, the economics literature has not devoted enough attention i n identifying the relevant tradeoffs associated w i t h delegating responsibility for the delivery of p u b l i c services to alternative private providers (for-profit, nonprofit), and this thesis attempts to make a c o n t r i b u t i o n towards this end. T h e approach i n the first two substantive chapters is p r i m a r i l y positive: we are concerned w i t h the fundamental question of what are the economic mechanisms that lead to the emergence of nonprofit firms and the a i m is to identify conditions under w h i c h this organizational form is more likely to prevail.  These chapters share a c o m m o n perspec-  tive: the choice of organizational form is made by r a t i o n a l entrepreneurs who take into account the benefits and costs associated w i t h this choice. C h a p t e r 2, investigates whether entrepreneurs choose nonprofit status as a c o m m i t m e n t device i n those markets that are characterized by c o n t r a c t u a l failures i n the p r o d u c e r \ c o n s u m e r relationship, a hypothesis w h i c h has been rather influential i n the economics literature. T h e answer t h a t emerges from the analysis i n that chapter is that w h e n a r e p u t a t i o n for honest behaviour can be sustained then nonprofit status is not necessary nor o p t i m a l , w h i c h suggests that explanations based on contractual failures i n the p r o d u c t market have less e x p l a n a t o r y power t h a n previously  92  thought. In chapter 3, the nonprofit c o m m i t m e n t was shown to be valuable i n terms of g i v i n g those entrepreneurs who choose this form unique access to the p o o l of volunteer labour. Importantly, this c o m m i t m e n t was shown to be effective o n l y i n sectors p r o d u c i n g goods a n d services that entrepreneurs consider meritorious. T h u s , this chapter provides a theory that is able to simultaneously e x p l a i n two key features of the nonprofit sector:  the  reliance on volunteers, and the focus i n the delivery of care-related activities. A l s o , this chapter highlighted the welfare gains that are achieved w h e n nonprofit organizations use a h i r i n g structure w h i c h allows t h e m to hire volunteers a n d subsequently sort t h e m into p a i d positions across firms i n the sector, based on their mission preferences. T h o u g h the models developed i n these two chapters are too simple a n d abstract to provide detailed policy recommendations, they could cast some light o n the ongoing p o l i c y debate as to whether the government should subsidize only nonprofit providers i n m i x e d sectors, such as child care. I n light of chapter 2, the effectiveness of subsidy policies that discriminate against for-profit providers, on the basis that they are untrustworthy to provide h i g h q u a l i t y care, seems questionable. T h e m o d e l considered there demonstrates that reputations can provide enough incentives for p r o f i t - m a x i m i z i n g entrepreneurs to offer h i g h quality services when the p l a y i n g field is leveled. T h e r e m a y be a number of good reasons w h y governments should subsidize nonprofits but our analysis suggests that, i n m a n y sectors, overcoming contractual failures is not one of t h e m .  O n the other h a n d , chapter  3 points to the desirability of s u b s i d i z i n g volunteer h i r i n g nonprofits, as a mechanism to enhance employment a n d service provision.  I n future work, the framework developed i n  this chapter could be used to investigate i n greater detail what tax-subsidy policy w o u l d improve employment and welfare. A n o t h e r theme of this thesis is t h a t understanding the workings of p u b l i c goods producing organizations requires the recognition that the broader group of stakeholders involved - donors, workers, volunteers, managers - are not s t r i c t l y self-interested, but m a y have other-regarding preferences. R e c o g n i z i n g this possibility, opens the door to a whole range of interesting issues regarding the selection of i n t r i n s i c a l l y m o t i v a t e d managers a n d workers and of the provision of incentives i n organizations e m p l o y i n g a l t r u i s t i c agents t h a t are surveyed i n chapter 4 of this thesis. I n p a r t i c u l a r , the m a i n message of this chapter is t h a t prosociality of employees has i m p o r t a n t i m p l i c a t i o n s for the delivery of p u b l i c services, as it not only affects the structure of o p t i m a l incentives but it also provides an efficiency rationale for w h y p u b l i c service delivery should be undertaken by organizations that do not have a residual claimant - a government bureaucracy or a non-profit firm - b y v i r t u e of their unique a b i l i t y to harness workers' i n t r i n s i c a l l y m o t i v a t e d efforts. C r u c i a l l y , this last i m p l i c a t i o n is shown to hinge on a subtle d i s t i n c t i o n i n the source of prosocial m o t i v a t i o n whether it is a c t i o n or output-oriented. T h e more systematic collection of micro-based d a t a  93  on organizations delivering p u b l i c services w i l l be very valuable i n d e r i v i n g further insights as to the relative roles of the alternative views of prosocial m o t i v a t i o n . M u c h more remains to be done i n developing theoretical a n d e m p i r i c a l i m p l i c a t i o n s of alternative i n s t i t u t i o n a l arrangements for the p r o v i s i o n of p u b l i c goods a n d services. F o r instance, this thesis has d r a w n a strict line between for-profits and nonprofits, whereas i n reality this d i c h o t o m y is becoming less stark as h y b r i d organizations that combine resources from the two sectors are engaging i n mission-related activities. T h e potential merits a n d pitfalls of these partnerships have not been scrutinized yet. A l s o , there are various issues of p o l i t i c a l economy and accountability that this thesis has not touched, w h i c h are i m p o r t a n t i n understanding the nature of the interaction between the government a n d nonprofit organizations. F i n a l l y , it remains to be seen whether and how a d d i t i o n a l behavioural elements, such as concerns w i t h fairness and identity, w h i c h are being integrated into economic analysis, w i l l interact w i t h the issue of organizational form, w h i c h has been the focus of this thesis. W e regard a l l of these areas as i m p o r t a n t ones for future research.  94  Appendix A  Omitted Proofs: Chapter 2 P r o o f of L e m m a 1: F i r s t we establish that Uj(0) U (q*(0))  =S(z-  U (q* (0))  iff z - c(q ) - b(q-  n  n  n  c(g*(0))) - b(q-  > C/ (g*(0)). T o see this, note t h a t n  q*(0)), while Uf(0) = z - c(q ) - b(qf  qj) > 5 (z - c(g*(0))) - b(q-  f  q* (0)) ^  q° ), so U}(0) > f  bqj - c(q ) + (1 -  n  f  5)z > bq*(0) - c(q*(0)). T h e last inequality is true because bqj — c(q ) > bq*(0) — c(g*(0)) s  f  since:  i^qj = argmax[bq — c(q)]|  Uf(m*) = U°{m*),  . A l s o , C/ (g*(m*)) > Uj(m*). n  T o see this, recall t h a t  a n d that <7 (<?;(m)) > U*(m) V m 6 [0,m]. N o t e that n  - f  d P  (  m , ) )  =-i(?-tf(m))  w h i c h implies that ^ , ( < ( m - ) ) | dm and that  0  <  t  d £/ (C(™*)) dm  =  <  n  2  n  |  t  dq*(m)  5  >  Q  dm  2  that is, C/ (g*(m)) is continuous, a n d U - s h a p e d (it is decreasing, for m such that q^Jjn) < q, n  a n d increasing for m such t h a t q* (m) > q) a n d Uj(m) is continuous, s t r i c t l y decreasing a n d n  linear for m G [0,m], there exists a unique m € (0,m*) such t h a t U (q*(m)) n  therefore U (q^(m)) n  is = Uj(m)  = Uj(m),  and  for m = m .  P r o o f of L e m m a 2: W e want to show t h a t Uf(q*j{m)) > C/ (g*(m)) , or equivalently t h a t n  z-m{q-q* (m))-c(qj(m))-b(q-q* (m)) f  f  > <J(z - m ( § " - g * ( m ) ) -  c(q*{m)))-b(q-q^(m)) (A.l)  95  T o show that (A.l) z - m(q-  holds note that  q}(m)) - c(q}(m)) - b{q- q}(m)) > z - m(q-  g*(m)) - c(q*(m)) - b(q-  q*(m))  since q*j T (O)  = arg max[(6 + m)q — c(q)\  w h i c h implies that z-m(q-q* (m))-c(q}(m))-b(q-q* (m)) f  for  > 6 (z - m(q - q*{m)) -  f  c(q^(m)))-b(q~ql(m)  5 G (0,1), w h i c h establishes (-4.1).  P r o o f of L e m m a 3: F i r s t note that when c(q) — \ q t h e m a r g i n a l cost is c'(q) = q, l  w h i c h implies that qj — b a n d  =  while c(qj)  = \b  s u b s t i t u t i o n into (2.6) a n d (2.10) implies that qj(m) c(q* (m)) = ±(6 f  +TO)  2  a n d c{q* (m)) = ±(\(b + n  a n d c(q^) — \{jb) .  2  Also,  2  — b + m a n d q £ ( r a ) — \{b + Sm), so  5m)) . 2  W e show part (i) by inserting the values for  qj,q^,c(qj),c(q^),q^(m),q^(m),c(qj(m))  a n d c(g*(m)) into (2.16) a n d (2.17), a n d simplifying to obtain: \ 8Am)  ' J\  = { > 1  m /2 2  T — ^ (l-6)(z-£-qm)+m*  if 0<m<m* . * . . _ if m <m < m  ,  (A.2) '  v  f  and 5m /2 2  72 r -(l-*)^-|j-5-mj+6m2 ^  i  7  0 (m)={ n  if n  m < m < m* ±n ^ in ^ in  if  m*  <TO< TO  (  A - 3  j  w h i c h establishes part (i) of the lemma. For part (ii), it is useful to first compute m*. F r o m (2.4), we have (1 - S)z - (c(g ) - 5c(q° ))  - b(q -  s  f  m  s  (l-5)q-q  n  n  qj)  + 5q^  s f  {l-8)z-(\b -5\(\b?)-b{)b-b)  z - g  2  (l-5)q-b  =  + 5]b  q  W e need to show that first, for m G (0, m*), 8 (m)  > Bf(m),  n  8m /2 2  — (1 — 5)  (z  —  T | —  >  1  -  qm j + dm  96  or equivalently that z- b  TO  <  —  ^  = m*  (A.4)  so the inequality holds. Second, we want to show t h a t for m G ( m * , m ) , j3f(m) >  (3 (m), n  or equivalently t h a t m /2  1  2  2<  26  O m >  (1 - 5) (z - ^ - qm)  (A.5)  m  + m  z  so the second inequality is also established. For part (hi), differentiating f3 (m) w i t h respect to m yields: n  8m  dPn( ) dm m  - ( 1 - 5) (z - & - qm)  + 5m  - \5m  2  (25m + q(l -  2  -(1 - <5) (z - g - g m ) + 5m  2  5))  2  i m p l y i n g that d(3 (m n  dm  |  0  5m  -(1-5) 6 J  m = 2  Z  So for m G (0, m*),  d 0  g^  ^z - ^  - qm ) +  5m  -5m  2  2  (25rn + q{l-5))  =Q  2  2m*  5  < 0, that is, f3 (m) is decreasing. n  For part (iv), differentiating (3f(m) w i t h respect to m:  dj3 (m)  m  f  (1  —  5)  dm  (z  — g - qm) + m (1 - 5) ( j  2d  k  2  gm) +  2  (2m - q(l -  5))  m  z  i m p l y i n g that b  2  —J. dm  so Pf(m)  >  0 4* m  &  m = 2[  [1 — 5) I z (  z- — ^  — —  2o  —  qm \ + m  2  - ^m  2  (25m + q(l - 5)) = 0  h  2m*  is flat i n (0, m*) increasing i n ( m * , 2 m * ) , and decreasing i n (2m*, m ) , w h i c h  implies that it reaches a m a x i m u m at 2m*.  97  Appendix B  Equilibrium Strategies Supporting the Relational Contracts in Chapter 3 B.l  Information Sets  W e let hf(t)  denote worker i's p u b l i c history up to t i m e t, w i t h hf(t)  has not been involved i n a separation due to cheating, a n d hf(t) a manager j's  p u b l i c history is denoted hj ^),  — 1 i f the worker  = 0, otherwise. Similarly,  w i t h h™(t) = 1 i f the manager has not  1  been involved i n a separation due to cheating, and h™{t) — 0, otherwise.  W e let  qi{t)  denote worker i's effort c o n t r i b u t i o n up to t i m e t, w i t h  = 1 i f the worker has delivered  promised effort and  denote whether manager j has  = 0, otherwise. A l s o , we let fj(t)  honoured a l l previous promises made to workers, w i t h fj(t)  — 1 i f she has a n d fj(t)  — 0  otherwise. Furthermore, if worker i has p r o v i d e d promised effort when w o r k i n g for j or has shirked but has not been caught (an event w h i c h occurs w i t h p r o b a b i l i t y 1—/z) then we let qij(t) = 1, whereas if the worker has been caught s h i r k i n g (an event w h i c h occurs w i t h p r o b a b i l i t y /x) it is qij(t) = 0. Similarly, let fij(t)  denote whether manager j has honoured a l l previous  promises made to worker i, w i t h fij(t)  = 1 i f a l l promises were honoured a n d fij(t)  — 0,  otherwise. Agents k n o w a l l previous wage payments made since this is verifiable information. W e let H(t)  = {wo,w\, ...Wt-i}  denote the history of wage payments made up to time t.  Let W denote the set of a l l workers a n d M. the set of a l l managers, then worker i's information set i n p e r i o d t, is given by the collection of the p u b l i c histories of a l l workers and managers up to t i m e t — 1, h (t w  — 1)U h (t M  — 1) U H(t — 1), as well as the private  information he has from his o w n employment history qi{t — 1) a n d his interactions w i t h  98  employers  U fij(t — 1), where Mi  is the set of managers for w h o m worker i has worked.  jeMi  Similarly, manager j's  i n f o r m a t i o n set i n p e r i o d t comprises the collection of the p u b l i c  histories of a l l workers and managers up to t i m e t — 1, h (t w  — 1 ) U h (t M  — 1)U H(t — 1), as  well as the private i n f o r m a t i o n she has from her o w n history as employer fj(t  — 1) a n d her  U quit — 1), where W,- is the set of workers that manager j  interactions w i t h her workers has employed.  B.2  Strategy Space  Strategies consist of rules that specify a worker's and a manager's set of actions at each information set and t i m e t. • Worker:  A strategy <J {t) for the worker specifies two sorts of actions. w  F i r s t , it  specifies whether to accept an employment offer (volunteering or internship) from every manager.  A n offer consists of an u n p a i d p o s i t i o n along w i t h a promise of  p r o m o t i o n to a wage p o s i t i o n ( w i t h i n the organization i n the case of a n internship, i n a n organization of m a t c h i n g type i n the case of volunteering), when a vacancy is created, as well as a wage offer (w). I n the second stage, for a worker who has accepted the offer from a given employer, a n d is either i n the u n p a i d or the p a i d position, the strategy specifies whether to provide h i g h effort (qi = 1) or not (qi — 0) and whether to continue i n the employment relationship or quit. • Manager:  A strategy a (t) m  for a manager specifies the following set of actions.  F i r s t l y , it specifies what type of employment offer to make to workers: volunteering or internship, a n d the accompanying wages. Secondly, i f a volunteering structure is implemented, it specifies whether to honour the promise to promote a worker from the p o o l of volunteers when a p a i d p o s i t i o n opening has occurred (fj = 1) or to renege on the promise (fj = 0) by filling the vacancy w i t h an intern hired from the general pool. F i n a l l y , it specifies whether to continue a n employment relationship or not.  B.3  Equilibrium Strategies Supporting the Volunteering Structure  In what follows we describe the actions that the e q u i l i b r i u m strategies (a* (t), w  a* (t) j m  s u p p o r t i n g the volunteering structure prescribe i n every possible i n f o r m a t i o n set. W o r k e r ' s strategy  a* (t): w  1. If manager j's incentive c o m p a t i b i l i t y constraint, as defined i n (3.11), is satisfied, and h™(t — l) = 1 a n d hf(t  — 1) = 1, a n d qi(t — l)fij(t 99  — l) — 1, then accept a volunteering  position p r o m i s i n g p r o m o t i o n t o a wage p o s i t i o n of w , v  (ICV), a n d set  satisfying  qij — 1. Otherwise, do not accept a volunteering position. If the worker is already i n — 1) = 1 a n d hf(t — 1) = 1, a n d  a p a i d position then accept any wage offer. If  qi(t  —  l)fij(t — 1) = 1, a n d the up-front wage w satisfies (ICV), then set q^ — 1, v  otherwise set q^ — 0.  hf(t — 1) = 1, a n d qi(t — l)fij(t — 1) = 1, then accept a n internship p o s i t i o n i n organization j p r o m i s i n g a wage of w , satisfying (ICI), a n d set q^ — 1. Otherwise,  2. If  1  do not accept a n internship position. If the worker is already i n a p a i d p o s i t i o n t h e n accept any wage offer. If hf(t — 1) = 1, a n d  qi(t — l)fij(t — 1) = 1, a n d the up-front wage offer w satisfies (ICI), then set qij — 1, otherwise set qij = 0. 1  3. T e r m i n a t e a relationship w i t h a manager i f promised p r o m o t i o n or promised wage offer have not been met.  M a n a g e r ' s strategy  a* (t): m  1. If the manager's incentive c o m p a t i b i l i t y constraint (3.11) is satisfied, a n d /i™(£—1) = 1  and hf(t — 1) = 1, and qij(t — l)fj(t — 1) = 1, then: a) Offer worker i a volunteering position, b) H o n o u r the promise t o promote a worker i from the volunteer p o o l into a p a i d p o s i t i o n (fj — 1) whether i has volunteered for j or not, when there is a p a i d work vacancy,  c) If a worker i is a n existing p a i d worker w i t h /i™(£ — 1) = 1 a n d  hf(t — 1) = 1, a n d qi(t — l)fij(t — 1) = 1, who has received previous payment of w > w , make h i m an up-front wage offer of w satisfying (ICV). v  v  2. If the manager's incentive c o m p a t i b i l i t y constraint (3.11) is satisfied, a n d  hj ^—!) = 0 1  a n d hf(t — 1) = 1, and qij(t — l)fj(t — 1) — 1, then: a) Offer worker i a n internship position,  b) H o n o u r the promise t o promote a worker i w h o has interned for y o u  into a p a i d p o s i t i o n (fj — 1), when there is a p a i d work vacancy, c) If a worker i is an existing p a i d worker w i t h a n internship history w i t h y o u a n d hj ^ 1  — 1) = 1 a n d  hf(t — 1) = 1, a n d qij(t — l)fj(t — 1) = 1, then make h i m an up-front wage offer of w. 1  3. If (3.11) is satisfied, a n d hf(t - 1) = 1, hf(t - 1) = 1 a n d q^t - l)fj(t - 1) = 0, t h e n make no offer to worker i. 4. If (3.11) is satisfied, a n d hf(t  - 1) = 1 a n d hf(t - 1) = 0, then make no offer to  worker i. 5. If (3.11) is violated, a n d then:  hf(t - 1) = 0, hf(t - 1) = 1 a n d qij(t - l)fj(t - 1) = 1,  a) Offer worker i a n internship position b) H o n o u r the promise to promote 100  worker i into a p a i d p o s i t i o n (fj  = 1), w h e n there is a p a i d w o r k vacancy,  c) If  worker i is a n existing p a i d worker w i t h a n internship history and hf (t — 1) = 1, and qij(t — \)fj(t  — 1) = 1, then make worker i a wage offer of  6. If (3.11) is violated, and either hf(t-l)  = 0, or hf(t-l)  w. 1  = 1, or q^t-l)fj(t-1)  = 1  does not h o l d , then make no offer to worker i. T h e above strategies induce a perfect e q u i l i b r i u m of the repeated game, i n w h i c h m a n agers choose to set up a volunteering structure. Workers accept volunteering positions w i t h a promise of p r o m o t i o n to a p a i d p o s i t i o n p a y i n g w  v  and choose not to shirk, while managers  honour their promises to promote only workers w i t h volunteering experience and rehire workers who have provided the promised effort.  N o t e t h a t the above strategies describe  behavior b o t h on and off the e q u i l i b r i u m p a t h , for instance, after one of the parties reneges on a promise. T o see this, note that under the e q u i l i b r i u m strategy o-* (t) a manager who m  has cheated on a promise to promote volunteers and has therefore lost reputation, w i l l continue to exploit future volunteers, a n d this w o u l d be a best response to workers' e q u i l i b r i u m strategy er* (t) of not accepting volunteer positions i n organizations w i t h stained reputaw  tions. I n t u r n , a worker's best response facing a manager who has lost r e p u t a t i o n is to o n l y accept internship positions p a y i n g w  1  prescribes.  > w , w h i c h is what the e q u i l i b r i u m strategy cr*™(£) v  A l s o , this is the best the manager c a n do since under <J* (t) workers offered w  a lower up-front wage w i l l shirk. O r suppose t h a t a worker shirks. T h e n the e q u i l i b r i u m strategy of the manager states that the worker should not be hired again. T h i s is o p t i m a l given that the worker's e q u i l i b r i u m strategy says t h a t a s h i r k i n g worker w i l l shirk again even i f the wage offer is w . v  Furthermore, this is the o p t i m a l t h i n g for the worker to do,  since the e q u i l i b r i u m strategy of the manager calls for a s h i r k i n g worker not to be h i r e d again.  B.4  Equilibrium Strategies Supporting the Internship Structure  W o r k e r ' s strategy <Tj (£): 1. If manager j's incentive c o m p a t i b i l i t y constraint, as defined i n (3.12) below, is satisfied, and h™(t — 1) = 1 and hf(t  — 1) = 1, a n d qi(t — l)fj(t  — 1) — 1, then accept a n  internship p o s i t i o n p r o m i s i n g p r o m o t i o n to a wage p o s i t i o n of w , 1  satisfying  (ICI),  and set qij — 1. Otherwise, do not accept an internship p o s i t i o n . If the worker is a l ready i n a p a i d p o s i t i o n then accept any wage offer. If hJfft — 1) = 1 and hf(t — 1) = 1, and qi(t — l)fj(t  — 1) — 1, and the up-front wage w  1  otherwise set qij = 0.  101  satisfies (ICI),  then set q\j = 1,  2. A c c e p t any non-negative up-front wage offer. I f 1, a n d the up-front wage offer satisfies set  h™(t — 1) — 1, a n d qi(t — l)fij(t — 1) =  w satisfies (ICI), t h e n set qij = 1, otherwise 1  qij — 0.  3. T e r m i n a t e a relationship w i t h a n o r g a n i z a t i o n i f promised p r o m o t i o n or promised wage offer have not been met.  M a n a g e r ' s strategy <r- (t): 1. If the manager's incentive c o m p a t i b i l i t y constraint (3.12) is satisfied, a n d  1) = 1  and hf(t — 1) = 1, a n d qij(t — l)fj(t — 1) = 1, then: a) Offer worker i a n internship position,  b) H o n o u r the promise t o promote a worker i w h o has interned for y o u  into a p a i d p o s i t i o n (fj — 1), w h e n there is a p a i d work vacancy, c) If a worker i is a n existing p a i d worker w i t h a n internship history w i t h y o u a n d /i™(i — 1) — 1 a n d  hf(t — 1) = 1, a n d qij(t — l)fj(t — 1) = 1, then make h i m an up-front wage offer of w. 1  2. If the manager's incentive c o m p a t i b i l i t y constraint (3.12) is satisfied, a n d h™(t— 1) = 0 and  hf(t — 1) = 1, a n d qij(t — l)fj(t — 1) = 1, t h e n offer a n up-front wage offer w  1  satisfying (ICI). 3. If (3.12) is satisfied, a n d h^ifb - 1) = 1, hf(t - 1) = 1 a n d q^t - l)fj(t - 1) = 0, then make no offer to worker i. 4. If (3.12) is satisfied, a n d hf(t  - 1) = 1 a n d hf(t - 1) = 0, then make no offer to  worker i. 5. If (3.12) is v i o l a t e d , a n d  hf(t - 1) = 0, h™(t - 1) = 1 a n d q^(t - l)fj(t - 1) = 1, t h e n  make worker i a wage offer of w . 1  6. If (3.12) is violated, a n d either  hf{t-l)  = 0, or hf(t-l)  = 1, or qij{t-l)fj(t-l)  = 1  does not hold, then make no offer to worker i. T h e above strategies give rise t o a perfect e q u i l i b r i u m of the repeated game, i n w h i c h workers accept internship positions w i t h a promise of p r o m o t i o n t o a p a i d p o s i t i o n p a y i n g w  1  a n d choose not to shirk, while managers honour their promises t o promote interns into  p a i d positions a n d rehire workers w h o have p r o v i d e d the promised effort.  102  Appendix C  Omitted Proofs: Chapter 3 P r o o f of L e m m a 4: It is Vf = w + p[pVi + Vf  =  (l-p)Vf}  + 0pV-  w  (C.l)  l-0(l-p)  and Vg = - e  h  + / ? [ ( l - / 3 ) V £ + /3Vg -e  v.'.=  h  +  0(A-0)Vf  3  1-0  (C.2)  2  while  w + Ojj -  e  1  p  =  h  (C.3)  1-0  i j  and V*=w  1 +  6 +0[pVV lj  w + 6ij + 1  V = %3 s  l-(3{l-p)  103  +  (l-p)V° \  0pV  j  a  So, incentive c o m p a t i b i l i t y implies:  yp > ys 13  -  W + 8 +0pV°  =  lJ  1-0(1-P)  13  p  7// + %  I  =  l - m - r i  W + Ojj  1-0(1-P)  ™ + PPV/J yi-p(i-  P  )  0JMV  1  H -  I  i _ 0(1 — /i)  (1 — /3(1 -  (1 - / J ( l -  p))  0 PP  (-e  2  +  h  + 0(1 -  0)V?\  i _ ^ 2  (l-P(l-rf)(l-P(l- ))[ p  J  S u b s t i t u t i n g from (C.3) and rearranging yields the incentive compatible wage i n (ICI). A l s o note t h a t straightforward c o m p u t a t i o n yields:  d  w  ^ — (1 — 0) e  h  a  — p (w +  e ^j, h  w h i c h is positive under the c o n d i t i o n stated i n the l e m m a .  P r o o f of L e m m a 5: A n assortatively matched pair generates s t r i c t l y more surplus t h a n one where types differ. W h e n workers' type matches the type of the organization, p r o v i s i o n of the mission good (g ) m  is enhanced (g  m  w i t h o u t assortatively matched pairs.  = g  m  > g^).  Consider a m a t c h i n g - e q u i l i b r i u m  A n organization e m p l o y i n g a worker of a different  type w o u l d have an incentive to attract a worker of the same type b y offering h i m some share of the higher surplus. T h i s w o u l d also be preferred by the worker thus u n d o i n g the stability of the e q u i l i b r i u m . P r o o f of L e m m a 6: S i m i l a r to t h a t of L e m m a 4, so o m i t t e d . P r o o f of L e m m a 7: Follows from the fact that i n the n o n - m i s s i o n sector there is no c o m mitment benefit to being nonprofit. T h u s , managers w i l l find it o p t i m a l to set u p for-profit firms since the for-profit status makes t h e m full residual claimants of the organization's net earnings. D e r i v a t i o n of the S o r t i n g conditions (C.4) a n d (C.5): W e derive the sorting conditions of workers by c o m p u t i n g directly Vu(m),  Vy,(b) and Vf (m),Vf  (b) for i €  S u b s t i t u t i n g recursively (C.3) into (C.2) a n d then into ( C . l ) gives:  v»  ( r o )  = l-0  ^ + 0p™(E ) m  ^ & * ) * , (l-0 )(l-0 + 0p™(E )) 2  m  ( l - / 3 ) ( l - / ? + /3p™(£ )) 2  m  104  {7711,7712}.  0p (E )e b  w l-0  h  b  + 0p (E )  (1 - 0 )(1  b  - 0 +  2  b  l-0  +  0p™(E )) m  0 p (E ) m  m  2  )(l-0  (w  + 6 - e)  v  +  and (SW2) - 0)  b  b  + 0p {E ))  0p™(E ))  h  for i € { m i , m }  h  2  m  - (1 + 0){w + e )  I  h  b  + 9)  v  b  and rearranging yields:  0w {E )  (w (E )  b  - (1 - 0 )(w  h  b  p (E )(l b  +  2  - 0) \0w\E,)  b  m  for i 6 {u,mi, 1712}  b  h  2  p (E )(l  p (E )  0pb(E ))  are i m p l i c i t l y defined below b y (C.7) and (C.9) respectively. S u b s t i t u t i n g  b  0(l-0  +  (l-0 )(l^-0  m  these expressions into (SW1)  m  )(l-0  h  m  + Pp™(E )  and E  —e)  1  m  +(l-0 m  (w  0p (E )e  2  where E  b  b  b  2  w  mm)  b  0 p (E 2  +(l-0  0p (E ))  -  <  0 pb(E )w (E ) 2  I  b  b  - (1 + 0){w + e ) h  (C.4)  < 0 ( l - 0  + 0P {E ))  (w {E ))  b  - (1 - 0 )(w  v  b  + e ) -  2  m  0 p {E )w {E  h  2  b  I  b  b  For mission-motivated managers the sorting constraint ( S M I ) implies that: ,  h ( 7 ;  w  -/  .  ,n .  Pb(G (E ))g£ b  - w (E ) b  Pm(G (E ))g m  and the one for u n m o t i v a t e d managers (SM2)  m  -  m  b(g ) m  w (E ) v  m  implies that:  p (G (E ))g m  -  f  b  m  m  -  m  w (E ) v  m  so c o m b i n i n g these two, one obtains p {G {E ))gj-w\E )-b{g ) b  b  b  b  p (G (E ))g m  m  m  m  <  ^  - w (E )  p (G (E ))g£ b  b  -  b  Pm(G (E ))g  v  m  <  m  m  m  m  w (E ) J  b  -  w (E )  (C.5)  v  m  P r o o f of P r o p o s i t i o n 6: P a r t (a). T h e choice of nonprofit organizational form follows from C o r o l l a r y 2.  T h e e q u i l i b r i u m strategies s u p p o r t i n g the volunteer structure are de-  scribed i n A p p e n d i x A . T o prove the rest of the p r o p o s i t i o n we analyze the interaction of incentive c o m p a t i b i l i t y conditions for workers and managers.  105  O n the managers' side,  free-entry ensures that incentive c o m p a t i b i l i t y (ICM) K (Pm(G ),E )  = (G )9m  V  m  binds:  m  Pm  -w  m  = 6(0 )  (C.6)  n  O n the workers' side, incentive c o m p a t i b i l i t y requires t h a t c o n d i t i o n (ICV)  is satisfied.  C o m b i n i n g (C.6) a n d (ICV) yields: (l-P )(l  +P  2  V  {  j ^ - P ( l - p ) ) ~ -e +— h  L  m  E  m  J  i  h  -  _ -w-6  tLl  (G (E ))g  Pm  m  m  (C.7)  h  + S(4> ) = 0 n  m  A s s u m p t i o n 1 ensures t h a t the two conditions cross i n the relevant region, that is, ( C . 7 ) has a solution i n the interval (0,  L ). m  P a r t (b). T h e choice of for-profit status follows from l e m m a 7. T h e e q u i l i b r i u m strategies s u p p o r t i n g the internship structure are described i n A p p e n d i x A . O n the managers' side, free-entry implies that incentive c o m p a t i b i l i t y (3.13) binds: 7r (p (Gb),E ) I  b  b  = p (G )g i  -w  1  b  b  = K  (C.8)  O n the workers' side, incentive c o m p a t i b i l i t y requires that c o n d i t i o n (ICI) is satisfied. N o t e that (C.8) is downward sloping because the inverse d e m a n d function pb(Gb) is decreasing i n the level of employment  T h e free-entry-condition requires that e q u i l i b r i u m must lie o n  the downward sloping curve defined by: w  = Pb(G )g  1  ~ K, while the workers' incentive  l l  b  b  c o m p a t i b i l i t y implies that e q u i l i b r i u m must lie o n the u p w a r d sloping curve defined b y :  wHE  )=  [l-?)(l v  P ^ - , 8 ( l - , ) ) ^b-^b -  +  (l — P)  -  2  1  h c  +  A'(i+/^-/3 ) 2  „  (i+0<&£-i?  E q u i l i b r i u m occurs at the intersection of these two. A s s u m p t i o n 2 ensures that the two conditions cross i n the relevant region, that is,  (l-P )(l+P -^f-P(l-p)) 2  -  f _02)  {  - ± to ( i + p ^ m  _  1  r  -e + ^ (i + P  J  - p) 2  U  h  ^  _  -w-e -p (G (E ))g^+K P) r  b  -  b  b  =0  2  (C.9) has a solution i n the interval (0, L )b  P r o o f of C o r o l l a r y 3: Follows from observing t h a t increasing (p) or (9) shifts workers' incentive c o m p a t i b i l i t y c o n d i t i o n downwards so the e q u i l i b r i u m point moves along the d o w n w a r d sloping managers' incentive c o m p a t i b i l i t y constraint. 106  Similarly, increasing  p (G ), m  m  Pb(Gb), shifts up managers' incentive c o m p a t i b i l i t y constraint, w h i c h causes the e q u i l i b r i u m to occur at a higher point along workers' u p w a r d sloping incentive c o m p a t i b i l i t y constraint. P r o o f of P r o p o s i t i o n 7: F i r s t , let us define workers' value functions associated w i t h the benchmark scheme of h i r i n g workers d i r e c t l y into p a i d positions. W e denote the expected lifetime value of being i n a p a i d p o s i t i o n a n d n o t - s h i r k i n g (U ), p  a n d s h i r k i n g (II )  a n d being i n the general p o o l (U ).  s  JJP  =  ^  BM  W  U  P  +  e  , . _h £  pjjp  +  ™—+y  =  being i n a p a i d p o s i t i o n  It is  9  e  (  a  i  o  )  (  C  .  n  )  while U  = w + p[pU  9  + (1 -  p  p)U ] p  w + PpUP  U  9  1 - 0(1 - P)  and U  = w  s  + % + Q [pU  a M  g  w  + d  B M  +  (l-p)U  s  0pU  9  lJ  1-p  +  + pp  Incentive c o m p a t i b i l i t y requires that:  -t  ^  r\ .  i-p  r\  i  + pp  i-p  r\  r\  + pp  <^  l-p  +pp  yi-p(i-p)J  S u b s t i t u t i n g from (C.10) a n d rearranging implies: w™  > l + ^ - W - / * ) ^ pp  _ ^  +  -  where 6y = 0 because of r a n d o m m a t c h i n g . Therefore, ( C . l l ) is workers' incentive compatr  ible wage i n the b e n c h m a r k case. R e c a l l that w  v  = ^  ^|i+^p_^  is the incentive compatible wage under the volunteering structure. (i+pp /g ) 2  <  ^'  w  B  M  w  u  l ^  a  v  e  a  hig  ^  e+ Because 6  ~ W = 0 2  m  r  107  W=  ~ ^  w  < d  intercept and increase more steeply i n p t h a n  n e r  A l s o , note t h a t the free-entry c o n d i t i o n i n the b e n c h m a r k case becomes:  Pm{Gm)g  ^  h  h  h  and w . v  R e c a l l t h a t the free-entry c o n d i t i o n for the volunteering structure is w =  Pm(Gm)9m~Q(4> )n  Therefore, the benchmark free-entry c o n d i t i o n is shifted inwards. F o r this to be true, it has to be that: Pm(G )g m  -  m  6(<T) >  ™™  Pm{G  Pm(G )  )d  m  [2g  m  - <&] >  26(<T)  w h i c h is the c o n d i t i o n i n the proposition. Consequently, e q u i l i b r i u m i n the benchmark case w i l l occur at a lower employment level as figure 3 illustrates. P r o o f of P r o p o s i t i o n 9: F i r s t note that workers' incentive c o m p a t i b i l i t y constraint w i t h internships (ICI)  is shifted up by the difference (8 — 6 ) relative to workers' incentive c o m h  p a t i b i l i t y constraint w i t h volunteers (ICV).  r  In a d d i t i o n , managers' incentive c o m p a t i b i l i t y  constraint is shifted d o w n . T o see this, note that the managers' b i n d i n g incentive c o m p a t i b i l i t y constraint for internships is w r i t t e n as: Pm(G )g m  m  — w — K'  vo = (G )g^ Pm  rn  — K,  n  where K is the level of profits that w o u l d make the incentive c o m p a t i b i l i t y constraint for managers b i n d . Therefore, the free-entry c o n d i t i o n for internships is shifted inwards i f Pm(G )gm  - &(4> ) > Pm(G )g  ~K=>  n  m  m  m  (G )  Pm  m  [dm ~ 9 ) m  > 0(0")  -  K  w h i c h is the c o n d i t i o n i n the proposition. B o t h of these effects i m p l y that the two constraints that define e q u i l i b r i u m w i l l always cross at a point w i t h more employment (Ey is supported, as illustrated i n figure 5.  > E{)  i n the case where volunteer h i r i n g  N o t e also that, as long as (3.15) gives rise to  indifference curves that are steeper t h a n the managers' incentive c o m p a t i b i l i t y constraint (i.e. ^+s -w-2e h  h >  dp (Gn,)g* ^ ro  t  h  e  n  t  h  e  v o  i  u n  t e e r i n g e q u i l i b r i u m (point V) w i l l be welfare  i m p r o v i n g for workers relative to the internship e q u i l i b r i u m (point / ) .  108  Appendix D  A Parametric Example of a 'Sorting' Equilibrium in Chapter 3 In this A p p e n d i x we provide a parametric example w h i c h demonstrates the existence of the S o r t i n g e q u i l i b r i u m , by checking that it satisfies the existence conditions (C.7), (C.9), (C.4) a n d (C.5).  D.l  Parameter Values  W e make the following assumptions o n the functional forms of the inverse d e m a n d functions Pm{G ) m  a n d Pb{Gb) a n d o n the parameters of the m o d e l . L e t (G (E ))  Pm  m  m  Pb(G (E )) b  b  = 5= 6.5 -  and  109  5(£ /2)  1 / 2  m  2.5(£ /2) / 1  f e  2  Table D . l : P a r a m e t e r values Parameter  Value 4 2  e  m  2.5  K  2  p  0.7 1  L h  3  e  h  2  w  0.5  b  2  e  0.2 0.5 N o t e t h a t the values of the parameters are chosen such t h a t the c o n d i t i o n /j. <  v  _  ;  —  w+e  h  is satisfied, that is, Zf t {1  = ^  ]  = 0-24 > 0.2  A l s o , note that the c o n d i t i o n i n P r o p o s i t i o n 4 is satisfied, s i n c e p ( G ( E ) ) ( g m  [5 - 5 ( x / 2 ) / ] * 2 > 2.5 = 6 0 ) 1  2  n  m  m  —g)  m  b  =  for x G (0,1). T o see this, note t h a t the solution to  [5 - 5 ( z / 2 )  1 / 2  ] * 2 - 2.5 = 0  is (x = 1.125)  D.2  Computing Equilibrium in the Mission Sector  R e c a l l that e q u i l i b r i u m i n the mission sector is defined b y the following two conditions: W  V  (i-/? ) 2  w (E ) v  m  = -  (i  +  =p {G )gm-Q{4> )  (D.l)  n  m  m  p i ^ m ^ - p i i - , , ) )  \  r  \  , ;  e  +  f e  1  _  0  2  )  L E l  7  W  -B  (D.2)  h  S u b s t i t u t i n g yields (1 - 0 ) 2  1—' \ }  (1 + 3%^§±  ^^'f-  - (3 (1 - »j)  ^\  w  V+  ( l  _  2)  0  ^,-e +e{ )-p {Gm)g h  7  n  (p  m  m  = (D.3)  110  T h e n (D.3) implies that (1 _ Q . 7 )  (1 - 0.7 )(1 + 0 . 7 £ 3 f £ - 0.7 * (1 - 0.2)) 2  2  -0.5-2-(17.5-20(E /2) / ) (1 + 0 . 7 ^ | ^ - 0 . 7 ) 1  0.7 * 0.2(1 + 0 . 7 ^ f | ^ - 0.7 ) 2  m  2  T h i s equation has two solutions, we pick the one i n the relevant region, t h a t is, for E  m  (0,1). T h e solution is (jE  m  = 0.771  w h i c h implies that:  p (E )  = 1.014 while w  m  v  m  D.3  G  = 5.076  Computing Equilibrium in the Profit Sector  R e c a l l that the equations that determine the e q u i l i b r i u m are: Pt,(G )gt-w'=  K  t  _ ( 1 - ^ ( 1 + ^ - ^ ( 1 - , ) )  (1-^)  -  E q u i l i b r i u m point is s o l u t i o n to (1-0.7 )(1 + 0 . 7 ^ - 0 . 7 * (1-0.2)) (1 - 0 7 ) " . - 2+ " ' 0.5-(ll-5(E /2) / ) = 0 0 . 7 * 0.2(1 + 0 . 7 | 2 g - 0.7 ) (1 + 0 . 7 ^ g - 0 . 7 ) ' 2  2  1  n  F  1  n  2  V  V  1  T h i s equation has two solutions. W e pick the one i n the relevant region, for E  b  T h e solution is: J £  f c  1  G (0,3).  = 1.338}, w h i c h implies t h a t p {E )  = 0.241 a n d w = 6.910  b  1  b  D.4  2  6  2  Checking the Sorting Constraint for Workers  W e verify that the sorting conditions of workers hold b y c o m p u t i n g d i r e c t l y Vjf (m), vf (b) and Vf(m).  U s i n g the parametric values from the table a n d the e q u i l i b r i u m values we  obtained above i t is ~ , 1/f (m) = 0 /  0.5  0.7*1.014*2  1 - 0.7 + 0.7 * 1.014  (1 - 0.7 )(1 - 0.7 + 0.7 * 1.014) 2  +  ( 1 - 0 . 7 » ) ( 1 - 0.7 + 0.7. 1.014) < 5  111  076  ~ > = °' 2  7 0 6  2  ~  a  n  ,  0.5  0.7*0.241 * 2  1 - 0.7 + 0.7 * 0.241  (1 - 0.7 )(1 - 0.7 + 0.7 * 0.241) 2  0 . 7 * 0.241 2  ( 1 - 0 . 7 » ) ( 1 - 0 . 7 + 0 . 7 , 0.24!) ' - ' ° " » =  +  ~ , V- (m) —  6  9  2  2  0  8  1  0.5  0.7*1.014*2  1 - 0.7 + 0.7 * 1.014  (1 - 0.7 )(1 - 0.7 + 0.7 * 1.014)  Q /  *"'™"'" >  €  2  2  ( 1 - 0 . 7 2 ) ( 1 - 0.7 + 0 . 7 . 1.014) < ' °  +  '  f O T  0  5  7 6  +  " > =  2  2  2  '  6  3  6  '  ta  6  < " * • •"»>  Therefore, V?(m)  = 2.636 > Vf(b)  = 2.081 for i 6 { m , m } 1  2  and y » ( 6 ) = 2.081 > "\/ (m) = 0.706 9  n  w h i c h implies that workers' sorting constraints are satisfied.  D.5  Checking the Sorting Constraint for Managers  R e c a l l that the sorting c o n d i t i o n for managers is p {G {E ))g  - w (E )  h  h  b  b  b  p (G (E ))g m  m  - b{g )  J  b  m  p {G {E ))g  <  b  - w (E )  b  b  b  Pm(G (E ))g  v  m  ~  h  m  m  m  m  w ^) 1  -  m  w (E, v  But p {G {E ))gj; b  b  - w'jEb)  b  p {G (E ))g m  m  m  -b{g )  =  - V(E )  m  W  13 - 5 ( 1 . 3 3 8 / 2 ) / 1  m  2  - 6.91 - 1  20 - 20(0.771/2)1/2 _  m  5  .  0 7  6  = 0.4  and Pb{G {E ))g  h  b  p (G (E ))g  b  m  m  m  b  ~ w^Eb) - w (E ) v  m  m  _  13 - 5 ( 1 . 3 3 8 / 2 ) / 1  2  - 6.910  15 - 15(0.446/2)1/2 - 4.910  so for (j/ € (0.4,0.66) managers' sorting conditions are met. 1  112  = 0.66  

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