Lower Prices for Customers,and Less Charity Care? The Prospects for Mixed-Market Competition With Nonprofit and Hybrid Firms

The Arrival of Mission-Oriented For-Profit Legal Forms in the United States

In the United States, most large mission-driven enterprises incorporate as nonprofits. The defining features of a nonprofit firm are its avowed charitable or social purpose, the favorable tax treatment that comes with nonprofit status, and, central to economists’ modeling of nonprofit behavior (Hansmann, 1980), the “nondistribution constraint” dictating that net revenues must be directed to its charitable purpose and not to the enrichment of shareholders.

Until recently, and in contrast to businesses in many other countries, incorporated profit-seeking firms in the United States were more or less tightly bound by what we might call a “nonredistribution constraint”: Shareholders could mount legal challenges if value was directed away from them to other stakeholders or to social purposes. This view of American business was famously articulated by Nobel laureate Milton Friedman in 1970 in the New York Times: “[T]here is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits . . . without deception or fraud” (Friedman, 1970).

During the next 40 years this would relax, with many states adopting constituency statutes allowing management to consider stakeholders other than shareholders. But it was not until the benefit corporation was introduced in 2010 that a primarily profit-seeking business could formally incorporate with a declared social purpose. Whereas low-profit, limited-liability corporations (L3Cs) were designed to give nonprofit firms greater access to capital markets, ¹ benefit corporations and similar incorporation options, now widely available in the United States (Feldman, 2021), “transform standard for-profits into dual-mission entities” with a required “purpose of creating general public benefit” and are permitted to declare a commitment to a “specific public benefit” in their charter (Brakman Reiser & Dean, 2017, p. 53). Reporting requirements include a benefit report on their activities in support of non-shareholder constituencies and any mission specified in their charter.

Primarily profit-seeking but with an avowed social purpose, these hybrid firms’ commitment to multiple goals creates a problem of trust when managers cannot commit to a particular division of resources between the pursuit of public purpose and profit. One possible advantage of having an increasingly broad array of hybrid forms available—enterprises may choose their state of incorporation and requirements vary across states—is that entrepreneurs might be able to use their choice of form to signal their intended balance between “mission and margin,” thereby resolving the trust problem. This seems not to be the case: Brakman Reiser and Dean (2017) document the ways in which fiduciary standards, reporting requirements, and penalties for noncompliance all fall short of committing the hybrid firm to a particular mission-margin balance.

There is a cynical reason to think that incorporation as a hybrid of the benefit-corporation type might be attractive to investors and create less of a trust issue between shareholders and other constituencies than nonprofit scholars have anticipated. As we discuss in the next section, formal models of imperfect competition suggest that there are circumstances under which public-facing missions such as “expanding community access to affordable health care” can increase the profits of profit-seeking firms. In other words, markets for quasi-public services may attract profit-seekers with pseudo-public motives.

Competition Between For-Profit and Nonprofit Firms

Nonprofit scholars first modeled mathematically the case in which nonprofit firms enter into competition with for-profits as a side venture to generate money for their organization (James, 1983), such as a hospital leasing parking spaces to neighboring businesses, trading off the distastefulness of the commercial activity against the funding it provides. Attention shifted to nonprofits’ principal markets of operation as nonprofit scholars documented differential behavior between for-profit and nonprofit firms, for example as providers of care in nursing homes, psychiatric facilities, and facilities for the mentally handicapped (Weisbrod, 1988). Harrison and Lybecker (2005) focus our attention on the motives of nonprofit hospitals by modeling a market in which a for-profit hospital competes with a nonprofit hospital, allowing the nonprofit hospital to maximize a weighted average of profit and either output, quality, or charity care. Stenbacka and Tombak (2020) consider the importance of cost differentials between standard-quality and high-quality medical treatments in a world in which universal health insurance offers payment for the standard-quality option and the nonprofit hospital cares about the well-being of the customers it serves, demonstrating that the size of the cost differential can determine which hospital provides the high-quality treatment. Moon and Shugan (2020) consider a hospital market in which a for-profit competes with a nonprofit that maximizes a combination of profit and output; they generate results consistent with the empirical observation that the more profitable hospitals providing more premium specialty medical services are likely to be nonprofits. ²

While many papers focused on the hospital industry, another strand of literature was interested in the “unfair competition” between a tax-paying for-profit and a tax-exempt nonprofit firm operating in the same market. Liu and Weinberg (2004) use a duopoly model to demonstrate that it is not the tax advantage so much as it is the nonprofit’s objective function that, ironically, leads it to generate more profit than its profit-seeking rival. Sansing (2000) explores the conditions under which a joint venture between a taxable for-profit and a nonprofit might be more socially efficient than competition between them. He constructs a Nash duopoly model in which the firms simultaneously choose their production levels of a homogeneous good. The nonprofit maximizes a combination of the profit it earns to fund its social purpose and the net value received by all customers served in the market, that is, consumer surplus; the for-profit firm seeks to maximize profit. Lien (2002) and Ferreira (2009) build on this model to consider the effects of the tax rate faced by the for-profit firm when demand is uncertain. Lien also modifies the model to allow the nonprofit to be concerned with the total surplus generated in the market, that is, the sum of consumer surplus, tax revenue, and after-tax profits. Goering (2008) and Flores and García (2016) show that if the nonprofit’s costs are high relative to its competitor’s, the nonprofit’s altruism might actually lead to a reduction in social welfare.

Kaneda and Matsui (2003) point out that, if the two firms have the same costs, the nonprofit with its concern for consumer surplus ends up making more profit than the firm that sets out to maximize profit, not because of its tax advantage but because of its altruistic concern for customers in the market. Kopel and Brand (2012) explore the conditions under which a socially concerned firm such as a nonprofit will earn higher profit than an explicitly profit-maximizing one. They find that deviating from profit maximization by putting a weight on consumer well-being increases shareholder value, but only up to a point. They note that hybrid organizational forms provide a potential avenue for achieving that profit.

When Lien (2002) allows the nonprofit’s altruism to extend to a concern with social efficiency, encompassing not only consumer surplus but also the profit and tax revenue generated in the market, he is allowing it the broad scope we might more naturally associate with a public enterprise. We model the nonprofit as having a more focused public purpose, such as the availability of health care or education, with no concern for the profits of its competitors and the taxes they generate, and indeed we see this as a fundamental distinction between a public enterprise and a private nonprofit enterprise. Similarly, we question whether a profit-seeking firm will have a public concern as broad as that of the nonprofit firm. We extend this literature on duopolistic competition by modeling the hybrid firm as having a narrower social concern, the consumer surplus going to its own customers, in contrast to the nonprofit’s concern with the total consumer surplus produced in the market.

The advent of the benefit corporation gives a for-profit duopolist the option of reincorporating as a hybrid firm with a customer-facing component of its objective function, a move with the potential to expand its market share and with expanded market share to increase its profits. What might competition against this sort of hybrid firm rather than a standard profit-maximizer mean for a commercial nonprofit who shares a market with it? To analyze this question, we model a hybrid firm that is primarily but not exclusively profit-seeking, and accountable to shareholders for both profit and social purpose.

Modeling Competition Between a Commercial Nonprofit and a Hybrid Firm

In this section, we model competition between a commercial nonprofit and a hybrid for-profit competitor of the sort represented by the benefit corporation, using competition between a nonprofit and a traditional for-profit as a point of comparison.

Each firm’s choice of how much to produce will depend on its objectives, its costs, and its constraints, and we consider these in turn. The firm’s choice also depends on the production decision of its competitor, because this affects the market price. We assume they compete in a market with just two firms and that, in equilibrium, their decisions are such that, given what the other firm is doing, each firm is doing the best it can. In the language of game theory, we seek Nash equilibria in a single-period simultaneous two-player game of quantity choice with a homogeneous good, tweaking the standard Cournot duopoly model to include our mission-sensitive firms. For simplicity, each firm faces constant average cost, ³ and market demand is linear.

We assume that the commercial nonprofit maximizes a weighted sum of all consumer surplus generated in the market and its own profit. Consumer surplus captures the benefits accruing to the market’s paying customers as the difference between the maximum amount they would have been willing to pay for the goods or services they purchased and the amount they actually paid, and we refer to this piece of the nonprofit’s utility function as intra-market altruism (IMA). Profit is assumed to be spent on mission-related activities that generate no revenue; this piece of the utility function is referred to as extra-market altruism (EMA).^4,5

The central example of the mission-related activities funded by profit is the provision of the nonprofit’s commercial service at no charge to persons who cannot afford to participate in the market: Hospitals and health clinics provide charity care and schools give scholarships, for example. The only restriction of the model on the nature of this extra-market altruism is that it is assumed not to affect the market demand of paying customers or the nonprofit’s costs. This implies that profit cannot be spent on anything that materially changes quality in the eyes of paying customers, or to provide a public good that affects their demand for the purchased service. In the language of quasi-public goods, this is the assumption that consumers’ demand for the private aspects of the good is not affected by the provision of the public aspects of the good. This restriction rules out some interesting possible cases: For example, well-to-do families might be willing to spend more to send their children to a college whose generous financial aid brings together a diverse student body. The nonprofit may, however, devote its profits to a mission-related aspect of its services that does not affect consumers’ willingness to pay, funding a public good such as basic research or a dimension of quality that consumers are unwilling to pay for. For example, nonprofit hospitals may be early adopters of electronic recordkeeping and nonprofit colleges may devote considerable resources to periodically redesigning their general education programs, even though the value of their efforts is unseen by patients, students, and their families.

Finally, we assume that our nonprofit firm’s spending is limited by its revenues. In practice, donations allow a commercial nonprofit to spend more on its extra-market altruism than just its net revenue. For simplicity, we set the level of donations, grants, and so on at zero.

The hybrid firm, like the nonprofit, has an objective function that includes both profit and a measure of consumer surplus. Profit is divided between return to shareholders and the financing of extra-market altruism; EMA is attractive because contributions to social causes are readily documented and can address a wide range of social purposes. Consumer surplus is attractive in part because its pursuit increases market share. Because we are interested in hybrid firms of the benefit corporation sort, primarily profit-seeking but with an avowed social purpose, we constrain the hybrid to weigh profit at least as heavily as consumer surplus in its objective function. Because the hybrid must document its contribution to its declared social purpose, we model it as caring about its own contribution to consumer surplus, taking as given the amount of output produced by its nonprofit rival. Graphically, the consumer surplus that enters the hybrid’s objective function is the shaded triangle in Figure 1.

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Figure 1.

The hybrid firm’s addition to consumer surplus

The traditional for-profit firm is assumed to maximize profit. We allow its constant per-unit cost of production to differ from those of its nonprofit and hybrid counterparts, reflecting potential differences in taxes and subsidies, access to financing, stakeholder commitments that affect costs, and so forth.

More formally, we consider a model in which firms compete in a market with linear inverse demand p = d – q, where q is the sum of the firms’ output sold in the market. Firms make their quantity choices simultaneously; the objective functions of the nonprofit, benefit corporation, and traditional for-profit firm, respectively, are:

U n ( q n ) = α n ( d − q − c n ) q n + ( 1 − α n ) q 2 2 ,

U b ( q b ) = α b ( d − q − c b ) q b + ( 1 − α b ) q b 2 2 , and

U f ( q f ) = ( d − q − c f ) q f ,

where α b ∈ [ 1 2 , 1 ] and α n ∈ [ 0 , 1 ] represent the relative weights the benefit corporation and nonprofit place on profit. The constant marginal cost of production for firm type i is c_i and there are no fixed costs of production. We constrain all three firm types to nonnegative profit: d − q − c i ≥ 0 ; this constraint is never binding except in some instances for the nonprofit.

In the Technical Appendix, we solve for Nash equilibria in simultaneous, one-period games in which the firms choose their level of output. We consider in turn the cases in which (1) the nonprofit firm has the market to itself, (2) the nonprofit competes against a standard for-profit firm, and (3) the nonprofit competes with a benefit corporation. These models yield the results that are discussed next.

Results

Discussion and Directions for Future Research

When a commercial nonprofit shares a market with a hybrid firm, our model suggests that it matters a great deal what the nature of the two firms’ altruistic concerns are. If the nonprofit operates in a market solely to generate profit to support charitable activities, the nonprofit is best off if its hybrid competitor is also interested only in social purposes unrelated to the market’s paying customers. In this case, the hybrid’s altruism has no impact on its behavior in the market it shares with the nonprofit: Both the nonprofit and the hybrid behave as if they were profit maximizers. The consumers in the market may actually be made worse off by being served by these altruistically minded firms than if they were served by profit maximizers: If nonprofits and hybrids operate at higher costs than traditional for-profit firms, perhaps because both have costly commitments to their workers or suppliers, these higher costs can lead to an equilibrium with higher price and less output than would have been provided by a traditional for-profit duopoly.

A hybrid firm of the sort represented by the benefit corporation, principally profit-seeking but with a declared public purpose, can represent a more powerful presence than a traditional for-profit firm when competing with a nonprofit firm. As hybrid firms increase their level of intra-market altruism, nonprofits experience decreases in both the quantity they sell and the amount of net revenue they generate for charitable purposes. The hybrid firm’s interest in producing consumer surplus is unambiguously bad news for a nonprofit that is wholly concerned with generating net revenue to fund charity care.

The type of nonprofit that should most welcome the arrival of hybrid firms is the nonprofit that operates in a market because it is centrally concerned with the welfare of the customers in that market. Early childhood education facilities, nursing homes for low-income elderly, drug rehabilitation centers, and family-planning clinics are examples of service delivery nonprofits that are devoted to the well-being of their customers and might plausibly applaud the expansion of the capacity of other service providers in their area.

While the welfare of paying customers for these important services is increased by its competitor’s intra-market altruism, the nonprofit’s ability to provide charity care is curtailed. It follows that, if the amount of profit that the hybrid corporation devotes to charity care is sufficiently small, the emergence of hybrid firms will redistribute welfare from those outside the market to paying customers within the market. In industries such as health care and education, this has the potential to exacerbate inequalities between the insured and uninsured, and those who can and cannot afford to pay tuition.

Besides their paying customers and their clients receiving charitable services, nonprofit organizations may honor costly commitments to the well-being of other stakeholders, such as their workers or their suppliers, and costly commitments can give a cost advantage to their competitors. Intra-market altruism alone is not sufficient to drive a nonprofit out of the market: to monopolize the market, its competitor must have a cost advantage over the nonprofit organization. However, it can be shown that the required cost advantage over the nonprofit is smaller in the case of a hybrid firm that displays intra-market altruism than in the case of a traditional for-profit competitor. The model cautions that the arrival of competitors with a concern for consumer surplus may limit the nonprofit’s ability to make costly commitments to the well-being of other stakeholders.

This analysis suggests avenues for future research, both formal and applied. We model producers as simultaneous quantity choosers who care about consumer surplus; there may be important contexts in which nonprofits strategically choose quality, care about quantity, are able to move first, and so on. A firm’s extra-market altruism might be allowed to affect the demand for its product, perhaps serving as a virtue-signaling advertisement.

We model the hybrid for-profit firm as accountable to shareholders by restricting their claims of consumer surplus creation to the extra surplus created when the hybrid’s output is added to the nonprofit’s output. Because the hybrid’s social purpose may be distinct from the market in which it operates, we model the hybrid’s extra-market altruism as irrelevant to the nonprofit. In specific settings, other assumptions may be of interest.

We have focused on the consequences for commercial nonprofits of competition with hybrid firms. Pivoting to questions of economic efficiency, it can be shown (see Result 4 in the Technical Appendix) that, unless the nonprofit firm has a cost advantage, the economic surplus generated in the commercial market unambiguously increases with the hybrid’s emphasis on intra-market altruism. If a for-profit firm can reincorporate as a hybrid without increasing its per-unit costs of production, it follows that more economic surplus is generated in the commercial market when the nonprofit competes with a hybrid firm than with a purely for-profit firm. While this result may be of interest in its own right, understanding the broader implications for efficient (not to mention equitable or just) resource allocation will generally involve modeling the firms’ charitable uses of the money raised in the commercial market (Eckel & Steinberg, 1993).

Scholars have explored the impacts on an organization’s publicness—the degree to which its commitments, behaviors, and governance resemble those of public institutions—of the sector in which the organization is located and the resources available in its environment (Bozeman, 1987; Moulton & Eckerd, 2012). In our model, in accordance with publicness theory, allowing a for-profit firm to reincorporate as a public-facing benefit corporation increases its publicness: it serves more customers at a lower price, and it undertakes charitable activity. Function follows form. What is intriguing, and not generally stressed in publicness or resource theory, is that the organizational forms of these other organizations have implications for the functioning of nonprofit organizations themselves. While anyone familiar with the American crises of medical bankruptcy and student loan debt is likely to agree that lowering prices and expanding access to medical care and higher education are in the public interest, market transactions between buyer and seller are quintessentially private-sector behaviors. Our nonprofit organization, finding itself sharing a market with the more public-facing benefit corporation, faces incentives to behave less publicly, scaling back the resources it devotes to its public purposes beyond the well-being of its paying customers. While this particular reaction is driven by the structure of our model, the lesson is general: in thinking about the influence of an organization’s environment on its behavior, it can pay to look beyond resources and regulations to its rivals as well.

A similar caution applies to the study of mission drift. Mission drift is defined as “a process of organisational change, where an organisation diverges from its main purpose or mission” (Cornforth, 2014). It is often attributed to “founder’s syndrome” as the sway of an influential founder recedes, to resource dependency on a primary revenue source, to changes in the regulatory environment, or to a shift in the organization’s values that emerges from the tension between the logic of the market and the logic of social purpose (Cornforth, 2014). In our model, as its competitor adopts a hybrid form, the nonprofit reduces its level of charity care while serving its paying customers at a reduced price. This changed behavior on the part of the nonprofit looks like mission drift when in fact its competitor’s mission drift has changed the nonprofit’s best strategy for pursuing its unchanged mission. A change in strategies may reflect a change in mission or it may instead reflect a successful navigation of changes in the environment in which an enterprise functions. Our analysis underscores the importance of market conditions—or, in the parlance of the nonprofit zoo, the importance of habitat—to the study of mission drift in social enterprises.