To Profit or Not to Profit: The Commercial Transformation of the Nonprofit Sector

To Profit or Not to Profit The Commercial Transformation of the Nonprofit Sector

Nonprofit organizations are becoming increasingly like private firms. The transformation is bringing a shift in financial dependence from charitable donations to commercial sales activity, with little-recognized consequences. To Profit or Not to Profit is a coordinated set of studies of why fund-raising for nonprofits is mimicking that of private firms and what consequences it is having. User fees and revenue from "ancillary" activities those not contributing directly to the organization mission except for the profit generated - are mushrooming, with each having important side effects. User fees may price out of the market some of the nonprofit's target group. Ancillary activities may distract the nonprofit from its central mission. These issues are examined from two perspectives. One focuses on issues that apply to nonprofits generally: the role of competition, a framework for analyzing nonprofit organization behavior, the effects of distributional goals and differential taxation of nonprofit and for-profit activity revenue, the effects of changes in donations on commercial activity, and conversions of nonprofits to for-profits. A second set of studies focuses on specific industries: hospitals, universities, social-service providers, zoos, museums, and public broadcasting. The book concludes with recommendations for research and for public policy toward nonprofits. Burton A. Weisbrod is John Evans Professor of Economics and Faculty Fellow of the Institute for Policy Research at Northwestern University. From 1990 to 1995 he served as director of that public-policy research unit, then known as the Center for Urban Affairs and Policy Research. Previously Professor Weisbrod was Evjue-Bascom Professor of Economics at the University of Wisconsin-Madison and cofounder of its Health Economics Training Program. He has held visiting professorships at Brandeis, Harvard, Princeton, and Yale universities, as well as the University of California-Berkeley, the State University of New York-Binghamton, the Australian National University, and the Universidad Autonoma de Madrid, Spain. Professor Weisbrod is the author of two previous books and numerous articles on nonprofits, including the landmark analysis The Nonprofit Economy (1988), and has authored, coauthored, or edited 14 other books and more than 160 articles.

To Profit or Not to Profit The Commercial Transformation of the Nonprofit Sector

Edited by

BURTON A. WEISBROD

CAMBRIDGE UNIVERSITY PRESS

PUBLISHED BY THE PRESS SYNDICATE OF THE UNIVERSITY OF CAMBRIDGE

The Pitt Building, Trumpington Street, Cambridge, United Kingdom CAMBRIDGE UNIVERSITY PRESS

The Edinburgh Building, Cambridge CB2 2RU, UK http://www.cup.cam.ac.uk 40 West 20th Street, New York, NY 10011-4211, USA http://www.cup.org 10 Stamford Road, Oakleigh, Melbourne 3166, Australia Ruiz de Alarcon 13, 28014 Madrid, Spain © Burton A. Weisbrod 1998 This book is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 1998 First paperback edition 2000 Typeset in Times Roman 10 pt, in Quark XPress™ [MG] A catalog record for this book is available from the British Library Library of Congress Cataloging in Publication data To profit or not to profit: the commercial transformation of the nonprofit sector / edited by Burton A. Weisbrod. p. cm. A collection of papers initiated, discussed, and refined at two working conferences held by the contributors. Includes bibliographical references and index. 1. Nonprofit organizations - United States - Finance - Congresses. 2. Associations, institutions, etc. - United States - Finance - Congresses. 3. Public institutions - United States - Finance - Congresses. 4. Fund raising - United States - Congresses. 5. Volunteerism - United States - Congresses. 6. Profit - United States - Congresses. I. Weisbrod, Burton Allen 1931HD2769.2.U6T6 1998 338.7-dc21 97^5976 CIP ISBN 0 521 63180 7 hardback ISBN 0 521 78506 5 paperback

Transferred to digital printing 2003

Contents

List of contributors Foreword by Kenneth J. Arrow Preface

page vii ix xi

1 The nonprofit mission and its financing: Growing links between nonprofits and the rest of the economy Burton A. Weisbrod

Part I Basic issues and perspective 2 Competition, commercialization, and the evolution of nonprofit organizational structures Howard P. Tuckman 3

4

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1

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Modeling the nonprofit organization as a multiproduct firm: A framework for choice Burton A. Weisbrod

47

Pricing and rationing by nonprofit organizations with distributional objectives Richard Steinberg and Burton A. Weisbrod

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Differential taxation of nonprofits and the commercialization of nonprofit revenues Joseph J. Cordes and Burton A. Weisbrod

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Interdependence of commercial and donative revenues Lewis M. Segal and Burton A. Weisbrod

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Conversion from nonprofit to for-profit legal status: Why does it happen and should anyone care? John H. Goddeeris and Burton A. Weisbrod

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Part II Industry studies 8

Commercialism in nonprofit hospitals Frank A. Sloan

9

Universities as creators and retailers of intellectual property: Life-sciences research and commercial development Walter W. Powell and Jason Owen-Smith

10 Commercialism in nonprofit social service associations: Its character, significance, and rationale Dennis R. Young 11 Zoos and aquariums Louis Cain and Dennis Meritt, Jr. 12 Commerce and the muse: Are art museums becoming commercial? Helmut K. Anheier and Stefan Toepler 13 The funding perils of the Corporation for Public Broadcasting Craig L. LaMay and Burton A. Weisbrod

Part III Overview, conclusions, and public-policy issues 14 Commercialism among nonprofits: Objectives, opportunities, and constraints Estelle James 15 Conclusions and public-policy issues: Commercialism and the road ahead Burton A. Weisbrod Appendix: IRS Forms 990 and 990-Tfor nonprofit organizations References Index

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195 217

233 249

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306 317 336

Contributors

A. WEISBROD is John Evans Professor of Economics, and Fellow of the Institute for Policy Research, at Northwestern University. HELMUT K. ANHEIER is Associate Professor of Sociology at Rutgers University and Senior Research Associate at the Institute for Policy Studies at Johns Hopkins University. KENNETH J. ARROW is Joan Kenney Professor of Economics, Emeritus, Professor of Operations Research, Emeritus, at Stanford University, and recipient of the Nobel Memorial Prize in Economic Science in 1972. Louis CAIN is Professor of Economics at Loyola University of Chicago and Adjunct Professor of Economics at Northwestern University. BURTON

JOSEPH J. CORDES is Professor of Economics and Director of the

Graduate Program in Public Policy at George Washington University. JOHN H. GODDEERIS is Professor of Economics at Michigan State University. ESTELLE JAMES is Lead Economist, Policy Research Department, at the World Bank. CRAIG L. LAMAY is Assistant Professor at the Medill School of Journalism at Northwestern University. DENNIS MERITT, JR., is Associate Adjunct Professor of Biology at DePaul University and a past President of the American Zoo and Aquarium Association. JASON OWEN-SMITH is a graduate student in Sociology at the Uni-

versity of Arizona. W. POWELL is Professor of Sociology at the University of Arizona.

WALTER

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Contributors M. SEGAL is Economist at the Federal Reserve Bank of Chicago. FRANK A. SLOAN is J. Alexander McMahon Professor of Health Policy and Management and Professor of Economics at Duke University. RICHARD STEINBERG is Professor of Economics, Public Affairs, and Philanthropic Studies at Indiana University / Purdue UniversityIndianapolis. STEFAN TOEPLER is Research Associate and Adjunct Professor at the Institute for Policy Studies at Johns Hopkins University. HOWARD P. TUCKMAN is Professor of Economics and Dean of the School of Business at Virginia Commonwealth University. DENNIS R. YOUNG is Professor of Nonprofit Management and Economics at Case Western Reserve University. LEWIS

Foreword

Kenneth J. Arrow

In every modern economy, no matter how strong the pledged and actual allegiance to the ideology of the market, there is a significant portion in which production is not governed by the maximization of profit and there are no legal claimants to any of the revenues. The decision-making entities in this nonprofit sector are, of course, operating in the context of a market economy. They have to purchase inputs on the market, and in many cases (e.g., hospitals, universities) they receive revenues from the users of their products. To finance the purchase of these inputs, they frequently receive, in addition to their user fees, donations. The government not only subsidizes these donations through tax laws but also frequently gives these nonprofits direct subsidies. Finally, nonprofit institutions profit from gifts of time from volunteer workers. Thus the resources that support the activities of nonprofits are received through a variety of channels: user fees, direct and indirect government subsidies, and donations of money and labor. The role of nonprofit institutions in the United States is certainly considerable and worthy of study. Their revenues make up about 10 percent of the GNP, and they own roughly 10 percent of all property. Their special role, particularly their tax status, is justified on the grounds that they supply uniquely valuable services. However, the links between the commercial and nonprofit sectors are growing rapidly, and the lines that divide them are getting harder to define. In some cases, profit-making and nonprofit firms directly compete - for instance, in consulting work for public policy. They also cooperate, as when private firms give grants to universities to do research in areas of interest to those firms; but these grants and other donations to nonprofit institutions from the private sector can entail conditions - such as not publishing research - that conflict with the nonprofits' aims. The property-tax exemptions for nonprofit firms create additional tax pressures on private property owners. Perhaps the most striking possibility of all is the commercialization of nonprofit firms. When competing with for-profits, nonprofits may develop a large value; pressure to capitalize on this value may come from insiders, who usu-

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ally wind up with a major part of the gains. The motive for commercialization may also arise out of the desire, and perhaps even need, to expand. Such expansion requires capital obtainable only on the bond or equity markets, and thus out of reach of a nonprofit institution. It is curious that there is a sense of pressure on nonprofits at a time when they have been expanding. Perhaps there is some problem with the measures. A reduction in outside support (relative to an expanding economy) may have led to an increase in commercial enterprises to raise money (such as gift shops in museums). This will appear as an expansion of the nonprofit sector even though the distinctive output of that sector may not have increased - only the commercial services identified with it. The economic analysis of the nonprofit sector has always suffered from the difficulty of defining the objective functions of its units. The objectives even of a business firm faced with investments whose returns depend on judgment of the uncertain future - and run by managers whose interests are not necessarily those of the stockholders - suffer from some ambiguities that theory has not succeeded even in formulating clearly. The objectives of nonprofit firms, however, are generally multiple and, in any but the simplest cases, hard to define. Burton A. Weisbrod has been one of the very few scholars who has consistently and over a long period of time brought to bear theoretical and empirical research tools in this complex field. Now he and his colleagues have focused on a phenomenon always extant but of growing significance: the commercialization of the nonprofit sector. Almost all of what is known regarding this development is to be found in these pages.

Preface

This volume is not the literary equivalent of the proverbial camel - a horse put together by a committee. Rather, it is a genuine product of intense teamwork. Great effort was made by all the contributors to incorporate their work as part of a single, unified analysis of the forces causing the growing commercialism of nonprofit organizations, the forms that commercialism is taking, and the likely consequences. The process of producing an integrated volume began with lengthy conversations with the prospective authors, to determine not only their interest in joining the team but also their willingness to agree to procedures that would impose some strictures in order to produce a cohesive book. The next stage was a working conference lasting a day and a half, during which the proposed perspective and approach were discussed, to give each participating author full opportunity to propose modifications; time was then allotted to the discussion of the two-page outlines that each author had circulated prior to the conference. In this way, each participant learned about the plans of all the others, and the volume's integration was advanced. Nine months later a second working conference was held. First drafts of all papers had been circulated in advance, and each of us served as a discussant of another's paper. As the organizer of the overall research project, I gave written comments and suggestions to every author and had subsequent conversations to expand on the revisions that were proposed. The highly interactive process generated multiple linkages across chapters. I want to thank every author not only for the fine research contribution, but for the superb teamwork. It was a pleasure to work with authors who were dedicated not only to scholarly excellence, but to producing a book that would be more valuable than the sum of its parts. This book would not have been possible without the support of the Andrew W. Mellon Foundation for the research and the working conferences. I thank the Foundation and its president, William G. Bowen, for their confidence and assistance. I also thank Anne Fitzpatrick and Laura McLean for their valuable xi

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and wide-ranging administrative help - coordinating the work of the contributors, handling organizational arrangements for the conferences, editing the entire manuscript - and for maintaining the good humor that made the process flow smoothly. I appreciate their assistance greatly. I also thank Elizabeth Selvin for her fine administrative support in the final stages of the publication process, Jeffrey Ballou for reviewing and providing helpful comments at the pageproof stage, and Michael Gnat for his valuable editorial help throughout the publication production process.

CHAPTER 1

The nonprofit mission and its financing: Growing links between nonprofits and the rest of the economy

Burton A. Weisbrod Introduction Massive change is occurring in the nonprofit sector. Seemingly isolated events touching the lives of virtually everyone are, in fact, parts of a pattern that is little recognized but has enormous impact; it is a pattern of growing commercialization of nonprofit organizations: Nonprofit hospitals are launching health clubs open to the public, with the latest exercise equipment and Olympic-size swimming pools, generating substantial profits and threatening the for-profit fitness center industry (Stone 1997). Nonprofit museums are opening glitzy retail shops, generating revenue that is now a larger percentage of operating income than that from federal funding or admissions and memberships (Dobrzynski 1997; Mullen 1997). Nonprofit universities are engaging in research alliances with private firms and suppressing research findings that are unfavorable to those firms' profit prospects (Altman 1997; Kolata 1997). Nonprofits in various industries are forming for-profit subsidiaries, engaging in joint ventures with private firms, and paying executives compensation at "Fortune 500" levels (Farhi 1997; Gosselin and Zitner 1997;Abelson 1998). Commercialism in the nonprofit sector sounds like a paradox: Nonprofits are supposed to be different from private firms, for whom commercialism is their very lifeblood. To some people, though, the uniqueness of nonprofit organizations is by no means self-evident; perhaps they are really not different from priI would like to thank Jeffrey Ballou for his comments.

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Burton A. Weisbrod

vate firms, but are just as influenced by business motives and opportunities for self-aggrandizement. Late in 1997 two apparently unrelated events brought front-page headlines. One involved a contract between the American Medical Association and the Sunbeam Corporation, a manufacturer of consumer electronic products, with the AMA promising to endorse Sunbeam products, such as heating pads and vaporizers, in return for payments expected to yield millions of dollars ("The AMA's Appliance Sale" 1997; Graham and Van 1997). The other involved the purchase by Chicago's Field Museum of Natural History of "Sue," the largest complete Tyrannosaurus rex fossil in existence - the $8.3 million cost being financed largely by McDonald's and the Walt Disney Company. McDonald's will get several "life-size replicas of the ferocious dinosaur, one of the most widely recognized dinosaurs and a powerful promotional tool" (Swanson 1997b: 9), and one of the replicas will be displayed at McDonald's DinoLand USA attraction at Disney's new (1998) Animal Kingdom theme park. In addition, the museum will display the original in its new McDonald's Fossil Preparatory Laboratory, and there is talk of miniatures, with the Field Museum name, being included in hamburger Happy Meals (Swanson 1997a). Both the AMA and Field Museum cases involved nonprofit, tax-exempt organizations contracting to receive multimillion-dollar payments from private firms. Both arrangements generated money but also criticism. The criticism of the AMA was so intense that its top leadership resigned and the AMA broke the agreement with Sunbeam, resulting in a $20 million breach-of-contract lawsuit (Collins 1997; Zuger 1997). The nonprofit sector has been both criticized and acclaimed. The rationale for its special tax treatment and subsidies rests on the belief that it provides services that are materially different from, and preferred to, the services that private enterprise provides. The theoretical case for expecting such differential behavior has been examined elsewhere (Weisbrod 1975,1988; Hansmann 1980; Rose-Ackerman 1986; Gray 1991). This book builds on the foundation of that literature, examining the ways that the mechanisms used to finance nonprofits' activities affect, and are affected by, the nature of those activities. In the United States, the past three decades have seen a tripling of the number of nonprofits, from 309,000 in 1967 to nearly one million today. Their total revenues, less than 6 percent of GNP in 1975, exceeded 10 percent in 1990 (Herman 1995). From 1980 to 1990, nonprofits' paid employment grew by 41 percent - more than double the overall growth of national employment (Salamon et al. 1996). As the nonprofit sector experiences such rapid growth, attention to it is bound to increase - and indeed it has. Why is the nonprofit sector growing? Special privileges for nonprofits are justified largely on the grounds that they perform the kinds of public-type functions typically identified with government - helping the disadvantaged, provid-

The nonprofit mission and its financing

3

ing social services, and supporting museums, schools, environmental preservation, and medical research. When the government is able to provide these services in forms and amounts that voters want, little role exists for nonprofits. However, when populations are very diverse, services that satisfy the majority may leave many people severely undersatisfied; nonprofits are thus understandable as an alternative mechanism for providing public-type services. The more homogeneous a society is, the more similar are its citizens' preferences, and the smaller the need for nonprofit organizations (Weisbrod 1975).1 This perspective on the relationship between nonprofits and government implies that the growth of nonprofit activity reflects an increase in the gap between perceived social need and government provision. From the perspective of any nonprofit organization, the need for its activity depends on the size of the aggregate problem and the degree to which government deals with it, in addition to the degree to which other nonprofits are active. If a nonprofit university sees the need to modernize its scientific research facilities in order to pursue cuttingedge research, but grants from government and donations from private sources are either decreasing or rising slowly, the lure of commercial revenue is likely to be powerful. Similarly, if the number of homeless people is growing despite whatever actions governments are taking, nonprofits fighting poverty are likely to be attracted to commercial mechanisms to generate additional revenue. Nonprofits' pursuit of additional revenue may reflect not only pressures to increase output but also increases in the cost of producing a stable output. As providers of heavily labor-intensive services, nonprofits tend to face a "cost disease." William J. Baumol and William G. Bowen, although not focusing on nonprofits, identified the cost-increasing pressure on service providers generally; they showed that in the service sector the limited opportunity to use capital to increase labor productivity drives costs upward (Baumol and Bowen 1966; Baumol 1967). In the nonprofit sector a museum, zoo, day-care center, or homeless shelter, for example, may have little potential for increasing productivity; hence, over time, overall economic growth will increase their costs and expand their search for revenue simply to sustain output. Whether this is equally true for other nonprofit subsectors, such as hospitals and colleges, is less clear. 1

In countries with relatively homogeneous populations, such as in Scandinavia, government is sufficient to meet the wants of its citizens for the various collective-type services; thus we find that governments are in fact considerably larger in those countries, while the nonprofit sectors are relatively unimportant. This helps to explain two phenomena that have been widely observed: first, the far greater importance of the nonprofit sector in the United States than in other countries; and second, the growing importance of nonprofits everywhere, as population migration and information flows through television and computers are having the effect of magnifying diversity in country after country. Nonprofit organizations accounted for one-seventh of net new jobs in France during the 1980s and one-ninth in Germany and the United States (Salamon and Anheier 1994, 31). Nonprofits' real expenditures grew by 240 percent in Hungary, 78 percent in Japan, and 55 percent in the United States (Salamon et al. 1996,22,28,40).

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As the nonprofit sector grows, the debate over its proper role in a modern economy continues, periodically grabbing public attention: Private firms claim they are victims of "unfair competition" from subsidized, tax-exempt, nonprofits, pressuring lawmakers to restrict nonprofits' commercial activities (RoseAckerman 1990); the federal government considers revising the personal income tax in ways that will affect incentives to donate to charitable nonprofits; local governments introduce the latest device for extracting money from supposedly tax-exempt nonprofits. In short, what brings the activities of nonprofits into the limelight is their links with the rest of the economy. Contrary to the common view, nonprofits are far from independent of private enterprise and government. They compete with and collaborate with these other organizations in countless ways in their efforts to finance themselves, to find workers, managers, and other resources to produce their outputs, and to develop markets for those outputs. As the nonprofit sector grows in size and commercial activities, is it becoming indistinguishable from the private sector? The fundamental issue is how, if at all, does revenue source affect an organization's behavior? This question is significant because at root is whether the organizations in the rapidly growing nonprofit sector deserve the subsidies and tax exemptions they receive from individuals and from federal, state, and local governments. This book demonstrates the enormous complexity of attempts to answer this question, and the equally great importance of doing so. U.S. nonprofits, and particularly the nearly three-quarters of a million that are deemed "charitable" and "social welfare" nonprofits - those exempt from federal taxation under sections 501(c)(3) and (4) of the Internal Revenue Code - do not operate outside the overall economy. Their interactions with private enterprise and government are taking a dizzying, ever-growing variety of forms. In some instances the drive for revenue is bringing nonprofits into headlong competition with private enterprise; this is most apparent in the hospital industry, where increasing pressure to contain health-care costs is bringing massive industry reorganization and intense price competition (see Chapter 8). In other cases, nonprofits are collaborating with these other sectors - as in biotechnology research, where universities and private enterprise are forming joint ventures, finding ever more complex ways of cooperating in the interest of generating revenues and facilitating scientists' mobility between the academy and private firms (see Chapter 9). The keys to understanding the interrelations of nonprofits with other parts of the economic system are the differential constraints on them relative to government and private enterprise, and the differential goals. Constraints are more easily observed. Whenever "rules" - regulations, taxes, or prices - differ among economic sectors, organizations can gain from exchanges between sectors. If, for example, prices differ, perhaps because of differential subsidies, then the unsubsidized sector will buy from the low-cost, subsidized sellers, other things be-

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ing equal. Nonprofit and for-profit organizations face differential restrictions on whether their income is taxed, differential availability of resources such as volunteer labor, differential restrictions on their freedom to lobby legislators (Arenson 1995b), and differential access to private and public subsidies. Differential goals, while more difficult to observe, are also important, as we shall see. Competition Nonprofits are competing increasingly with for-profit firms, and in an amazing variety of forms. The competition between nonprofits and private firms is made even more complex by the fact that at the same time that nonprofits are moving into activities that have previously been the domain of for-profit firms, private firms are expanding into traditionally nonprofit areas. Thus, private health clubs have entered an industry long the preserve of the nonprofit YMC As and YWCAs in the United States, and for-profit amusement parks "are encroaching on [nonprofit] museum turf by adding educational aspects to their entertainment products" (Becker 1995). Whenever private firms and nonprofit organizations become more competitive with each other, regardless of which enters the industry later, the likely result is that the two types of competitors will become increasingly indistinguishable. This expectation, however, should be regarded as a hypothesis to be tested, for even its theoretic basis is not firmly established. It is possible that competition could sharpen distinctions, leading to increasingly different market niches for nonprofits and for-profits. The nature of competition between nonprofits and for-profits, as well as of competition among nonprofits, remains poorly understood (but is examined in greater detail in Chapter 2). Among the industries we examine in Chapters 8-13 there is considerable variation in the relative sizes and growth rates of the nonprofit and for-profit sectors: In higher education (Chapter 9), social service agencies (Chapter 10), zoos (Chapter 11), and museums (Chapter 12), there is little or no private-enterprise sector. In the hospital industry (Chapter 8), by contrast, the nonprofit sector, although quantitatively dominant, is confronting competition from an increasingly aggressive private-enterprise sector. In television broadcasting, moreover, "public" (i.e., nonprofit-sector) television sustains a niche market in an industry dominated overwhelmingly by private firms (Chapter 13). Cooperation The commercialism of nonprofits does not necessarily involve their competing with private firms; it also occurs through cooperative mechanisms in which nonprofits and private firms join forces. Between 1980-1 and 1987-8, for example, private-industry support for university research more than doubled in

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real terms (Webster 1994). Virtually every major U.S. university has joined forces in some manner with large multinational firms, especially pharmaceutical and chemical firms (Blumenthal et al. 1996): Harvard University has contracted with the German chemical company, Hoechst A.G.; Washington University, with Monsanto Chemical Company; and Northwestern University, with Dow Chemical (see Chapter 9). Scientific research is not the only area in which nonprofit universities are becoming allied with private firms. Athletics is another. The University of Michigan recently reached a multimillion-dollar agreement to advertise athletic shoes for Nike; in a masterful obfuscation, Nike agreed to "help" the university design their uniforms! Even charities are engaging in such alliances: The March of Dimes (MOD) recently teamed up with Kellogg's, the manufacturer of breakfast cereals; the MOD received $100,000 in return for what amounts to an endorsement of Kellogg's Product 19 - a cereal that contains folic acid, which helps prevent birth defects of the spine and brain. This is no isolated example; the nonprofit MOD even has a senior staff member with the title Director of Strategic Alliances, National Promotions, to develop such money-generating arrangements (Mclver 1995 a). Nonprofits have discovered that there are massive potential financial benefits from such symbiotic relationships with private firms - benefits that are not occasional and random, but are systematic consequences of powerful economic forces. Universities and other nonprofits such as hospitals, museums, and charities receive many subsidies that can be converted into something salable to private firms or consumers. How should we look at all these market-oriented changes? Are they helping to strengthen nonprofits and make them more effective contributors to meeting society's needs, or are they weakening nonprofits, diverting their efforts, leading them into economic behavior that is counterproductive - perhaps even undermining public support, financial and political? The tension between a nonprofit's focus on raising revenues and on its publicserving social mission is well illustrated by universities' partnerships and alliances with private firms involving research in the life sciences, which are increasingly common, lucrative, and contentious. Over a decade ago, A. Bartlett Giamatti, then president of Yale University, noted this tension and pointed to "the academic imperative . . . to seek knowledge objectively and to share it openly and freely, while the industrial imperative is to garner a profit, which frequently creates the incentive to treat knowledge as private property" (Peterson 1983, 123). The subsequent growth of university-industry research collaboration may be exacting a price in the form of pressure from private firms to suppress discoveries that are adverse to their interests and profits (Chapter 9). Conflicts over the dissemination of adverse findings have occurred in a number of recent cases, involving researchers at the University of California at San

The nonprofit mission and its

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Francisco (UCSF) and at the University of Washington at Seattle. At UCSF, a researcher, operating under a grant from a private pharmaceutical firm, found that the effectiveness of a brand-name thyroid drug was no greater than that of generic versions that were considerably less costly - a finding that led the researcher to withdraw the paper, under threat of a lawsuit by the funder, on the eve of its publication in the Journal of the American Medical Association (Altman 1997). At the University of Washington, research findings that were unfavorable for private firms - that a popular form of spine surgery might not be effective, and that a popular drug for lowering blood pressure was associated with increased risk of heart attacks - were, according to the researchers, greeted by political pressure to eliminate the Federal agency that paid for the spine research and "harassment from drug companies and their academic consultants" (Kolata 1997). The "invasion of commerce into medical care" has been seen as "an epic clash of cultures between commercial and professional traditions .. ." (MeArthur and Moore 1997). Others, though, see nonprofits' emulation of, and involvement with, private firms as a sign of efficient resource utilization. Interaction between nonprofits and government The changes occurring in the nonprofit sector not only impact the relationships between nonprofits and for-profit organizations, but also influence the way nonprofit organizations interact with the governmental sector. When nonprofits expand, governments lose revenue. In the United States, the loss is particularly important for local governments, whose major source of revenue is property taxation: Every parcel of land that moves out of the taxed, private-enterprise sector and into the untaxed, nonprofit sector entails further loss of tax revenue. At a time when governments are searching desperately for new sources of income to deal with the growing problems of crime and poverty and the loss of revenues from the federal government, the expansion of nonprofits is a serious fiscal threat. The most recent report by the U.S. Treasury Department stated that 10 percent of all property in the country was held by tax-exempt nonprofits in 1977 (Arenson 1995c), and the figure is surely higher today: Indeed, the city of Syracuse, New York, found that 59 percent of its real estate was tax exempt in 1993; for Buffalo, New York, it was 34 percent (Glaberson 1996). Local governments are responding to this erosion of their tax base, developing innovative ways to circumvent state laws that grant exemptions from local government taxation, in order to collect revenue from nonprofit organizations. For example, cities are withholding zoning approval and building permits for new buildings unless the nonprofit university, hospital, or symphony orchestra agrees to pay a "voluntary" tax (often termed payments in lieu of taxation, or PILOT). Tension between nonprofits and governments is becoming so intense that lawmakers are searching for reasons to withdraw tax-exempt status alto-

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gether. This tension has escalated as evidence has surfaced that certain nonprofit executives were receiving levels of pay that were unseemly for charitable organizations. When Americans learned of compensation of over $500,000 per year for nonprofit organization executives such as the president of United Way of America, William Aramony, the chief executive of the PTL Ministry, the Reverend Jim Bakker, and the president of Adelphi University, Peter Diamondopoulos (Hancock 1996), most were shocked. Both Aramony and Bakker went to prison, but in the process the public faith in nonprofits was shaken (Gaul and Borowski 1993; Arenson 1995a). Nonprofits are increasingly being seen not as public-spirited philanthropies but as self-serving entities that pursue the interests of their top officials and board members. Another form of tension between nonprofits and government involves the application of antitrust laws to nonprofits whose activities have traditionally been regarded as benevolent. In 1991 the U.S. Department of Justice brought an antitrust action against a group of nonprofit universities for price fixing in their granting of financial aid to prospective students. One of the schools refused to abandon the practice, contending that the price fixing - which it admitted actually promoted social welfare because it increased overall opportunities for low-income students ("MIT Wins a New Trial in Price-Fixing Case" 1993). In effect, the university was saying that its collusion with other schools was socially valuable, whereas collusion in the private enterprise sector was not. The Justice Department disagreed. Neither side, however, could call upon solid research to buttress its case.2 Nonprofits and government are not always at odds; instances of cooperation between these two sectors have been documented as well. For example, nonprofits in the United States have discovered money-making opportunities in working with state governments to market automobile license plates. Thirtysix states now permit some nonprofits to benefit from specialty license plates that advertise arts organizations, universities, environmental groups, and garden clubs. The University of California at Los Angeles (UCLA) is collaborating with the state of California to sell a license plate that finances student scholarships (Herman 1995). Such cases of what amount to joint ventures between nonprofits and governments appear to be rare at present, but fiscal pressures on both types of organization are bound to generate more such novel alliances in the future.

2

Nonprofit hospitals, too, have fallen victim to antitrust laws, as proposed mergers have been held to be anticompetitive. Again, public policy hangs on matters about which little is known: whether nonprofit and for-profit organizations use monopoly power in materially different ways. One recent study, however, indicates that nonprofit hospitals that gain greater market power are likely to reduce prices, whereas for-profits are more likely to raise them (Lynk 1995).

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9

Financing

Many nonprofits face increasing financial pressure because the gap between their resources and what they see as social "need" is growing (see, for example, Wong [1997] on food pantries). This results from government-program retrenchment, in part, but the situation varies substantially among segments of the nonprofit sector. For arts and cultural nonprofits, revenues from government have decreased in real terms, increasing at an average annual rate of only 0.8 percent in nominal dollars during 1982-92 - considerably below the rate of inflation (Hodgkinson and Weitzman 1996,12). In the nonprofit health-services sector, revenues from government have grown in real terms; yet need, as reflected by the number of uninsured persons, has grown nonetheless, thereby increasing the pressure on nonprofits to find additional resources. "Need" is difficult to define and measure, but if nonprofits search for new revenues, they have few choices: to increase private donations and/or to increase income from the sale of goods or services - that is, "commercial" activity. Increasing donations is not promising for most nonprofits, although it has been rather successful for public television (Chapter 13). In the aggregate, individual giving has remained rather constant, at around 1.9 percent of personal income, for over two decades; between 1973 and 1994 it has ranged between 1.77 percent and 2.00 percent, with no apparent trend (AAFRC 1995,48). Although some new and imaginative forms of appeals for donations are being developed, there is little reason to expect that donations can be increased significantly unless tax laws are substantially changed. Such tax-law changes are being discussed, particularly the granting of tax credits to encourage charitable donations, but their future is beyond the control of any nonprofit organization. New commercial activities are the major path open to nonprofits to generate additional revenue; and once nonprofits enter the realm of finding salable outputs, they are in the domain of private enterprise, where selling goods and services is the preeminent source of private-sector revenue. Nonprofits that pursue revenue in the same ways that private firms do are likely to emulate those firms, and by becoming more like them may undermine the fundamental justification for their own special social and economic role. To what extent this occurs is important for public policy, since the justification for the subsidies and tax exemptions to nonprofit organizations hinges on nonprofits' differentiation from private firms. When nonprofits enter a new industry in search of revenues - for example, as hospitals are doing by establishing profit-seeking athletic clubs - it is natural to ask what distinguishes their weight rooms, saunas, and fitness clubs from those at traditional for-profit gyms and, hence, what justifies their tax advantages (Lambert 1997). It should be noted, though, that if a nonprofit becomes more commercial in its pursuit of revenue, it does not necessarily imply a forsaking of "core" values or mission.

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A significant source of income for many nonprofit organizations is user fees, charges levied on people who use elements of nonprofits' mission-related outputs that can be sold. Universities can charge tuition, hospitals can charge patient fees, museums and zoos can charge admission. As Chapter 4 emphasizes, however, user fees are a "double-edged" sword: The revenue helps with the finance problem, but the prices also unintentionally keep away some persons whose use of the services constitutes one of the organization's social goals. Increased tuition, patient fees, and admission charges inevitably price some intended consumers out of the market. One potential way to deal with this dilemma is to discriminate in price, charging lower prices or nothing at all to the target population of "deserving" consumers, while charging others higher prices. In the process of instituting user fees, nonprofits are increasingly using techniques out of the private-enterprise "playbook." Universities are pushing up tuitions (prices) at rates that have captured the front cover of Newsweek with the attention-getting "$1,000 a Week: The Scary Cost of College" (April 29,1996). They are increasingly engaging in price discrimination - charging differential prices by fine-tuning student financial aid to be more competitive - and they are negotiating with parents over those financial-aid packages (Asinof 1997). The percentage of freshmen receiving tuition discounts has grown at large colleges, from under 50 percent in 1990 to 60 percent in 1996, and the increase has been similar at small colleges (Passell 1997). Museums and zoos, which traditionally charged no admission at all, so as to maximize access, have dropped that policy wholesale, with few remaining free to everyone (Chapter 11). User fees are not the only evidence of growing commercialism among nonprofits. Universities, for instance, are reaching out to new markets - pursuing unconventional students such as senior citizens and people seeking weekend education (NPR 1997), and carefully scrutinizing opportunities to find other things they can sell profitably. They are even offering souvenir parts from sports stadiums that are being torn down: Notre Dame is selling bricks from parapets at its stadium, Indiana University has sold pieces from its basketball court for plaques, and Princeton is auctioning team benches and ticket-window signs (Fairclough 1997). Hospitals, too, are doing more than raising the daily hospital fee (approaching, and even surpassing, $1,000 per day). They are also reaching out to new markets - not only expanding into activities such as the fitness centers mentioned above, which have little to do with traditional patient care, but moving into new patient care activities that they had chosen to forgo until financial pressures mounted. Thus, hospitals are opening potentially highly profitable heart transplant units, and with speed that has generated charges of "unwise procedures," high mortality rates, and "potential malpractice" (Burton 1996); and they are "racing to develop and market equipment for . . . minimally invasive heart operations, vying for . . . a lucrative market." At least one hospital has put up billboards advertising the new procedure (Winslow 1997a).

The nonprofit mission and its financing

11

Commerciallike behavior by nonprofits is extending to labor markets as well as to output markets. Thus, nonprofit arts organizations and symphony orchestras have been accused of succumbing to union pressures to generate high salaries even at the expense of higher admission prices and reduced markets; the arguments have suggested that these nonprofits are acting like private firms rather than like public-serving organizations (Ritenour 1997).3 As we have already illustrated, nonprofits are also engaging in a growing array of new, ancillary activities designed simply or primarily to raise money. In the process they appear to be emulating private firms, finding ways to attract more paying customers. Prospective contributors are being treated increasingly as objects of psychological analysis to discover their motivations (Mclver 1995b). Universities, hungry for applicants, are offering guarantees of jobs after graduation (Quintanilla 1996). The winds of change and of commercialization are everywhere. This increase in commercial activities in the nonprofit sector raises the question of whether nonprofit organizations are merely "for-profits in disguise" (Weisbrod 1988), as Chapter 14 posits. To consider them as such might well be a mistake, however, because there is some evidence (presented in other chapters) that the way nonprofits use their opportunities to sell services reflects their social-service missions to reach particular target populations, not simply to maximize profit. There is also evidence that when contrasted in the same industry, nonprofits and for-profits behave in systematically different ways. For instance, pricing, including price discrimination, by nonprofits can be used not simply to generate revenue, but to achieve the organization's distributional mission (Chapter 4). Thus, while nonprofits may charge user fees to generate revenue to support their preferred, mission-oriented activities, they may and do establish price below marginal cost - even at zero - for certain consumers, such as the homeless, schoolchildren at zoos (Chapter 11), or indigent sick people at hospitals (Chapter 8). It is not clear, though, whether universities are acting differently than would a profit maximizer when they offer price discounts to students who use services during off-peak hours (weekends, evenings, and summers). It may be that they are operating at maximum profitability in these markets, applying a form of marginal cost pricing; but they could also be operating less profitably, or even unprofitably, in an attempt to appeal to certain underserved groups (Arenson 1996). Also arguing against the for-profits-in-disguise theory is the evidence that nonprofit and for-profit organizations behave in systematically different ways in markets where they coexist. In the day-care industry nonprofits have been found to have more experienced teachers, to be more trusted by consumers, and to encourage more parental involvement as volunteers in the classroom (Mauser 3

Why this type of behavior is occurring at this time is not clear. The direct pursuit of additional revenue, which may explain much of observed commercialism, does not seem to apply here.

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1993). In the nursing-home industry and the mentally handicapped facilities industry, nonprofits have been found to have significantly lower prices; to provide more labor per patient in such forms as registered nurses, dieticians, and volunteers; to make greater use of waiting lists; and to generate greater consumer satisfaction (Weisbrod 1998). In a number of industries within the healthcare sector it has been found that nonprofits provide greater access to persons regardless of ability to pay (Schlesinger 1998), although that differential appears to be decreasing in response to fiscal pressure. In the hospital industry it has also been found that nonprofits have significantly lower yearly variation in profit rates, which has been interpreted as evidence that they pursue non-profitmaximizing goals, seeking instead to maximize organization utility subject to a profit constraint (Hoerger 1991). Such findings of differential organization behavior suggest, but do not necessarily prove, that when financial constraints allow, nonprofits do behave in a fundamentally different manner from for-profit organizations. Nonprofits do appear to exhibit greater willingness to deviate from profit-maximizing choices in the interest of other goals, such as serving particular target groups, engaging in basic research, or providing other public-type services. The entwining of mission and revenue sources Nonprofit organizations confront a dilemma, as does public policy toward them: how to balance pursuit of their social missions with financial constraints when additional resources may be available from sources that might distort mission. When the mission is to provide collective services of the sort typically identified with government, but with taxing power not available, what are the consequences of using other forms of financing? When, as is increasingly the case, the finance mechanisms involve selling other things to finance the collective outputs, what are the effects? Can nonprofits simultaneously emulate private enterprise and yet perform their social missions? Are public-interest goals and private-enterprise money-raising measures compatible? Nonprofits are generally well aware of the issues, as is clear from the industry studies in Part II. The dilemma was voiced recently by I. Michael Hey man, Secretary of the Smithsonian Institution, who, while discussing the decision to seek "corporate sponsorships" to raise additional money, noted that maintaining the nonprofit's "integrity" was important, but that "the costs are outweighed by the benefits" (NPR 1996). Whether "costs" are seen in terms of adverse effects on an organization's mission or on prospective donors' perceptions of such effects on that mission, or both, is an open issue; that is, the actual impact of a particular fund-raising mechanism on organizational behavior may differ from that perceived by outsiders.

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13

The sources of financial support for all organizations, whether nonprofit, forprofit, or governmental, are crucial determinants of the organization's behavior - the kinds of goods and services it produces, the combinations of labor and capital it uses to produce them, and the ways it distributes the outputs. An organization that is completely dependent on revenue from sales of goods and services - "commercial" activities - will produce only things it can sell profitably, will use production processes that minimize production costs, and will provide outputs to all who are willing to pay more than marginal cost of production, giving nothing away unless that generates sufficient revenue from other sources. This characterizes the private firm. An organization that depends entirely on revenue from taxation responds to a different set of incentives. Thus, a government agency that is financed fully through taxation can be expected to produce services that are determined through the political process, not via private markets. Moreover, it can distribute its outputs to the target consumers at a zero price, since it needs no additional revenue. A "pure" nonprofit organization may be thought of as dependent entirely on yet a third source of revenue: donations, in the forms of contributions, gifts, or grants. In the extreme case, with donations coming exclusively without "strings" attached (except that they must be put to the nonprofit's tax-exempt purposes), the organization can distribute output as it wishes. This is similar to the distributional situation for government agencies, but the goals of the nonprofit may well differ from those of government, and the constraints imposed on nonprofits tend to differ from those that the political process imposes on government. Nonprofits can also be expected to differ from private firms and possibly from government in the way they combine labor and capital in the production process. Nonprofits receive enormous amounts of volunteer labor: The vast majority of the total of nearly nine million full-time equivalent volunteers went to nonprofits, where they constituted the equivalent of 36 percent of total employment in 1994, compared with 9 percent in government (largely in schools), whereas in private enterprise volunteers are a negligible percentage of total employment (Hodgkinson and Weitzman 1996, 13). There is also evidence that nonprofits are able to employ paid labor at lower prices than private firms; such reduced labor supply prices constitute a kind of donation, one that because of its form does not appear in data on charitable giving. As a result of such lower labor supply prices and volunteered labor, nonprofits can be expected to use more labor-intensive production processes than would an otherwise comparable private firm. To say that private firms, government agencies, and nonprofit organizations tend to rely on distinct sources of finance - sales for the firms, taxes for the

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agencies, and donations for the nonprofits - is not to say that any of these types of organization relies on a single source.4 Our focus on nonprofits is designed to highlight the extent to which large changes are occurring in the economy in ways that affect nonprofits' ability to pursue their missions. Donations from private sources are of declining relative importance, as Table 1.1 shows: Whereas nonprofits in 1964 received private contributions equaling over 53 percent of their total operating expenditures, that number shows a large and continuous decline to less than 24 percent in 1993. Volunteered time has also declined in recent years, from 9.2 million full-time equivalent workers in 1989 to 8.8 million in 1993 (Hodgkinson and Weitzman 1996, table 2.13). With the change in revenue sources come changes in organizational performance as nonprofits adjust. It should be noted, though, that not enough is known to be certain about the direction of causation - whether changes in contributions of time and money are the cause or the result, or both, of changes in nonprofit organizations' activities. What finance options are open to nonprofits? The central distinction that needs to be emphasized between "donations" and "sales" is the degree to which the recipient organization must relinquish control over its activities in order to satisfy the party offering the resources. Chapter 7 discusses this point, highlighting control as the key element of "conversions" of nonprofits to for-profit legal status. Any organization selling its output can succeed financially only by offering outputs for which buyers - be they individuals, firms, governments, or nonprofit organizations - are willing to pay. In that sense the seller's ability to succeed in pursuing its goals is constrained by buyers' wants. Similar constraints sometimes accompany "donations." The offer of a donation, without restriction, to support a nonprofit's organization mission does not constrain organization behavior in pursuit of its goals, but not all donations are unconstrained. Yale University, for example, recently returned a major "gift" because its purpose was to support a program that, in the end, was not endorsed by the university administration and faculty. Similarly, Grove City College, in Pennsylvania, turned down the opportunity to receive financial help through the federal government student loan program because the college is not willing to accept at least some of the restrictions imposed by the seven thousand regulations delineated under laws authorizing student grants and loans (Ritter 1996); contributions from governments, just as from private sources, can restrict an 4

Henry Hansmann has distinguished between "donative" and "commercial" nonprofits, reflecting the difference between those that are dependent primarily on one or the other source of revenue (Hansmann 1980). However, there are nonprofits at virtually all level of dependency on donations from one source or another, and there are distinct differences among industries. For nonprofits engaged in legal aid, 97 percent of their revenues have come from "contributions, gifts, and grants"; for civil rights nonprofits, 65 percent; welfare nonprofits, 43 percent; cultural nonprofits, 27 percent; health nonprofits, 8 percent (Weisbrod 1988,76 [table 4.2]).

The nonprofit mission and its

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Table 1.1. Private contributions as percentage of all nonprofit operating expenditures, 1964-93 Year

%

Year

%

Year

%

1964 1965 1966 1967 1968 1969 1970 1971 1972 1973

53.5 52.8 50.4 48.8 47.7 45.3 41.5 41.5 39.1 36.8

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983

34.7 33.1 33.8 34.2 33.0 32.7 32.3 32.4 31.0 30.3

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

30.6 29.7 32.0 28.5 27.3 26.9 25.5 24.5 23.6 23.6

Source: Hodgkinson & Weitzman, Nonprofit Almanac 1996-1997. San Francisco: Jossey-Bass, 1996, tab. 2.1.

organization's pursuit of mission. Moreover, the effects of such restrictions are not limited to donations to private nonprofit organizations; public organizations also are affected. The University of California at Berkeley recently balked at accepting a multimillion-dollar grant from a Taiwan foundation because it required the university to commemorate a former president of Taiwan who had been blamed for "repression of thousands of political dissidents" (Golden 1996). The fact, however, that the university still considered whether to accept the funds, despite the constraint they carried, points up the vagueness of many nonprofit and public organization missions, which makes it easy to debate whether the package of the funds and constraints would or would not be acceptable. In short, when there are strings attached to donations, those revenues are essentially akin to sales. Unrestricted donations can be used to advance the organization's mission, and so they are preferred by the organization to revenues that entail restrictions. Whether restrictions are imposed by prospective "donors" or by buyers of goods, however, the effect is the same. If an organization must produce some ancillary output for sale in ordinary commercial markets to generate revenue (as when a hospital sells laundry or laboratory testing services) or if an organization must tailor its production to a donor's wishes (as when an arts organization must forgo politically controversial subjects in order to get a grant from the National Endowment for the Arts [NEA]), funding poses a problem for the pursuit of "mission" as that is seen by the nonproflt's trustees and leadership. There is likely to be conflict over whether the advantages of having

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the additional funds to pursue the mission exceed the disadvantages of the constraints. (Of course, restrictions do not necessarily constitute constraints: An organization may wish to use even unrestricted marginal funds in the same manner as that prescribed by restricted funds.)5 For private firms, benefits and costs have a single metric - organizational profit; for nonprofits and public agencies, the mission metric is more complex. For the NEA, for example, the choice is how to deal with Congress's displeasure with some past grants, which implies that future funding - "contributions" - may depend on the willingness of the NEA to alter its view of its mission (Fritsch 1996). Nonprofit organizations are becoming more dependent on commercial activity in one form or another, and less on contributions from either private or government sources, but all industries have not been changing equally. Cost interdependencies between mission-related and ancillary activities, for example, can lead to varying commercial profit opportunities being available to nonprofits in different industries. Table 1.2 shows considerable industry variation in the growth of sales revenue from "program services" in recent years, although program services encompass user fees from both mission-related and ancillary activities. For nonprofits in health care, the share increased to 89.3 percent of total revenues in 1992 from 86.7 percent in 1987, and it soared to 35.5 percent from 16.1 percent for environmental/animal-related nonprofits. By contrast, this measure of commercialism actually decreased for nonprofits engaged in international and foreign affairs, while it remained stable in the arts, culture, and humanities sector. The potential dilemma for a nonprofit organization involves its need for resources but the likelihood that the methods used to generate those resources will require sacrifice of control over their use. No source of revenue has unambiguous effects. While some donations are unrestricted, others limit recipient control, as illustrated above. At the same time, "sales" (or "program service" revenues), while highly restricted insofar as buyers must be satisfied or they will not buy, can generate profit that can then be used freely in pursuit of a nonprofit's mission. Thus, the distinction made in a number of the chapters between a nonprofit organization's revenue from donations and from sales is a proxy: The conceptual distinction is between revenue that is unconstrained, facilitating advancement of the nonprofit's mission, and revenue that is constrained, forcing the nonprofit to choose between forgoing the funds or distorting its social mission. 5

Constraints on how contributions are used may actually augment the supply of funds. This could occur if informational asymmetries (i.e., donors not knowing how funds would be used) would cause donors to give less unless the use of funds was appropriately restricted. A university alumnus, for example, might wish to earmark a gift for financial aid, to be certain that the money would not go for a football-stadium Scoreboard. At the same time, the fungibility of money can have a net effect quite different from that reflected in the donor's restriction.

The nonprofit mission and its

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Table 1.2. Sources offunds, nonprofit sector industries, 1987 and 1992 Private contributions (%)

Government grants (%)

Program services (%)

Industry0

1987

1992

1987

1992

1987

1992

Arts, culture, and humanities Education Environmental/animal Health Human services International, foreign affairs All nonprofits*

38.3 14.2 35.8 3.8 18.2 54.2 11.6

38.7 13.3 30.2 3.3 19.1 58.3 10.2

11.0 11.9 8.3 2.4 25.5 26.8 7.9

10.5 11.0 6.5 2.3 24.4 26.6 7.5

26.7 56.8 16.1 86.7 43.5 13.2 69.1

26.5 60.8 35.5 89.3 46.4 8.3 73.5

Note: Row amounts do not sum to 100% for either year because of the exclusion of "other" sources of revenue. "Numbers of organizations for each industry are not given in the source. includes industry sectors not included above, which total 6.0% of total revenues in 1987 and 5.8% in 1992. Source: Adapted from Hodgkinson & Weitzman, Nonprofit Almanac 1996-1997. San Francisco: Jossey-Bass, 1996, tab. 5.11.

The issues are subtle. The scope of nonprofits' missions is generally defined so broadly that it is often unclear whether a particular fund-raising mechanism will or will not be constraining. Moreover, even when nonprofits engage in "unrelated" business activities, they often argue that these activities, while providing needed funds, do not distract the nonprofit from its social mission (see Chapter 10). The contrary view, difficult either to support or refute, is that the simultaneous pursuit of a nonprofit's mission - to provide certain privately unprofitable but socially desirable services - and the provision of profit-making ancillary activities poses inevitable conflicts. Such a claim is that the two processes - one to produce and distribute the mission-related good, the other to raise the funds to finance it - cannot be entirely separated; they are interdependent. The likelihood is great that cost interdependencies will be present between the mission-related and ancillary outputs. The reason is that the search for ancillary services that can be sold at a profit is likely to involve services that use many of the same resource inputs as do the mission-related activities. The same workers and managers may devote their time to both, and they are likely to share the same capital - buildings, space, and equipment. For example, sharing of inputs is involved when a university uses its engineering laboratories for both student instruction and commercial testing services for private industry. Chap-

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ter 5 reports estimates, for example, that added ancillary outputs have little marginal effect on total managerial costs, whereas added output of mission-related activities has substantial effects. Sometimes the mission-related and ancillary activities are linked not through their resource inputs but through the consumers to whom outputs are marketed. Museum shops cater to the people who visit the associated museums, and university bookstores cater to the students whose education constitutes a significant component of the university's tax-exempt mission. Private firms also produce and sell multiple goods, and when they do, the goods are also likely to be related through either their production or sales processes. What is special about nonprofits is that their choices of goods can be expected to reflect the tax-exempt status of some of their activities, but not of others, as well as the subsidized nature of many of their inputs. Tax considerations have implications for the allocation of the nation's resources between the "untaxed" nonprofit sector and the "taxed" private-enterprise sector; this is the focus of Chapter 5. The competitive tax advantage nonprofits have over private firms is greatest when the capital-labor ratio in the organizations is highest, and in geographic areas where corporate tax rates and real property tax rates are highest. The differential tax treatment of nonprofits and private firms can bring quite undesirable social consequences. The case of Bennington College, a nonprofit school in Vermont, highlights the possibilities. In 1983 the president of Bennington College made a discovery: Since Bennington was a nonprofit organization that paid no corporate profits taxes, it did not benefit from being allowed to charge depreciation as a cost of production; private firms, by contrast, did benefit, since depreciation reduced their tax liabilities. The college had found an opportunity to gain from exchange between sectors that differed in their tax rules. Soon Bennington agreed to sell all its buildings to an alumni group, for $3 million to $8 million annually, and lease them back for 99 years. "In effect, the college would get an interest-free loan and the alumni would reap tax benefits" (Biddle and Slade 1983). Both the college and the real estate purchaser benefited - as inevitably occurs when organizations face differential prices for the same commodity (Galper and Toder 1983). Not everyone gained, however: Taxpayers lost, as tax revenues declined. In effect, tax benefits were being sold. Congress subsequently prohibited such "sale-leaseback" arrangements, which have no economic justification but to reduce taxes. Nevertheless, the potential for mutual gain for the taxed and untaxed sectors remains. Other novel exchanges between the nonprofit and private enterprise sectors can be expected. After all, since organizations in both sectors can benefit from the differential rules under which they operate, the incentive to find ways to overcome the barriers to trade across sectors remains. The existence of taxed and untaxed sectors also provides an incentive for organizations to begin as nonprofits and later convert to for-profit status. Although

The nonprofit mission and its financing

19

generally restricted by law, the incentive can be enormous, since nonprofits are legally precluded from distributing their profits and surplus to managers or directors. If a conversion can be arranged - as has been occurring with dramatic frequency in the hospital and HMO industries - the potential for private gain is great; the consequences with respect to the nonprofits' social mission, however, is also critical, and the breadth of missions make it difficult to discern the validity of a claim that commercial activity distorts nonprofits' behavior toward nonmission activities. Analysis in Chapter 7 of the conversion process and the associated incentives shows how the massive private benefits can obscure changes that have important consequences for nonprofits' missions. Once it is recognized that nonprofits' social missions involve collective services that must be financed primarily out of some combination of donations (private or public) and revenue from sales, a number of elements of nonprofit organizations' behavior become more clear. Consider, for example, the question of whether hospitals should continue to be granted nonprofit charitable status, with the accompanying subsidies, in light of the fact that the vast majority of their revenue is raised through sales - providing care to persons who pay, either directly or, more commonly, through insurance, just as patients do in forprofit organizations (Chapter 8; see also Clark 1980). Similarly, nonprofit universities provide educational services to students, many of whom pay full tuition. Consumers who pay more than the marginal cost are, in effect, subsidizing those who do not. However, the social mission of a nonprofit, in any industry, should not be thought of as to do what a private firm would otherwise do. In the case of hospitals, the mission is to care for the indigent, to undertake research that generates widespread knowledge, and to provide such community services as education about drugs and maternal nutrition. In the case of universities, the social mission is the provision of basic research, education to the poor, and dissemination of information; these are the candidates for public encouragement. From one source or another, such collective goods - socially valuable but privately unprofitable - must be financed. As noted earlier, contributions from the private sector and government are important sources (Gr0nbjerg 1993). They are preferred insofar as they are unconstrained. Profit from sales to consumers - for instance, hospital patients or college students - who pay more than the marginal cost of their services is another. Nonprofits' tax exemptions are understandable as an indirect way of financing private provision of collective services. Public policy and the financing of nonprofits9 mission Attention to nonprofits' large and growing commercial activity is necessary because it highlights both the differences between what society expects from nonprofits and private firms, and the similarity in the financial constraints that they

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face. By focusing on the collective-good mission of nonprofits and their inability to levy taxes to finance that mission, this book points to a likely contradiction in public policy: The social goals of nonprofits may well be incompatible with the instruments society wants them to use to attain those goals. More public pressure is being placed on nonprofits to increase their activities to offset government cutbacks. At the same time, pressure is increasing on nonprofits to avoid commercial revenue-raising devices because they involve either competing with private firms or joining forces with them, both of which pose problems. Society cannot have it both ways. We cannot expect nonprofits' outputs to increase if their access to revenue is restricted. At present, public policy is permissive in its regulations as they affect nonprofits' access to commercial markets. However, the disadvantages of having nonprofits act increasingly like private firms are considerable. Public-policy makers need to understand how the ability of nonprofits to achieve their social goals is related to their access to revenue and, more particularly, their involvement with the sale of private goods. The challenge for public policy may well be to find alternative revenue sources that would make it possible for nonprofits to act less like private firms, at least in terms of their choices of outputs and target populations, and to concentrate more on their mission-related activities. This public-policy theme will recur in one chapter after another, with an overview in Chapter 15. For now it may be sufficient to note that there are dangers of commercialism when provision of collective services is the objective of public policy. Just as there "must" be a better way to finance political elections than to "sell" access to the White House Lincoln Bedroom, so too there must be a better way to finance great nonprofits such as the American Museum of Natural History, in New York City, than by converting it, albeit only one morning per week, "into a kind of Jurassic Gym, an exotic health club for an elite band of mostly Upper West Siders who . . . power walk their way past the dioramas" - in return for a contribution of at least $100 (Sontag 1997). Understanding nonprofits9 commercialism the chapters ahead The chapters that follow are grouped in three parts. Part I, "Basic Issues and Perspectives," deals with broad matters that apply to nonprofit organizations generally. Part II comprises industry studies that portray the varied mission goals and financial bases, and their changes. Part III provides an overview of our findings and their implications for research and for public policy toward nonprofits. More particularly, Chapter 2 sets the stage for examining the interplay of nonprofit organization mission and revenue sources. It shows how commercial

The nonprofit mission and its financing

21

activity by nonprofits typically involves increased competition with for-profits and with other nonprofits. It also considers how competitive commercial activity affects nonprofits' ability to pursue their social missions. Chapter 3 sets forth our conceptual framework. Viewing nonprofits as having missions to provide certain socially preferred services, it examines the question of financing nonprofits at a theoretic level, highlighting the relationships between a nonprofit's social mission-related activities and its ancillary activities undertaken purely as revenue providers. Chapter 4 explores the issue of user fees, examining the differences between the kinds of discriminatory pricing that a profit-maximizing firm would tend to employ and the kinds that a nonprofit would use if it is concerned about social goals or reaching particular target populations, rather than profit. For example, a for-profit firm would be less likely to admit large classes of unprofitable consumers for free - as many nonprofit museums do with school groups - or to cut prices for undergraduates who are highly able but poor, when less able but wealthier students who would pay a higher tuition price are turned away - as nonprofit universities commonly do. Chapter 5 shows how the differential tax treatment of commercial activities that are either "related" (and thus tax-exempt) or "unrelated" (and taxable) to the nonprofit's mission creates incentives that are sometimes surprising and often unintended. For example, it explains the anomalous situation in which nonprofits, overall, actually report that they are suffering losses in the ancillary activities that, while unrelated to their tax-exempt mission, have as their only justification that they are generating profits in support of the tax-exempt mission! In addition, this chapter explores the forces at work when nonprofit and for-profit organizations confront each other, but also when the clash between social mission and the lure of profit occurs within a nonprofit organization that engages in both mission-related and unrelated activities. Utilizing the theoretic model of Chapter 3, Chapter 6 explores the causal connections between unexpected, exogenous changes in a nonprofit organization's revenue from its preferred source, donations, and that organization's subsequent commercial activity. Data from the IRS for the period 1982-93 are utilized to estimate the effect of changes in donative revenue on subsequent levels of sales revenues - whether from mission-related user fees or from the sale of unrelated goods and services. This chapter examines a unique, decade-long panel data set for nonprofit organizations in the hospital, higher-education, and museum industries. Chapter 7, the final installment of Part I, focuses on what we have termed the "ultimate commercialism of nonprofits": their conversion to for-profit form. Increasingly common in the hospital and HMO areas, such commercialization poses severe public-policy challenges. This tension between the opportunity for private gain and the public-policy mission for nonprofits - social gain - is examined. A conversion to for-profit status may simply be privately beneficial to

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insiders, or an efficient reallocation of resources, or both; the challenge is to avoid the former. Particular attention is directed to the difficulty of ensuring that the assets of the nonprofit that is converting are used in ways that are consistent with public policy, since tax benefits contributed to the amassing of those assets. In Part II the framework presented in earlier chapters forms the foundation for studies of commercialism in hospitals, universities, social services, zoos and aquariums, museums, and public television. It becomes clear that the dependence of nonprofit organizations on revenue from sales varies greatly, as does the extent to which commercialism is growing in various industries. As the analysis in Chapter 3 suggests, opportunities for profitably expanding commercial revenue differ greatly across industries. Having focused on the constraints that commercial revenue can impose on nonprofits' public-serving mission - which is the ostensible justification for the subsidies and tax exemptions - and having highlighted the tension between the need for revenue to foster that mission and the danger that revenue-raising activities will compromise the mission, we turn in Part HI to an assessment of what has been learned. Chapter 14 considers two alternative interpretations of the actual role of nonprofits: one that emphasizes the importance of social mission, another that emphasizes the role of private self-interest. Chapter 15 concludes with a summary of the book's findings and interpretations. It also identifies needs for future research and the public-policy implications of our findings.

PARTI

Basic issues and perspective

CHAPTER 2

Competition, commercialization, and the evolution of nonprofit organizational structures

Howard P. Tuckman

Introduction Competition among nonprofits and between nonprofits and for-profits is a present day reality. What is its impact on nonprofit behavior in the marketplace? To what extent does it lead to commercialization of nonprofit activities? Does it cause nonprofits to alter their organizational structures or for-proflts to alter their services to copy nonprofit behavior? What effects does it have on nonprofits' ability to pursue their charitable missions? This chapter analyzes competition among nonprofits in settings where only nonprofits compete, and in markets where both nonprofits and for-profits coexist. It begins with a definition of competition and then presents five competitive forces and uses these to examine competition in a market where only nonprofits compete. The conditions under which commercialization is likely to occur are discussed, and the nature of competition in settings where nonprofits compete with for-profits is explored. Examples from the health-care industry are used to explore the evolving legal structures that nonprofits are employing in settings where they compete with for-profits. The chapter ends with a discussion of the challenge that these changes pose for public policy: to ensure that the evolving institutional changes, as well as the pressures toward commercialization, do not diminish the unique charitable role of the sector. The nature of nonprofit competition Competition, the pursuit of the same objective by two or more firms, creates rivalry among nonprofits for capital, labor, customers, and/or revenues. This rivalry is normally not motivated by a desire for personal acquisition of profits, The author acknowledges useful ideas from Richard Steinberg and Carol Babb.

25

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Howard P. T\ickman

although equity accumulation may become a goal of an organization (Chang and Tuckman 1990; Brody 1996,491). Nonprofits vie with each other for revenues, board members, customers, contracts and grants, donations, gifts and bequests, prestige, political power, and volunteers (Brody 1996,469). Their competition with other nonprofits for customers may involve the production of high-quality products, contesting of market share, or a concerted effort to hold the best reputation. Nonprofits also compete for alliances with for-profit and government entities (Weisbrod 1996). It is helpful to use the term basis for competition to refer to the way that competitors choose to compete to meet their customer/constituent needs. Basis for competition changes depending on the industry and the needs of the consumer. In the for-profit world, burger chains compete on the basis of who can produce food most quickly and on price; amusement parks on the latest and most exciting new rides; discount stores on price and variety of inventory; and convenience stores on location and speed in getting customers in and out of the store. In the exclusively nonprofit world, competition frequently is based on quality of service, ability to meet constituent needs, and reputation. For example, disaster-relief agencies usually compete on speed of response to an emergency; nonprofit hospices on quality of comfort offered to patients; and advocacy organizations on how well they articulate the position of their members, and on access to media and public officials. Nonprofits exist in a variety of settings, some involving competition with other nonprofits and others competition with for-profits. Limited situations exist in which nonprofits offering food to the poor face for-profit competitors; instead, competition is normally with other nonprofits. In contrast, nonprofit hospitals vie with for-profit competitors in many marketplaces. Though the relevant setting can be the local marketplace, national data are helpful in illustrating the different competitive settings faced by nonprofits. Table 2.1, which uses the Independent Sector definition of nonprofit organizations and is compiled from several national sources, shows the wide variation in the importance of nonprofit organizations in various industries, ranging from single-digit market share in legal services and radio-TV broadcasting to over 50 percent share in hospitals, museums, and job training. Note too that the importance of nonprofits has increased between 1982 and 1992 in some markets (e.g., nursing and personal care) and declined in others (e.g., child day-care services). Commercialization of nonprofits occurs when these organizatons decide to produce goods and services with the explicit intent of earning a profit. The decision to commercialize normally leads a nonprofit into a mixed-mode marketplace where it competes with for-profit organizations. Such competition can result either if nonprofits enter a market where for-profits already exist or if they are successful at creating a product that for-profits later choose to offer. Non-

27

Competition, commercialization, and organizational structures

Table 2.1. The importance of nonprofit organizations in the independent sector: Selected industries, circa 1982 and 1992 Pet. of organizations in independent sector^

Pet. of revenues in independent sector

Category

ca * 1992

ca. 1982

ca. 1992

ca.1982

Nursing and personal care facilities Hospitals Elementary and secondary schools Colleges and universities Religious organizations Legal services Individual and family services Job training and related services Child day-care services Civic, social, fraternal organizations Radio and TV broadcasting Producers, orchestras, and entertainers Museums, botanical, zoological gardens Foundations

28.4 51.4 23.5 46.0 100.0 1.1 79.7 69.8 31.1 100.0 3.3 23.4 86.6 100.0

21.3 51.0 8.7 51.5 100.0 1.1 88.5 79.4 41.2 100.0 5.1 19.3 94.3 100.0

30.9 66.0 24.8 34.6 100.0 1.1 90.5 83.3 41.2 100.0 3.2 24.6 94.3 100.0

26.9 63.4 9.1 31.9 100.0 1.3 94.3 84.0 52.1 100.0 4.3 25.0 97.5 100.0

a

As opposed to the for-profit and government sectors. ^Indicates that the exact date of the data varies by category. Source: Adapted from Hodgkinson & Weitzman, Nonprofit Almanac 1996-1997. San Francisco: Jossey-Bass, 1996, tab. 4.7, p. 201.

profit hospital entry into the medical-supply business provides an example of the former, whereas the entry of private health clubs into markets once dominated by YMCAs and YMHAs illustrates the latter. We shall deal with institutionally mixed industries later in this chapter; the next section explores competitive issues in marketplaces populated exclusively by nonprofits. Competition in exclusively nonprofit markets Lack of literature on competition in exclusively nonprofit markets Much has been written about the competition among health-care nonprofits in mixed-mode marketplaces and its implications (e.g., Gray 1986,1991) but, with the exceptions of Steinberg (1987) and Ben-Ner and Van Hoomissen (1991), researchers studying exclusively nonprofit marketplaces have paid scant attention to the effects of competition on nonprofit behavior. This is particularly true

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Howard P. Tuckman

in the social service, religious, and cultural areas where the literature focuses primarily on fund-raising issues and the problems associated with revenue accumulation. As Weisbrod (1996) notes, the lack of the power to tax means that when nonprofits face increased demand, they also face pressures to expand their resource base. Much of the available literature written about nonprofits operating in exclusively nonprofit markets has been devoted to how to accomplish this, and on the consequences of resource dependency (Gronbjerg 1992,1993). An important concern raised in the literature is that nonprofits can be heavily influenced by the goals and objectives of their major funders and this can affect their missions. Although a few authors (e.g., Young 1987) have identified nonmonetary objectives that cause managers of nonprofits to compete with each other, little attention has been paid to how competitive forces affect the goals of nonprofits, their financial condition, their behavior in the marketplace, and their ability to carry out their goals. Nonprofits face many competitive forces similar to those that affect forprofit organizations. For example, both are subject to changes in both supply and demand. Donations to nonprofits are determined, in part, by the value donors place on their services; nonprofits with highly valued missions offering services in scarce supply (relative to demand) may find fund-raising easier than do those with less highly valued missions - although evidence on this point is scarce, and measurement of "valued mission" independent of actual donations is difficult. Similarly, when nonprofits demand large numbers of volunteers, scarcities for this type of labor can develop. Exclusively nonprofit marketplaces When will a marketplace be populated solely by nonprofits? Normally, this will occur when a nonprofit supplies products or services that cannot be financed through exchange between buyers and private enterprise or government sellers. Weisbrod (1977) theorizes that nonprofits arise to fulfill the demand of particular groups for the production of "public" or "collective" goods. These goods have two key characteristics: They are nonrival, in the sense that one individual's consumption of them does not affect the consumption by another, and they are nonexcludable, in the sense that individuals who fail to pay for them cannot be excluded from their consumption. Nonprofit radio broadcasts, economic development efforts on behalf of a city or region, and scientific research provide examples of collective services. For-profits find it difficult to exist in such markets because the primary source of their funding would have to be donations and gifts, and donors are reluctant to donate to these enterprises, recognizing the potential for their contributions to flow into organizational profits and dividends rather than increased output (Hansmann 1980). Competition between for-profits and nonprofits is also unlikely in situations where excludable goods or services are produced and individuals receiving the

Competition, commercialization, and organizational structures

29

intended output cannot afford to pay: Housing the homeless, health care for the poor, and youth services to indigents are cases where competition is likely to be exclusively among nonprofits. In these circumstances, nonprofits act as financiers, seeking funds from donors and other sources, often buying goods from the for-profit sector and distributing them as charity. United Way provides a well-known example of this, as do Catholic and Jewish charities. Trust issues normally preclude for-profits from playing a financier role, primarily because for-profits have an incentive to increase profits by diverting donated funds from the donor's intended use (Hansmann 1980). A third market setting comprising solely nonprofits in competition may exist where goods and services could be produced and/or supplied by for-profits but where, for various reasons, nonprofits enjoy competitive advantage: where liability laws impose heavier penalties on for-profits than nonprofits; public policies provide and encourage donations and grants solely to nonprofits; public advocacy is detrimental to for-profits; volunteer labor is more available to nonprofits, and so on. Public policy can affect the mix of for-profit and nonprofit providers in these markets through its legal treatment of the respective entities (Steinberg 1993b). In markets populated exclusively by nonprofits, the basis for competition can be affected by the preferences of individual donors and foundations, the mores of professional organizations, and other third parties that emphasis charitable purpose. Shelters for battered women are almost exclusively the domain of nonprofits, and this places primary importance on the quality of the counseling received in these settings, rather than on raising market share or customer-based revenue (Ferris 1993). How and which services are delivered, who provides them, and for what periods of time are determined largely not by the standard of their contribution to profits, but by the professionals and volunteers who influence the way a nonprofit is run. Similarly, the values and goals of religious nonprofits affect fund-raising, recruitment of volunteers, service provision, and so on. Jeavons (1993,72) argues that "for religious organizations, the proverbial 'bottom line' is 'faithfulness.' The question is not just whether they provide a particular service and do so well; it is also whether they do so in such a way as to make the love of God and their own vision clear and visible to others." Hodgkinson et al. (1995, 216) report that contributors to religious organizations were far more likely than other donors to report that commitment to their religion or spiritual life was a key "life goal." Porter's jive competitive forces in exclusively nonprofit markets At least five forces influence the nature and degree of competition, as well as its basis (Porter 1980): ease of exit and entry, bargaining power of customers, bargaining power of suppliers, threat of substitute products or services, and ri-

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Howard P. Tuckman

valry among competitors. Porter uses these factors to analyze marketplaces populated by for-profits only; here we adapt them for use in understanding competition in markets populated exclusively by non-profits, and in those involving competition between nonprofits and for-profits. Ease of entry. The conditions governing entry into an exclusively nonprofit market can affect the types of product produced by nonprofits as well as product distribution. New nonprofits have an important impact on existing ways of providing customer service. An example is helpful: In the 1960s and early 1970s, economic education was provided primarily by university-affiliated centers under the purview of the Joint Council on Economic Education and funded by the Ford Foundation. The emergence of Junior Achievement as a substantial competitor in both national and local markets, as well as of other nonprofit economic education providers, created an interesting competitive situation in an exclusively nonprofit marketplace. The Joint Council affiliates initially emphasized mainline economic principles and delivered education to teachers primarily through university-affiliated faculty. In contrast, Junior Achievement affiliates emphasized applied business applications and sent businesspeople to teach in the classroom. Both organizations sought external funding from the business community, and both competed for position within the schools. Competition between the two major rivals changed the product of both organizations, causing Junior Achievement affiliates to develop instructional modules with greater economic content and the Joint Council affiliates to provide more real-world applications, such as modules on housing, insurance, and credit. Although the two competitors continued to rely t .1 different delivery modes - in one case teacher training and, in the other, celivery by businesspeople - some Junior Achievement affiliates added teacher trainers to their staffs. The emergence of competition in this area of instructional delivery influenced the content and delivery of economic concepts and ideas. Barriers to entry affect nonprofits, just as they do for-profits. Such barriers can take the form of high capital investment, as in the case of national consumer testing labs (Consumers Union), a strong speciality in delivering a service (Educational Testing Service), and/or success in attracting a national donor base (American Heart Association). In each instance, the entry of new competitors is made difficult by the advantages enjoyed by one or more existing firms: economies of scale, product differentiation, capital accumulation, cost advantages, and access to distribution channels. These limit the ability of new entrants to change the basis of competition. All nonprofits face a barrier to entry in the form of IRS regulations that affect their ability to qualify as 501(c)(3) organizations. This particular barrier is amenable to change through public policy. Beyond this legal hurdle, barriers to entry differ substantially by market. For example, local advocacy organizations

Competition, commercialization, and organizational structures

31

normally face paltry barriers to entry because of the low costs involved in establishing a presence in the advocacy marketplace. This implies the potential for substantial competition among advocacy organizations. Similarly, nonprofits providing housing services to the homeless likely face low barriers, given limited government regulation and few national organizations with which to compete (Milofsky and Blades 1991). By contrast, nonprofit hospitals and nursing homes encounter barriers imposed by government regulation, such as certificate of need and accreditation requirements, although these typically apply to for-profits as well. In these areas, government policies play an important role in shaping competition. National nonprofit organizations, on the other hand such as the National Rifle Association, Red Cross, and American Cancer Society - impose high barriers against new entrants because they take advantage of economies of scale, access to a large contributor base, and relatively ready access to distribution channels. Bargaining power of buyers. Buyer ability to influence competition among nonprofits increases when buyers are large and few in number, purchases occur in large volumes, products are available from many nonprofit producers, buyers of services are price sensitive, and buyers can become future suppliers of services. This is true whether buyers are other nonprofits, for-profits, or governments, and these factors affect even exclusively nonprofit marketplaces. For example, a foundation that purchases mental-health services for the poor from a nonprofit at a certain cost per patient has the potential ability to affect the length and frequency of the provided services. Similarly, a wealthy donor with few competitors can choose among several providers of homeless services and exercise considerable impact on both the type of accommodations provided and nonprofits' policies in caring for the homeless. As nonprofit hospitals are sold to for-profit hospital chains and their proceeds used to establish foundations to provide health-care services to the poor (see Chapter 7), these organizations influence competition in the markets in which they finance care (Lutz 1996). Nonpaying beneficiaries, such as the poor, usually are not a force affecting competition. In exclusively nonprofit marketplaces, where finance is entirely from third parties, their direct influence is likely to be limited. In situations where nonprofits compete for beneficiaries - whether to increase their market share (so that as "market leaders" they are more attractive to potential donors) or to use excess capacity - the beneficiaries may not remain long enough (or have the interest) to influence competitive behavior. On the other hand, nonpaying beneficiaries do appear to exert influence on volunteers by affecting their behaviors (Britton 1993) Large suppliers of capital clearly affect the types of service nonprofits offer and the way they deliver them (Useem 1987). For example, the federal government affected the basis of competition among social-service and community-

32

Howard P. Tuckman

development organizations by specifying which services it funded (Gronbjerg 1993). Medicare and Medicaid programs affected competition in health care by covering some services and not others, establishing payment schedules for different types of illness, and creating eligibility standards for health-care providers (Gray 1991). In this instance, public policy plays an important role in shaping competition. Third parties - that is, entities other than the ones who either provide or receive the services - are often the buyers for nonprofits, often through grants or contracts for services. This is the case for services for the poor such as health care, mental health, housing, and job training. In health care, in particular, both nonprofits and for-profits are increasingly affected by the trend toward largescale purchase of their services by HMOs and insurance companies (see Chapter 8). A few U.S. ballet companies have been blessed with benefactors who, through their donations, have made it possible to compete based on nationally known dancers. These donors have considerable influence on who is hired and on the offerings of the companies. Mental-health services are often contracted by federal and state governments, whereas individuals are the primary buyers of religious services. In each case, the purchaser can, and does, exercise influence over goals of the nonprofit sellers and the types of service offered. For nonprofits, competition is a process of harmonizing goals involving provision of collective goods and goods to the poor with the need to finance them. Bargaining power of the suppliers of nonprofit inputs. Suppliers affect competition in exclusively nonprofit markets through their impact on the prices of inputs, speed at which services are supplied, quality and quantity of goods and services supplied, and so on (Steinberg 1990). They affect competition when they are few in number, when their products are differentiated, giving each some monopoly power, and/or when they can offer a unique advantage to the nonprofits they supply. Examples of the impact of suppliers abound. Most nursing homes no longer compete on the basis of the quality of their internal pharmacies since prepackaged drugs can now be supplied externally at a lower cost, and more conveniently, by for-profit suppliers. The supply and price of housing available to nonprofits affect the quantity and quality of the housing offered to the poor and the amount of space that nonprofits can provide. Suppliers of computer software affect how effectively the clients of a legal service for the poor can be processed, and designers of museum displays affect the quality of the experience that patrons have when they visit an exhibition. In each case, the ability of nonprofits to compete is influenced by the nature of their supply relationships. The suppliers of the trained personnel that staff nonprofits can also have considerable impact on the quality of services these entities provide: Nursing

Competition, commercialization, and organizational structures

33

schools affect the level of care provided at nonprofit clinics, hospitals, and nursing homes. Likewise, the Catholic schools that produce teachers to staff nonprofit universities in developing countries have an important influence on the curricula taught at these institutions. The quality and quantity of trained volunteers can also have a strong impact on service delivery. Public policy affects these suppliers to the extent that it specifies specific training requirements. Nonprofits operating in exclusively nonprofit marketplaces can compete in supplier markets, particularly those involving human resources. Hall (1992) notes that the dramatic increase in the number of nonprofits in the past few decades created a demand for competent trustees that far exceeds the supply of persons with trustee experience or with understanding of trustee values, leading to intensified competition for competent board members, although the evidence is anecdotal. In support of his view, Brody (1996, 488) suggests that this leads to a "pecking order . . . with lesser boards serving as stepping stones for more important (visible) boards." Competition can also exist in the labor markets for senior management at nonprofits (e.g., CEOs of nonprofit hospitals), marketers, fund-raisers, and other skilled professionals (e.g., physical rehabilitation specialists) (Steinberg 1990). Availability of substitute products or services. Substitutes for services also affect competition in exclusively nonprofit markets by influencing the degree of monopoly power a nonprofit provider can wield. The fact that substitute services are available influences the price that nonprofit administrators can charge third parties and the way they make their appeal to donors. Availability of close substitutes also puts pressure on the administrators to reduce program costs. Drug-abuse services are provided largely by nonprofits on both an inpatient and an outpatient basis; these substitutes limit inpatient providers' ability to obtain funds by raising prices, lest payers shift to outpatient providers, and vice versa. Similarly, the presence of low- (or no-)cost counseling from religious organizations can affect, and is affected by, the prices and types of counseling from other mental-health providers. In exclusively nonprofit markets, the availability of substitutes helps to ensure cost consciousness. Public policy can affect this process by encouraging the development of substitute services, as in Medicare reimbursement for home health services. When the funders of nonprofits are well informed, the existence of substitutes competing for support puts pressure on competitors to be efficient in production and distribution. The widespread TV broadcasts of Sesame Street, for example, may have affected the type of education provided by such substitutes as early childhood education centers and producers of children's books. Similarly, the presence of competitive cable TV stations creates pressures for public TV stations to differentiate their products. In a different context, the avail-

34

Howard P. Tuckman

ability of drug therapies influences the willingness of nonprofit and for-profit mental-health organizations to use large amounts of the alternative therapy, counseling, to solve behavioral problems. Awareness of substitutes creates an incentive for nonprofit managers to monitor developments by competitors, as well as to rethink the value-added they offer. In exclusively nonprofit markets, this serves to keep nonprofits competitive in their service offerings. Public policy can facilitate this process by augmenting the flow of information on alternatives to consumers. Rivalry among competitors. In both for-profit and nonprofit marketplaces, attitudes toward rivalry are shaped by many things. Rivalrous political or social ideologies, such as the difference in beliefs between pro-lifers and prochoice advocates, affect the way that information is produced and delivered by organizations advocating these positions. This would also seem to be the origin of the competition between the liberal and conservative think tanks in Washington, D.C. Markets initially occupied by a few competitors in the 1950s and 1960s (e.g., Brookings Institution, Urban Institute) now house a variety of new competitors, such as the CATO Institute, Heritage Foundation, and a host of small policy organizations. The desire of donors to broaden ideological representation and input into the public-policy-research world has apparently spawned a vibrant new industry that bases its competition on access to policymakers, quick turnaround, and a reputation for quality work. Although research organizations with different ideologies are unlikely to have a common base of potential and actual donors, they compete for foundation and government grants and the attention of Congress, the federal agencies, the media, and the public mind. Competition also arises as a result of disagreements over how best to provide a particular service, as in the case of nonprofit birthing centers that compete with nonprofit hospitals for the business of pregnant women. Differences in ideas about how best to provide mental health, education, and youth services are in part responsible for the rich diversity of organizations (and funding sources) in the nonprofit sector. Particularly where outputs are hard to measure, as in the case of environmental advocacy, different delivery methods can persist for extended periods. Competition intensifies in the presence of one or a few rivals, a number of equal-sized competitors all determined to grow, the desire to beat a particular competitor, slow industry growth, lack of product differentiation, high fixed costs, excess capacity, and high exit barriers (Pearce and Robinson 1991). Public policy can impact these forms of rivalry in a variety of ways - for example, by restricting certain forms of competition, affecting the growth rate of an industry, and/or promoting entry by new competitors.

Competition, commercialization, and organizational structures

35

Is nonprofit competition less intense than far-profit competition? Competition is not necessarily gentler or less intense because it occurs among nonprofits, although it can be. In the 1990s, for example, the high fixed costs associated with the provision of inpatient hospital care, together with excess capacity in the industry, made nonprofit hospitals fierce competitors, the religious roots of many of these organizations notwithstanding (Gray 1991). Intense competition for patients occurred even when few or no for-profits were present, and it took a variety of forms as hospitals sought horizontal integration and then presence in related markets such as home health care. Intense competition also exists in the market for Sunday morning evangelical TV programs where nonprofit religious entities go to great lengths (and spend substantial sums) to compete for viewers likely to become church members and donors. This competition is fueled by the limited number of desirable time slots, existence of a market for TV-based delivery of religious ideas, and belief that one denomination has more to offer than another. For the most part, public policy has had a limited impact in this domain, primarily because of a reluctance to get deeply into the oversight of the activities of religious groups. The religious entities that sponsor nonprofits in the counseling, education, health, human service, and religious areas often have multiple impacts on competitive conditions. First, they provide an important source of labor and an entry point for individuals with entrepreneurship skills (James 1987). This enables them to affect the resource markets that supply nonprofit organizations, to influence the ideas and skills new entrants bring to the marketplace (impacting on service quality), and to provide a source of labor in areas that might otherwise have problems staffing nonprofits - for instance, supplying manpower to teach in rural African and Asian areas. Their ability to enlarge the labor pool is illustrated by the fact that missionary work by the Mormon church has led to the residency of a large number of foreigners in Utah. Religious entities also use their access to capital reserves to finance production of new products and services (Gray 1991). To the extent that they choose to underwrite an activity irrespective of its costs, competition within an affected industry can become bitter, particularly for organizations that have less access to donations and volunteer services. The environment is similar to the one that prevails when, for reasons of tradition or pride, family firms refuse to exit a declining for-profit industry (Porter 1980). In these conditions, competitors can assume a bunkerlike mentality in which each attempts to survive irrespective of the losses involved. These entities also affect competition through their desire to "best" another religious group, to reach or serve a specific market segment (often but not always defined in terms of religious objectives), and/or to deliver a particular

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Howard P. Tbckman

message. Examples abound of nonprofit hospitals built to enable one religious group to compete for patients with the hospital of a competitive denomination, of nursing homes set up to enable the elderly of a particular denomination to pray with their "own kind," of colleges originally created to ensure that education carries the "correct" religious message, and even of institutions built with the intention to convert individuals of different persuasions. In Memphis, Tennessee, during the 1980s, for example, two major hospital chains - Baptist Hospital and Methodist Hospital - engaged in a rivalry that involved buying up hospitals in adjacent counties. An important motivation for the buying spree was the desire of each chain to acquire hospitals before the other competitor did. This triggered a bitter acquisitions campaign that ultimately led to the creation of two large rival hospital systems. Deep pockets and strong ideological commitments can increase the level of rivalry. Religious ideas can also shape the basis for competition in an industry. For example, for many years hospice care was unprofitable; consequently, religious nonprofits were the primary source of supply for these services outside the home. The driving principle for these entities was to provide an alternate environment to the home or hospital where patients could live out their remaining days in dignity. The basis of competition was the provider's ability to offer the patient and the family peace of mind rather than highly specialized medical services.

Does competition give rise to the commercialization of nonprofits? The above discussion suggests that competition exists in a variety of forms in markets populated exclusively by nonprofits and that, in some circumstances, it can become intense. Interestingly, the presence of competition in these markets offers neither a necessary nor a sufficient condition for nonprofits to commercialize their products. Four conditions are likely to give rise to a nonprofit 's successful decision to commercialize: 1

The nonprofit must feel a need for additional revenues and perceive that the sale of its outputs will provide a viable means to realize its goals. 2 The nonprofit's governing board must decide that the pursuit of profits from sale of outputs is consistent with, or at least does not substantially interfere with, the mission of the organization. 3 The nonprofit must have products suitable for sale in the marketplace. 4 Consumers must be willing to purchase the products offered by the nonprofit.

Competition, commercialization, and organizational structures

37

When these conditions cannot be met - as might be the case of a nonprofit providing services to abused spouses or an economic development agency offering advice to potential newcomers - a decision to commercialize is unlikely to result in sustained for-profit activity. When they can be met - as in the case of a hospital offering diagnostic services or a museum offering laser shows - some products and services will be sold for the purpose of earning a profit. Competition in mixed-mode marketplaces Historically, nonprofits have both collaborated and competed with for-profits (Galambos 1993, 97). For example, for-profits have funded a variety of nonprofit economic development organizations designed to attract new businesses to a community or region. In Richmond, Virginia, for instance, a group of forprofit companies sponsored the Greater Richmond Partnership in an effort to build the reputation and job base of the area. Similar efforts can be found in Boston, Miami, and many other cities (Kanter 1995). Such collaborative efforts can be beneficial both to the parties involved and to the larger community. In their quest for additional revenues, some nonprofits have sought marketplaces previously occupied by for-profits. For example, the nonprofit Educational Testing Service opened a for-profit subsidiary that capitalizes on its expertise in testing student learning, and the nonprofit Consumers Union created a unit that publishes books on drugs, menopause, how to evaluate a doctor, how to deal with medical problems, how to eat better, and so on. On the other hand, private firms sometimes seek out, and find, profit opportunities in marketplaces previously dominated by nonprofits. Such new for-profit ventures have extended into traditionally nonprofit areas like day-care centers, upscale health clubs, hospitals, museums, and job training. These forays into new markets by forprofit and nonprofit organizations expand the situations in which mixed-mode competition takes place. Although third parties normally prefer to fund nonprofits, in some situations they finance both for-profits and nonprofits, and this too fosters mixed-mode competition. Third-party finance of for-profits can be found in the Medicare and Medicaid programs, in proposals to fund voucher schemes for education, and in workfare programs. Huge for-profit hospital chains such as Columbia/HCA would probably not have arisen without federal government willingness to finance their service provision, and it is unclear that they could survive in their current form if this source of finance were eliminated. Mixed-mode competition in health care moved from the single hospital to horizontal hospital chains (multiple markets in one industry), to ambulatory centers, doctors offices, insurance companies, nursing homes, and home healthcare networks involving multiple industries. Gray (1991, 322) refers to this as

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Howard P. Tuckman

the "movement toward a health care system that is oriented toward profitability, economic rationality, and cost containment.. . ." Examples of mixed-mode competition abound outside of health care: among colleges and universities, health clubs, theaters, radio and television stations, and in the biotech industry. In some cases, competition is limited to single local markets, as in the case of mental-health counseling; in others, it spans geographic and industry bounds, as is the case for hospitals such as Baptist Hospital in Memphis owning multiple hospitals, a nursing home, diagnostic clinics, after-hours emergency centers, a health center, and parking lots. Mixed-mode competition exists at the level of the individual product. Frequently, nonprofits decide to compete in for-profit markets by offering a limited number of products that are complementary to their mission and capable of generating revenue. For example, art museums sell posters that reproduce works of art that hang in their galleries; their stores can and do compete with the private-enterprise shops that sell art to customers. Similarly, science museums offer sound and light shows that compete with rock concerts and with other entertainment offered by for-profit enterprises. Whether a nonprofit competes successfully will depend on its ability to produce a higher-quality, low-cost, or differentiated product. Nonprofits are similar to for-profits in their need to position their products (Porter 1979). Reputation is one area in which nonprofits can have a substantial competitive advantage. For-profits build their reputations and use them to gain an advantage over their competitors. Nonprofits, however, may find it easier than forprofits to utilize the trust they have earned from their constituents, especially if they have a reputation for high-quality service delivery. Their challenge is to find ways to capitalize on the public's trust in them when they enter a commercial setting. A nonprofit museum sponsoring its own tours to Peru or Africa may be viewed as better able to provide an exciting educational tour than a commercial travel agency or tour group. Similarly, a nationally known nonprofit heart center may be able to use its reputation for quality treatment of patients to sell for-profit preventive health services more effectively than a national for-profit chain, and a nonprofit educational testing service may be able to sell educational training services better than its for-profit competitors based on its reputation as an expert evaluator of educational services. As in the case of for-profit enterprise, favorable cost structures can provide competitive advantage to nonprofits. This is particularly true in industries where size enables competitors to gain low average costs of service provision. Complementarities can exist in production (e.g., a nursing-home cafeteria offering catering services) or in consumption (an educational institution offering elderhostel services). Economies of scale can also provide competitive advantage, as in the case of a nonprofit opera company that builds scenery for its own pro-

Competition, commercialization, and organizational structures

39

ductions and then rents its sets to other companies. An excellent example of this is the Virginia Opera, which in 1996 contracted for scenic construction with such diverse entities as Lake George Opera Festival, Busch Gardens, Glimmerglass Opera, Utah Festival Opera Company, Encore Theater, Virginia Symphony, Hampton Roads Black Media Professionals, and the Jewish Community Center. Volunteer labor may also reduce the costs of production, in some cases significantly: The Daughters of the American Revolution have many annual reenactments of historical events, charging admission to attend. Their events are staffed by volunteers who receive no compensation for their activities, thus reducing the cost of producing an event and increasing the DAR's profits. Product differentiation also provides opportunities for nonprofits to gain competitive advantage. A well-known nonprofit may earn income selling Tshirts with its logo imprinted on the front, or by capitalizing on the ambiance of its facility (e.g, art museums renting rooms for private parties). Museums sell posters that celebrate specific exhibits, relying on the distinctiveness of the subject matter or the prestige of the event to attract poster buyers. Museum planetariums use their distinct environments to attract devotees of laser light shows, whereas zoos gain advantage from settings that offer unique entertainment - for instance, Halloween-associated events. The success of product positioning of this type is contingent on the ability of nonprofits to turn their environments into desirable settings. Nonprofits competing in mixed-mode product markets must deliver services efficiently if they wish to enhance their revenues. The subsidies that 501(c)(3) organizations receive offer some cushion against competition, but it makes little sense for nonprofits to subsidize their own for-profit activities if the goal of such activities is to generate revenues to subsidize the nonprofit activities (see Chapter 5). Thus, over time, the forces of competition are likely to push nonprofits toward increased use of for-profit business techniques, at least in relation to the products and services they sell in mixed-mode settings. This additional dimension of commercialization - the adoption of for-profit production and delivery techniques - can have far-reaching effects on the operation of a nonprofit, particularly if approaches learned in a mixed-mode setting are applied to production in exclusively nonprofit markets. Competition need not lead to commercialization in an exclusively nonprofit marketplace; but in a mixed-mode setting where commercialization has already occurred, competition can lead to changes in the mix of goods and services that nonprofits produce and in how they organize production and distribution. These changes may take simple forms, such as the opening of museum shops in malls and cities, or it may involve substantial structural changes in corporate form. The next section explores several structural adjustments that nonprofits have made in response to changing competitive conditions.

40

Howard P. Tuckman Competition and organizational form

Consider first situations where competition involves a need for capital to be used for acquisition and expansion. For example, many of the original Health Maintenance Organizations (HMOs) were organized as nonprofit subsidiaries of hospitals or health insurance plans, but enrollments in these plans mushroomed and competition with for-profits increased. As nonprofits, these HMOs found their access to capital seriously limited, and this led them to seek forprofit status. Once the profit motive became part of the mission of such organizations, a recasting of their nonprofit form took place, and most new HMOs organized as for-profits (Starkweather 1993). Similarly, many of the larger nonprofit Blue Cross and Blue Shield companies are now shifting to for-profit status to compete more effectively with for-profit insurers and gain better access to capital markets (see Chapter 7). Between the extremes of a nonprofit organization that offers an occasional salable product and the nonprofit with a strong appetite for capital involved in multiple markets, lie several organizational forms that have evolved in response to competitive conditions in mixed-mode settings. A majority of these new models of nonprofits are found in the health-care sector, in part because the pressures for cost containment have intensified competition in the past decade. Starkweather (1993) provides a categorization of the strategies that nonprofits use in mixed-mode competition. His analysis comprises two categories: holding companies and joint ventures. Holding companies Under an unrelated passive income strategy (Strategy I), for-profit activity has the sole purpose of producing income for the nonprofit parent, and the parent has nothing to do with the operations of the subsidiary. Such strategies fit situations where a hospital owns a series of parking lots or a university owns a real estate company. Under this holding company-subsidiary arrangement, a parent company is established and used to control one or more subsidiaries, usually through appointment of the subsidiaries' directors. For example, a nonprofit hospital restructures, creating a nonprofit parent, a nonprofit hospital subsidiary, and for-profit ambulatory surgery centers and diagnostic laboratories. These entities usually have different directors. Proceeds from the subsidiaries are transferred to the organizational parent. Because for-profits can sell shares, they offer access to capital markets not available under the nonprofit form. Strategy II is called passive investment, cost reducing, and its goal is to create competitive advantage by finding ways to lower the cost of delivering a service. Thus, a nonprofit might acquire a for-profit subsidiary to obtain services

Competition, commercialization, and organizational structures

41

from it at lower cost than if purchased on the open market: A hospital might acquire an equipment supply firm or a pharmaceutical supplier, and a nursing home a home health agency. Once again, the nonprofit does not actively involve itself in the daily operation of the subsidiary. Strategy III, active investment, revenue producing, is one in which the nonprofit involves itself in both development and operation of its acquired subsidiary. A hospital might use its administrative staff to run a sports-medicine clinic, a wellness program, or a home health service, the goal being to increase or secure market share or to diversify service offerings. The active interest of the parent is justified by the fact that the for-profit activity either is consistent with or a part of the parent's mission (e.g, the health club produces healthier clients), or is linked strategically to key aspects of the parent's competitive environment (e.g., the home health agency produces referrals to the home). Joint ventures Joint ventures take the form of partnerships between nonprofits and for-profits. Although nonprofits may not partner exclusively to make a profit, profit will be an important consideration for the newly formed entity. In health care, such ventures have been undertaken to bind doctors or other staff to the nonprofits with which they associate, to improve capital access, to secure referral sources, to provide products or services that could otherwise not be offered, and/or to diversify. Neither the for-profit partner nor any lenders of capital to the venture has access to the assets of the nonprofit in the event of financial failure, but assets owned by the joint venture itself are available to secure funding. The major advantage of joint ventures is that they permit parties to come together in formal legal alliance without changing their own organizational structures or, presumably, their respective missions. To create a joint venture, the partners establish a new, for-profit legal entity - either a corporation or a limited partnership - which sells ownership shares. One venture commonly found in the health-care industry involves partnership between a hospital and its physician investors; it includes a board of directors representative of both groups and contracts for provision of health-care services with the hospital, physicians, and other suppliers. In private-corporate form, a joint venture enjoys limited liability and certain other advantages. In a limited partnership, the owners have somewhat less liability protection but can take advantage of tax shelters, tax credits, and other pass-throughs. Limited partners are not liable for losses or liabilities of the joint venture above the amount they invest in the corporation. However, a limited partnership must have a general partner, and that individual or entity assumes liability for losses, as well as responsibility for management of the enterprise.

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Howard P. Tiickman

The advent of a new form, the legal liability corporation, will likely give rise to new varieties of joint venture structured in this format. Nonprofit health-care providers have made greater use of these mixed-mode legal structures than have other nonprofits. Starkweather (1993,124-5) creates a taxonomy for classifying the joint-venture vehicles in this sector. Ancillaryservice ventures are partnerships between hospitals and physicians designed to provide services that the partners share in common - for example, ambulatory surgery and magnetic resonating imaging. Third-party contracting ventures are established to facilitate contracting with health insurance companies, employers, HMOs, and similar organizations; such ventures normally discount services in return for increased patient volume. Leased-space ventures are used by hospitals to facilitate construction of medical office building facilities; the space is proximate to the hospital and is rented to practicing physicians who bring in business. Finally, speciality ventures partner hospitals with specialized forprofit firms that provide services to complement or substitute those the hospital would otherwise offer, in fields such as family counseling or alcohol and drug abuse; these ventures lease hospital space and provide on-premise services benefiting both partners. (Revolutionary arrangements In the preceding section we addressed situations where nonprofits either create subsidiaries or enter joint ventures with partners who would normally compete with them. Coevolution - "the notion that by working with direct competitors, customers, and suppliers, a company can create new businesses, markets, and industries" (Byrne 1996,47) - opens the possibility that, in certain situations, nonprofits will indeed collaborate with direct competitors. Abundant examples of this evolving method of doing business can be found in the for-profit telecommunications industry, where companies like AT&T and the "Baby Bells" compete in some markets and collaborate in others. Collaborative approaches can also be found in the aluminum industry, where companies like Reynolds joint venture with aluminum producers in places like China and Russia. At present, literature on collaborative ventures among nonprofit competitors and on their consequences is difficult to find. However, the hospital industry provides evidence that commercial nonprofits are engaging in a number of collaborative partnerships. (For examples involving nonprofit universities, see Chapter 9.) Table 2.2 describes deals pending between for-profit and nonprofit hospitals as of June 1996; some of these have been accepted, and some are reported as rejected (Lutz 1996). The table provides several insights into the evolving nature of nonprofit hospitals. Note that the buyouts that are occurring are often by combination, either between two or more nonprofits or between nonprofits and for-profits. Note too that many of the deals include shared equi-

Table 2.2. Multiple-partner hospital deals pending as of June 1996 Hospital for sale or development

No. of buyers

Investor-owned buyer

Tax-exempt buyer(s)

Deals accepted Memorial Hosp. (TX) Lincoln General Hosp. (LA)

2 3

Principal Hosp. Corp. None

Doctors Hospital of Stark County (OH) Massillon Community Hosp. (OH)

2 2

Quorum Health Group Columbia/HCA

Trinity Mother Frances Health Systems Willis-Knighton Med. Ctr.; Glenwood Regional Med. Ctr.; St. Francis Med. Ctr. Summa Health Systems Sisters of Charity of St. Augustine Health Systems Sisters of Charity of St. Augustine Health Systems Jewish Hosp. Health Care Systems; Alliant Health Systems St. Vincent's Health Service; Stamford Health Systems Hillcrest Health Care Systems Presbyterian Health Care Systems

St. Lukes Med. Ctr. (OH)

2

Columbia/HCA

Univ. of Louisville Med. Ctr. (KY)

2

None

St. Joseph Med. Ctr. (CT)

2

None

New Hosp. in Tusla (OK) Physicians Regional Hosp. (TX)

2 2

Columbia/HCA Lake Pointe Med. Ctr.

Deals rejected Itasca Med. Ctr. (MN)

3

None

Cookeville General Hosp. (TN)

3

None

Source: Adapted from Modern Health Care, June 21, 1996, pp. 146-8.

Allina Health Systems; Benedictine Health Systems; Duluth Clinic Baptist Hosp.; St. Thomas Hosp.; Vanderbilt Univ. Med. Ctr.

Price/Stake

Price not disclosed; 100% $10 mil. for 40% Not disclosed Not disclosed Not disclosed 15-yr. mgmt. contract; $242 mil. pledged over 5 yr St. Vincent's, 51%; Stamford, 49%; price not disclosed Deal in discussion Terms not available $9 mil. for 100% $61.3 mil.

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ty, joint operating agreements, and arrangements involving shared governance. The implications of these changes, as well as those above, are explored in the next section. Competition, commercialization, and the challenge to public policy It is not easy to provide satisfactory quantification of the impact of nonprofits on society. The proliferation of mostly small nonprofits, the inadequacy of IRS Form 990 (see Appendix) as an instrument for evaluation, the decentralized nature of the sector, and the broad nature of most nonprofit mission statements complicate the task of pinpointing impact. As a consequence, society has not had the benefits of a data base of studies to demonstrate that the outputs of nonprofits are meritoriously different from for-profit enterprise. The rapid growth of the nonprofit sector, continuing debate over the role of government, declining government payments to nonprofits, and heightened emphasis on justifying tax exemptions have increased the need for the sector to pay greater attention to questions of measurement. This need to identify impact is particularly strong with regard to commercialization. The increased commercialization of the nonprofit sector is likely to proceed unevenly among industries, if only because there are many areas where nonprofits are unable to produce goods and services salable in the marketplace. Although this could give rise to a desire for nonprofits in these industries to expand their missions to enable commercial activity, such a prospect does not seem likely because a broadening of mission may not be feasible for many types of charitable organization. What, then, might happen to these organizations if they are unable to commercialize? This is a serious question for public-policy makers interested in the future of the nonprofit sector to ponder. One possibility is that some of these will be forced out of business or made to curtail their service delivery. Alternatively, if their revenue needs continue to grow, some charitable nonprofits may look more intensely at unrelated business income as a source of additional revenue. The extent to which such income can provide significant contributions to revenue remains to be seen. Several challenges are posed by the evolving nature of the nonprofit organizational forms. The materials in this chapter suggest that Weisbrod (1996; and see Chapter 1) is correct in his prediction that increased fiscal pressures will lead to new forms of commercial activities and new organizational forms that blur the distinctions between for-profit and nonprofit organizations. It is difficult to evaluate nonprofits with general mission statements such as "to increase the welfare of children," and the magnitude of the task increases substantially when three or more nonprofits with varying mission statements join in partnership. If a joint venture does include other nonprofits, issues arise as to how to evalu-

Competition, commercialization, and organizational structures

45

ate the effects of the venture on the nonprofit mission of the originally nonprofit entity. When for-profit partners also are involved, additional complications arise as to how to determine whether, and to what extent, a dilution of nonprofit mission occurs. Evolution of organizational form and product content is both inevitable and healthy in a society built on competition and responsive to its challenges. The problem is to see to it that laws and economic institutions recognize the effects of these evolving changes, and that they not only adapt to them but also guarantee that nonprofits do not lose sight of the missions that brought them into existence. Brody (1996,536) may be correct in her assertion that the formal legal and economic differences among nonprofits and for-profits "are more of degree than of kind," but she is equally correct in noting that historical, political, psychological, religious, sociological, and legal factors create "real" differences between the sectors. The challenge for public policy is to ensure that the evolving institutional changes, as well as the pressures toward commercialization, do not diminish the unique charitable role of the sector. This will not be easy in an era where the quest for fresh revenues to secure institutional survival and foster growth is seemingly paramount.

CHAPTER 3

Modeling the nonprofit organization as a multiproduct firm: A framework for choice

Burton A. Weisbrod

Introduction To understand why nonprofits are exhibiting a stepped-up involvement in commercial activities - expanding into new areas of activity, entering increasingly into business arrangements with private industry, pricing and advertising more aggressively, and, in general, doing things that are novel for nonprofits but commonplace for private firms - we need to understand their goals, or missions, and the financial constraints on attaining them. This chapter presents the theoretic framework with which we analyze nonprofit organization commercial activities in the chapters that follow. Our focus is on private nonprofit organizations, although most of the analysis applies to government organizations as well. The decision by a nonprofit organization to produce a particular output, make it available to particular consumers, and finance it through specific finance mechanisms, reflects choices: whether to use revenue-raising techniques typically associated with private enterprise, such as entering new markets in order to generate profits, charging fees that raise revenue but restrict access in the process, and generally acting like profit-maximizing private firms; or to act differently from private firms, avoiding particular markets or revenue-raising opportunities that might conflict with their goals. Nonprofit organizations and private firms can be expected to make different decisions about engagement in "commercial" activities - profit-oriented actions in forms and degrees associated with private firms - if they have different goals or different opportunities and incentives. Incentives are important here. Nonprofit charitable organizations can receive tax-deductible donations, whereas private firms cannot; as a result, each has a vastly different degree of dependence on donations. Similarly, the fact that nonI thank Jeffrey Ballou, Louis Cain, Joseph Cordes, Ian Domowitz, John Goddeeris, Laura McLean, Lewis Segal, Richard Steinberg, and Dennis Young for helpful comments on an earlier draft. 47

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profit organizations pay no corporate profits tax on their mission-related activities - those deemed "substantially related" to their tax-exempt purpose - while paying full tax on profits from "unrelated" business activity, affects their incentives to engage in these differing kinds of activity. In contrast, for-profit firms generally pay profits tax on all activities, and so have little or no tax-induced incentive to choose one type of activity over another. (Tax laws do influence choices, however, through such measures as inducements to locate in enterprise zones and tax credits provided for research and development.) Goals also matter. Though it is an oversimplification, private firms can generally be characterized as seeking to maximize profit in the interest of stockholders. How to characterize the goals of nonprofits is less clear. Supporters of nonprofits represent them as public-serving institutions that engage in activities underprovided by private enterprise and government and that, more broadly, offer another avenue for individual expression of social concerns. Critics see more crass motives behind the goals of nonprofits: taking advantage of public subsidies and public trust to support inefficiency. They believe nonprofits to be nothing more than "for-profits in disguise (FPIDs)" (Weisbrod 1988). Doubtless, the vast array of nonprofits includes organizations at both ends of the spectrum. The analytic framework presented here is a structure for examining the behavior of nonprofit organizations and identifying in what ways they are similar to, and different from, profit-maximizing private firms. It guides much of the descriptions and analyses in the chapters that follow.

Framework for understanding nonprofit organization behavior The behavioral model of nonprofits that guides our analyses and descriptions of nonprofit organization behavior is built on the foundation developed by Estelle James (1983) and extended by Jerald Schiff and Weisbrod (1991). In this model, nonprofits are viewed as multiproduct organizations potentially producing three types of good that contribute in various direct and indirect ways to the organization's mission. The first type of good comprises the organization's output mission: This involves some type of collective good, such as basic science research, medical care for the poor, or preservation of endangered animal species or cultural heritage. It may also involve public "trust" that an organization will not act opportunistically against ill-informed consumers. The other two types of good involve private goods, which are not in themselves the mission but are potential sources of revenue for financing the primary, missionrelated output. One of these is incidentally related to providing the missionrelated good and has the potential to generate user fees; the other is unrelated, or "ancillary," to the mission.

Modeling the nonprofit organization as a multiproduct

firm

49

In short, a nonprofit chooses to provide varying amounts of each of three goods: 1

a preferred collective good, which is difficult to sell in private markets (e.g., basic research); 2 a preferred private good, which can be sold in private markets but which the nonprofit may wish to make available to some consumers independent of their ability to pay (e.g., access to higher education); and 3 a nonpreferred private good, which is produced solely for the purpose of generating revenue for the preferred good (e.g., paid advertising on public television).1 For each of the three goods we assume that the nonprofit can determine the amount it will produce (including none at all) and, subject to the constraints of competition, its price. Each type of good is considered below. The classification of revenue sources into three categories - donations (contributions, gifts, and grants), user fees, and ancillary activities - proves to be useful analytically; even though every source of revenue does not fall neatly into those categories, most do. A few examples from 1995 applications to the IRS for tax-exempt, nonprofit, status under section 501(c)(3) of the Internal Revenue Code illustrate the applicability of this classification. One organization, Suicide Anonymous Treatment, indicated that its "sources of financial support" would consist entirely of "government grants, foundation grants and individual contributions" (IRS form 1023, employer identification number [EIN] 954507672). The application by Contra Costa County Earth Day reported its chief sources of financial support to be more varied, encompassing two of the three revenue sources: "grants from corporations, foundations, and government agencies; revenues from concessions, booth rental, and the sale of other items; parking receipts" (IRS form 1023, EIN 68-0347329) - concessions, booth rental, and parking all being ancillary activities.2 A third new nonprofit, the Archaeological Society of Central Oregon (EIN 93-1133518) reported obtaining financial support from all three sources we identified: donations, raffles (ancillary commercial activity), and membership (user) fees. 1

2

Mancur Olson (1965) recognized more than thirty years ago that providers of collective goods, such as the American Medical Association in his example, confront a finance problem resulting from free-rider behavior. He also noted that such organizations may rely on by-product (which we term ancillary) services, such as professional journals and insurance, to generate profit for financing the collective activities. That is, they are not central to the social mission. They may, however, not be taxed as unrelated business activities, for they could be deemed by the IRS to be substantially related to the mission or, under other provisions of the tax law, excluded from taxation.

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Other essential elements of the model are as follows: the degrees of organization preferences for, or aversions to, engaging in each of the three kinds of activities; the effects that revenue-generating activities may have on the willingness of external funders to give donations (contributions, gifts, and grants); and the effects that revenue-generating activities may have on the nonprofit's costs of producing the mission-related output. This framework is not to be seen as a rigid structure that has been thoroughly tested. Rather, it serves as a guide as we examine nonprofits' commercial activity and discuss the reasons it is increasing, the forms it is taking and why, and its potential effects. The framework identifies variables and relationships to which we direct attention. Nonprofits' goals Understanding nonprofit organization behavior in general, and particularly its increasing reliance on commercial methods - the sale of goods and services is critically dependent on an understanding of organization mission. Many of the problems confronting both research on nonprofits and public policy toward them hinge on some rather unusual characteristics of nonprofits' goals or missions. One is that nonprofits - that is, their leadership - may have preferences about the kinds of activities in which they engage and the persons to whom the outputs are made available. This stands in contrast to the textbook model of the private enterprise firm, which has no such preferences, but cares only about opportunities for profit. The assumption that nonprofits as a class can be characterized usefully by a single set of goals and trade-offs is open to question. Managers (and directors) and their preferences can influence nonprofit organization behavior greatly because there is only a weak functional equivalent of private firms' stockholders - the IRS - and there is no threat of corporate takeover as there is in the private-enterprise sector. There are, of course, constraints on nonprofits. Some of these are imposed by law - on nonprofits' obligations and on the uses of any "profits" - and some are imposed by sources of funds, in addition to technological and input-price constraints. Given, however, the broad scope of many nonprofits' tax-exempt authority and the difficulty of defining and measuring outputs, there is room for considerable managerial discretion. Managerial preferences thus may interact with organization constraints to produce a managerial sorting process that determines nonprofit organization objectives and behavior. Nonprofits may behave as if they were individuals with unique utility

Modeling the nonprofit organization as a multiproduct firm

51

functions. They may also behave as if they were run by a committee of managers and directors, each of whom has distinct goals. Nonprofits' goals may be multiple and in conflict, and there is no simple measure of the efficiency of the trade-offs being made among goals. This too is unlike in private enterprise, where maximum profit reasonably characterizes an organization's goal. Thus, for a university, the goal of teaching all undergraduates in small classes led by senior professors conflicts (even apart from any cost considerations) with the goal of graduate training, which requires that graduate students obtain teaching experience. It also conflicts with universities' goal of expanding knowledge, which requires faculty to focus on cutting-edge scholarship of the sort usually associated with graduate rather than undergraduate training. Further conflicts become evident when universities' intermediate goals are considered: For example, a university may prefer to have faculty devote more time to being interviewed by newspaper, magazine, and television reporters who would bring favorable attention to the university, but this takes away faculty time that could be used to expand research. Nonprofits' goals are not only numerous, they are typically vague. Thus, it is difficult for society, the regulatory authority - the IRS in the United States or even the nonprofit itself, to determine the degree to which goals are being realized and, hence, the degree to which their achievement is being facilitated or retarded by some particular activity. What does it actually mean for a university to provide educational opportunity for all students who can benefit from it, for a hospital to provide care for all who need it, or for a museum to preserve a cultural heritage? How can an objective viewer determine any nonprofit's social contribution? With such broad goals, how can a nonprofit be held socially accountable - rewarded for being effective and punished for performing poorly (Herzlinger 1996)? Society's goals are generally intended not for individual nonprofit units but for the industry as a whole. The social goals for institutions of higher education - for example, to provide wide student access and choice of subject matter - do not require that every college campus be open to students of all ability levels and interests. Thus, although access to one particular facility may be critical to an individual student or family, society's planning problem and its assessment of overall college-sector performance involve a broader, systemic perspective. The goals of nonprofits are not easily characterized in terms analogous to the essential goal of private firms to maximize profits; but some evidence can be gleaned from observing their revenue-generating activities. Our focus on nonprofits' increased commercialism can shed light on those goals, although it should be noted that this commercialism has potentially important consequences regardless of what the rationale may be for pursuing them.

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When a nonprofit has a goal that encompasses more than reaping profit, that affects its provision of each of the three types of good identified earlier - preferred collective, preferred private, and nonpreferred private. We examine nonprofit activities in these three types of market within a framework in which there are two kinds of organizational goal: to provide certain kinds of services and to avoid engaging in certain other kinds of activities. Together, these constitute a number of hypothesized deviations from profit-maximizing behavior, with nonprofits providing more of some goods ("preferred" or "mission-related") and less of others ("nonpreferred") than would a profit-maximizing private firm. The nature of those two types of good (or service) is explored, with the hypothesis that preferred goods correspond to those that are socially desirable but privately unprofitable and, hence, are underprovided in private for-profit markets. Nonpreferred goods are hypothesized to be those that can be and indeed are sold, may be provided by private firms, and are potential sources of revenue for nonprofits seeking funds to finance their mission-related activities. We do not assert that nonprofits necessarily behave in the manner described. Rather, the following chapters explore evidence that nonprofits' growing commercialism reflects predictable responses to the tension between goals and revenue constraints. Relatedly, the chapters also shed light on the usefulness of the distinction between nonprofits' preferred and nonpreferred activities, and the revenue and cost interrelations between them. Preferred activities Consider the case of a nonprofit with the central goal of providing socially valuable but privately unprofitable services. Such a goal - which has been referred to elsewhere as bonoficing (Weisbrod 1988) - can involve provision of two types of good. One type involves "collective," or "public," goods. These include, for example, basic research, as by universities and medical research organizations (see Chapter 9); the preservation of endangered species, as by zoos and aquariums (Chapter 11), and of cultural heritages by museums (Chapter 12); the provision of television programming that has social value but cannot be sustained through the sale of commercial air time (Chapter 13); environmental protection; and trustworthiness about hard-to-monitor dimensions of service quality, such as whether any charitable organization claiming to aid the poor or to provide "tender loving care" to the elderly frail in a nursing home is actually doing so. Another type of preferred output may involve certain private goods or services targeted to the poor or other "socially deserving" groups. These include, for example, hospital care for the indigent (as explored in Chapter 8) and access to social-service agency activities such as scouting (see Chapter 10). Both types of output - some collective, some private - may be encompassed in the organization's mission.

Modeling the nonprofit organization as a multiproduct firm

53

Nonpreferred activities A second goal or objective of a bonoficing nonprofit might be, but is not necessarily, to avoid engaging in certain types of activity. It may wish not to compete with private firms in the sale of conventional private goods or, in general, not to produce goods or services other than those that contribute directly to its mission. In this model nonprofits derive positive utility from greater achievement of their mission, but negative utility from activities that represent distractions from that mission - which could include activities that generate funds that can be used to finance increased mission-related activities.3 Thus, some potential revenue sources, such as unrestricted donations and, particularly, unsolicited donations are preferred to others - not simply because they are obtained easily and without restrictions, but because they require neither efforts that distract an organization's leaders from pursuit of the mission nor any compromise of that mission. By contrast, the production of commercially salable ancillary services may boost revenue but be disliked by managers and trustees. Thus, universities dislike selling research services to private firms when that interferes with the broad dissemination of knowledge; public television stations dislike broadcasting "commercials" that advertise private firms; and academic health centers dislike shifting their focus from basic research on unsolved medical problems to treatment of children with common colds (as necessitated by the development of university-based HMOs). Involvement in ancillary goods and revenue-generating activities can take many forms. While we direct particular attention to nonprofits' decisions to produce salable goods and services, the organizations may also choose to make "passive" investments, such as buying securities in profit-making firms. The hypothesized aversion of nonprofits to commercial activity may apply also to such investments, which the nonprofit owns but does not operate; some nonprofits may want to avoid owning stock in tobacco or gambling firms, for example. Little is known, however, about the extent of such preferences. In any event, if they are present, they are unrelated to tax consequences: Income from passive investments is not taxed, even though income from active investments that are unrelated to mission is subject to the Unrelated Business Income Tax (UBIT). There is another plausible way to look at this. Instead of seeing some activity as entering the organization's objective function negatively, one could think as follows: Nonpreferred goods might not enter the nonprofit's objective function at all; they do, however, generate revenue, and thus enter the constraint set. Nonprofits would therefore limit production of these goods not because they dislike them but because such production diverts resources from activities that enter the objective function positively. In this model nonprofits would maximize profit in ancillarygoods markets, whereas in the model presented above, nonprofits would prefer to produce less than would maximize profit. (I owe this point to Jeffrey Ballou.) Evidence presented later suggests that nonprofits do indeed underprovide relative to a profit maximizer.

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Our model also suggests that nonprofits prefer to minimize the use of user fees - charges for private goods that are related to the organization mission, such as college tuition, hospital patient fees, and museum admission charges. Apart from revenue and cost interdependencies that could make it unprofitable to employ user fees, it is not obvious why nonprofits would want to avoid them. Why would universities prefer to set tuition at zero? Why would museums and zoos prefer to have no admission fees? Why would hospitals and day-care centers rather not charge their patients and clients? One answer involves the outputdistribution goal that many nonprofits have. Their mission is often not merely to provide particular services but to make them available either to everyone (e.g., medical research and public television) or to particular consumer groups (e.g., food, shelter, and medical care to the indigent; scouting services to youth). The problem with user fees is that they inevitably have the side effect of discouraging consumers whom it is the nonprofit's mission to serve. Thus, there is potential conflict between increasing user fees to raise revenue and maximizing the nonprofit's contribution to its mission. Profit-maximizing private firms in these fields, by contrast, have no such distributional mission, and so they understandably place fundamental reliance on user fees as their source of revenue. The disadvantage of user fees to nonprofits with distributional goals would disappear if the organizations were able to determine each consumer's willingness to pay. A nonprofit could, then, charge prices that would raise revenue without deterring consumption by any person in the mission-related target group (see Chapter 4, and Steinberg and Weisbrod 1997). With such full information, prices could be set differently for various consumers, in ways that maximized not profit but achievement of mission. Some consumers might be charged less than marginal cost, or even zero, and less than their marginal willingness to pay; others, less central to the target group, could be charged higher prices, perhaps even more than marginal cost if competition among nonprofits were limited. Nonprofits' dislike of ancillary activities, which though not mission related do provide revenue for cross-subsidizing the mission-related output, has a quite different basis from the aversion to user fees. Provision of an ancillary output may have one or more direct negative effects - apart from any favorable indirect effect operating through the revenue it generates - on organization mission: 1

It may distract management, causing a weakening of its attention to the organization's central mission. 2 It may cause mission displacement - sacrifice of some element of the organization's goal in order to satisfy prospective purchasers of the ancillary services who would impose restrictions that compromise the nonprofit's mission. A good example, cited above, is when a university has the opportunity to raise revenue by performing research for a private firm that insists on propri-

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etary rights to the results, whereas this is inconsistent with the university's mission of full dissemination of research findings. Thus, we model nonprofits as preferring to maximize production of missionrelated goods and to minimize production of either of the two kinds of good that can generate revenue. Within this framework, the two generators of nondonative revenue - ancillary goods and user fees - are seen as being pursued for their financial contributions only. Moreover, if they bring disutility, they will be undertaken at levels below what would maximize their monetary contributions. In short, if this model characterizes nonprofits aptly, such organizations will not act as profit maximizers in these revenue-raising commercial markets. Revenue from donations Donations, encouraged by income-tax deductibility, and volunteer labor, which is an in-kind donation, may provide some support, but further resources are accessible to a nonprofit only if it engages in revenue-generating activities that it may prefer to avoid.4 Donations are nonprofits' major alternative revenue source to the "commercial" sources of user fees and profit from ancillary activities. Since the following chapters make extensive use of data on donations, it is important to clarify the relationship between the theoretic concept of a donation and the operational definition as applied by the IRS and nonprofits in their reporting of revenue on the Form 990 tax return. In particular, we distinguish between donative revenue that is exogenous, coming to the organization essentially regardless of its activities, and donations that are endogenous, or influenced by the nonprofit's activities. Exogenous donations, we suggest, are preferred as a revenue source to either form of commercial activity. Obtaining them does not require the nonprofit to divert activities from its mission.5 This preference stands apart from the fact that there is no resource cost required for fundraising; that is, because such donations permit the nonprofit to focus entirely on its mission, a dollar of exogenous donations may be preferred to a dollar of net revenue from any other source. Of course, many nonprofits devote resources specifically to fund-raising. This is, in effect, an ancillary activity, because its main purpose is to raise revenue. The finding that nonprofits engage in less fund-raising than would maximize their net revenue (Weisbrod and Dominguez 1986) leads to the possibil4

5

Henceforth we do not address separately the market for volunteer labor or other donations in kind. The presumption is that they respond, and are responded to, in the same manners as donation of money. However, that is not entirely clear; the market for volunteer labor deserves further attention - both its supply and demand sides (Menchik and Weisbrod 1987). Whether any donations are entirely exogenous may be questioned. Still, there may be important differences in the degree to which donations from various sources respond to a nonprofit's activities.

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ity that fund-raising may be a nonpreferred ancillary activity. This possibility has led to questions of whether fund-raising should be regarded as an "unrelated business activity," since it is not, itself, a part of organization mission (Suhrke 1996). The hypothesized preference for donations over commercial revenue results from the assumption that donations are exogenous - obtained without the organization having to engage in fund-raising efforts (possibly a nonpreferred ancillary activity). Not surprisingly, donations have been found to be responsive to fund-raising efforts (Weisbrod and Dominguez 1986), but they may also respond to other organization activities. Surely, charitable contributions respond to a nonprofit's mission-related outputs, to its reputation for efficiency and integrity, and hence to its trustworthiness to use donated funds effectively, although there has been little research on these relationships. Commercial activity responds to donative revenue If it is correct to characterize nonproflts as we have, the extent of their involvement in commercial markets, through either ancillary goods or user fees, can be expected to vary inversely with exogenous donations. That is, other things equal, donations crowd out commercial activity. An exogenous decrease in donations - for example, in government grants to academic health centers or the arts - may be expected to cause those nonproflts to expand commercial activity, approaching, but not reaching, profit-maximizing levels because of the disutility from increased commercialism. The disutility would result from a negative direct effect of the activity on mission. The potential negative effect that commercial activity - involving quid pro quo sales - can have on a nonprofit's mission can be illustrated by recent involvements of a nonprofit university and a public school system in selling services to private firms. Universities are increasingly contracting to sell research services to private industry (see Chapter 9), and the contracts sometimes require the university to keep the research results "under wraps." Such an arrangement, which conflicts with a university's mission of full dissemination of knowledge, is typical of contracts between universities and the Walt Disney Company for research on such things as special polymer materials for its audio-animatronic characters, such as U.S. presidents (Wu 1996). Similarly, many public schools, hard pressed financially by declines in government grant support, have turned to ancillary, noneducational activities that have brought charges that students are being exploited in return for profit-oriented commercial advertising. Channel One, a twelve-minute current events television program that includes two minutes of paid advertising, has been allowed into 12,000 schools in the United States, where it is viewed by eight million students. In return for accepting

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the commercials the schools have received television sets, VCRs, and a satellite link (Honan 1997). In another case, the Seattle School Board voted in 1996 to permit corporate advertising in the schools, leading the district's chief financial officer to speculate that the next step might be "the cheerleaders, brought to you by Reebok." Presently, students in Colorado Springs ride buses carrying corporate logos and walk hallways decorated with posters advertising Mountain Dew soft drink (Stead 1997). Such compromising of mission in the interest of revenue may be termed mission displacement. When it occurs, it is likely to take subtle forms that are hard to observe. Rarely will an organization reject its mission outright, for even if the nonprofit's leadership were willing to do so, such a rejection would have vast consequences for them in terms of their fiduciary responsibility, as well as for the organization's tax-exempt status and its donative revenues. Nonetheless, the potential for mission to be compromised, albeit in less direct forms, exists, particularly so in light of the breadth of many nonprofits' missions, which can make it difficult to define operationally when an action is inconsistent with the mission. A potentially important issue (but beyond the scope of this study) is whether involvement in commercial markets causes nonprofit organizations to alter the kinds of leadership they employ. The question is whether increased commercialism leads to "managerial displacement," the substitution of managers and directors who are especially knowledgeable about markets where profit is the measure of success, for leaders who are efficient in the preferred-goods market. Such managerial sorting might take the form of nonprofits hiring more executives or directors with backgrounds in the private business sector. While this would reflect the intended shift in the organization's behavior, it also could set in motion a dynamic process in which the fundamental character of the nonprofit is changed. Anecdotal evidence that such convergence of management is occurring can be seen in the "revolving door" that is increasingly characteristic of managerial movement between universities and the private medical technology sector. The head of Bristol-Myers Squibb's research enterprise recently returned to Harvard University, and faculty from Baylor College of Medicine, Duke University, and Cambridge University have moved to private-sector managerial positions with corporate giants SmithKline Beecham PLC, Merck & Company, and Perkin-Elmer Corporation (Winslow 1996; also see Chapter 9). Our behavioral model, in which nonprofits prefer to avoid both types of commercial activity - sale of ancillary goods and user fees - but want the revenue that they can bring, has a number of testable implications. As suggested above, one is that when nonprofits do engage in the kinds of commercial activities just illustrated, they do less of it than would maximize profit from those activities, because the negative utility from engaging in the activities will be balanced

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against the revenue generated. As a result of not maximizing net revenue, they will also not be able to maximize output of their preferred, mission-related activities, because of the desire to avoid the nonpreferred activities. Another implication of nonprofits' hypothesized dislike of commercial activity is that its use will respond to certain exogenous changes. These include not only exogenous changes in donative revenue, the generally preferred source, but also to exogenous changes in what is equivalent: a change in the perceived severity of "need" for mission-related output. Thus an increase in poverty or in the number of uninsured hospital patients can be expected to increase nonprofits' commercialism. If net revenues from user fees or ancillary activities are not being maximized by service providers in those industries, there is latitude for increasing revenues and, ultimately, mission-related output. These two implications are illustrated by the case of the British Museum and its current financing problems. The British government has traditionally given grants (donations) to the museum, which have constituted most of the museum's $84.5 million annual budget. Late in 1996 the government announced that it would begin to reduce its contribution. Under impending fiscal stress from the cut in grants, the museum hired a consultant, who recommended imposition of an entrance charge, contrary to its historic policy. Such a revenuegenerating fee could have been introduced earlier, but it had not, ostensibly because it was believed to be inconsistent with the museum's mission of open access. The museum had not been maximizing its revenue from admission fees, but the museum's director opposed the consultant's recommended admission charge of $8.50, claiming it "would fly in the face of the museum's mission while discouraging perhaps half its annual visitors from coming." Despite the revenue potential, the museum decided against the fee; yet the trustees apparently recognized that the revenue shortfall could become serious enough to overcome their aversion to an admission fee, for they stated that the introduction of charges cannot be ruled out (Lyall 1997). Apparently a "sufficient" cut in government grants could bring a user-fee response. Donative revenue responds to commercial activity Just as donations may affect commercial activity, the level and nature of commercial activity can affect donations. Donors may prefer that a nonprofit avoid user fees, maintaining free access to its services; alternatively, they may prefer that the organization work to meet its own financial needs by charging fees where that can be done without compromising its mission. Regarding ancillary goods, donors may prefer either that a nonprofit develop revenue-generating ancillary-good markets, or oppose it as an inappropriate diversion from the mission. In any of these cases, donations could be affected either positively or negatively by the form and level of commercialism.

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More complex model: Interdependencies among revenue sources and among production costs Interdependence among revenue sources If we consider all sources of a nonprofit's revenue to be interdependent, then the nonprofit might be maximizing its total revenue from all sources and, hence, maximizing the provision of its preferred, mission-related activity, even if it were failing to maximize its revenue from any one source. As noted above, if a nonprofit attempted to augment revenue from exogenous donations by increasing its commercial activity, that could have a negative impact on donations; in other words, donations may well be at least partially endogenous to nonprofits' commercial success. Donors might decide that their contributions or grants are not needed, or they might want to display opposition to certain commercial activities by withholding donations. There is some reason to believe, for example, that rapidly rising tuition (user fees) at public universities is not just the result of a shortfall of government grants, but also a cause of it, as legislators have come to see that the university will sustain itself financially with less funding from government grants. Donations and commercial revenues, whether from user fees or ancillary activities, may also be related positively; an increase in commercial revenue could cause donations to increase. This would occur if donors - perhaps foundations or individuals - wished to reward "self-help." In this case, the predictions of our simple model, outlined previously, might no longer hold. If increased commercial financial success generated additional donations as well, these rewards could outweigh any direct disutility from commercial activity, and the nonprofit might act to maximize profit in its ancillary-goods or user-fee markets. The same result would hold if revenue sources were independent and there was no disutility from commercialism. The nonprofit would then be expected to maximize profit in commercial markets, so as to maximize, in turn, achievement of its mission. An illustration of revenue interdependence will suggest the breadth of forms that they can take. In this case, which involves nonprofit academic medical centers, a change in revenue from user fees, resulting from an exogenous change in competitive behavior, has affected efforts to increase revenue from donations; thus causation here runs in the opposite direction from the British Museum case, in which a change in donations was affecting policy toward user fees. Academic medical centers have long cross-subsidized their basic science research - arguably their principal mission-related output - with revenue generated by the user fees that their faculty member physicians charged patients. This revenue source has provided nearly $1 billion a year to support research. Dramatic change within the health-care sector, however, has increased the power

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of managed-care organizations to put downward demand pressure on medicalcare prices, which has reduced the user-fee revenue available for cross-subsidizing university research (Winslow 1997b). "Large health-care purchasers agree that research and doctor training are important medical-school functions," but (apparently recognizing the collective-good elements of these functions) they seem to be unwilling to pay for them. This free-rider behavior, having brought an exogenous reduction in revenue for the research and training missions, has led to a campaign, launched by a group of scientists and with the support of Senator Daniel Patrick Moynihan, to increase government grants for research, financed by a new tax.6 This illustrates more than the offsetting, or "crowding out," effects of one revenue source on others. It also shows that "grants," particularly from government, can have the characteristics of ancillary activities, having to be "sold" (to legislators, and sometimes to private donors) in ways that may differ only imperceptibly from sales in private markets, and that are equally distracting and disliked by nonprofits. Thus, it is noteworthy that the tax and the support for research, which could have been put forward in the past but was not, has now been proposed in apparent response to the severe financial problems of the nation's academic medical centers. Were it to pass, it would suggest that government contributions from one source are not independent of government contributions from another. In any event, the proposal itself seems consistent with a model in which nonprofits pursue a particular source of revenue more or less vigorously depending on the availability of other sources. This would suggest that the nonprofits were not previously maximizing revenue from the unpursued source, unless it were the case that the initial decrease in grants had the effect of increasing the probability that the new tax would be enacted. Interdependencies among costs Costs, as well as revenues, may be interdependent. Until this point, we have assumed implicitly that the costs of producing the preferred mission-related good (henceforth referred to simply as the mission-related good) and each of the nonpreferred commercial goods are independent of one another. Thus, a change in the rate of production of an ancillary good, for example, was assumed to have no effect on the cost of producing the mission-related good. In fact, they are likely to be related. They would, for instance, be related if, as is quite probable, particular ancillary goods are selected because of their expected profitability, and that is most likely when the same resource inputs can be used for both the mission-related and commercial good. (Chapter 5 presents some evidence in support of this expectation, showing that aggregate labor costs appear to in6

The proposal was to levy a 2 percent surcharge on health-insurance premiums.

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crease little when ancillary goods production increases.) It is not surprising, then, that nonprofit hospitals are raising revenue by selling laboratory services, zoos are selling animal-breeding services, and public television stations are renting access to their studio space as well as to broadcast time (i.e., "underwriting"). Again, as with revenue interdependencies, the existence of cost interdependences makes it more difficult to specify the response expected from a nonprofit confronted with an exogenous change either in one revenue source or in perceived social need. An increase in commercial activity could bring multiple effects, not only on revenue from that activity but on other revenue sources and on marginal production costs for the mission-related and commercial goods, which could in turn have further effects. Summary: Private choices and public policy For any organization, revenue sources influence output decisions, and output decisions in turn influence revenue availability. In the context of nonprofit organizations, it is useful to think of their making two choices that can be expected to define both their output mix and its financing. The first choice involves the kinds of output to be produced and the consumers who will be targeted; the second is how it will finance itself. The framework adopted here shows the complex ways that these two choices are related. The goods and/or services that are a nonprofits' output can be viewed as being of three types: Two are preferred, in the sense that they constitute the organization's social mission and provide the justification for government subsidies and tax exemptions. A preferred, or mission-related, good may be either collective, such as basic research, preservation of the environment, or propagation of endangered animal species; or private, aimed at a target population for which there is a consensus that the social value of particular services exceeds recipients' ability to pay - for example, hospital care for the medically indigent, access of youth to community centers, and attendance of schoolchildren at zoos and museums. Although the latter type, preferred private goods, provide private benefits to the targeted individuals, they are still, in a sense, also collective in that many people other than the recipients value the provision of the services to the target group. One essential characteristic of such private-type services is the potential for charging user fees. Nonprofit organizations may also choose to produce a third type of good, which we term ancillary. Ancillary goods are produced only because of the organization's desire to raise revenue to finance its preferred goods. There is a significant interrelationship between each type of good and the tax laws that determine whether its related activities are or are not taxable, depending on whether they are judged by the IRS as being substantially "related" to the nonprofit's tax-exempt purpose. This interrelationship is discussed more

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thoroughly in Chapter 5. For now, it should be noted that the theoretic distinctions among the three types of good may not be the same as the regulatory-tax distinction among them. For example, a particular treatment program in a hospital, such as an aggressively marketed heart transplantation unit, could be regarded by the IRS as related to the hospital's exempt purpose even though the activity is nonpreferred by the organization and would not have been provided to the same extent, if at all, were it not for the financial stress from declining revenues. Similarly, a nonprofit's goals may be such that certain activities are deemed important to fulfilling its mission despite an IRS ruling that the activity is taxable. Thus, the nonprofit American Economic Association continued its book publishers' display activity at its annual meetings, based on a belief that it was professionally valuable, despite an IRS ruling that it was "unrelated" to the association mission and hence taxable. Whether a specific good is preferred or nonpreferred by a nonprofit can depend on its particular characteristics. Although elaborate fund-raising galas are untaxed, they are likely to be nonpreferred, whereas straightforward provision of information to prospective donors about the organization's needs is likely to be a preferred - or, at least, neutral - good, although both generate donations. Similarly, obtaining a donation that is given with few or no restrictions on its use is preferred, whereas procuring one that has constraining "strings" attached is more usefully thought of as the sale of a nonpreferred ancillary commodity - the donor offering a sum of money in return for some consideration - even though conventional terminology, and the IRS, would count it as a donation. Some nonpreferred activities are clearly unrelated to the organization's exempt, or charitable, mission. When a university sponsors a rock concert at its football stadium, it is not engaging in an educational activity. When a hospital or a museum provides cafeteria services to its staff and visitors, it is not providing health care or cultural preservation. In these cases, however, the profit generated is "excluded" from taxation, under the IRS code, for such reasons as that it is engaged in only occasionally or is undertaken for the convenience of its mission-related beneficiaries (visitors to the facility). The fact that the revenue is not taxed is relevant to nonprofits' decision making, but that is different from the question of whether the activity per se is preferred by the nonprofit's controlling authority (board of directors and top management). There are many nonpreferred activities that could generate profit to increase provision of the preferred good. Hospitals may (and some have) become food caterers and suppliers of commercial laundry or laboratory services. Museums may (and do) establish retail sales stores, on and off premises, that sell T-shirts and other items having nothing to do with their exempt purpose except to generate revenue. Nonprofit associations such as the American Medical Association publish journals that sell advertising space, thereby generating "unrelated business income," profit from which is taxable. These activities may tend to be

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avoided by nonprofits for either or both of two separable reasons: the taxation, which tends to cause the organization to turn to other, untaxed, revenue-raising devices, and the nonpreferred or ancillary character of the activity. These examples serve to illustrate the differences between the theoretic concepts of preferred and nonpref erred outputs, on one hand, and the regulatory concepts of untaxed (related and excluded) and taxed (unrelated) outputs, on the other. As nonprofits seek funds they may be driven into nonpreferred markets and activities; it is then in their interest, however, to minimize the taxes paid. This, in turn, leads in two directions, both with potentially important implications for public policy. First, one probable consequence of nonprofits' commercial expansion is an attempt to push outward the regulatory boundary between taxed and untaxed activities. Because of the breadth of nonprofits' legal missions and the limited resources available to the IRS to police those borders, the expectation is that nonprofits will continually be edging them outward. Second, when nonprofits do engage in unrelated business activities, they are likely not to choose activities randomly but to select those for which expected profit is greatest, while balancing profitability against the possible disutility of engaging in the activity. It is likely that this process will lead to the selection of activities that, while nonpreferred, are complementary, in either production or consumption, with their preferred outputs. Nonprofits can then be expected to allocate increasing portions of joint costs to their taxable activities, even if most or even all of those costs would have been incurred anyway, as their production of taxed activities increases. Such cost allocations minimize tax burdens and maximize net, aftertax revenues for cross-subsidization of the preferred collective goods - thereby also posing issues for the process of competition between nonprofits and forprofit firms in those private-goods markets. Our framework recognizes that nonprofit organizations often have opportunities to charge user fees for private services that are complements to their collective good missions. However, although hospitals charge patients they treat, colleges charge their undergraduates, museums charge attendees, and Scout troops and community centers charge members fees, such revenue is not equally available to all nonprofits. For example, nonprofits that support medical research or aid the poor - public television stations are another case in point have fewer opportunities to charge user (or viewer) fees and, hence, are more likely to pursue ancillary-goods markets to supplement donative income. Moreover, as was noted earlier, charging a fee when possible entails the disadvantage that some target beneficiaries will be excluded. Thus, tensions are likely between nonprofits' pursuit of socially preferred, collective outputs and their engagement in commercial markets where revenue raising is the goal. Reappearing throughout subsequent chapters are the choices that nonprofits must make among the three sources of revenue:

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The relative dependence of nonprofits on each source varies considerably among industries. So do the forms, but this framework helps to organize understanding of the choices across quite diverse segments of the nonprofit sector. When, for example, an academic health center charges fees to patients who are being treated for illnesses that are the object of its research mission, it is doing essentially what a museum is doing when it charges admission fees to visitors. Likewise, when it contracts with a private pharmaceutical company to perform clinical trials (as part of the process of meeting Food and Drug Administration requirements for determining the safety and efficacy of new drugs), this is comparable to a museum opening retail stores in shopping malls, or a nonprofit university press publishing a book with little scholarly appeal but a substantial sales potential - both are justified primarily by their contribution to revenue. Both user fees and sale of ancillary services involve nonprofits in charging prices for salable private goods. In choosing how much to do of each, nonprofit organization management and trustees can be expected to balance the desirability of raising additional revenue, which can be used to augment missionrelated output, against two forms of undesirability: that some members of a target population will be unintentionally excluded (a possible consequence of user fees) and that the mission will be compromised (a potential result of engaging in ancillary activities). This framework of nonprofit choice among outputs and sources of revenue is employed in a variety of ways throughout the ensuing chapters to describe, interpret, and assess the growing commercialism of nonprofit organizations in the United States, to understand its probable future, and to highlight choices and dilemmas for public policy.

CHAPTER 4

Pricing and rationing by nonprofit organizations with distributional objectives

Richard Steinberg and Burton A. Weisbrod

Introduction The growing commercial activity of nonprofit charities, hospitals, educational institutions, arts organizations, day-care centers, nursing homes, and religious organizations has led many to question the legitimacy of the nonprofit designation and the concomitant tax and regulatory advantages conferred upon the sector. As noted in Chapter 1, if nonprofit organizations are engaging in commercial activity, it is easy to regard them as simply "for-profits in disguise" (Weisbrod 1988); however, there are many varieties of commercial activity. This chapter focuses on the ways in which nonprofit organizations and private firms can be expected to differ in their use of various pricing and other mechanisms through which their goods and services are distributed. We emphasize the potential importance of distributional goals to nonprofits - that is, their concern about reaching certain target populations - and suggest that insofar as they have distributional concerns they will use allocation mechanisms (pricing practices, waiting lists, and the like) differently and have different effects on clients and others, compared with private firms. Economists and other social scientists have looked at many aspects of nonprofit organization behavior, but we are unaware of any research that has examined the array of alternative allocation mechanisms employed by nonprofits, let alone their relationships to organization missions. Thus, our most important purpose is to provoke researchers, practitioners, and other readers to look across industry boundaries and particular allocation methods to refine understanding of the distribution of goods and services by nonprofit organizations - not only what nonprofits do, but for whom they do it. We leave to future researchers the We thank Lisa Whitecotton and Daniel Delany for research assistance, Kirsten Gr0nbjerg, Robert Coen, Wesley Lindahl, and participants at Northwestern University's colloquium on the commercial activities of nonprofit organizations for helpful suggestions. Steinberg acknowledges support from the Indiana University Center on Philanthropy and from the Andrew W. Mellon Foundation.

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task of making our hypotheses more precise and performing appropriate empirical tests, but we focus on hypotheses likely to prove testable in practice. Much of what we have to say applies equally well to allocation decisions by government agencies, even though our focus is on private nonprofit organizations. Nonprofit organizations and governmental agencies generally espouse goals other than profit maximization, such as fairness, redistribution, trustworthiness, public-goods provision, advocacy, education, preservation of values, accessibility, social innovation, empowerment, participation, and promoting individual expression. Profit maximization could provide a means to these ends, perhaps guiding the allocation decisions of a museum shop that sells T-shirts, a fundraising campaign, or other ventures designed to raise revenue for the nonprofit's preferred, mission-oriented services. Sometimes these other purposes are accomplished as a side effect of profit maximization. For example, for-profit firms must consider their reputations for fair and honest dealings if they are to keep their customers. Sometimes, competitive pressures are such that the only alternative to profit maximization is bankruptcy. However, nonprofit organizations and governmental agencies, motivated by other goals, often appear to allocate their outputs persistently in a manner that does not maximize profits. Some organizations legally defined as nonprofit may seek to maximize profits derived from some but not all of their activities. Other organizations legally defined as nonprofit may seek to maximize profits derived from all activities, and thus function as for-profits in disguise. The purpose of this chapter is to characterize nonprofit departures from profit-maximizing behavior. In the next section we delineate the varieties of fee schedules, nonprice requirements, and use of purchasing incentives, and present hypotheses regarding differences in the use of these mechanisms between nonprofit and profitmaximizing organizations. In a later section we outline the effects of allocation mechanisms on an organization's clientele, in order to develop corollary hypotheses about the consequences of the differential allocational or distributional processes. The varieties of nonprofit allocation How are an organization's outputs allocated among potential consumers? Forprofit firms use price as the primary allocation mechanism: A price is posted, those willing and able to pay the price receive the good or service, and the price is bid up or down to the point where every potential consumer willing to pay for it is able to purchase the product. Monopolistic for-profit firms select a higher price and produce a lower quantity, but still satisfy consumers' desired purchases at the selected price. For-profit firms also employ various forms of price discrimination, complex pricing mechanisms, and, more rarely, nonprice rationing mechanisms. The unifying principle governing all these allocation tech-

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niques is the quest for profits. Profit maximization implies that a perfectly pricediscriminating firm would charge each consumer his or her reservation price providing that the firm's marginal cost can be covered - although the cost of determining that price limits its use. Auctions, tournaments, intertemporal price discrimination, nonlinear pricing that varies with the quantity purchased, and rationing by waiting all represent profit-maximizing responses under imperfect information. Do nonprofits use these mechanisms differently from private firms? Nonprofit organizations certainly use prices, although perhaps in a different fashion. Organizations in both sectors employ a variety of complex pricing schemes that include sliding-scale fees and other forms of price discrimination, multipart prices with separate access and usage charges, nonlinear prices with caps and deductibles. They also use nonprice allocation mechanisms such as waiting lists, restrictive eligibility requirements, recruiting and marketing techniques, lotteries, and quality dilution. Table 4.1 catalogs the variety of allocation mechanisms we discuss and summarizes our hypotheses about differences between their use by nonprofit and for-profit organizations. Because of the variety of goals, outputs, environments, and constraints facing different kinds of nonprofit organizations, our hypotheses should be understood as pertaining to nonprofits in general, although not to all of them. Variations within the nonprofit sector in the use of these outputdistribution mechanisms would provide further guidance for future research seeking to test our hypotheses. The simplest distributional mechanism is uniform pricing, of the textbook variety, where consumers are offered the opportunity to purchase any quantity of a good or service at the same price per unit and this price is the same for all consumers. Nonprofit organizations often employ such uniform pricing, particularly for those activities that generate "unrelated business income" (income generated from the sale of goods and services unrelated to the organizational mission). A natural working hypothesis would be that nonprofits employ uniform pricing under the same circumstances and in the same way as profitmaximizing firms. For-profit firms employ it when, given informational and other constraints, this practice would maximize the financial surplus eventually distributed to owners. Nonprofits may employ it for unrelated goods when this practice would maximize the financial surplus available to further the organizational public-goods or redistributional mission, or the private agendas of those in control of the organization. Profits are a means to an end in both cases, although the ends differ. As Chapter 3 shows, the public-serving nonprofits may seek to maximize profits in markets for some goods in order to finance their mission-related activities. However, Schiff and Weisbrod's 1991 adaptation of James's 1983 model suggests that unrelated business activities are disfavored in organizational util-

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ity, so that when uniform pricing is used, nonprofits will underproduce unrelated goods and services relative to the profit maximizer (see Chapter 3). Thus, any empirical test of this hypothesis would need to specify which activities are disfavored or nonpreferred by which nonprofit organizations. Sliding-scale fee schedules are a form of price discrimination in which consumers pay different prices per unit based on observable characteristics of the client (such as income, family size, age, or the severity of the client's dysfunction) rather than on the particular costs of serving that consumer. Sliding scales are used by both nonprofit and for-profit sellers, and they are common in day care for children, mental-health services, church and synagogue membership charges, and professional-society dues. Similar practices appear in other industries under a variety of names. For example, college financial aid granted on a need basis creates a sliding scale for net-of-aid tuition. Diverse copayment rates on health insurance create price discrimination in net health-care costs to patients, based partly on observable consumer characteristics. Special prices for students or retirees at museums and on public transit systems are other instances of price discrimination equivalent to a sliding scale. Nonprofit organizations that are concerned with the consequences of their allocation mechanism would ordinarily choose an income-based fee schedule, with high-income consumers paying higher fees. Profit-maximizing organizations would also offer income-based fees (when income is the best feasible proxy for consumer willingness to pay), because this way they could raise prices for some without losing other customers who could be profitably served. In this respect, nonprofit and for-profit sliding-scale fees would look quite similar. However, the lowest price selected by a nonprofit that had distributional objectives would often fall below the marginal cost of serving this group, whereas profit maximizers would select a lowest price at or above marginal cost (Steinberg and Weisbrod 1997). The fact that nonprofit organizations provide services free of charge to consumers who will never become paying customers supports this hypothesis, although one needs to distinguish voluntary free care from charity care required by regulators and from care purchased and paid for by third parties such as government. Sometimes price discrimination by nonprofits is tied simply to consumers' stated willingness to pay more, and to no other characteristic. For example, many nonprofit organizations have membership categories (supporting member, patron, etc.) that charge different fees but provide essentially the same service (or provide token added benefits that do not appear to justify the higher fees). In effect, the consumer is mixing a donation and a purchase. Supporting memberships do not count as donations under the tax laws insofar as there is an exchange of value, but because the value received by the consumer is unaltered by the consumer's selection of a membership category, these memberships combine donation with purchase, thereby constituting what amounts to

Table 4.1. Nonprofit use of allocation mechanisms Allocation mechanism

Examples

Price Uniform pricing

Hypotheses about nonprofit departures from profit-maximization

Nonprofits and for-profits use uniform prices identically for those outputs unrelated to the nonprofit mission (except for disfavored activities).

Sliding-scale fees (interpersonal price discrim.)

Day care; Mental health care; Professional-society dues; Net-of-financial-aid tuition

Voluntary price discrim. (when eligibility for particular prices cannot be verified by the seller) Intertemporal price discrim. Noncash payments

Supporting-member dues; Donations Nonprofits use extensively. The practice is not generally feasible for for-profits to arts orgs.; National Public (except in cases where the volunteer can control, at least in part, who benefits Radio; Volunteering from her contribution, as in for-profit day care).

Nonprofits more likely to price-discriminate and to choose a lowest price that is below the marginal cost of serving their customers.

Free-entrance days

Nonprofits more likely to use this for those who will never be profitable to serve.

Habitat-for-Humanity pricing (fees plus "sweat equity")

Nonprofits may require partial payment in the form of labor or in-kind. For-profits stick to cash. Nonprofits more likely to use waiting lists. For-profits more likely to react to persistent excess demand by expanding capacity or increasing price.

Eligibility reqmts.

Day care; Nursing homes; Colleges, universities University admissions ("merit"); Fraternal societies; Religious orgs.; Work-shelters for the handicapped; Food pantries

Externally imposed eligibility reqmts. Quality dilution and opportunistic quality sharing

Meet govt. contracting reqmts.; Conform with tax/regulatory reqmts Soup kitchens; Homeless shelters; Museums and zoos; Worker training

Nonprofits more likely to construe requirements broadly for unprofitable clients and narrowly for profitable clients.

Product bundling

Museums; Colleges, universities

Nonprofits more likely to bundle "merit goods" in pursuit of paternalistic objectives. For-profits more likely to bundle in pursuit of profit.

Recruiting target populations

Hospital location; School field-trips to museums

Nonprofits more likely to target mission-related populations regardless of expected future profitability.

Nonprice Waiting lists

Nonprofits more likely: (1) to use requirements poorly or negatively correlated with willingness to pay; (2) to restrict eligibility to those who cannot pay. For-profits more likely: (1) to use requirements positively correlated with willingness to pay; (2) to use eligibility requirements to establish a niche market.

Nonprofits more likely to hold excess capacity in order to avoid quality dilution. For-profits more likely to dilute quality in cases of contract failure.

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voluntary price discrimination. Donations in general constitute a form of voluntary price discrimination because each donor determines the size of contribution (Hansmann 1981a; Ben-Ner 1986; Spiegel 1995); the same holds for donations of volunteer time. We hypothesize that sliding scales and voluntary price discrimination are more common in nonprofit than for-profit organizations for three interrelated reasons. First, there is more scope for a sliding scale when the range of consumers is broad, as it is for nonprofits that serve persons unwilling or unable to pay marginal costs. Second, consumers are more likely to reveal their willingness to pay truthfully when dealing with a nonprofit because they know that when revelation causes them to pay a higher price, that price is supporting a mission they support rather than lining a stockholder's pockets (Ben-Ner 1986). Third, the redistribution accompanying the use of sliding-scale fees sometimes constitutes the nonprofit's mission, rather than serving merely as a means for raising revenue to accomplish some other mission. Other forms of interpersonal price discrimination are based on occupancy rates and other such production-cost factors rather than on consumer characteristics. In the for-profit world, this kind of price discrimination is common whenever marginal costs are markedly lower than average costs. Commercial airlines, hotels, and movie theaters discriminate by varying prices seasonally or by day of week or time of day, in order to fill empty space, furthering their profits. The key question is whether nonprofits price-discriminate in order to achieve other, nonfinancial goals. If nonprofits employ first-come, first-served opportunities or waiting lists rather than higher prices to adjust to peak-level demand, these forms of price discrimination would be evidence of nonfinancial goals. Nonprofits, like for-profit firms, employ various forms of intertemporal price discrimination. Performing-arts groups discriminate over time when they distinguish advance ticket prices from at-the-door prices. We have no hypothesis regarding sectoral differences in this practice. However, some nonprofit museums charge admission fees but waive them intermittently on a regular basis, offering, for example, Free Tuesdays. Totally free admission, even on an occasional basis, appears to occur more typically in the nonprofit sector. For-profits sometimes offer promotional prices and free samples in an effort to convert these consumers to paying customers, but rarely do they offer free services targeted to those who will never pay the marginal costs of provision. Sometimes nonprofit organizations require consumer or user fees in nonmonetary forms, such as labor or a mixture of cash and other forms of payment. For example, Habitat-for-Humanity, a nonprofit devoted to providing lowincome housing, requires its customers to pay in both cash and labor ("sweat equity"). This type of pricing is uniquely well suited to nonprofits. For-profits could certainly benefit from labor supplied by their customers but prefer them

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to pay exclusively in the form of cash because it can be used to hire more efficient workers. In contrast, nonprofits may prefer this "inefficient" payment scheme when it directly supports some part of the organizational mission (e.g., encouraging self-help) as well as supplies resources (e.g., labor, materials, and money for advancing the housing-construction mission). Nonprice allocation mechanisms, while sometimes combined with positive prices, may also serve to allocate a good or service that is given away at a price of zero. Most obvious is rationing by waiting, through either explicit queuing or the use of waiting lists. We hypothesize that nonprofits are more likely to use waiting lists, whereas for-profits are more likely to react to persistent excess demand by expanding capacity and/or increasing the price. Evidence supporting this hypothesis for the nursing home and mentally handicapped facility industries is presented in Weisbrod (1988, 1998). When a nonprofit gives goods away or sells them at a price below that which would clear the market, it often specifies formal eligibility requirements that serve to ration the available output. Consumers may be required to provide evidence (or at least assert) that they meet eligibility standards involving income, wealth, family size, gender, religious affiliation, political persuasion, age, employment status, disability, or the like before they are eligible to receive the good or service. Sometimes organizations define their own criteria for determining eligibility for service; other times the eligibility criteria are defined by a contracting government agency. In either case, nonprofit and for-profit organizations may differ in the forms of eligibility requirements and the ways they are implemented, insofar as their organizational goals are distinct. We consider, in turn, the cases of internally and externally selected eligibility rules. When the organization freely chooses its eligibility criteria, we hypothesize that nonprofits are more likely to use requirements that are poorly (or negatively) correlated with the consumer's willingness to pay, and may even restrict eligibility to those who are unable to pay. Profit maximizers use eligibility requirements to extract more consumer surplus through price discrimination: "Super saver" airline fares restricted to those who stay Saturday night are an attempt to fill seats with those who would not pay higher fares, while allowing the airline to charge more to those - largely business travelers - willing to pay more. Discounts by hotels and car-rental firms to American Association of Retired Persons (AARP) members are another attempt to use eligibility requirements to segment the market. Eligibility requirements are used by profit maximizers as screens for generally unobservable willingness to pay; they allow firms to price-discriminate without incurring the public-relations backlash and threat of antitrust suits that would accompany a more direct attempt at perfect price discrimination across individuals. Nonprofits may also use eligibility requirements to raise additional revenue by capturing more consumer surplus - using the revenues to finance manage-

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rial perks or to cross-subsidize other, mission-related outputs; or they may use such requirements to further the organizational mission directly, by reaching out to particular target populations. Thus, nonprofits, we hypothesize, differ from for-profits in the nature of eligibility requirements, defining their target clientele so as to further their social mission directly rather than to maximize profit. Nonprofits often provide services only to the poor, to persons of a particular religion, ethnicity, or age, or to the most severely afflicted. Overall, insofar as they differ from for-profits in their goals, they will employ restrictions that are well correlated with mission but less well correlated with consumer willingness to pay. Unfortunately, it is difficult to test this hypothesis cleanly because profit maximizers also might use requirements that are poorly correlated with individual willingness to pay. In the case of for-profits, standards poorly correlated with individual willingness to pay are not instruments for advancing a social mission but part of a strategy to establish a niche market by appealing to snobbery, class interests, ethnicity, and the like. Eligibility requirements that serve to differentiate the product provide some monopolistic power to the seller, and so enhance profits. When government agencies contract with nonprofits or private firms to provides services such as home health care or primary-school management, it is typically the agencies who specify eligibility requirements. For example, Smith and Lipsky (1993,142-3) cite the case of emergency shelters in Massachusetts that are obligated by government contractors to serve the "most disadvantaged" first. Nonprofits and for-profits may differ, however, in the faithfulness with which they implement these requirements. This is important because it is difficult and expensive for the government contractor to determine whether the clients served by an external agent actually are the most disadvantaged or meet other (possibly subjective) contract criteria. We hypothesize that sectoral differences in behavior will depend upon whether the target population can be served profitably under such conditions. If clients cannot be served profitably, nonprofits pursuing social goals will be less likely than for-profits to take advantage of their informational superiority to interpret the contractually imposed eligibility requirements in a fashion that restricts access; if, instead, clients can be served profitably, nonprofits would be more likely to interpret eligibility requirements in a fashion that permits access only to the contractor's intended target clientele. Profit maximizers will tend to use their inevitable discretion by operation alizing eligibility requirements in ways that further profits, declaring "borderline" clients eligible if serving them would be more profitable than serving more disadvantaged persons, declaring them ineligible otherwise. If a contract specifies more than one fee class, profit maximizers would place clients in the most profitable fee class they can get away with. For example, Medicare payments to hospitals depend on the Diagnosis Related Group (DRG) in which a patient is placed. Even before the system was introduced in October 1983, computer

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software programs had been developed to determine the highest-paying DRG consistent with a given patient's specific conditions and diagnoses. Through the years that followed, the phenomenon of DRG creep - the drift of patient classification by hospitals into higher-priced diagnostic groups - was observed (Steinwald and Dummit 1989). It remains unclear, however, whether opportunism is the source of this phenomenon. Whether this discretionary behavior differed between nonprofit and forprofit hospitals is also not clear. In general, nonprofits are thought to be more trustworthy contractees, reducing the need for the contractor to monitor and enforce contract compliance (Ferris and Graddy 1991) or to engage in lengthy negotiations over contract terms (DeHoog 1984). On the other hand, the nonprofit mission (serving clients) may conflict with the government-agency mission (keeping costs down while appearing to the electorate to be handling the social problem), and in these cases nonprofits would be less appealing to the contractor. In the case of Medicare, if a nonprofit hospital feels that certain costly procedures are medically desirable for a particular patient, it might place that patient in a more lucrative DRG rather than provide those procedures at a loss or prescribe less costly treatment. For-profit hospitals might prefer to place the patient in a lower-priced DRG that is more consistent with government guidelines and not attempt to provide the more expensive procedures. A third form of nonprice allocation is quality dilution. For example, a soup kitchen faced with unexpectedly large demand may thin its "gruel"; a homeless shelter may line the floors with somnolent souls; a hospital may put three patients in a room designed for two, or place patients on gurneys in corridors; and a college may increase its student-faculty ratio. We hypothesize that nonprofits have output quality as a goal, and so are more likely to hold excess capacity in order to avoid quality dilution in times of unexpectedly high demand. This prediction is consistent with the theory presented in Holtman (1983). In contrast, for-profits may dilute quality even when demand is as predicted in order to cut costs and increase profits. This occurs when there is contract failure - where, owing to either the circumstances under which the good is provided or the nature of the good, the consumer is unable to verify that the quality of the product is at the promised level (Hansmann 1980). Some nonprofits employ product bundling, requiring purchasers of one product also to purchase other products. Thus, a homeless shelter may require residents to obtain psychological or addiction counseling; a parochial school may require students to attend religious services, buy a school uniform, and do volunteer work. For-profits also employ product bundling, but do so in order to enhance profits rather than fulfill a social mission. James (1986) argues that a desire to inculcate values and tastes lies behind the decisions to found an educational, health, or social-service agency and to organize it as a nonprofit. She uses the example of religious organizations:

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[T]he object is not to maximize profits but to maximize religious faith or religious adherents, and schools are one of the most important institutions of taste formation or socialization. Similarly, hospitals are a service for which people will have an urgent need at times, and so constitute a good way for religious groups to gain entry. The nonprofit form is chosen because the main objective is often not compatible with profit-maximizing behavior. For example, religious schools, set up to keep their members within the fold, may have to charge a price below the profit-maximization level in order to entice the largest numbers to enroll, (p. 155) Sometimes nonprofits go beyond product bundling, preferential pricing, and eligibility restrictions in order to solicit actively the participation of target populations. Thus, nonprofit hospitals are more likely to locate in low-income areas (Pauly 1987), and museums negotiate with schools to arrange field-trip visits.

Effects of nonprofit allocation In this section, we characterize the broader impact of nonprofit price and nonprice allocation practices on customers and donors. As summarized in Table 4.2, we hypothesize that nonprofit behavior produces a different division of economic value between consumers and producers and among consumers; a different allocation of the risk that the product will cost more (or be of lower quality or quantity) than anticipated; a different self-selection among potential consumers; a different signal to consumers and donors; and different incentives to economize on resource consumption. Market activities generate economic value divided between that received by producers (producer surplus) and consumers (consumer surplus). Producer surplus is the difference between revenues received and the (variable) cost of production; consumer surplus is the difference between consumers' willingness to pay and their outlays of time and money for the product in question. In the for-profit world, total surplus is determined and divided so as to provide the largest piece of the "surplus pie" to the owners of the firm. Sometimes (as in uniform pricing by a for-profit monopoly), the pie is made smaller as a side effect of providing a larger piece to the producer, but the size of the producer piece (in absolute terms, not as a share) is maximized. Profit-maximizing firms would be unconcerned with the distribution of either output or consumer surplus among different types of client unless consumers were to rebel strongly against perceived unfairness. This sort of consumer reaction would reduce the equilibrium size of the piece given to producers, but producers would still act to maximize the size of their piece. In contrast, nonprofits often care about the allocation of surplus even when sales revenue would be unaffected or negatively affected by the nonprofit's pursuit of its concept of equity. We hypothesize that nonprofits are more likely to expand consumer surplus at the expense of producer (or even total) surplus.

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Table 4.2. Effects of nonprofit distributional mechanisms Effect of allocation mechanism

Hypotheses about differing effects of nonprofit and profit-maximizing behavior

Dividing total surplus Between consumers For-profits maximize producer surplus. Consumer surplus is provided and producers only insofar as it enhances producer surplus. Nonprofits are more likely to expand consumer surplus at the expense of producer (or even total) surplus. Among consumers For-profits do not care except insofar as the distribution of consumer surplus affects producer surplus. Nonprofits are more likely to consider fairness and distribution in the design of their allocation, cost-sharing, and pricing mechanisms. Allocating risks

For-profits bear risk only when there is a compensating increase in return. Nonprofits are more likely to bear the largest feasible share of risk, regardless of compensating financial returns, in order to ensure that their clients are not harmed.

Screening

For-profits use mechanisms designed to uncover those with highest ability and willingness to pay. Nonprofits are more likely to use mechanisms designed to uncover those with greatest "need" (as in addictions treatment or child-abuse prevention), those who are most worthy (say, because they appear to be pious), or those with high willingness but not ability to pay. For-profit mechanisms are also designed to deter those who would be most costly to serve (cream-skimming). Nonprofit mechanisms are less likely to deter high-cost clients; on the other hand, nonprofits are more likely to use exclusionary screens for noncost reasons (e.g., to deter those who are poorly motivated).

Providing a signal of trustworthiness To consumers Nonprofits are more likely to use waiting lists and highly selective and clients eligibility requirements to signal their quality. For-profits are more likely to use high prices to signal quality. To donors and Nonprofit use of fees depends upon the preferences of major funders grantmakers regarding provision of seed money vs. operating support. Providing an incentive Nonprofits are less likely to use high prices and more likely to use nonto economize on price mechanisms to provide incentives for consumers to economize on resource consumption the use of nonprofit outputs. Nonprofits often use token fees to signal the importance of economizing.

The possibility that at least some nonprofit social-service agencies occupy a middle ground has been presented by McCready (1988), who considers their use of Ramsey pricing. This is a self-financing approach, in which user fees are set so as to maximize the size of the pie, and is therefore intermediate to profit maximization (expanding producer surplus at the expense of total surplus) and

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some nonprofit notions of equity (expanding consumer surplus at the expense of total surplus). It would finance reductions in price for some nonprofit outputs by increasing prices for other, revenue-generating outputs. Whether the price of a particular output is increased or decreased depends upon whether the quantities of desired purchases by consumers and desired sales by producers are very sensitive to price. Price-sensitive outputs would be priced below marginal cost, whereas insensitive outputs would be priced above marginal cost. Ramsey pricing is designed neither to accomplish redistributional goals nor to treat some outputs as more mission-related than others; but it does differ from profit-maximizing pricing in that it results in a larger total of consumer plus producer surpluses. Nonprofits may also be concerned with the distribution of surplus among consumers, seeking "fairness" for its own sake, apart from revenue implications. We hypothesize that nonprofits are more likely than for-profit firms to articulate and implement notions of fair distribution in their choice of pricing and nonprice rationing mechanisms. One notion of fairness sometimes employed is the "fair share of cost" notion, usually implemented as equal division of the costs of providing a collective good. Lohmann (1980) notes: This method of fee collection is most appropriate for short-term projects or projects in which clients form a closely knit group whose unity is reinforced by such "sharing." ... [This method] may be of greatest interest to those involved in community organization and group work activities, in which the collection of fees on an occasional basis for specific projects may be the only fund-raising activity necessary. Senior citizens groups taking bus tours, youth groups planning parties, and social action groups planning demonstrations or protest marches may best be handled using the fair-share-of-cost method, (p. 86) Other notions for fair nonprofit pricing borrow from the literatures on tax equity and bargaining fairness. Prices, like taxes, may be thought fair if they are proportional to either the benefits received or the consumer's ability to pay. Horizontal equity (equal prices for similarly situated consumers) may also be thought to be important and to constrain nonprofit patterns of price discrimination and market segmentation. We are unaware of any nonprofits that specifically seek to implement formal notions of bargaining fairness (see, e.g., Moulin 1988; Young 1994), but clearly the potential is there. Although some nonprofits are particularly concerned with fairness, others distribute their outputs in a,manner contrary to their stated mission. Favoritism, nepotism, kickbacks, self-dealing, and other abusive power relationships can govern nonprofit allocation, particularly when allocation criteria require subjective judgments on the part of the nonprofit employee. There is more scope for such abuse in the nonprofit sector because nonprofits are not subject to financially motivated takeover bids that limit abuse among for-profits. On the other hand, insofar as nonprofit managers and board members are dedicated to the

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organizational social mission, this provides an internal check on abuse (Handy 1995). The choice of fee (or other rationing) structures also affects the allocation of risk. For example, a daily fee - say, on hospital care - places all the financial risk that the inpatient stay will be unexpectedly lengthy on the consumer, whereas a fee based on completion of a specified task (such as the DRG-based system for reimbursing hospitals for their Medicare patients) places all the risk on the provider. It would be worthwhile to explore whether nonprofits differ from other organizations in their proclivities to accept or shift risk. There is little extant theory to turn to for predictions, but much would seem to turn on two factors: First, differences in organizational goals are likely to prove important. Those nonprofits that desire to serve target populations regardless of ability to pay would seem to be more likely to bear this risk than for-profits or other sorts of nonprofit. Second, budgetary flexibility is likely important. Those nonprofits that receive substantial unrestricted donations would seem to be more able to bear risk. At the same time, the higher costs of borrowing because of nonprofits' inability to sell shares of stock might make them less willing to bear risk (Hansmann 1981b). Profit-maximizing organizations are not directly concerned with the composition of clientele, caring only insofar as the client mix affects aggregate net revenues. Abstracting, for the moment, from any differences in the costs of service provision to various clients, the most desirable are those with the greatest willingness to pay for the service in question (or those who can attract other clients of this kind). When willingness to pay is not directly observable, which is typically the case, the price mechanism can serve as a screen to distinguish those with highest demand. Thus, nonprofits may use pricing for the same reason that for-profits do: to generate revenue from those who can pay (Moran 1985). Even with identical desires to distinguish among consumers on the basis of willingness to pay, nonprofits with distributional objectives would differ from profit maximizers in their choice of fee structures: Profit-maximizers would select fees that are as close as possible to the consumer's reservation prices, whereas distributionally concerned nonprofits would screen the same consumers but generally charge them lower prices (Steinberg and Weisbrod 1997); such nonprofits would forgo some revenue in order to advance their overall goals, balancing their pursuit of distributional goals with their revenue needs. Consumer willingness to pay results from both the consumer's preferences for a particular good or service and that consumer's ability to pay. When two consumers have the same ability to pay, differences in willingness to pay reflect preferences; however, in general one cannot distinguish whether someone who is willing to pay a large sum is wealthy and relatively unconcerned with the cost or is of modest means and greatly desires the good or service. Nonprofits sometimes care about the intensity of want or need, apart from wealth,

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whereas profit-maximizers always care about the willingness-to-pay composite. Sliding-scale fees based on income allow nonprofits to screen on the basis of innate preferences by correcting for differences in purchasing power, as Oster(1995) explains: It is common practice . . . for private schools to require that even the most indigent student pay at least a small fraction of tuition. This practice helps to sort among parents and identify those families with the highest value on education, (p. 99) Price serves a screening function whether or not the nonprofit wishes to serve those with the greatest willingness to pay. Soup kitchens, for example, are more concerned with hunger than ability to pay. If the need for a subsidized meal is observable, price does not have to serve this screening function - the combination of price, or some other rationing device, and eligibility restrictions would be sufficient. However, if the nonprofit desires to serve those with an important but unobservable characteristic - for example, "true need" - price is at best an imperfect screen, most useful if the unobservable attribute is correlated with willingness to pay. At worst, price may be counterproductive: Any price that is sufficiently low to allow low-income households to purchase the good or service will also attract higher-income households that do not need a subsidized price. As a result, absent stigma and other social/psychological factors, price screens will fail to distinguish the target population reliably. In this case, additional or alternative screens might be used - for example, locating the soup kitchen in a run-down neighborhood will keep away the nonpoor looking for a free lunch at the same time it provides a convenient location for the needy. Having a waiting list, whether for admission to a nursing home or for supper at a soup kitchen, may be another effective device for sorting out consumers when the organization's goal is not profit maximization but aiding a particular target population (Nichols, Smolensky, and Tideman 1971). People who are willing to wait are showing the intensity of their preferences and the availability of alternatives, and the nonprofit may wish to serve persons for whom alternatives are poor. The problem is to get people to reveal their true circumstances. A soup kitchen can give food away at no charge, but its budget constraint and distributional goal require it to try to target the poor and only the poor; since they generally have low opportunity costs of time, waiting in line helps to sort out those who are most in need, for they are the ones most likely to be willing to wait. In the case of nursing homes, willingness to be on a waiting list for admission provides some basis for sorting prospective patients who are willing and able to pay a higher price from those whose incomes are more limited. Thus, although either a waiting line or a waiting list is inefficient given a goal of profit maximization, they may be efficient insofar as nonprofits' objective functions include distributional goals.

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The possibility that the screening, or demand-revelation, function of price will be counterproductive is highlighted by two examples. Titmuss (1971) noted the problem with using consumer payments for blood to compensate blood donors. Blood markets suffer from informational asymmetry problems: Even persons who had reason to believe their blood was tainted by hard-to-detect infectious diseases - hepatitis was the focus at the time - could profit nonetheless from the sale of their blood because buyers were unable to distinguish "good" blood from "bad." If, argued Titmuss, blood money were prohibited, then only altruists, who presumably would not wish to inflict their diseases on others, would supply their blood. A second example of the limitation of price as a screening mechanism involves drug and alcohol treatment centers and those persons who deny their addiction problems. Charging them fees would be counterproductive, all else held equal, because those in denial would be least willing to pay for treatment. The effectiveness of the screening function of fees for organizations in either sector depends on the behavior of competitors, both non- and for-profit. In either sector, a high fee cannot be used to screen for high-willingness-to-pay clients unless competitors follow suit. The same is true for nonprofits that use willingness to pay as a screen for some other characteristic that concerns them. For example, a graduate department of economics concerned with output quality, not monetary profit, might wish to admit the "best" students regardless of willingness to pay. Presumably those who could use a graduate education as a springboard to a highly successful career would be willing to pay more than others, all else being equal, but aid offers from actively competing schools would bid up the required amount of aid, generate rents for the student, and thereby eliminate any department's ability to use high fees as a successful screen for the student's supply price. Another aspect of screening that deserves mention is cream skimming, where organizations seek to serve the most profitable clients. For example, when the government contracts with a private job-placement and training agency, a profit maximizer paid on the basis of the number of persons it places has an incentive to screen out hard-to-place clients. Similarly, cream-skimming insurance companies try to screen out those who drive dangerously, and cream-skimming hospitals have a profit-related incentive to screen out poor and uninsured patients. Nonprofits, if they pursue broader public-interest goals and especially if they have distributional goals that favor the poor, would differ from for-profits in their propensity to cream-skim. It is not obvious, however, in which direction they would differ. If the nonprofit hospital accepts more low-cost, insured patients and receives reimbursement that does not distinguish, within Diagnosis Related Group, low- from high-cost patients, it obtains more net profit that can be applied to the treatment of other target-group patients or toward further-

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ing some other element of the nonprofit mission, such as community health education. In any case, in unregulated-price markets, competitive pressures may force all providers to attempt to cream-skim, although this same competition will drive prices down to marginal costs, depriving all competitors of profit from low-cost patients. The allocation mechanism chosen sends signals to consumers and others as to the quality of service. If an organization thrives after maintaining a higher price than its competitors, it is signaling to prospective consumers, by its survival, that other customers find the product to be of higher quality than the competitor's. We hypothesize that nonprofits are less likely to use price as a signal of quality because use of this kind of signal conflicts with their distributional objectives. Instead, nonprofits are more likely to use waiting lists or highly selective eligibility requirements as a signal. We have no reason to believe either approach would more reliably convey information about quality to consumers, but do hypothesize that different modes of signaling are employed by the two sectors. Allocation mechanisms also provide a signal to third-party funders (private donors, grant makers, and governments) about the social value of service provision, as Dan Delany (personal communication, 1996) explains: The fee and wait-list combination [chosen by an alternative health center for people with AIDS] ... signaled a level of legitimacy for a service that had not been viewed as such for some time. Clients willing to pay, even after waiting in excess of a year for service, was a powerful statement to fellow service providers, government officials charged with delineating funding priorities, and other funding sources. The choice of allocation mechanisms also signals to third-party funders the organization's competence and philosophy. The choice of fee structures signals the funded nonprofit's managerial competence and degree of commitment to move towards self-sufficiency, which many funders value. On the other hand, allocation mechanisms may signal an organizational insensitivity to need. When a soup kitchen charges fees, funders may question the organization's commitment to serving the needy, the quality of its management, or the kitchen's longterm stability. Thus, we hypothesize that nonprofit use of fees depends upon the preferences of major funders and the nature of the service provided. (The potential effect of user fees on donations was noted in Chapter 3.) The ability of any organization to contribute to the public interest in efficiency and distributional equity depends on the actions of both the organization and its customers, patients, or clients. Consumers should have reason to restrict their use of costly services, to seek less costly alternative modes of service delivery, to take preventive actions that reduce their need for services, and to devote effort toward being a "good" client on whom agency efforts will not be wasted. The high fees charged by profit maximizers provide consumers with a reason to economize in all these ways, even though it is no part of the profit-

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maximizer's profit-making mission to help society in this way. Nonprofits whose distributional concerns make them averse to high fees would not have this automatic beneficial side effect of solving these "moral hazard" problems. Thus, some nonprofits temper their distributional concerns and charge token fees, and others provide efficiency-inducing incentives through nonfee mechanisms. David E. Mason (personal communication, 1996) provides an example: [T]he Laubach Literacy organization . . . published teaching and reading materials . . . , trained volunteer tutors, and conducted adult literacy programs . . . in 17 countries. . . . Though the money paid by those who used the reading material was so insignificant that the central office reaped virtually no income from it, we always charged a token fee. We found the learners took better care of the material, and attached a value to it because the fee was required. In the same vein, fees can induce effort on the part of a third-party payer rather than the client. Private education, where the parents are the third party, provides an example (Oster 1995): [Private-school fees] also help to insure that parents have some "stake" in their children's education, so that price plays an ideological role as well. Given the extent to which education has been increasingly seen as a collaborative effort between parents and schools, some pricing may be quite important, (p. 99) Although user fees usually provide positive efficiency-inducing incentives to clients and third parties, there are dangers. Lohmann (1980) points out that, in the field of mental health, [t]he use of strong-arm tactics in the collection of past-due accounts . . . would be considered inappropriate.... One mental health agency . . . has largely solved this problem by linking payment of fees to the clinical context: reluctance to pay fees is interpreted as a non-cooperative attitude on the part of the client, and the issue is taken up by the clinical staff. Such an approach, however, may strike some as taking unfair advantage of client vulnerabilities. Certainly, it can be seen that significant tensions can arise between the "helping" thrust of an agency and its need for fee revenue, (pp. 81, 89)

Conclusion Nonprofit organizations and for-profit firms both engage in commercial activities, charging fees for services provided. Some analysts, policymakers, and mass media conclude from this observation that commercial nonprofits are simply for-profits in disguise - a conclusion that is premature. Unlike for-profits, nonprofits have a variety of distributional and other "bonoficing" objectives, and they operate under different legal constraints, so that they may set their prices (and design their nonprice allocation mechanisms) on a different basis. In this chapter, we have illustrated a wide variety of ways in which distributional goals might be pursued, each suggesting a testable implication. Our tests are

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informal and, we hope, suggestive, but they call for formal testing and interpretation. A balanced assessment of the commercial activities of nonprofit organizations requires analysis of the magnitude of differences between nonprofits' and for-profits' pursuit of distributional objectives, a judgment regarding the social value of pursuing distributional goals through nongovernmental organizations, and evaluation of alternative means of pursuing these objectives. We do not assert, nor have we demonstrated, that nonprofits differ from private firms in their concern for how outputs are distributed among beneficiaries. All nonprofits are not the same, any more than all private firms are. Nonprofits may not behave the same way in all markets, perhaps acting differently in ancillary-goods markets, where the focus is on revenue generation, than in their use of user fees for their target populations, where revenue generation may be balanced with distributional considerations. The distinctions we have discussed in this chapter are intended as conjectures that call for testing. It is important to determine whether, and under what conditions, nonprofits are effective mechanisms for expressing complex social goals involving output distribution.

CHAPTER 5

Differential taxation of nonprofits and the commercialization of nonprofit revenues

Joseph J. Cordes and Burton A. Weisbrod

Introduction As the nonprofit sector has grown in economic importance, so too has its reliance on income obtained from a variety of commercial activities - that is, activities involving the sale of goods or services. Because commercial income earned in the nonprofit sector is largely, if not entirely, tax exempt, this trend raises several questions: Are nonprofit organizations encouraged to pursue commercial ventures that they would otherwise eschew because the income from such activities is tax exempt? When nonprofit enterprises move into commercial markets, does their tax-exempt status give them an economic advantage? Does the prospect of earning tax-free income create incentives for nonprofit organizations to divert their energies from core philanthropic activities in order to pursue commercial ventures that are justified only because they generate revenue for the core activities? How does the differential tax treatment of nonprofits affect choices among commercial ventures? To answer these questions, we must recognize some distinguishing attributes of nonprofits (Weisbrod 1977,1988; Hansmann 1980; James 1983; Steinberg 1991; Eckel and Steinberg 1994). Unlike for-profit enterprises, nonprofit organizations may regard the pursuit of profit in any market as a means of achieving other "more important" organizational goals, rather than as an end in itself. In addition, donations, an important source of revenue for many nonprofits, may be sensitive to these commercial activities. For example, donors may care about how nonprofits divide their efforts between profit-making activities and producing what donors believe to be the organization's "primary" output. We are grateful to David Bradford, Charles Clotfelter, Susan Rose-Ackerman, and Bruce Davie for commenting on earlier drafts; to Cecilia Hilgert, Margaret Riley, Michael Alexander, Daniel Skelley, and Gary Jurevich, of the IRS, for help in obtaining and interpreting data on nonprofit organizations; and to Cagla Okten for research assistance.

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For these reasons, nonprofit managers may view commercial ventures differently than would for-profit competitors, and these differences must be considered when analyzing the effects of differential tax treatment of nonprofit enterprises. For a nonprofit organization, decisions on whether to engage in any commercial activity often quite rightly involve more than expected profitability. Following Chapter 3 and James (1983), our basic theoretical framework is one in which nonprofit organizations seek first and foremost to maximize their ability to provide a charitable good or service, while avoiding production or distribution of ancillary activities that can hamper achieving the primary mission. The ability to produce the preferred output, however, depends on the revenue not only from donations but also from user fees and - what is central in this chapter - from the production and sale of ancillary commercial outputs. Nonprofit managers may view these ancillary outputs as a mixed blessing. Although profits from such activities provide needed income to supplement donations and allow increased provision of the primary output, the leadership of the nonprofit may dislike producing secondary output in principle, especially if that seems inconsistent with the organization's underlying objectives. When nonprofits enter commercial markets to sell ancillary outputs, they face different tax rules than do for-profit producers of the same outputs. This chapter describes the nature of these tax differentials as well as implications for nonprofit organization behavior. We then consider the major effects of choices made by nonprofit organizations to engage in commercial activities, determining whether these choices are intentional, efficient, and equitable, and considering whether observed behavior of nonprofits in commercial markets is consistent with our predictions. Differential tax treatment of nonprofit organizations Income earned by for-profit enterprises is subject to tax in various forms. At the federal level, and in most states, businesses pay profits taxes on their income; and at the state and local level, businesses are taxed on property values. Nonprofit organizations, however, are subject to different tax rules that provide very broad, if not complete, exemptions from these taxes. Nonprofit charitable organizations are generally exempt from paying state and local taxes on property used "primarily" for the organization's exempt purpose; and nonprofits are exempt from federal and state corporate income taxes on income from activities that, even if commercial, are deemed to be substantially related to the organization's primary exempt purpose. In principle, neither the state nor federal tax exemptions are intended to apply to taxes that would otherwise be incurred in the pursuit of commercial activities that are not related to the nonprofit's primary exempt purpose. Thus, since the 1950s, nonprofits have been subject to a federal Unrelated Business

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Income Tax (UBIT), which is meant to tax nonprofits on the same basis as forprofit corporations on income earned in a "trade or business" that is "regularly carried on" by a nonprofit and not "substantially related" to the nonprofit's exempt purposes (Simon 1987; Hansmann 1989). States that levy corporate income taxes have followed the federal government's lead in this area by imposing their own unrelated business income taxes; and most states require that property be used primarily for an exempt purpose to qualify for property-tax exemptions. The attempt by federal and state governments to tax unrelated commercial activities is intended to limit the extent to which nonprofits can exploit their taxexempt status to produce commercial outputs having little or no connection to the organizations' primary "tax-exempt" output (Steinberg 1991). In practice, however, it has proved administratively difficult for federal, state, and local taxing authorities to differentiate taxable and nontaxable commercial activities (Simon 1987; Mikesell in press). Thus, tax experts widely agree that for many nonprofits, most, if not all, income earned from commercial undertakings is effectively tax exempt. Moreover, opportunities to shift reported revenues and costs between taxed and untaxed activities can allow nonprofits to avoid taxation even when an activity is clearly unrelated to its tax-exempt purpose. Differential taxation and nonprofit behavior How do these tax differentials affect choices that nonprofits make about both the degree and the forms of their commercial ventures? Answering this question first requires discussing the kinds of investment decisions that nonprofit organizations make, and how these may differ from those made by for-profit enterprises. Modeling the investment choices of nonprofit organizations We represent the nonprofit organization as an entity that seeks to maximize the utility from providing a preferred, "core," or mission-related nonprofit good or service, subject to the constraint that spending on that good cannot exceed revenue (James 1983; Schiff and Weisbrod 1991). Revenue depends on donations, user fees (discussed in Chapter 4), and profit from commercial activities, which is the focus of this chapter. As in any organization deciding whether to invest in a business venture, there is an opportunity cost to a nonprofit engaging in commercial activities. As RoseAckerman (1982) noted, although nonprofits can finance investments in commercial activities from "free cash" or accumulated reserves, the use of these funds is not free; every dollar invested in the commercial activity could instead be used to earn income from passive investments in securities. The nonprofit

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could also borrow some or all of the funds needed to finance the commercial activity, but at a cost. The key question is whether the nonprofit can realize a greater rate of return by investing in ancillary commercial activities rather than in passive investments. Following Schiff and Weisbrod (1991), we also assume that donations increase with the nonprofit's production of preferred, mission-related goods and with its fund-raising expenditures as well. In addition, we assume that commercial activity may negatively affect donations if opposed by donors or positively if viewed as appropriate self-help. Maximizing a nonprofit's utility subject to the financial constraint implies that nonprofits will invest in fund-raising up to the point where a marginal dollar spent on eliciting donations equals the cost of fund-raising. However, fundraising in itself could also be seen as a nonpreferred, ancillary activity, in which case the organization would stop short of the amount of fund-raising that would maximize revenue from this source (Weisbrod and Dominguez 1986). A similar condition defines the required return, or hurdle rate, that an additional dollar invested in a commercial activity must earn to justify the investment. For nonprofits this hurdle rate does not depend exclusively on the financial cost of funds, as would be the case for a for-profit enterprise, because the organization or its potential donors might have a distaste for engaging in ancillary commercial activity. When such distaste is present, the nonprofit will invest in a commercial activity to the point where marginal profit on an additional dollar spent on the commercial activity equals the sum of the financial cost of funds,plus an additional premium to compensate for the loss in utility and/or donor contributions resulting from increased investment in the commercial activity. This hurdle rate is the starting point for analyzing what motivates nonprofits to invest their resources in commercial activities. Nonprofit and for-profit behavior in the absence of taxation We first consider briefly how nonprofit and for-profit organizations would be expected to behave if all returns from commercial activities were untaxed. This setting is clearly unrealistic, but it provides a useful baseline for understanding the effects of differential taxation. In such a world, a typical for-profit organization would invest in a commercial activity until the marginal profit per dollar invested in the activity equaled the opportunity cost of funds. Whether a nonprofit organization would use the same investment criterion depends, as noted, on whether it or its donors had a distaste for engaging in commercial ventures. Were there no aversion to undertaking commercial revenue-generating activities, a nonprofit would act as a profit maximizer in commercial markets regardless of its goals; that is, it would

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behave just like a for-profit enterprise with regard to the decision about whether and how much to invest in a commercial activity. Nonprofits would want to maximize net revenue from commercial activities to maximize funding of mission-related output. Thus, if there were no aversion by the nonprofit or donors to commercial activities, nonprofits would behave in the same way as for-profits in the commercial market even though the pursuit of profit was not a goal for the nonprofit as a whole. Both types of enterprise would use the same criterion - profitability to evaluate whether or not to invest in a given commercial activity. If nonprofits received no special subsidies, they would compete on an even footing in capital markets with for-profits, who could not then complain about being undercut by "unfair competition." However, if either the nonprofit or its donors had a distaste for engaging in commercial activities, the financial test that a nonprofit would apply before engaging in a commercial activity would actually be relatively more stringent. It would not be enough for a commercial activity to earn a profit commensurate with the financial opportunity cost of funds. The marginal profit would have to exceed the financial cost of funds by enough to compensate for the disutility of the activity and net loss of contributions from donors; thus, a nonprofit would engage in less commercial activity than would be profit maximizing. Aversion to commercial activities could be strong enough to cause the nonprofit to avoid certain ancillary commercial ventures entirely. If economic return to a commercial activity were set by competition among for-profit producers, the marginal profit that could be earned by a nonprofit could not exceed the financial opportunity cost of capital. In such a case, the nonprofit could not earn a marginal profit high enough to cover both the cost of funds and the "aversion premium" required for engaging in the nonpreferred activity. Even so, nonprofits might still choose to engage in some commercial activities if there were cost complementarities between these activities and the preferred, mission-related output and if the nonprofit benefited from donations or subsidies. This could allow the nonprofits to earn a greater marginal return on the commercial activity than could for-profit competitors lacking such benefits. Thus, in a world in which both nonprofits and for-profits were untaxed, the propensity of nonprofits to seek out commercial sources of revenue would depend on whether the nonprofit and/or its donors saw pursuing profit as a means to finance - that is, cross-subsidize - its mission. Commercial activities seen as conflicting with the mission, while regarded as economically profitable by forprofits, would not be worth undertaking by nonprofits. Such aversion could be overcome, however, if nonprofit production of preferred output brought sufficient cost advantages in ancillary markets. In the more general case, in which individual nonprofits have varying degrees of aversion for commercial ventures and differing abilities to exploit cost complementarities, we would expect en-

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try into commercial markets to be concentrated in activities where aversion is least - perhaps because the activity is "closest" to the nonprofit's mission - and where there was the most potential for exploiting cost complementarities between commercial outputs and their preferred output. Effects of differential taxation of nonprofit and for-profit enterprises A central insight of our model is that when a nonprofit is averse to pursuing profit in commercial markets, it will engage in commercial activities only if it expects to earn a premium above the competitive rate of return that it could earn from passive investments. This implies that differential taxation of non- and forprofit enterprises, by itself, would not provide a financial incentive for nonprofits to pursue otherwise objectionable commercial ventures. The importance of tax-induced investment premiums Consider a case in which nonprofits have no special tax incentive to engage in commercial ventures, despite exemption from taxes on ancillary business profits. Such a situation would arise if for-profit enterprises were subject to a neutral tax on business income, one that taxed income from all sources at the same rate and allowed interest on debt to be deducted (Rose-Ackerman 1982). Although one might think that the exempt nonprofit would have an incentive to seek out tax-exempt commercial activities under these circumstances, nonprofits would earn no premium above the competitive return by doing so. If profits from all business activities were taxed at the same rate, the marginal profit that a nonprofit could earn from investing in a commercial venture would equal the opportunity cost of funds, as it would in the no-tax case. Moreover, as in the no-tax case, if either the nonprofit or its donors had a distaste for engaging in commercial activities, the nonprofit would prefer investing passively if all it could do is earn the same rate of return as would a for-profit competitor. Exemption from tax would allow a nonprofit to earn a higher return from commercial activity; however, it would also raise the financial (opportunity) cost of engaging in such a venture because the financial returns from passive investments would also be tax-exempt, whereas interest on debt would not be tax-deductible. Under a neutral income tax, these two features of the tax exemption would exactly balance each other so that the nonprofit and for-profit would face the same incentives at the margin for investing in a commercial enterprise. Effects of property and corporate tax exemptions There are, however, several important instances in which differential taxation of nonprofits potentially allows nonprofits to earn premium returns from invest-

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ing in commercial ventures that exceed the competitive return. One is the exemption from local property taxes for nonprofits. If for-profit enterprises must pay these taxes, a for-profit would invest in a commercial activity up to the point where the marginal profit per dollar invested was enough to cover the opportunity cost of funds plus the property tax per dollar invested. Since nonprofits do not pay property taxes, in effect they would earn the same pretax total return as a for-profit, without having to pay the property tax.1 Exemption from corporate profit taxes on commercial activities deemed to be "substantially related" to the nonprofit's primary purpose creates another potentially exploitable tax premium (Cordes and Sheffrin 1981; Rose-Ackerman 1982). This comes about because, unlike in the example discussed above, business income is not taxed at the same rate regardless of source; rather, corporate income is taxed once at the corporate level and then again at the individual level, whereas income earned by unincorporated enterprises is taxed only once at the individual level. To compensate for the double taxation of corporate income, the pretax return to an additional dollar invested in a commercial activity undertaken by a corporation will come to exceed the interest rate. For-profit unincorporated firms, however, would continue to invest up to the point where the marginal return equaled the opportunity cost of funds. This model implies that nonprofits have no particular tax incentive to invest in tax-exempt activities dominated by unincorporated enterprises, because competition in capital markets will cause these activities to earn the same pretax return as could be earned by investing passively in bonds. (As Hansmann [1989] has noted, with a corporate tax, nonprofits would have a tax disincentive to hold corporate common stock, because as shareholders they could not avoid paying the corporate tax, collected directly from the corporation). There would, however, be a tax incentive for nonprofits to engage actively in taxexempt related commercial activities dominated by corporate producers, and compete with for-profits in those markets because they could earn a return exceeding the competitive return from passive investments. Tax treatment of unrelated business income Not all business income earned by nonprofits, however, is tax exempt. As noted above, profits earned from activities deemed unrelated to the organization's tax-exempt purpose are subject to both federal and state Unrelated Business Income Taxes (UBIT); and most states tax any property that is not used primarily for the organization's primary exempt purpose. In principle, these taxes would appear to discourage nonprofits from investing in unrelated commercial activities. If a nonprofit is already averse to earn1

In practice, some nonprofits may pay something like a partial property tax to the extent that they make "voluntary" payments in lieu of tax (PILOTs).

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ing income from such ventures, an investment subject to federal and state taxation would have to earn an even higher pretax return to make it worthwhile. In practice, however, many nonprofits may be able to arrange their financial affairs so that income that is nominally subject to federal and state UBITs may be subject to little or no tax. For example, a nonprofit could deduct a portion of "joint" costs - costs of inputs that contribute to both its mission-related and tax-exempt commercial outputs - against profits from its unrelated, taxed activity. Although such cost shifting would not by itself allow a nonprofit to escape paying taxes on property used solely to produce unrelated business income, property taxes could be avoided to the extent that the property used to generate such income was also "primarily" used for mission-related, exempt purposes. The presence of joint costs shared by related and unrelated activities not only permits but encourages nonprofits to shift costs. Indeed, there is striking evidence that nonprofits take advantage of such opportunities. Of the 32,690 nonprofits that filed UBIT returns in 1991, almost three out of five reported losses - negative taxable income - and for the UBIT filers as a group, total expenses allocated to providing unrelated activities exceeded total revenues, implying that, overall, unrelated activities are unprofitable (Riley 1995). Since nonprofits presumably engage in unrelated activities only to fund their tax-exempt activities, truly unprofitable unrelated services make no sense. In reality, cost shifting allows reported profit to be zero or even negative, even though there may be a substantial marginal profit from the unrelated activity that generates considerable revenue for the preferred, tax-exempt outputs. Empirical evidence Our framework predicts that the relative importance of commercial activities to nonprofits reflects three broad factors: 1 the abilities of particular nonprofits to exploit cost complementarities; 2 the nonprofit's aversion premium, which in turn depends on the preferences of both nonprofits and their donors; and 3 the size of the pretax investment premium that can be earned on commercial ventures. The model also predicts, moreover, that, despite the disadvantages of earning income from unrelated, and hence nominally taxable, commercial activities, nonprofits will undertake such business activities given a certain circumstance: The activities must allow the nonprofit to earn a pretax investment premium over and above the opportunity cost of funds. A major contributing factor is the opportunity to use the same inputs in both mission-related and the unrelated commercial market; this provides the opportunity for the nonprofit to shift costs and possibly revenue between taxed and untaxed goods to minimize taxes on the unrelated activity.

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We examined some of these predictions with data from the Statistics of Income (SOI) public-use sample of IRS Form 990 tax returns (see Appendix) filed in 1992 by nonprofit charitable organizations exempt from taxes under Section 501(c)(3) of the Internal Revenue Code. Measures of commercial activity Determining whether variables suggested by the theoretical model explain variation in the propensity of nonprofit organizations to engage in commercial ventures requires a means of measuring an organization's propensity to engage in commercial activities. One such measure is Commercial Share, defined as the share of the nonprofit's total revenue derived from sources that can reasonably be attributed to commercial activities that are exempt from taxation. We measure Commercial Share as the share of total revenue derived from program services, which is widely used to gauge how much nonprofit organizations depend on revenue sources other than contributions, plus other income from excluded activities and special events. To focus on commercial revenue sources likely to benefit from nonprofit tax exemption, Commercial Share excludes components of program service revenue (PSR) reported as unrelated business income. Another, dichotomous measure is whether the nonprofit had at least $ 1,000 in gross revenue from the unrelated business activity, and so was required to file a UBIT return. Although PSR, which is an important component of Commercial Share, is a commonly used indicator of the extent to which nonprofits engage in businesslike activities, it is not ideal because it includes income from activities such as tuition payments by students, which may be neither business activities in the sense discussed above, nor viewed as nonpreferred sources of revenue. Nonetheless, because Commercial Share includes income from a wide range of commercial activities, variation in this variable is likely to reflect variation among nonprofits in the propensity to rely on commercial sources of revenue.2 Measures of cost shifting We also seek to examine whether nonprofits attempt to shift costs to reduce taxable income subject to the UBIT. Froelich and Knoepfle (1996) note that nonprofits enjoy fairly wide latitude in allocating wages and salaries that are part of management and general "overhead" among their various functional activities. One option open to nonprofits reporting revenue from sales of goods is to include a portion of wages and salaries that would otherwise be included under 2

In principle, it would be desirable to distinguish between elements of program services that are businesslike and those that are not, but this is not possible in the public-use sample. The results reported in Table 5.1 were not sensitive to the use of alternative definitions of Commercial Share, some of which included unrelated business income.

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"managerial and general expenses" as part of the cost of goods sold. As Froelich and Knoepfle (1996) point out, nonprofits may choose this strategy for a variety of reasons, not all of which are motivated by taxes; for example, nonprofits may seek to minimize their reported management expenses to appear more efficient in using charitable donations. Still, a nonprofit subject to the UBIT has an additional incentive to shift wage and salary expenses into the cost of goods sold to reduce taxable income. As a by-product of reporting these expenses as costs of goods sold rather than as management costs, the nonprofit would also report lower amounts of managerial and general salary expense. Therefore, we use as a measure of cost shifting the variable Management/General Salaries, which is the ratio of wages and salaries reported as part of "management and general expenses" to total expenses reported on the Form 990 return. We hypothesized that when a nonprofit is subject to the UBIT, it will be more likely to shift a portion of these joint costs to the Form 990 category of "cost of goods sold," and hence report lower amounts of total management and general wages and salaries as part of its functional expenses. UBIT filers would thus be expected to have lower ratios of management/general wage and salary expense to total expenses than would nonprofits with otherwise identical attributes who were not engaged in commercial activity subject to the UBIT. Measures of cost complementarities and aversion It is difficult to construct suitable measures for an organization's aversion to undertaking commercial activities and for its ability to exploit cost complementarities, but we can use two reasonable, if crude, proxies. Entity size. It is likely that both opportunities for exploiting cost complementarities and the degree of aversion to pursuing commercial ventures will vary with the size of the nonprofit. Larger nonprofits may well have more opportunities than smaller ones to exploit cost complementaries. To the extent that smaller nonprofits are also likely to be relatively new, prospective donors might also be more likely to monitor the extent of their commercial activities. If so, aversion to commercial ventures would fall with an increase in the size of the nonprofit. The implication of these two hypotheses is that the propensity to engage in commercial activities should increase with the nonprofit's size, as measured by the variable Assets, the end-of-year assets reported by the nonprofit. This prediction is consistent with tabulations of aggregate data reported on Form 990 returns, which indicate that larger nonprofits receive a larger share of their revenue from commercial sources (Hilgert and Arnsberger 1992). These tabulations, however, are presented for nonprofits as a whole, and thus do not control for the nature of the nonprofit's primary output, as reflected by its grouping in

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the National Taxonomy of Exempt Enterprises (NTEE), which one might also expect to affect the likelihood of engaging in commercial activities. Source of donations. It also seems reasonable to assume that the aversion premium could vary with type of donor - for example, private versus government. Although the model does not make specific predictions about which type is more likely to oppose commercial undertakings by nonprofits, we construct the variable Pet. Public Contributions, which is the share of total contributions received from government sources, to examine the possibly differential effect of government and private "contributions, gifts, and grants." Type of activity. Both a nonprofit's aversion premium and its ability to exploit cost complementarities may also vary with the nature of its primary output. Universities or hospitals, for example, may have greater opportunities to develop cost complementarities than, say, human-service providers because of the variety of their resource inputs. Thus we include a series of dummy variables that correspond to the major NTEE categories of arts, education, health, and human services, which have sufficient sample size to generate meaningful results (see also Chapter 6). The comparison group in the regressions comprises nonprofits in various other NTEE categories (environment and animals, international, public, societal benefit, religious, mutual membership, and unknown). Measures of tax premiums Last, the model predicts that nonprofits should be more likely to invest in commercial activities that offer the prospect of capturing tax premiums exceeding the competitive return. Although the tax premiums generated by differential taxation at the federal level do not vary among nonprofits in a single year, local property tax and state corporate tax rates vary. In theory, there should therefore be some variation by state in the pretax investment premiums that can be earned from commercial ventures. Hansmann (1987) and Gulley and Santerre (1993) use interstate variation in property and corporate tax rates to examine whether aggregate market share of nonprofits in selected industries is higher in states with relatively high property and corporate tax rates - where the nonprofit's advantage is greatest. They find that, as the theory predicts, the market share of nonprofit organizations increases with the size of the tax differential. These studies focus on what might be described as the aggregate outcome of many individual decisions made by nonprofits to engage in commercial activity. We use data from the Form 990 returns to examine the behavior of individual nonprofits. To capture such variation we have added two dummy state-tax variables, using data published by the Tax Foundation (1993/4) and Minneso-

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ta Taxpayers Association (1996), to the individual observations in the 1992 public-use sample. These variables were constructed to distinguish states where relatively high local property tax rates and corporate tax rates would, in theory, allow nonprofits to earn relatively large tax-induced premiums. The variable Proptax = 1 in states where local commercial property tax rates ranked among the top ten in the country; the variable Corptax = 1 if the nonprofit is located in one of the nine states with a statutory tax rate in excess of 10 percent. Results Table 5.1 presents estimates of a regression of the variable Commercial Share on proxies for a nonprofit's aversion to commercial ventures and ability to exploit cost complementarities, as well as state-level tax dummy variables. Table 5.2 presents the probability (logit regression) that a nonprofit files a UBIT return (Form 990-T) as a function of the same variables. Table 5.3 presents estimates of a regression of Management/General Salaries on several characteristics of the nonprofit, including whether it was required to file a UBIT tax return. The results are generally consistent with expectations. Table 5.1 shows that the industry of a nonprofit's primary output significantly affects its propensity to rely on revenue from commercial sales. The significant, positive coefficients on the NTEE dummy variables show that nonprofits with mission-related outputs in the areas of arts, education, health, and human services all derive a larger share of funds from tax-exempt commercial activities than do nonprofits in the comparison group. Holding size constant, nonprofit providers of health services receive roughly $0.75 of every revenue dollar from such sources, reflecting the major effect of hospitals, followed by nonprofit providers of education and human services, which derive roughly $0.50 of every dollar from commercial sources. The results also show that after controlling for the nature of the nonprofit's mission-related outputs, size (Assets) of the nonprofit is associated positively with revenue share from commercial sources. The negative coefficient of Assets Squared indicates that although the propensity to engage in commercial activities increases with size, it does so at a decreasing rate. This suggests that, after some point, a nonprofit's ability to exploit cost complementarities encounters diminishing returns. When size is measured in dollars as a continuous variable, increases in asset size have a quite small effect on share of commercial revenue. The estimated coefficients on Assets and Assets Squared indicate that for a nonprofit with $20 million in assets, doubling its size would increase the share of revenue derived from commercial activities by roughly two-tenths of a percentage point. This relatively small effect may, however, reflect the fact that almost three out of every four charitable organizations in the SOI sample has a "large" asset size of $10 million or more. To examine this issue further, we therefore con-

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Table 5.1. Dependent variable: Commercial Share = program service revenue as a fraction of total revenue Variable Intercept NTEE classification Arts (# = 583) Education (#=1,960) Health (# = 3,516) Human services (#=1,689)

Coefficient

Variable

.184** (.010) .062** (.017) .357** (.012) .554** (.011) .289** (.013)

Assets (units of $10 mil.) Assets Squared Pet. Public Contributions Proptax Corptax

No. of observations Adjusted R2 F-statistic

Coefficient

.0094** (.0002) -1.46E-6** (3.OE-8) -0.050** (.011) .033** (.007) .042** (.011)

9,104 .259 353.98

Note: Results are not sensitive to the use of alternative definitions of Commercial Share, some of which included unrelated business income. Standard errors are shown in parentheses. ** Statistically significant at the .01 level.

structed a dummy variable equal to 1 if the nonprofit had assets of $5 million or more, and zero otherwise. Though the results are not shown here, when we replaced the continuous measure of size in the regression for Commercial Share with this variable, the coefficients of the other variables remained of the same sign and magnitude as shown in Table 5.1; and smaller nonprofits are quantitatively as well as statistically much less likely to rely on commercial revenues. The coefficient of the size dummy implies that the commercial revenue share among "small" nonprofits - those with less than $5 million in assets - is almost 17 percentage points lower than the corresponding commercial revenue share among larger nonprofits. Table 5.2 shows broadly similar patterns and effects of both the nonprofit's industry and size on its propensity to undertake taxable commercial activities. The odds ratios calculated from the estimated coefficients in the logit regression imply that nonprofit providers of health services are about 2.4 times more likely than the reference group to report revenue from program services subject to the UBIT. (The odds ratio is the ratio of the predicted probability that the organization files a UBIT return to the predicted probability that it does not.) Non-

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profit organizations in the arts and education are both about twice as likely as nonprofits in the reference group to receive such revenue. Nonprofit humanservice providers, however, are about 50 percent less likely than those in the reference group to engage in unrelated business activities subject to the UBIT. Assets also affect the probability of filing a UBIT return. The estimated coefficients of Assets and Assets Squared indicate that doubling the size of a nonprofit with $20 million in assets would increase its odds of filing a UBIT return by roughly 12 percent. Replacing the continuous asset-size variables with a size dummy also results in a much larger estimated effect of asset size: Nonprofits with assets of $5 million or more are roughly five times more likely to file a UBIT return than are other nonprofits. Whether size is proxied by a continuous or a dichotomous variable, however, it should be noted that larger nonprofits are also more likely to file UBIT returns simply because the scale of their unrelated activities is more likely to trigger the UBIT filing threshold of $ 1,000 in gross income. Our results indicate that the source of donations affects a nonprofit's commercial activities - as measured by both commercial revenue share (Table 5.1) and filing a UBIT return (Table 5.2). The greater the share of contributions that a nonprofit receives from public rather than private sources, the less likely the nonprofit is to rely on revenue obtained from commercial activities (tax exempt and taxable). The estimated coefficients of Pet. Public Contributions in Tables 5.1 and 5.2 imply, respectively, that a ten-percentage-point increase in the share of contributions received from public sources reduces the revenue share derived from program services by half a percentage point, and lowers the odds that the nonprofit files a UBIT return by about 20 percent. A possible explanation is that public donors are more likely than private donors to be averse to commercial activities of nonprofits. Tables 5.1 and 5.2 also show that nonprofits are more likely to rely on commercial revenue sources when located in states with relatively high taxes. The estimated coefficients of both the property- and the corporate-tax variables are positive and statistically significant in the regression for Commercial Share, indicating that nonprofits in high-tax states are more likely to depend on commercial sales for revenue. The magnitudes of the coefficients imply that location in one of the ten states with the highest commercial property tax rates raises the nonprofit's commercial revenue share by about 3 percentage points; and location in a high-corporate-tax state raises commercial share by 4 percentage points. These results are generally consistent with previous research showing that cross-state variation in property and business taxation helps to explain the relative importance of nonprofits in certain industries. Table 5.2 also indicates that nonprofits located in relatively high-corporatetax states are also more likely to undertake unrelated - taxable - business activities. The odds ratios calculated from the estimated coefficient imply that non-

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Table 5.2. Likelihood that a nonprofit files a UBIT return (logit regression) Variable Intercept NTEE classification Arts (N = 583) Education (N= 1,960) Health (N =3,516) Human services (N = 1,689)

Coefficient

Variable

Coefficient

Assets (units of $10 mil.) Assets Squared

.056** (.003) -8.90E-6** (5.81E-7) -0.233** (.083) -.010 (.056) .287** (.075)

-1.886** (.080) .727** (.121) .633** (.093) .857** (.085) -0.621** (.118)

Pet. Public Contributions Proptax Corptax

No. of observations % correct predictions Chi-square

9,104 74.3 846.80

Note: UBIT = 1 if nonprofit required to file a UBIT return, 0 otherwise. Standard errors are shown in parentheses. ** Statistically significant at the .01 level.

profits located in high-corporate-tax states are about one-third more likely to file a UBIT return than are nonprofits in states with lower taxes. These results would be unexpected if unrelated business activities in these high-tax states were actually taxed. However, the ability of nonprofits essentially to avoid taxation of profit by shifting costs and revenue between taxable and nontaxable activities tends to make unrelated business activities relatively more attractivefinancially.In these cases, we would expect variation in state-level tax rates to have the same effect on a nonprofit's decision to engage in an unrelated business activity as in a tax-exempt activity. In this vein, the results in Table 5.3 provide more direct statistical evidence that nonprofits take advantage of opportunities for reducing their taxable income by shifting costs when they are subject to the UBIT. To test the hypothesis that UBIT filers have an incentive to shift wage and salary expenses into cost of goods sold, we restricted our attention in the SOI sample to nonprofits reporting at least $1,000 in gross receipts from sales, thereby giving them the opportunity to shift management and general wage and salary expenses.

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As predicted, we find that nonprofit organizations that filed a UBIT return reported lower ratios of management and general wage and salary costs to total expense on their Form 990 returns. The estimated coefficient indicates that the ratio of such costs to total expenses among UBIT filers is about 1 percentage point lower than for organizations not subject to tax. The magnitude of the coefficient may seem to indicate only a moderate degree of cost-shifting, but the amount of wage and salary expense that is estimated to be shifted must be compared with the amount of potentially taxable income. Among firms required to file a UBIT return, the 1-percentage-point difference in the ratio of "shiftable expense" to total expense amounts to roughly $650,000. This figure may be compared with the amount of "gross profit from sales" (gross receipts minus cost of goods sold) reported by UBIT filers - approximately $2.2 million. In other words, the amount of expenses estimated to be shifted from overhead wages and salaries is almost a third of "gross profit." In addition to the dummy variable UBIT, we also included the variable Contributions, which is the ratio of revenue received from private direct and indirect contributions, plus special fund-raising events, to total revenue. This variable is intended to control for the degree to which the nonprofit cares about its reported management expense for reasons other than taxes (e.g., any adverse effect on donations). The implication is that organizations that depend more on contributions would be more apt to care about the reported amount of management expense, and hence have an incentive to shift management/general wage and salary expense into cost of goods sold, whether or not they were subject to the UBIT. Although tangential to our analysis, the coefficient of this variable is significant and of the expected negative sign, indicating that nonprofits that depend more on contributions are also more likely to report lower ratios of management/general wage and salary expense to total expense. To see whether the above results reflect cost shifting, we also estimated the same equation as that presented in Table 5.3 for the subsample of nonprofits in the SOI sample with little or no opportunity to shift expenses from elsewhere on the Form 990 return into the cost of goods sold because they had less than $1,000 in gross sales. Although the results are not reported here, neither the UBIT nor the Contributions variable was statistically significant in these regressions. This is what one would expect in the case where shifting wages and salaries out of management and general expenses into cost of goods sold was not an option, providing some further evidence that the estimated coefficients in Table 5.3 are indicative of cost shifting that is motivated by both tax and other motives. These results also suggest that increased commercial activity by nonprofits may indirectly affect public perceptions of the "effectiveness" of different organizations. Nonprofits that can deduct cost of goods sold have opportunities to report expenses on the Form 990 return in ways that make financial ratios of-

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Table 5.3. Dependent variable: Ratio of management and general wage and salary expenses to total expenses Variable Intercept NTEE classification Arts ( # = 280) Education (N = 432) Health (#=316) Human services (#=252) No. of observations Adjusted R2 F-statistic

Coefficient

Variable

Coefficient

.098** (.006) .017** (.007) -0.016* (.006) -0.018* (.007) -0.016* (.007) 1,476 .045 9.59

Assets (units of $10 mil.) Assets Squared UBIT Contributions

-0.0006** (.0000) 1.3E-6** (5.7E-7) -0.0096* (.004) -.0205** (.006)

Note: Standard errors in parentheses. * Statistically significant at the .05 level. ** Statistically significant at the .01 level.

ten used to gauge an organization's "fund-raising effectiveness" (e.g., the ratio of management and general expenses, plus fund-raising costs, to contributions) look more favorable. In addition to examining the shifting of costs from managerial expense to cost of goods sold, we also investigated the extent to which nonprofits' unrelated business activities are taxed very little because joint costs are allocated to those activities on the UBIT return - IRS Form 990-T - thereby reducing or even eliminating reported profit. When resource inputs are joint, determined essentially by the level of mission-related activity, the true marginal costs of engaging in unrelated business activities will be small, or even zero. How much of the costs reported by nonprofits as attributable to taxable, unrelated business activity on the Form 990-T returns is simply a reallocation of joint costs? Is it true that commercial activity in unrelated business is as unprofitable as most UBIT returns indicate? To answer these questions we sought to determine the extent to which costs claimed on UBIT returns are truly attributable to the unrelated activities, and to what extent they would been incurred even if those activities were not undertaken. Specifically, we regressed a nonprofit's "total compensation" costs on the

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magnitude of its activities in related and in unrelated markets, using an organization fixed-effects estimator. The predictions were that 1 2

additional related activity, as measured by the gross revenue it generates, would be associated with greater labor-compensation costs, but additional unrelated activity, also measured by its gross revenue, would be associated with less, even no, additional compensation costs.

The different expectations for the cost effects of related and unrelated, untaxed and taxed, activities hinge on the joint-cost hypothesis. Data are from the SOI samples of Form 990 returns for the four years 19903. We analyze separately the regression equations for each of three industry groups. The number of organizations varied somewhat from year to year, but for the four years included 6,662 observations for hospitals, 2,014 for universities, and 572 for museums. Thefindingsare striking. In each of the industries we found, as hypothesized, that (1) additional gross income from untaxed activity had a positive, statistically significant, and substantial effect on total compensation, and (2) additional income from taxed (UBIT) activity had no significant effect on total compensation (Table 5.4).3 It seems, not surprisingly, that nonprofits are selecting unrelated commercial activities that use the same inputs required for the mission-related activities, so that the marginal costs of added unrelated activity are essentially zero. How do these findings compare with the allocation of labor-compensation costs to the unrelated, taxed activities on actual UBIT returns? We were able to examine these returns for a small subsample of nonprofits to determine the relationship between gross revenue and the compensation costs that were deducted as attributable to the taxed activities. The picture is very different. Table 5.5 shows regression estimates for the effect of additional gross unrelated business income on labor-compensation expense reported on the Form 990-T return. Data were available only for 1990. An incremental dollar of unrelated business gross income was associated with an additional, and highly significant, twenty-two cents of reported compensation costs in hospitals, fourteen cents in higher education, and five cents in museums. For this subsample, we also replicated the regression equations in Table 5.4, and with the same findings (not shown, but available from the authors): Increased income from untaxed activities was associated with a positive and significant effect on total compensation costs, as shown on the Form 990, but increased gross income from taxed, unrelated activities was associated with no statistically significant increase in compensation costs. In short, increased unrelated business income appears to lead 3

Untaxed activities are of two types: related and excluded. The latter are not taxed even though they are not related to the nonprofit's mission. Exclusions are given when activities are incidental or occasional, or are undertaken "for the convenience of" persons such as hospital patients and museum visitors. Our findings are affected little by omitting excluded income.

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Table 5.4. Dependent variable: Total labor-compensation costs, 1990-3 (Form 990 returns)

Variable Gross UBI Related and excluded income /?2

Hospitals (6,662)«

Higher education (3,260)*

Museums (572)*

0.068 (.057) 0.100** (.0026) 0.985

0.048 (.046) 0.062** (.007) 0.988

0.538 (.901) 0.270** (.058) 0.971

Note: Standard errors are given in parentheses. ^Number of data points over the four years, 1990-3. * Significant at .05 level. ** Significant at .01 level Source: Our computations from data in IRS-SOI data tapes for 501(c)(3) nonprofits, 1990-3.

Table 5.5. Dependent variable: Total labor-compensation costs, 1990 (Form 990-T returns) Variable

Coefficients Hospitals (TV = 24)

Gross UBI Constant *2

0.224** (.037) $42,743* (20,016) 0.736

Universities (N= 12) 0.143** (.011) $35,517 (20,177) 0.702

Museums (N = 7) 0.046* (.017) $12,765 (11,541) 0.178

Note: Standard errors are given in parentheses. * Significant at the .05 level. ** Significant at the .01 level. Source: Random sample of nonprofit organizations filing IRS Form 990-T (UBIT) tax returns drawn from the larger SOI annual sample of nonprofit organizations.

to no increase in actual compensation costs, but does lead to an increase in the compensation costs that are allocated to taxable income. Commercialism in the form of unrelated business activity is growing . The number of filers of UBIT returns has doubled between 1985 and 1995, from 24,103 to 50,034 (Herman 1997). Between 1990 and 1993, the latest year for which data are available, gross activity (unrelated business income) increased by nearly 35 percent, from $3.5 billion to $4.7 billion (in nominal dollars). At

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the same time that gross income was soaring, opportunities to avoid taxation by allocating joint costs appear to have been broadly recognized, and so much more in expenses were deducted that taxable income actually fell. Aggregate net taxable unrelated business income, -$631 million in 1990, dropped to -$1.2 billion in 1993 (Riley 1995, 1997). If further analysis sustains our findings, the consequences are dramatic. Most, if not all, of the labor-compensation costs reported on UBIT returns reflect not true costs of the activities but only allocation of fixed costs that would have been incurred even were there less or no unrelated business activity. This does not imply any illegalities, but it does raise questions about accounting rules for joint-cost allocations between taxed and untaxed activities. Policy implications The theory and the evidence presented above suggest that differential taxation of nonprofits and for-profits creates opportunities for nonprofits to earn abovenormal returns on commercial ventures, thus helping them overcome a "natural" aversion to pursuing profits in ancillary markets. As Rose-Ackerman (1982) first observed in the context of a model assuming no such aversion, this means that changes in the taxation of for-profit firms, while not specifically applying to nonprofits, can nonetheless raise or lower the tax premium that nonprofits can earn from commercial activity in competition with for-profits. Indeed, even though the taxation of nonprofits has remained essentially unchanged for many years, changes during the 1980s that occurred in the tax treatment of their forprofit corporate competitors first decreased and then increased the tax premiums that nonprofits could potentially earn from commercial ventures. In the early 1980s, changes in business taxation set in motion by the Economic Recovery Tax Act of 1981 (ERTA) significantly reduced the effective tax rate on corporate profits. The effect of this change was to reduce the gap between the return that nonprofits could obtain on commercial activity in markets dominated by private corporate producers and the return that nonprofits could earn on passive investments. For the five years in which ERTA was in effect, differential taxation of nonprofits should, in theory, have reduced the relative financial incentives to engage in active commercial activity . The Tax Reform Act of 1986 (or TRA 1986), however, raised the effective federal tax rate on corporate profits. This should have increased the return available to nonprofits on commercial activity in markets dominated by corporate producers, thereby creating stronger tax incentives for nonprofits to invest in commercial activities, particularly those "related" to their exempt mission.4 4

The same point can be stated differently. One can imagine three organizational forms that compete with each other: for-profit corporations, for-profit unincorporated businesses, and non-profit organizations. If the tax system works to the disadvantage of for-profit corporations, it will

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The effect of TRA 1986 on the incentive to engage in unrelated business activity, however, is ambiguous. On one hand, because the UBIT parallels the corporate income tax, increasing the effective tax rate on corporate income would have reduced the incentive of nonprofits to engage in unrelated business activities if the income from such activities was actually taxed. On the other hand, raising the effective corporate tax rate could have the opposite effect of encouraging nonprofits to engage in unrelated business activities if the income from such activities was effectively tax exempt - because of either lax enforcement or cost shifting. This latter possibility seems to have been plausible, in light of both the small amount of aggregate UBIT taxable income reported by nonprofits in 1991 and our empirical analysis of the effects of UBIT filing status on reported expense ratios of nonprofits. Whatever the changes in incentives, however, competition between taxexempt nonprofits and private firms poses numerous issues that were discussed in Chapter 1 - in particular, whether nonprofit commercial activities, whatever their goal, are efficient uses of resources and fair to the taxed organizations. This subject has received considerable attention, beyond the scope of this chapter (Rose-Ackerman 1982; Weisbrod 1988;Hansmann 1989; Steinberg 1991). The preceding discussion, however, highlights two points that have not been emphasized in this literature: The first is that differential taxation of nonprofits is likely to provide the greatest financial incentive to pursue profit in activities that are economically related to nonprofits' primary mission-related outputs. The second is that such increased competition with for-profits may be economically efficient. It may encourage nonprofits to use existing resources to expand the output of ancillary goods that, without differential taxation, would be profitable to produce, but which would not be produced because of nonprofits' aversion to profit-making activities. Conclusion A central theme of our analysis is that the effects of incentives operating through the tax system on nonprofits' commercial activities are best understood in a framework that explicitly accounts for the interaction between differential taxation and the following: nonprofit executives who may be averse to commercial activity, donors whose giving may be sensitive to such activity by the nonprofits, and cost complementarities between nonprofit core activities and the

presumptively work to the advantage of the other two organizational forms. The boundaries of tax-induced competition between these organizational forms will shift in response to changes in tax policy. ERTA shifted these boundaries in favor of for-profit corporations, and by implication against unincorporated businesses and nonprofits, while subsequent tax changes had the opposite effect. We are grateful to David Bradford for suggesting this point.

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secondary money-raising commercial efforts. Within this framework, differential taxation encourages nonprofits to pursue commercial ventures they would otherwise avoid, by providing excess financial returns that nonprofits can exploit because of their tax-exempt status. The opportunities to earn such excess returns, however, are likely to be greatest in markets for ancillary goods that are related via cost and revenue complementarities to the organization's primary mission-related outputs. This limits and channels the extent to which differential taxation encourages greater commercialism among nonprofits. The framework also yields several predictions, which we have examined empirically. As expected, we find that the propensity of nonprofit organizations to undertake both tax-exempt and taxable commercial activities depends on the nature of their primary mission-related output and size (as proxied by NTEE industry category and assets); on the relative importance of public versus private contributions; and on the size of the excess return created by differential taxation of nonprofit and for-profit business. We also find that organizations that engage in taxable commercial activities are more likely to apportion joint costs so as to shift such costs from tax-exempt to taxable sources of income.

CHAPTER 6

Interdependence of commercial and donative revenues

Lewis M. Segal and Burton A. Weisbrod

Introduction and overview As Chapter 3 outlines, nonprofit organizations' principal sources of finance are donations and sales. That is, they can generate revenue through some form of contribution, or they may sell products and services. Proxy measures for the former are what the Internal Revenue Service terms "contributions, gifts, and grants," and for the latter, what it terms "program service revenues" (PSRs), which include user fees and revenue from ancillary activites. Since we utilize these data extensively, it is important to be clear that PSRs encompass all salesgenerating activities, whether central to the nonprofit's mission or not. Moreover, "mission relatedness" of an activity is determined by the nonprofit and also by the IRS - and these two perspectives may differ. While some activities that generate program service revenues will be treated by the IRS as taxable, because they are unrelated to organization mission, and other activities as related and, hence, not taxable, the nonprofit's own view may differ. It may judge that an activity is not central to its mission even though the IRS considers the income generated nontaxable; similarly, the nonprofit may view an activity as central to its mission even though the IRS determines it to be unrelated. In the short run, nonprofits have additional sources of revenue - they may receive interest and dividends from investments, and can borrow and draw down assets; but in the long run their financial health depends on their ability to generate donations and to sell services profitably. This chapter asks: Are these two revenue sources - one philanthropic, the other commercial - interrelated? More particularly, does a change in donative revenue - for example, a cut in government grants - influence nonprofits' commercial activity, or vice versa? We thank the Aspen Institute Nonprofit Sector Research Fund for contributing to support of the research reported here; Ian Domowitz, John Goddeeris, and Richard Steinberg for helpful comments on earlier drafts; and Cecilia Hilgert for assistance with interpreting IRS data. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago.

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We examine the hypotheses that nonprofits' commercial sales activities are mechanisms for financing their principal, tax-exempt mission, and that nonprofits prefer to avoid such activities, engaging in them reluctantly and then only for their profitability. If sales activities are "nonpreferred," there are several testable implications: One, on which we focus, is that those activities are undertaken to a degree that varies inversely with the nonprofit's revenue from the preferred source, donations. If there is aversion to commercial activity, despite its potential financial contribution to the organization's mission, then donations would "crowd out" commercial activities, with decreased donations causing expansion of commercial activity and increased donations diminishing it. A second testable implication of an aversion to commercial activity is that nonprofits engage in it less than would maximize profit and, hence, less than would maximize revenue to finance their preferred, mission-related activities. Testing this hypothesis is beyond the scope of this chapter, but our results do shed a bit of light on it. One piece of prior evidence is the finding that nonprofits spend less on fund-raising than would maximize their net profitability (Weisbrod and Dominguez 1986; but see also Steinberg 1986). It seems plausible that an aversion to engaging in fund-raising would reflect a larger predisposition to avoid activities that are, themselves, not part of the organization's mission, apart from their net revenue. If there is aversion to commercial activity, revenue from donations would be preferred to an equivalent sum from profitable sales activity. A plausible conjecture, therefore, is that an exogenous decrease in donations would be offset, but less than fully, by an increase in net, after-tax revenue from commercial activity. To test the magnitude of such crowding out, however, it is necessary to estimate the profitability of commercial sales, the fraction of increased gross revenue from sales that can be used to cross-subsidize mission-related activities. Little is known about the profitability of various nonprofit-sector commercial activities, and meaningful data are unavailable (although Chapter 5 makes a foray into that area). Theoretical relationships between revenues from donations and from program services The relationship between revenue from donations and from commercial activity can take a variety of forms, as Chapter 3 indicates. If nonprofits are indeed averse to commercial activity, donations will crowd out commercial activity, and there will be a negative relationship between the two forms of revenue. There could, alternatively, be a positive relationship, "crowding in," if increased commercial activity is viewed favorably by donors and leads to increased donations. In addition to such interrelations between revenue sources, there could

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be interrelations between costs: Producing commercial goods and raising donations could be subject to economies of scope. Finally, the two forms of revenue could be independent and unrelated, as would be the case if nonprofits acted as profit maximizers in the commercial markets in order to obtain as much net revenue as possible for support of their missions, and if commercial and missionrelated activities were separable in their costs and revenues. Crowding out of commercial activity by donations is most likely when it involves sale of goods and services that are viewed by the nonprofit's management as most unrelated to the nonprofit's mission - activities engaged in only for their financial contribution. It may also apply, however, to activities that are related to the mission. For example, as Chapter 3 shows, nonprofits frequently, though not always, can demand user fees of the persons they serve in pursuit of their mission. Colleges can charge students tuition, hospitals can charge patients fees, and museums and zoos can charge visitors admission. They may prefer to avoid such user fees, however, lest they inadvertently discourage utilization by persons in the target population (Chapter 4), which would make this revenue-raising source nonpreferred. For-profit firms, by contrast, are presumed to be indifferent among alternative money-generating activities, caring only about the net profitability. Thus, while a private firm would be expected to pursue commercial market opportunities at maximum profit levels, if nonprofits prefer to avoid commercialism they will engage in it reluctantly, whether or not the IRS treats it as taxable and only if the organization cannot obtain "sufficient" donations - in short, only if the net revenue it generates is great enough not only to be profitable (after any tax) but to overcome the disutility of engaging in it. Contemporary concern about escalating college tuition illustrates the issues and trade-offs. Rising college production costs, not accompanied by offsetting government grants or private donations, have forced choice between retrenchment, on one hand, and raising additional commercial revenue either from user fees or ancillary activities. All are occurring, but along with sharp rises in tuition - "tuition and fees doubling from 1976 to 1994" - has come increasing concern about the effects, including "pricing as many as 6.7 million students out of higher education" (Applebome 1997, A17). In terms of the analytic framework we utilize, public and private donations and grants are the preferred sources of revenue, but their shortfall may have led to increased use of a nonpreferred source, user fees. As Chapters 3 and 4 explain, the aversion to user fees as a source of revenue is caused by their negative effect on the target population - in this case, students. This is despite the increased use of price discrimination, in the form of student financial aid, in attempts to minimize the adverse effect of increased tuition on the target population of students. As the tuition example makes clear, the hypothesis that nonprofits have preferences among alternative revenue sources is separate from legal definitions of "related" and "unrelated" business activities and their differential tax treatment.

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For a nonprofit organization there are no tax consequences of obtaining revenue from user fees rather than from donations, although there is a difference to the payers, since donations are tax deductible, at least for itemizers. The nonprofit's preference for donations is the consequence of the hypothesized negative effect of user fees on the organization's mission, not on tax considerations. A mission that encompasses distributional goals, as discussed in Chapers 3 and 4, would cause a nonprofit not to be indifferent between a dollar of revenue from donations and a dollar from user fees. So, too, a nonprofit may not be indifferent between raising funds through user fees and netting an equal amount through after-tax profit from provision and sale of other, non-mission-related outputs - termed ancillary in Chapter 3. Whatever their legal form, and whether or not the IRS applies the Unrelated Business Income Tax (UBIT) to them, these are activities that are seen by the nonprofit as elements outside of its mission, and in some cases incompatible with that mission. Aversion to ancillary activities may reflect a view that commercialism - acting in ways identified with private firms, and thinking about markets and profitability in their terms - detracts from the spirit and goals appropriate to nonprofits. To the extent this is the case, as noted above, there is no necessary identity between what a tax authority, the IRS, treats as unrelated and what the organization leadership regards as not contributing to its mission. Thus, a nonprofit hospital that decides to open a major heart-transplantation unit, which it expects to generate substantial profit, knows that this will be regarded by the IRS as a mission-related activity, and hence nontaxable, even if the hospital would not be establishing that unit were it not for its profitability. An aversion to commercial activity has the same effect as a tax on it, increasing the effective marginal cost of production and thus decreasing the effective marginal profit from commercial activity. This leads to our central hypothesis: Commercial activity in any form - whether involving user fees or expansion into ancillary markets - can be expected to be sensitive to the level of donations, changing inversely to it. This chapter examines the microeconometric empirical evidence to determine whether there is a negative causal relationship between donations and commercial activity. We do not study separately revenue resulting from UBIT activities and from untaxed activities, which are aggregated in program services (but see Chapter 5, which does examine some relationships between the two). During the 1980s the nonprofit sector, as a whole, became increasingly reliant on sales revenue relative to donative revenue. As Table 6.1 shows, "contributions, gifts and grants" (donations) to charitable (501(c)(3)) organizations from both private and government sources declined as a share of total revenue between 1982 and 1993, while the share from program services (sales) grew.

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Table 6.1. Revenues from donations'1 and from commercial activities for charitable 50J(c)(3) nonprofits, 1982-93b (in billions of constant dollars)c Component as % of total revenue Tax year

Donations (CGG)

Total revenues

Total CGG

Private CGG

Govt. CGG

Program service revenue (PSR)

1982 1983 1985 1986 1987 1988 1989 1990 1991 1992 1993

$42.79 46.59 51.83 54.85 54.30 58.38 61.70 64.80 63.71 71.80 70.78

$203.42 231.78 249.43 266.86 273.56 299.79 320.73 332.25 359.54 383.15 390.63

21.0 20.7 20.8 20.6 19.8 19.5 19.2 19.5 17.7 18.7 18.1

11.2 10.9 11.3 12.9 11.7 10.9 10.8 10.9 9.8 10.2 9.9

9.8 9.8 9.4 7.6 8.2 8.6 8.5 8.6 7.9 8.5 8.2

63.4 65.9 62.6 64.3 68.2 67.5 68.4 70.6 70.3 71.0 71.3

a

Reported to the IRS as "contributions, gifts, and grants" (CGG). ^Excluding 1984, for which data are not available. C A11 dollar values are deflated by the Consumer Price Index for All Urban Consumers (1982-4 = 100). Source: Entries for 1982 and 1983 are derived from Hodgkinson et al., Nonprofit Almanac 19921993. San Francisco: Jossey-Bass, 1992, tab. 4.5. Entries for 1985-93 are authors' calculations from the IRS, Statistics of Income Division, data tapes.

Of course, revenue, whatever its source, is not equivalent to profit. The true margin of expected net revenue from any source is an important determinant of a nonprofit's choice among revenue sources, but evidence is difficult to obtain. What we expect, but cannot test, is that organization mission will cause differential preferences among potential sources, so that it will not be the case that marginal profitability from all sources will be equated, let alone equated with the opportunity cost of capital. In our theoretic framework we emphasize this distinction between the nonprofit's preferred and nonpreferred activities: The organization prefers to engage in its mission-related pursuits; it becomes involved in revenue raising, a nonpreferred activity, only as necessary to achieve its mission. Some donations may come to the organization with little or no effort, but such exogenous income may be judged by the nonprofit to be suboptimal and lead it to devote resources to increasing contributions or to profit-making commercial activities. Fund-raising to garner additional contributions and program services to garner sales revenues are quite similar in their goal, which is largely to generate re-

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sources that would permit expansion of the mission-related activities. This also is the intention behind user fees, as discussed above. Seldom is a source of revenue entirely exogenous, entirely independent of organizational effort. We judge, however, that there is a greater measure of such independence with respect to contributions, gifts, and grants (CGG) than for commercial sales revenues. Changes in federal government funding of grants to hospitals, universities, and arts organizations, for example, can dramatically change donative revenue, as has been the case recently with sharply diminished federal grants to the National Endowment for the Arts ("Republican Effort to Eliminate Arts Agency Survives Challenge" 1997) and to public television (see Chapter 13). In a later section we turn to empirical tests to determine to what extent, if any, nonprofit commercial activity in the form of program service revenue is a response to changes in exogenous revenue from donations. Difficulties emerge as we look for operational counterparts to the concepts of preferred and nonpreferred sources of revenue, and the differential tax treatment of various forms of revenue creates another force affecting organization choice among alternative sources of revenue.1 Available data from the IRS Form 990 return (Appendix) provide proxy measures that map (imperfectly) to the aforementioned theoretic concepts: CGG to the preferred, unconstrained revenue sources, and PSR to the nonpreferred revenue sources that involve activities, including commercial sales, sometimes seen by nonprofits as digressions from their missions. Our concept of a nonprofit's commercial activity encompasses all endeavors that involve a transaction with a consumer paying for output received. Payment, of course, is a matter of degree. A "pure" nonprofit organization is one that finances production entirely through unrestricted donations generated costlessly and distributes its charitable output, at a zero price, to all "deserving" persons: Output is simply given away. This polar case is the ideal for two reasons: 1

Only with a zero price can the organization be reasonably assured that no deserving person is being denied access to its service, although some nonprice form of rationing might be required if the total quantity available is insufficient. 2 Only by remaining free of commercial activity can the nonprofit concentrate its managerial resources on providing services rather than on debates over the appropriateness of engaging in the sale of other goods and services in order to raise money. 1

"Contributions, gifts, and grants," as reported on the IRS Form 990 information return, sometimes constitute what we would term sales - e.g., for the naming of a building at a hospital, college, or community center. At the same time, some revenue reported as sales - "program service revenues" on the Form 990 - has a substantial donative element, as when consumers pay more for a service provided by a nonprofit than they would pay to a for-profit firm.

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In the contrasting case, typical of a private firm, the organization receives no donations, gives away nothing, and charges a profit-maximizing price for its output. The distinction between a nonprofit's reliance on donations and on revenue from sales is central to this chapter's focus on whether donative revenue crowds out program service revenue. Actual nonprofit organizations are arrayed on a continuum in terms of the percentage of revenue they derive from sales. The purely donative nonprofit derives none of its revenue from sales (Hansmann 1980); at the opposite pole are nonprofits that derive all of their revenue from sales. One index based on this finance-source characteristic is the collectiveness index, the proportion of an organization's total revenue derived from donations (see Weisbrod 1988 for discussion and application). Table 6.2, based on IRS tax data for charitable nonprofit organizations in 1987, displays a complementary metric: the proportion of total revenue that comes from commercial sources. Its value varies substantially by industry, with health organizations being the most commercial (with sales accounting for 89 percent of total revenue) and community-improvement organizations being the least (only 11 percent). The more use a nonprofit organization makes of prices to raise revenue, the more it is emulating the private sector; whether such commercial activity takes a form that involves competition with the private sector is another matter. Chapter 1 shows how nonprofits' commercialism takes both forms, and Chapter 9 illustrates well the growing collaboration between universities and private enterprise in scientific research. The current chapter attempts to explain the forces affecting the commercialism of the nonprofit sector - its increased dependence on revenue from sales - independently of whether it involves competition or cooperation with for-profit firms. We have reviewed, within the context of the multiproduct model presented in Chapter 3, building on James (1983), the reasons for expecting one or another relationship between the level of a nonprofit's commercial activity and its revenue from donations. One analytic perspective indicates that exogenous contributions and commercial activity will be either unrelated or inversely related, depending on the degree to which commercial activity itself, apart from the revenue it generates, detracts from the goals of the nonprofit; but other perspectives suggest positive relationships between donative and commercial revenues. We explore several of these possibilities, including the effects of a change in service provision by other organizations, economies of scope in production, complementarities in revenues, and price rationing of output. The section on the empirical relationships between donations and sales uses our newly developed panel of tax-return data covering the period 1985-93 for large nonprofit "charitable" - 501(c)(3) - nonprofit organizations. Much of the prior empirical research on the mix of revenue sources used cross-sectional data and focused on a single industry, such as universities (James 1983) or socialservice agencies (Schiff and Weisbrod 1991). We examine each of five indus-

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Table 6.2. Percentage of charitable 50J(c)(3) nonprofits engaging in unrelated business activity0

NTEE classification and code

% filing UBIT return^

PSRas%of No. of total revenue observations

Science and technology research institutes, services (U) Health - general and rehabilitative (E) Disease, disorder, medical disciplines (G) Arts, culture, and humanities (A) Educational institutions and related activities (B) Community improvement, capacity building (S) Religion related, spiritual development (X) Human services - multipurpose and other (P) Recreation, sports, leisure, athletics (N) Mental health, crisis intervention (F) Philanthropy, voluntarism, and grant making (T) Housing, shelter (L) Youth development (O)

9.3 9.2 6.3 6.1 4.9 4.6 4.5 3.1 3.0 2.5 2.3 1.9 1.2

46 89 36 27 56 11 54 41 50 43 24 68 69

128 3,369 167 666 2,040 488 234 893 183 179 492 702 185

a The data are an asset-based sample, and the estimates presented are weighted averages based on the sampling weights. However, differences in asset distribution across industries may skew the estimates. bThe UBIT return, Form 990-T, is required for all nonprofits that receive at least $1,000 in gross unrelated business income in a given year. Source: Authors' calculations from the IRS, Statistics of Income Division, data tapes.

tries, using a variety of techniques. The panel data permit us to consider time lags and organization-specific effects. Our findings may be summarized as follows: 1. Aggregate trends for the panel show that although sales revenues are increasing faster than donative revenue, both have increased in real terms. We attempt to determine whether the slower rate of growth in donations caused any part of the increase in commercial activity. We begin by documenting the positive cross-sectional correlations between contributions and sales. Not surprisingly, there is a scale effect such that larger organizations tend to receive larger amounts of revenue from each type of source, donative and commercial. The panel nature of the data lets us control for organization-specific attributes of the nonprofit that do not change over time, including the scale of the organization, its geographic location, and its efficiency. 2. Controlling for organization-specific (fixed) effects, for the full panel of nonprofits, we find a significant negative relationship between donations and

Interdependence of commercial and donative revenues

113

sales revenues, consistent with the theory that nonprofit organizations have an aversion to commercial activity. 3. Taking a longer view, we also examine the relationship by using the change in three-year averages, 1985-7 compared with 1991-3, and again find a strong negative relationship. 4. All of these approaches assume that donations are exogenous, an assumption we relax in two ways. First, we use fund-raising expenditures to remove, or instrument out, whatever portion of donations is within the organization's control. These expenditures prove to be an important influence on donations: Current and lagged values of fund-raising expenditures, in conjunction with firm-specific effects and lagged contributions, explain about a third of the yearto-year variation in donations. Second, we use lagged donations, rather than current donations, as a regressor to explain the extent of commercial activity. These produce some changes but do not alter the overall tenor of our findings. Regression analyses based on log values of the dependent and independent variables, however, reveal substantially smaller results, near zero and even positive for some industries. 5. Finally, we employ a statistical test of causality that allows for a feedback effect whereby variation in sales revenues causes changes in donative behavior, and that also allows both donations and commercial activity to be simultaneously affected by unspecified and unmodeled forces, such as government spending, changes in the economic environment, or changes in need. The perspective presented in Chapter 3 and summarized above portrays nonprofit organizations in two dimensions: the types of services they produce and their sources of revenue, with the two being related. Thus, anything altering the donative revenue that a nonprofit realizes without its having to produce the nonpreferred output would affect the level of commercial activity in the opposite direction. A drop in government grants, such as has affected many of the nonprofit subsectors examined in Part II of this volume, is likely to bring expansion of nonpreferred commercial output, other things equal. That prediction of a negative relationship could be reversed, however, if, as is also noted in Chapter 3, there were more complex interdependencies, so that a change in commercial activity had further effects. In addition to direct effects of donations on commercial activity, there could also be reciprocal effects, of commercial activity on donations. These would be positive if donors favored nonprofits' self-help, revenue-raising efforts and rewarded them, or negative if donors disapproved of commercial activity.2 In addition to revenue interdependencies, there could be cost interdependencies. If the production processes are complementary, an increase in ancillary2

In the latter case, this effect would strengthen the expectation of a negative relationship between donations and sales.

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good production will decrease costs for the mission-related outputs, thereby reducing revenue needs. Because of such interdependencies of costs and revenues - about which little is known - an exogenous decrease in donations could have a positive, negative, or zero effect on commercial activity, even if the direct effect we hypothesize is negative. In such cases of interdependent revenues or costs, the effect on the nonprofit of an exogenous change in donations would be to shift the donations function or the cost function for the preferred good. Thus, reality may be more complex than our simple model. No strong prediction can be made. Little is known regarding whether managers or donors are indifferent as to the nature of the nonprofit's revenue-generating tactics, and whether they generally regard commercial activity as detracting from the organization mission, apart from the revenue generated. Anecdotal evidence, however, suggests that nonprofits do sometimes forgo opportunities to obtain added revenue because they prefer to avoid engaging in those activities. For example, recently Oxford University turned down a gift of $34 million, to establish a new school of business, apparently because it reached a judgment that a business school was incompatible with its mission - that is, "with the historical values of the university"; the view was expressed that "education should prepare people for public service, not profit" (Ibrahim 1996). It is not clear, however, whether such decisions reflect a sense of organization mission or a recognition of effects on other donors. It is hard to say which set of assumptions about organization objectives, revenue interdependencies, and cost interdependencies is more likely. Moreover, we conjecture that the more likely set differs across industries: Donors to arts organizations, hospitals, colleges, and antipoverty activities need not respond in the same way to increased commercial activity in ancillary markets. Similarly, opportunities for nonprofits to utilize their preferred-good inputs to expand production in ancillary markets may well be more limited in some industries than in others. Day-care centers, for example, employ inputs that are quite specific to use by young children and are in use for much of the day and even evenings, and so appear to have relatively little potential for utilization in ancillary revenue-generating activities. Hospitals are more promising loci for production of ancillary outputs, as they provide services that involve a wide variety of inputs for inpatients and outpatients, health-care related but also involving food preparation, laundry, television rental, and so on, and that have substantial excess capacity. Changes in provision of the preferred service by other suppliers The multiproduct model is extendable in several directions that provide further insight into the relationship between contributions and commercial activities.

Interdependence of commercial and donative revenues

115

We consider the case of a nonprofit that is concerned with the aggregate level of provision of the preferred good, not simply with its own production. An exogenous decrease in production by others would raise the marginal utility schedule for the nonprofit's own production, and its desire to increase production. Would this cause the organization to engage in more commercial activity? Again, the answer depends on whether the commercial activity is a neutral or a nonpreferred activity. A decrease in provision by government agencies or by other nonprofits has essentially identical implications for a specific nonprofit organization as we described for a fall in the organization's revenue from donations. In all these cases the effect is to increase the marginal utility of the nonprofit's preferred output and, hence, to cause it to pursue added revenue more aggressively. Diminished donations, ceteris paribus, reduce production of the preferred good, moving the organization back along its marginal utility schedule to a greater marginal utility of output. A fall in exogenous provision shifts the entire schedule outward, again increasing marginal utility from added output of the preferred good. The result in both cases is an increase in the marginal utility of the preferred output, which could be great enough to overcome the disutility from additional ancillary commercial activity. Thus, we expect such commercial activity to be correlated negatively with a decline in provision by other agencies and organizations. Again, however, this result relies on commercial activity being nonpreferred, and it could be strengthened or weakened by revenue and cost interdependencies, as explained above. Analogous to a change in other providers' output of the preferred good would be a change in the overall magnitude of social "need" for the nonprofit's services. To see this, consider a nonprofit social service agency that observes an increase in poverty. This would be equivalent to a decrease in other suppliers' - nonprofit or governmental - provision of antipoverty services, and it would increase the willingness of a nonprofit organization to initiate or expand production of profit-generating ancillary goods. As we have noted, it could also increase private donations. If such a simultaneous increase in both sources of revenue occurred, it would not reflect a change in one causing the change in the other, but the simultaneous effect on both revenue sources of the exogenous change in need or in production by others of the preferred good. The point, which becomes important when we turn to the empirical work, is that findings of correlation or, for that matter, lack of correlation, between donations and commercial activity can reflect many plausible scenarios and, hence, are difficult to interpret. Price discrimination in the provision of preferred goods Nonprofits' commercial revenue from "sales" can come not only from sales of an ancillary, nonpreferred good, but also, as we pointed out earlier, from fees

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charged to consumers of the preferred, mission-related good. Thus, a positive correlation between donative and commercial revenue may also result from the increased use of price as a rationing mechanism for preferred goods. Access to preferred goods that are of the private-good type can be rationed by varying price according to recipients' perceived ability to pay, while also taking account of the nonprofit's target consumers - those it seeks to help the most. Thus, a decrease in, say, government grants could cause nonprofit hospitals to charge private-pay patients more; and colleges could increase their full tuition, collecting more from students with the greatest demand while increasing financial aid to those with more elastic demand, possibly leaving their net prices unchanged. Such price discrimination might be interpreted as a form of nonpreferred activity, engaged in reluctantly, at less than profit-maximizing levels, thus being responsive to exogenous changes in revenue. Nonprofits that have distributional goals, seeking to provide the preferred output to particular beneficiaries, can choose to use additional donations to cut prices below marginal cost to their target consumers. (For further analysis of price discrimination by nonprofit firms with distributional goals, see Chapter 4 and Steinberg and Weisbrod 1997.) Recognizing the role of prices and price discrimination of preferred goods is important, for nonprofits' commercial (i.e., private-enterprise-like) activity is not limited to markets for ancillary goods. Price discrimination cannot be used, however, for preferred goods that are collective in nature. Universities can discriminate in their pricing of education, a private-type preferred good, but cannot do so in their provision of collective goods, such as basic research. Zoos can discriminate in admission fees to viewers, but not in their provision of the collective good, animal species breeding. (For an analysis of commercialism in zoos and aquariums, see Chapter 11.) Nonprofits whose missions are to provide collective goods have little opportunity to charge user fees, and so their options are more limited. In light of the complexities we have discussed, it is not surprising that our findings, reported in the next section, indicate no simple and consistent pattern. There is considerable variation among industries, some showing negative effects of donations on their commercial activity, but others showing positive effects, and still others showing none. In addition, findings are not entirely robust to alternative specifications. Negative relationships between donations and commercial activity are found in some specifications, although by no means uniformly. The industry studies in Chapters 8-13 further demonstrate the variation in provision of ancillary outputs and in dependence on user fees. The empirical relationships between donations and sales A crude measure of a nonprofit's ancillary activity is its engagement in moneyraising activities that the IRS regards as unrelated to their tax-exempt mission,

Interdependence of commercial and donative revenues

117

thereby generating income that is subject to the UBIT. Table 6.2 (see the previous section) shows, for 1987, wide variation in the percentage of nonprofits in each industry that reported such income, ranging from 1.2 percent in the youth-development sector to 9.2 percent in the health sector. Our empirical analyses in the next subsection suggest a pattern, but one that varies among industries. We assembled the panel data used for this study from Internal Revenue Service Form 990 tax returns collected annually between 1985 and 1993. The sampling scheme used by the IRS Statistics of Income (SOI) Division is based on the asset level reported on the nonprofit's tax return. The composition of the SOI sample varies from year to year, with larger (greater asset) nonprofits being more likely to be included than smaller ones. Although the sample varies over time, all organizations with more than $50 million in assets (not controlling for inflation) are included each year. Our analysis uses the "balanced" panel of the 2,679 nonprofit firms observed in all nine years. These large organizations, though only a small percentage of all nonprofits, represent a substantial portion of the total assets and revenue activity in the nonprofit sector. There are two sources of possible bias from the use of this panel of nonprofits. First, in addition to the fact that nonprofits with low asset levels are underrepresented, only "surviving" organizations are included; that is, organizations that cease to exist or, for any other reason, do not file a return in any of the sample years are not in the panel. Similarly, nonprofits that are "large" (over $50 million in assets) in some year but not in others are excluded from the panel if data for them are not available in the years when their assets fall below the threshold. Nonetheless, the relationship between organizational revenue from sales and from donations (referred to in the IRS Form 990 returns as "contributions, gifts, and grants") is worth examining for this important subset of nonprofits. Our findings will not necessarily be generalizable, however, to the full population of nonprofit organizations, most of which are small. There is, on the other hand, a positive dimension to the limited sample: The focus on large organizations provides a degree of homogeneity that is useful given the limited information available from the tax returns. Two-thirds of our panel consists of nonprofit organizations involved in health and education activities, as characterized by Independent Sector using their National Taxonomy of Exempt Entities, which has been adopted by the IRS. Table 6.3 presents the industrial distribution of the organizations studied. We analyze first the combined sample of all organizations, and then the nonprofits in each of the five industries for which the panel includes over a hundred organizations - specifically, hospitals (NTEE code E22), which are approximately 70 percent of the health category (code E), and universities (code B43), which are about 40 percent of the education category (code B), along with housing and shelter, human services, and arts, culture, and humanities.

Lewis M. Segal and Burton A. Weisbrod

118

Table 6.3. Industrial composition of balanced panel of50J(c)(3) tax returns, 1985-93, based on the National Taxonomy of Exempt Entities (NTEE) NTEE classification and code

Frequency

% of sample

Health - general and rehabilitative (E) Hospitals, general (E22) Educational institutions and related activities (B) University or technological institute (B43) Housing, shelter (L) Human services - multipurpose and other (P) Arts, culture, and humanities (A) Philanthropy, voluntarism, and grant making (T) Community improvement, capacity building (S) Science and technology research institutes, services (U) Youth development (O) Disease, disorder, medical disciplines (G) Religion related, spiritual development (X) Mutual, membership benefit organizations, other (Y) Animal, related (D) Mental health, crisis intervention (F) International, foreign affairs, and national security (Q) Public, society benefit - multipurpose and other (W) Recreation, sports, leisure, athletics (N) Medical research (H) Employment, job related (J) Environmental quality, protection, and beautification (C) Unknown/unclassified (Z) Social sciences (V) Public protection (I) Food, nutrition, agriculture (K) Public safety (M)

1,121 (779) 643 (265) 155 143 128 92 89 37 31 28 27 21 20 20 19 19 17 16 14 13 12 6 4 2 2

41.8 (29.1) 24.0 (9.9) 5.8 5.3 4.8 3.4 3.3 1.4 1.2 1.0 1.0 0.8 0.7 0.7 0.7 0.7 0.6 0.6 0.5 0.5 0.4 0.2 0.1 0.1 0.1

Totals

2,679

99.7«

Source: Authors' calculations from the IRS, Statistics of Income Division, data tapes. Does not equal 100% because of rounding.

a

The upper portion of Table 6.4 (rows 2-5) presents descriptive statistics on the organizations in the panel at the beginning of the time interval, 1985.3 All values are in millions of constant dollars, adjusted by the Consumer Price Index (1982^- = 100). In 1985 the average nonprofit in the panel received $6 million in contributions, gifts, and grants while generating more than five times that 3

Data are also available for 1982 and 1983, although not for 1984, when the IRS did not take a sample. Because of the missing year, we examine data only for the period beginning with 1985.

Table 6.4. Descriptive statistics for balanced panel of 50J(c)(3) tax returns, 1985-93

1. Number of organizations 2. CGG (mil. of 1982-4$) 3. Program service revenue (mil. of 1982-4$) 4. Assets (mil. of 1982-4$) 5. Pet. filed a UBIT return 6. Real growth of CGG revenue 7. Real growth of program service revenue 8. Real growth of assets 9. Increase in fraction filing UBIT return

Full balanced panel

University or technol. inst. NTEE code B43

Hospital, general NTEE code E22

Housing, shelter NTEE code L

Human services multipurpose & other NTEE code P

Arts, culture, humanities NTEE code A

2,697

265

779

155

143

128

1985 average ($) 24.4 6.0 32.4 87.9 23

53.6 222.5 34

1985-93 (% change) 21 18

1.3

0.6

3.9

7.9

57.0 73.3 36

4.1 18.0 5

5.6 20.2 10

3.6 48.2 26

38

44

17

9

61 53

38 19

63 43

16 22

50 9

47 42

15

25

24

0

-1

10

Abbreviations: CGG, Contributions, gifts, and grants; NTEE, National Taxonomy of Exempt Entities; UBIT, Unrelated Business Income Tax. Source: Authors' calculations from the IRS, Statistics of Income Division, data tapes.

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- $32.4 million - in program service revenues. The size and relative importance of these revenue sources varies widely by industry: The average hospital is far more commercial, receiving only $1.3 million in contributions but having $57 million in sales revenues. At the other extreme, the average arts organization in our panel received more than twice as much in contributions as in sales revenues. Row 5 of the table displays the fraction of firms filing a Form 990-T tax return, reflecting their receipt of revenue from unrelated business activities. This measure again discloses great variation among industries in their involvement in commercial activity, in this case with unrelated ancillary activities: More than a third of hospitals and universities filed a UBIT return, compared to only 5 percent of the housing and shelter organizations. Such variation in commercial activity is consistent with our prior view that because of the differing technologies of production in the various missionfocused activities, there would be variation among industries in their potential not only for developing profitable markets for ancillary goods, whether legally related or unrelated, but also in their opportunities to generate revenue from user fees for mission-related activities. At the same time, these findings are also consistent with other models, such as that organization objective functions, including aversion to ancillary activities and to user fees for mission-related activities, differ across industries. Between 1985 and 1993 the revenue from each of the two principal sources, contributions (i.e., CGG) and sales, increased substantially in constant dollars. Contributions, gifts, and grants to nonprofits in our panel grew by more than 21 percent (row 6), but sales grew 61 percent (row 7), nearly three times as much. There has, indeed, been increasing reliance of nonprofit organizations on commercial activity. Consistent with this view, the fraction of nonprofits filing a tax return for unrelated business activity increased from 23 percent in 1985 to 38 percent eight years later. This upward growth trend, however, masks variation over time: Although average real contributions grew continuously for our panel of nonprofits, there was variation from year to year in that growth. Moreover, in any particular year many nonprofits did not experience growth, with 40-60 percent of the sample experiencing a decline. The discussion of the earlier section, "Theoretical relationships between revenues from donations and from program services," suggested that a decline in exogenous donations to a nonprofit organization may cause it to turn, if reluctantly, to increased commercial activities in order to cross-subsidize its preferred activities, implying a negative "crowding out" relationship between donations and commercial activity (see also Chapter 3). Other parts of the analysis, however, suggested a positive, "crowding in" relationship, due to such additional forces as the possible effects of commercial activity on donations and the abil-

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121

Table 6.5. Regression analysis of balanced panel of50J(c)(3) tax returns, 1985-93 Specification0

Estimate

Effect on program service revenue of: 1. Contributions 2. Contributions, w/ firm effects 3. Contributions, w/ firm and time effects 4. Contributions, w/ firm effects instrumenting for the possible endogeneity of contributions 5. Lagged contributions, w/ firm effects

-0.13** -0.43**

Effect on log program service revenue of: 6. Log contributions^7 7. Log contributions, w/ firm and time effects*7

0.10** -0.02

Long-run regression analysis avg. (1991-3) - avg. (1985-8): 8. Effect on program service revenue of contributions 9. Effect on log program service revenue of log contributions^

-1.05** -0.02

Long-run regression analysis omitting zero values, avg. (1991-3) - avg. (1985-8): 10. Effect on program service revenue of contribution 11. Effect on log program service revenue of log contributions*7

-0.73** -0.02

Statistical tests for the direction of causality0 12. Significance of lagged contributions on program service revenue 13. Significance of lagged program service revenue on contributions

0.76** -0.09** -0.13**

0.01 0.40

a

All dollar values are deflated by the Consumer Price Index for All Urban Consumers (1982-4= 100). ^Log-log regression models use zero in place of log(0). c Tests are based on a vector autoregression with firm fixed effects, and two lags of contributions, program service revenue, and fund-raising expenditures. Longer-lagged values are used as instruments. * Statistically significant at the .10 level. ** Statistically significant at the .05 level. Source: Authors' calculations from the IRS, Statistics of Income Division, data tapes.

ity of the organization to utilize the resources from its preferred goods in the production of ancillary goods. To test these relationships we apply a more disaggregate, microlevel analysis. We begin by describing the methodology and results for the full panel of organizations in Table 6.5. The panel data permit us to examine changes over time while controlling for unobserved organization characteristics that do not change over time; that is, we employ a "fixed-effect" regression model that

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takes into account characteristics of each organization that, although not directly observable, are specific to the organization over time. Our findings indicate that unobserved heterogeneity among organizations is of major importance. Rows 1 and 2 of Table 6.5 present the regression estimates of the effect of a one-dollar increase in contributions on the contemporaneous level of sales, with and without inclusion of a firm-specific component; the results differ significantly and substantially. The regression without the fixed effect estimates that a one-dollar increase in contributions is associated with a seventy-six-cent increase in sales activity - no crowding out effect here. We believe, however, that this estimate reflects scale differences across organizations such that larger organizations receive more revenue, both commercial and donative, than smaller ones. The regression estimate reflects a positive correlation due to scale but does not reflect causality. Inclusion of fixed effects, which we believe to be important, results in a statistically significant negative coefficient on contributions. As implied by the cross-subsidization model with aversion to commercial activity, changes in total contributions are negatively correlated with changes in gross sales revenue. The negative result for the fixed-effect model in the pooled sample of organizations is robust to a variety of alternative specifications, including the addition of time-trend variables to capture aggregate economic conditions (row 3), the inclusion of fund-raising expenditures in an attempt to deal with the possible endogoneity of donations (row 4), and the use of a one-year lagged independent variable instead of contemporaneous donations to deal with endogeneity as well as effects over time (row 5). Controlling for the endogenous portion of contributions somewhat increases the negative relationship between donations and sales. The coefficient displayed in row 5 of Table 6.5 suggests that a one-dollar decline in exogenous donations causes an increase in commercial activity of forty-three cents, although the profit available to cross-subsidize preferred activities is surely less. As a further robustness check we estimate the model in logs rather than levels, with (row 7) and without (row 6) fixed effects. These results are much closer to zero, suggesting that large values - which receive relatively less weight in the logarithmic formulation - have significant influence on our estimates, even though the data sample is already limited to organizations with large amounts of assets, and even though we used fixed effects. The log-log model with fixed effects again produces a negative coefficient, but it is not statistically significant. The interpretation of the estimate in row 7 is that a 1 percent decrease in donations causes a 0.02 percent increase in commercial activity. The effect of changes in contributions on sales activity might well depend not on single-year, transitory changes, but on changes expected to be "permanent." The single-year changes might measure fluctuations that are smoothed across time, which may induce fluctuations in assets rather than sales. More-

Interdependence of commercial and donative revenues

123

over, data for any given year can be misleading, since year-end donations may sometimes be reported in the next year. To address these concerns we use threeyear averages of the data in the regression model. That is, for each nonprofit we form the average of gross sales and of contributions for 1985-8 and, again, for 1991—3; then we compute the change in each variable between the two periods, thereby smoothing effects that might result from, say, a large amount of donations arriving either shortly before or shortly after the end of a nonprofit's fiscal year. Row 8 of Table 6.5 presents these estimates based on a specification in levels. The result, again, is strongly negative and statistically significant. However, the log-log specification (row 9) continues to produce a statistically insignificant result. The difference between the level and log specifications led us to explore the data further. We noted that there were particularly large fluctuations involving transitions to or from zero contributions. For example, the returns for the New England Medical Center Hospital (EIN 042374071) report contribution above $20 million per year for 1985-8, zero contributions for the next two years, and then contribution levels above $40 million for the next three years. Perhaps such zeros are reporting error; perhaps they reflect large transitions of organizations undergoing radical change - we do not know how to explain such anomalies. Moreover, although the Internal Revenue Service scrutinizes tax returns for internal consistency, it does not examine the consistency of the returns over time. In order to reduce the effect of large transitions involving zero contributions, we repeated the long-run analyses, omitting from the estimation of mean contributions any reported zero. Thus, if an organization had two years with positive donations followed by a year with zero, we used the two positive values but excluded the year with the zero contributions. As we expected, the estimates for the effect of contributions on sales are somewhat smaller in absolute value than had been found when the zero observations were included, but they remain largely consistent with the earlier analysis. Overall, we find somewhat mixed relationships between an organization's donative income and its revenue from sales. For the aggregate sample, Table 6.5 shows that a number of formulations, particularly those employing firmspecific effects, indicate significant, negative relationships (lines 2-5), whereas others, based on log values, show effects that are negative but insignificant (lines 7 and 9) or, in one case, positive and significant (line 6). The differences between relationships observed in levels and in logs are noteworthy. For reasons not well understood, there seem to be larger absolute responses, but smaller percentage responses of sales activity. Negative relationships in Table 6.5 generally show effects less than unity. At the outset of this chapter we conjectured that when nonprofits use commercial activity to replace lost CGG, they replace them only partially. Moreover, since commercial revenue is only partially profit, the replacement rate is even lower

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than is indicated by the coefficients on sales. This finding is consistent with the hypothesized aversion to commercial activity, although we cannot be certain as to the influence of cost and revenue interdependencies. The structural regression models employed thus far assume that causality runs from donations to sales. Explanations put forth in the theory section, however, suggest that even if causation does run in that direction, it could simultaneously run in the reverse direction - fluctuations in commercial revenue affecting donative revenue - or that both variables could be responding to a third variable omitted from the analysis. One way to detect such relationships is to use a system of simultaneous equations to determine whether fluctuations in one variable precede fluctuations in the other, after controlling for all other available information. A statistical model that provides a test of such so-called Grainger causality is the panel vector autoregression described in Holtz-Eakin, Newey, and Rosen (1988). Using it, we relate current sales activity to the preceding two years' data on donations, fund-raising, and sales revenue. Separately, there is an equation with donations as the dependent variable and the same set of regressors. All of the data arc first-differenced - that is, differences between years are used - to remove the firm-level effect we identified as important in the earlier analyses. This transformation, combined with the presence of a lagged dependent variable, produces a correlation between the error term in the regression and the transformed right-hand-side variable that is eliminated using earlier data as an instrument. That is, we regressed the change in sales activity in year t on the changes in sales, contributions, fund-raising, and assets in years t—\ and t-2 while using the data prior to t-2 as instruments. Using this technique on the data for all industries, we find evidence that contributions statistically cause - that is precede - changes in sales, but sales do not cause contributions. The causality tests in row 12 of Table 6.5 reports the significance level of a joint F-test measuring the degree to which lagged contributions are a significant predictor of current sales after controlling for the organizational fixed effect and prior values of all the variables. Industry-specific effects of donations on sales revenue Results for five industry subsamples are presented in Table 6.6, which we have limited to the most important specifications. These five subsamples constitute 55 percent of our aggregate sample; the balance consists of nonprofits (shown in Table 6.3) in industries for which samples are quite small. Ourfindingsfor the housing/shelter and arts/culture sectors largely match the aggregate estimates - in our preferred, fixed-effect, formulations (rows 2 and 4) - in both the nonlog and log estimates. The estimates from the log-log specification, insignificant for the combined sample, are negative and statistically significant for the two industries (row 4).

Table 6.6. Regression analysis by industry of balanced panel of 50J(c)(3) tax returns, 1985-93 University or technol. inst. NTEE code B43

Hospital, general NTEE code E22

Housing, shelter NTEE code L

0.92** 0.15**

2.54* -0.01

0.67** -0.38**

1.63** 1.21**

0.10** -0.15**

0.21** -0.02

0.08* 0.02*

0.18** -0.22**

0.27** 0.14**

0.33** -0.10**

Long-run regression analysis, avg. (1991-3) - avg. (1985-8) 5. Effect on PSR of contributions 0.34** -0.01 6. Effect on log PSR of log contributions^7

0.78* 0.03

-0.43 -0.27**

2.95** 0.19

-0.23** -0.06

0.22 0.30

0.01 0.27

Specification* Effect on program service revenue of: 1. Contributions 2. Contributions, w/ firm and time effects Effect on log program service revenue of: 3. Log contributions^ 4. Log contributions, w/ firm and time effects^

Human services multipurpose & other NTEE code P

Arts, culture, humanities NTEE code A

0

Statistical tests for the direction of causality 7. Significance of lagged contributions on PSR 8. Significance of lagged PSR on contributions a

0.32 0.06

0.01 0.01

0.81 0.36

All dollar values are deflated by the Consumer Price Index for All Urban Consumers (1982^ =100). ^Log-log regression models use zero in place of log(0). 'Tests are based on a vector autoregression with firm fixed effects, and two lags of contributions, program service revenue, and fund-raising expenditures. Longer-lagged values are used as instruments. * Statistically significant at the .10 level. ** Statistically significant at the .05 level. Source: Authors' calculations from the IRS, Statistics of Income Division, data tapes.

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For the other three industries, however, findings are quite different. Between contributions and sales for universities and human-service organizations, we find relationships that are both positive and statistically significant, but the relationship is essentially zero for hospitals (row 2). The log estimates (row 4) are also positive and significant, except for in the case of universities, where there is no significant effect. These three industries comprise 44 percent of our aggregate sample. The fact that we find positive relationships between contributions and sales for them, but negative relationships for the aggregate, indicates that there are many organizations in the panel that exhibit negative relationships in industries where samples were too small to analyze. The association of increased donations with increased, rather than decreased, commercialization in an industry is not consistent with the simple multiproduct organization model in which commercial activities are disliked. It is consistent, however, with that model if, in those industries, there are economies of scope in production - that is, cost complementarities or complementarities in revenue. As we explained earlier, there is no reason to believe that such interdependencies are equally important across industries. We also noted other circumstances that could elicit a finding of a positive relationship between donations and sales, even if commercial activity is disliked; for example, a reduction in government grants could cause a simultaneous increase in private contributions and commercial activity. There is a clear need to learn more about both cost and revenue interdependencies in nonprofit organizations before it will be possible to state with confidence the effect on commercial activity of changes in some source of donative revenue. The results of tests of causality from commercial activity to donations also vary by industry. Rows 7 and 8 indicate that fluctuations in donations affect commercial activity in the housing sector, while in the university sector it appears that the driving force is the reverse, from sales to donations. In two industries, hospitals and arts, there is no evidence of causation in either direction, suggesting that both donations and sales are being influenced by a third factor. In another industry, human services, there is evidence of significant causation running in both directions. Concluding remarks The appropriate model for nonprofit behavior remains far from settled. So, too, is an understanding of how nonprofits come to have particular combinations of revenue from donations and from sales of goods and services, and particular combinations of revenue from mission-related and unrelated activities. However, a multigood production model, in which nonprofits determine the extent of activity in several sectors, is promising. Using data for 2,679 nonprofits observed from 1985 to 1993, we estimated a set of structural and reduced-form

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models that suggest that exogenous declines in donations yield significant increases in commercial activity for some industry sectors but not for others. The results vary considerably by industry, a finding that is understandable in light of differential organization goals as well as differences in interdependencies among revenue opportunities and in cost interdependencies between missionrelated and ancillary goods production. Our findings indicate strongly the need for more analyses of output and revenue determination in specific industries where nonprofits play a major role. Several questions raised during the analysis require further research. First, within our model of nonprofit behavior, contributions are considered exogenous. Relaxing this simplification involves determining the extent to which organizations can influence contributions, including the effect of a nonprofit's commercial activities on willingness of individuals and organizations to give it donations, and the extent to which other unspecified events affect both sales and donations. For example, changes in sources of sales revenue, such as through the adoption of Medicare and Medicaid in the health industry, can affect organization behavior and, in turn, the supply of donations (including volunteer time). Second, a dynamic model of behavior suggests that nonprofits may draw down assets in response to exogenous transitory fluctuations in donations. Debate over whether government spending on social welfare programs has crowded out private donations, so that current and prospective reductions in government support will lead to increased private donations, illustrates the importance of these issues. In addition, our findings that reduced donations have quite different effects on commercial revenue-raising activity in the highereducation, hospital, arts, housing, and human-services components of the nonprofit sector highlight the danger of generalizing about the responses of the sector, as a whole, to exogenous changes in donations.

CHAPTER 7

Conversion from nonprofit to for-profit legal status: Why does it happen and should anyone care?

John H. Goddeeris and Burton A. Weisbrod

Introduction: Conversion as the ultimate commercialism? If to behave commercially is to act like a for-profit firm, then the ultimate expression of commercialism for a nonprofit is to convert its legal status to the for-profit form. Conversion is increasingly common, most notably in health care, and is now attracting considerable public attention. Some observers believe that nonprofits and for-profits inevitably behave in fundamentally different ways, and question whether conversions can ever serve the public interest. Others are more concerned about the terms, arguing that public assets must remain devoted to the purpose for which nonprofit status was originally granted, and not be redirected toward private gain. This chapter seeks to advance understanding of nonprofit conversions and their public-policy implications. To set the stage, we introduce some key issues by reviewing briefly conversion activity in health care. We then consider the concept of conversion more closely, discussing various means of transferring control of nonprofit assets. Next we explore the possible motives for conversion, and speculate about the reasons for the rampant conversion activity in health care. Finally, we discuss at some length the important public-policy questions raised by conversions. In our view, the most important are the following: 1 Under what circumstances is conversion appropriate? 2 How should the nonprofit's assets be valued? and 3 What should happen to the financial assets that remain after the conversion? The authors thank Daniel Fox, Bradford Gray, James Schwartz, Steven Rathgeb Smith, and William White for helpful comments, and Elizabeth Selvin for valuable research assistance.

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Conversions in the health maintenance organization (HMO) industry have been common and increasingly controversial. Nonprofit firms - the only type eligible for federal subsidies under the Health Maintenance Organization Act of 1973 - initially dominated this industry. When direct federal subsidies ended in the early 1980s, however, market share began to swing heavily toward forprofits, partly through entry of new for-profit HMOs and their growth, but also partly from conversion of nonproflts (Iglehart 1984). From 1981 to 1995, the percentage of HMOs classified as nonprofits plummeted from 82 percent (accounting for 88 percent of overall membership) to 29 percent (41 percent of members) (Claxton et al. 1997, 12). One of the earliest conversions was the transformation of the HMO of Pennsylvania into U.S. Health Care in 1981. Some successful nonprofit HMOs followed this lead to become publicly traded corporations in the 1980s, with relatively little scrutiny. However, when managers and directors of Health Net - one of California's largest HMOs - offered to buy it for $108 million in 1991, consumer groups and other HMOs noticed the seeming undervaluation of the nonprofit's assets. When California's Department of Corporations finally approved the conversion in 1992, it required a vastly higher payment: $300 million plus an 80 percent ownership interest in the new for-profit HMO. These proceeds were given to the nonprofit Wellness Foundation. Despite the massive increase in payment, some Health Net insiders reaped very large personal financial gains. For that reason, and because the foundation's stock ownership made it dependent on the financial success of Health Net, these arrangements have also been criticized as inadequately protecting public assets (Hamburger, Finberg, and Alcantar 1995). Actual and proposed conversions of various Blue Cross health-insurance plans into for-profit entities have also provoked controversy. In June 1994 the national Blue Cross and Blue Shield Association decided for the first time that for-profit firms could affiliate with the organization (Freudenheim 1994), paving the way for several conversions. Even earlier, some plans had created substantial for-profit subsidiaries. The most prominent example is California Blue Cross, which in 1992 restructured so that 90 percent of its assets went into WellPoint Health Networks, a for-profit subsidiary. To Blue Cross, this was not a conversion - the parent entity continued to exist and owned 80 percent of WellPoint - but consumer groups and the Department of Corporations maintained that this arrangement potentially diverted public assets toward private ends. Ultimately, WellPoint agreed to purchase all of the assets of California Blue Cross (including use of the name) in 1996, completing the conversion and providing $3 billion in cash and WellPoint stock for the creation of two new charitable foundations (Hamburger et al. 1995; Schaeffer 1996).

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Accelerating conversion activity in the hospital industry has been propelled largely by the aggressive action of Columbia/HCA, the nation's largest chain of for-profit hospitals (Kuttner 1996a,b). Nationwide, thirty-four conversions of nonprofit hospitals to for-profits took place in 1994, fifty-eight in 1995, and more than a hundred government or nonprofit hospitals were expected to affiliate with or convert to for-profits in 1996 (Langley and Sharpe 1996). Interest in conversions extends to prestigious academic medical centers: The university hospitals at George Washington University, Columbia University, the University of California at Irvine, the Tufts University New England Medical Center, and state universities in Oklahoma and South Carolina are among those being sold to, or at least holding discussions with, for-profit hospital chains (Freudenheim 1997). As the number of conversions has grown, so has scrutiny from community groups and state attorneys general and other regulatory bodies. Primary concerns are whether a greater focus on profit will lead to a loss of unprofitable but valued community services, and whether hospital assets accumulated through community investment in nonprofits will be redirected toward private gain. In a case that cuts across the hospital and health-insurance industries, Columbia/HCA agreed to buy 85 percent ownership of Blue Cross and Blue Shield (BCBS) of Ohio for $299.5 million (Tomsho 1996). As in the California case, BCBS of Ohio argued that because it would continue to exist, the deal would not be a conversion. Moreover, BCBS of Ohio had already converted in 1986 from a nonprofit to a mutual company owned by its policyholders. This complicated the question of its charitable obligations, because a mutual has no legal obligation to provide charity care or any other unprofitable service, whatever its social value. Among the controversial features of the Columbia deal were over $15 million in severance packages, characterized as consulting fees and agreements not to compete, which would go to three BCBS of Ohio executives. Ohio's Attorney General sued to block the transaction, and the national Blue Cross and Blue Shield Association voted to revoke the use of its trademark if the deal went through (Kuttner 1996b). Factors peculiar to the health-care sector surely contribute to the drive for these conversions, but increasing pressures to engage in commercial activity are common throughout the nonprofit sector. Greater access to capital is argued to be a major advantage of the for-profit institutional form in health care; but if that is important for explaining conversions, it is presumably also an advantage in other industries such as colleges, museums, and social-welfare organizations. If, as critics claim, a major attraction of conversion is the opportunity for nonprofit managers and board members to benefit privately, a similar opportunity surely exists in other industries as well. It therefore seems prudent to think about the phenomenon of conversions and its public-policy implications more broadly. It is also important, from a public-policy perspective, to develop appropri-

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ate legal processes for determining the conditions under which a conversion is socially desirable, and to establish incentives that will encourage desirable and discourage undesirable conversions. What is a nonprofit conversion? On the face of things, "conversion to for-profit status" suggests that a nonprofit entity simply reorganizes as a for-profit firm. However, even a clear conversion of form is complicated by the fact that the nonprofit's assets do not belong to individuals. If the nonprofit ceases to exist, where should these charitable assets go? Just as important, various other interactions between a nonprofit firm and the for-profit sector are possible (including for-profit subsidiaries and joint ventures), which, while stopping short of full conversion, accomplish at least some of the same ends. It is useful to think of any change in control over assets or responsibility for liabilities from the nonprofit to the for-profit sector as a kind of conversion. A joint venture between a nonprofit and a for-profit is a conversion if it alters the locus of control over core assets of the nonprofit - as it has, for example, in arrangements between Columbia/HCA and various nonprofit hospitals. Conversion may occur even when assets are sold for a "fair market value": If the assets are deployed differently by the new private owners, their market value may be insufficient to replace the collective goods that will be lost. Even making a passive investment in a private firm involves converting some assets, in the sense of relinquishing some control. A nonprofit may also contract with a for-profit firm for management services. Whether such a contract involves significant public-policy issues depends on how much control is transferred, the degree to which the for-profit firm is constrained, and on the reward structure for the for-profit. Such transfers of managerial control have been made increasingly in hospitals and academic medical centers, as well as in public school and prison systems. Schools in Minneapolis, Hartford, and elsewhere have been put under private-sector management by firms such as The Edison Project and Apollo Group, Inc., and prisons have been increasingly privatized through management contracts with firms such as Corrections Corporation of America and Behavioral Systems Southwest. In these cases the nonprofit (or public) organization, rather than being sold, transfers control to a private firm for a finite period of time, with a variety of contractual constraints spelled out. However, if nonprofit institutions are most valuable in cases where some socially important dimensions of performance are very difficult to define in a contract and to monitor (Weisbrod 1988), any transfer of managerial authority to a for-profit may threaten the nonprofit's original goals.

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Although we shall generally speak of only two organization types, nonprofit and for-profit, there are in reality various legal forms of nonprofit, each facing somewhat different constraints, just as there are different organization types in the for-profit sector (e.g., incorporated and unincorporated businesses). The nonprofit mutual-benefit corporation, for example, shares with the for-profit form the fact that its assets are privately owned, in this case by the organization's subscribers or members. Thus, a change in organizational form from charitable nonprofit to mutual-benefit nonprofit, as has occurred for a number of Blue Cross plans in the past decade, is in an important sense a conversion. Despite such complexities, we focus in this chapter on the issues involved when the resources of a nonprofit entity are substantially shifted to for-profit control, and the nonprofit ceases to exist in its previous form. Cases of this type - such as the conversion of California Blue Cross to WellPoint Health Networks, or the proposed purchase of most of BCBS of Ohio by Columbia/HCA - are attracting the most public notice. For purposes of public policy, however, we should remember that conversion is a matter of degree. Given the increasingly bright searchlight of public attention focused on total conversions, the goals motivating conversions will likely be pursued through more subtle means. We expect more joint ventures, partial buyouts, and complex interorganization contracts that preserve the apparent independence of each organization while actually shifting the locus of control. What motivates conversions? Modeling choice of institutional form Determining why managers and trustees of a nonprofit organization would seek to convert it to a for-profit requires asking why the nonprofit form was chosen initially, and then what changed to make it less desirable. It is often useful to model organization behavior as the maximization of an objective function subject to constraints. From that perspective, the choice of organizational form, nonprofit or for-profit, is a choice of constraints, because these differ for the two types of institution. The particular form is chosen because it is the most conducive to attaining the founders' goals.1 Constraints are imposed both by the legal system and by the market. Legal constraints that differ between for-profits and nonprofits include tax liability on income, real property, sales, and so on; access to tax-deductible contributions; access to equity capital; restrictions on "profit" distributions; the availability of 1

The problem is most appropriately viewed as a dynamic one, with the firm looking at long-run objectives and the possibility that constraints may change in the future, and recognizing possible change in organizational form at a later date.

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government grants and subsidized loans; and regulatory requirements regarding product offerings, pricing, and access. Nonprofits possess certain tax advantages but lack access to equity capital (because that would imply private ownership shares), and they are legally restricted by the nondistribution constraint (Hansmann 1980) from distributing any profits or surplus to managers or board members. The market also constrains behavior. For-profit and nonprofit firms are constrained by demand conditions, although not necessarily identically. In some cases, buyers might regard nonprofits as more trustworthy and prefer to purchase from them. Trust is particularly important for goods with essential attributes that are difficult to monitor directly - for instance, the "tender loving care" provided in a nursing home or day-care center. If at least some buyers regard nonprofit status as a signal of trustworthiness, demand will differ between the two types of firm, even if all observable product characteristics are identical. Differences in market-imposed constraints might also affect the supply of labor or other resources. Volunteer time is more readily supplied to nonprofit firms, and even paid workers sometimes accept lower wages to work for nonprofits (Weisbrod 1983; Preston 1989; Roomkin and Weisbrod 1998; but cf. Goddeeris 1988), perhaps because they identify with a nonprofit's goals and derive satisfaction from working to achieve them. For-profit and nonprofit firms coexist in a number of important industries: Health insurance, hospitals, nursing homes, and day-care centers are leading examples. Nonetheless, there may be important differences in behavior across organizational type, even within an industry, and different choices about organizational form may reflect different managerial objectives. Suppose, for example, that the founding managers of a medical clinic care about two things - their own monetary compensation and providing subsidized health care for the poor - and must decide whether to organize as a nonprofit or for-profit. There is likely to be some trade-off between managerial compensation and the amount of collective goods that can be supported in either sector, once chosen. Maximal monetary compensation may be higher in the for-profit sector, if the nondistribution constraint actually limits compensation of nonprofit managers; but larger collective-good output may be possible in the nonprofit sector because of tax advantages and the ability to attract donations. Managers who place less value on the collective goods would thus organize as for-profits. Those with a strong enough preference for providing such services would pick the nonprofit sector. Why do conversions occur? Within this framework, how can we explain conversions? A useful working hypothesis is that changes in legal constraints or market opportunities are the primary cause. If, for example, nonprofit firms are exempt from a property tax that

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other firms must pay, a cut in the tax rate reduces one advantage of the nonprofit form. Such a policy change could induce an organization with a sufficiently weak preference for the nonprofit form to switch status (Chapter 5). Although a shift of managerial goals in the direction of personal financial gain could also account for a conversion, economists generally find it more fruitful to model goals or preferences as stable, and to predict behavioral changes on the basis of changes in constraints. Constraint changes - particularly changes in tax laws or regulations, but also the availability of private donations and government grants and contracts - are relatively easily observed, and they affect all similarly situated firms in the same way. Moreover, without a model that predicts systematic changes in goals that simultaneously affect many organizations, and only in certain sectors, such an "explanation" does not elucidate today's pattern of conversions. At the same time, organizational goals or preferences are not entirely independent of constraints. A nonprofit organization's goals are determined by its managers and board, since it has no stockholders or other owners, and this set of key decision makers often changes over time, sometimes in response to changes in constraints. Goals may change endogenously as the nonprofit encounters budgetary difficulties in the pursuit of its original goal, and the organization takes on board members who represent sources of actual or potential finance. In the early 1980s, for example, a nonprofit food bank in Phoenix with local volunteers as directors witnessed a struggle in which food manufacturers, such as Beatrice Foods and Kraft, and food marketers came to dominate the board (Birnbaum 1982). In the course of time, an organization's goals may change considerably, as managers with greater concern about finance replace those whose visions were of public-service outputs. As the altered goals grow less compatible with traditional nonprofit constraints, conversion may become appealing. A decision to convert can thus be viewed as a rethinking of the original decision about choice of organizational form, which may be triggered by changing constraints or managerial goals. There are, however, important differences between a conversion decision and the initial choice of form. A desire to convert may evolve naturally over an organization's life cycle, for example, even if the external environment and goals do not change. For a newly established nonprofit firm with few assets, the nondistribution constraint may not matter, as the firm has little or nothing to distribute. As the market value of assets grows, however, the firm's managers and board will be tempted to distribute some of that value to themselves. If public policy permits conversions to occur in a manner that effectively subverts or even weakens the nondistribution constraint, a conversion may occur. Some organizations could even pursue a long-range strategy of forming as nonprofits and converting to for-profit status if successful. On the other hand, if a conversion occurs and the firm's behavior shifts to-

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ward maximizing market value, the collective goods it was providing as a nonprofit are not necessarily lost in the process: The income from the accumulated assets could be redirected toward their continued provision (as could the increased taxes, if any, that the firm will now pay as a for-profit entity, although their disposition is outside the control of the firm's decision makers). Laws and regulations about the disposition of assets after conversions will thus have an important impact on incentives to convert, as we explore in more detail below. The Bennington College case discussed in Chapter 1 illustrates another motivation for the conversion of control over at least some assets (Galper and Toder 1983). The college sold its buildings to a private firm and then leased the buildings back. The difference in tax rules applied to the nonprofit college and for-profit private firm - tax deductions for depreciation on the buildings were of no value to the college - made this advantageous for both, though nothing changed in the use of the buildings. The gains to the participants came at the expense of other taxpayers, and the IRS ultimately prohibited this particular form of legal legerdemain. Even so, differences in rules for different organizational forms continue to create incentives for transactions between them that are privately advantageous but of no social value. These incentives always exist, but they may become stronger or weaker with changes in legal constraints or market conditions, and they may interact with other motives for conversion. Although we have emphasized conversions from the nonprofit to the forprofit form, nothing in the theory we have outlined requires that conversions go only in that direction. If some firms were near the margin when initially selecting the for-profit sector, a change in constraints that increased the attractiveness of the nonprofit sector might tip them toward conversion. A possible asymmetry between conversions in the two directions is that to the extent conversions are part of a long-term strategy motivated primarily by private gain, we might expect the more successful nonprofits to seek conversion to for-profit status (to escape the nondistribution constraint), whereas for-profits that seek conversion would be the relatively unsuccessful ones. For these for-profits that have done less well than their initial expectations and are only marginally viable, nondistribution may not be an important issue, and the prospect of tax advantages or subsidies available to nonprofits may look increasingly attractive. Recent studies of the hospital industry document that conversions among public, nonprofit, and for-profit institutions occur in all directions (Ferris and Graddy 1995; Needleman, Chollet, and Lamphere 1997). Needleman and colleagues find that between 1990 and 1995 alone,fifty-sixfor-profit hospitals converted either to nonprofit or public institutions. Understanding recent health-care conversions Just why conversions are so widespread in the health-care sector today requires analysis beyond the scope of this chapter. In brief, however, there is reason to

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believe that changes in the legal and regulatory environment, as well as in the nature of market competition (i.e., constraint changes), have made it more difficult for nonprofit health insurers, and nonprofit hospitals, to survive in competition with for-profits.2 Indeed, several policy changes have made it more difficult for health-care nonprofits to finance collective goods successfully. For HMOs, the end (in 1983) of federal grants and loans for development reduced the nonprofit advantage; this change appears to coincide with and perhaps stimulated the shift toward for-profit status. For Blue Cross and Blue Shield plans, too, tax advantages have eroded over time: Exemption from the federal corporate income tax was ended in the Tax Reform Act of 1986, and many states have limited the special tax advantages of Blue Cross plans. Changes in tax policy in the 1980s also reduced advantages of nonprofit hospitals over for-profits in the issuance of tax-exempt debt (see Chapter 8 and Sloan 1988). Simultaneously, the nature of competition in the health-care marketplace has been changing. Research and medical care for the indigent (and, to a lesser degree, training of medical students and residents) are difficult to finance through direct sales. Historically, they have been financed out of a combination of government grants and profits from government and private insurance payments for medical care, payments that exceeded the costs of care and left room for crosssubsidization. However, an era in which third-party payers passively reimbursed hospitals for their self-reported costs or charges has given way to one of standardized payment rates (led by Medicare's adoption of pricing based on Diagnosis Related Groups [DRGs]) and even active price competition. The health-care financing system and government policies of the past (including the Hill-Burton Act of 1946, which subsidized construction of hospital beds) encouraged an enormous buildup of hospital capacity in the postWorld War II period. As hospital admissions began to fall in the early 1980s (due to technological changes but also to DRG-based payments and the growth of managed care), average occupancy levels fell and have remained low, currently around 65 percent. The interest of nonprofit health-care organizations in conversion coincides with a drive toward consolidation in the industry.3 Some analysts have stressed a link between excess capacity in health care, particularly in hospitals, and both of these movements, conversion and consolidation. As the market for hospital services became more price competitive and the level of overcapacity more apparent, hospitals often came to look to affiliation with larger organizations, often for-profits, as vital (Coye 1997; Hollis 1997). 2

3

The March-April 1997 issue of Health Affairs, devoted to hospital and health plan conversions, is a good source of additional discussion. Consolidation can bring social benefits, to the extent that it creates efficiencies through the realization of economies of scale and elimination of excess capacity. Consolidation in health care, however, is surely also motivated by a desire for greater market power, which benefits organizations that achieve it at a cost to the rest of society (Fuchs 1997).

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The debate over conversion of hospitals to for-proflts is often entwined with one over local versus more distant control (Langley and Sharpe 1996). One motivation for preferring to affiliate with for-profits is the perception that a forprofit company will find it easier to take bold actions necessary for the organization's survival, such as layoffs or elimination of services - a perception that at least one former hospital executive claims is "always present" in nonprofit hospital conversions (Coye 1997). This may equally be a basis for local opposition to such a conversion by employees and other input suppliers. As government and employers have sought to become more prudent purchasers of health care, health insurers similarly have needed to compete more for enrollees on the basis of price and to embrace managed-care principles. In addition, access to capital has come to be seen as critical to survival for health insurers, and as favoring for-profit firms over nonprofits, which cannot sell equity interests.4 Conversions in health care may thus be a natural adaptation to changes in government policies and in the market environment wherein the organizations operate, changes that have been more pronounced there than in other industries in which nonprofits are significant players. Such conversions thus appear to illustrate the revenue-substitution process - presented abstractly in Chapter 3 and examined quantitatively in Chapter 6 - carried to an extreme. At the same time, as we discuss in a later section, it seems that financial enrichment of key nonprofit decision makers has often been an incentive for the conversion of nonprofit HMOs, and in at least some proposed conversions of Blue Cross plans. The possibility that it is private financial gain, through subversion of the nondistribution constraint, that primarily has motivated health-care conversions is difficult to rule out. Public policy and conversions In this section we examine the three related public-policy questions identified at the outset of this chapter: 1

Under what circumstances is a conversion of a nonprofit firm to forprofit status socially appropriate? 2 How should the nonprofit's assets be valued? 4

It is interesting to ask why access to equity capital would have increased in importance, and whether this situation is temporary or permanent. The health-insurance industry is apparently undergoing a transitional period of high capital investment, in information technology and network building, associated with the adoption of more aggressive managed-care techniques. Part of the interest in access to equity capital is for financing acquisitions, as the health-insurance industry consolidates. Either of these motives suggests that if for-profits have an advantage in this regard, its importance is temporary. Capital investment would be a stable share of revenues for a "mature" insurer that is not expanding rapidly, and could be financed largely with internal funds.

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What should happen to the financial assets remaining after the conversion?

Public policy ideally should be structured so that conversions of nonprofit firms to for-profit status occur when, and only when, they advance "social welfare." Defining and operationalizing this rule, however, is a significant challenge. Addressing question 1 is an essential first step to thinking clearly about policy. If conversions can improve society's welfare, we should be concerned not only with preventing conversions that are inappropriate or on the wrong terms, but with creating an environment that does not unduly hinder the beneficial ones. Questions 2 and 3 are thus closely related to each other and to question 1. Whether a conversion is deemed appropriate depends upon all the terms of the deal, including the valuation of the assets to be transferred and what happens to those assets and to the nonprofit's other obligations and responsibilities. How questions 2 and 3 are answered in practice also affects the incentives of organizations to seek conversions. As we have noted, we shall focus on conversions in which the assets of a nonprofit entity are substantially shifted to for-profit control. Nonetheless, we are mindful that the more restrictive public policy is toward complete conversions, the greater will be the incentives to shift control of assets in more complex ways involving "partial" conversions. When is a conversion socially appropriate? This question involves important issues of both economic efficiency and distributional equity. With regard to efficiency, the concern of conventional benefitcost analysis, we may say that a conversion is appropriate if the assets will produce greater social value under a for-profit form of organization. Social value is ordinarily conceived of as the aggregate of what members of society are willing to pay for what the organization produces (Haveman and Weisbrod 1975). It is difficult to argue that conversion of a nonprofit firm to for-profit can never advance social welfare. Because of the stronger incentives for minimizing costs and responding to consumer demands that come with private ownership of assets, as well as possibly greater flexibility associated with access to equity capital, the same resources could plausibly produce greater value in the forprofit than in the nonprofit sector. Were it not so, we must question why the forprofit is the primary form of organization in most industries. Even if we accept that privileges associated with nonprofit status were originally granted to advance some social objective, in particular cases that decision may come to be viewed by public-policy makers as an error. Circumstances may also change, and the evolution of market forces may make it increasingly difficult for nonprofits to compete. There may also be a social decision to use different means

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to promote social objectives once attended to by nonprofit firms, calling into question their reason for existence. For example, New York State now requires other insurers to share Empire Blue Cross and Blue Shield's past responsibility as "insurer of last resort," while at the same time it has abolished subsidies that helped Empire support unprofitable business. Empire is now seeking to convert to for-profit (Freudenheim 1996; Rosenthal 1996a). Conversions of nonprofits bear some resemblance to corporate takeovers within the for-profit sector. It is frequently argued that such takeovers must be efficiency enhancing or they would not occur. The argument in brief is that if one firm or management group is able to offer enough for the assets of another to wrest control, it must be because the new management will do a better job with those assets, will deploy them in a way that increases the value that they produce. This argument is appealing because in many circumstances within the for-profit sector, activities that increase private market value also produce social gains. This presumption - immortalized in Adam Smith's metaphor of an "invisible hand" guiding resource allocation efficiently - is strongest for competitive markets, with firms operating under the same sets of rules, producing ordinary private goods.5 We should be cautious, however, about using market value as a guide to social value when we compare institutions that operate under different legal constraints (see Chapter 5). Even within the for-profit sector, whenever firms operate under different rules, comparing market values of assets can be misleading. A case in point is the U.S. corporate income tax, which falls differentially on returns to capital employed in the corporate sector. As Harberger (1974) demonstrated long ago, such a tax leads to an equilibrium where similar assets earn the same private return (have the same market value) everywhere but have higher social value in the more heavily taxed sector. An organization's desire to convert from a less heavily taxed (nonprofit) to a more heavily taxed (for-profit) form creates at least some presumption that the conversion would enhance efficiency because the organization would take on added tax liabilities by converting. An even more fundamental issue, however, is that some outputs have social value, yet are not profitably provided by private enterprise. Health care for the poor and basic medical research are examples. Relying on for-profit firms exclusively, without public subsidies, will lead to inefficiently low provision of these collective - or "public" - goods due to 5

In some circumstances this premise is questionable even for takeovers involving only for-profit entities. Suppose, for example, that a corporate raider is able to increase his or her target profitability by taking away promised health-care benefits from retired workers and thereby lowering costs, which the old management was unwilling to do. This reduction in welfare of the retirees may lead to a higher market value for the firm, but in a proper benefit-cost analysis the cost to retirees should also be taken into account. For an interesting discussion, see Krugman (1994, chap. 13).

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familiar free-rider problems. Nonprofit organizations may provide more of these goods than for-profits operating in similar markets, although the evidence is not entirely clear, and there is some indication of lack of difference (see Chapter 8 regarding hospitals). Public policy toward conversions of nonprofits should not overlook the impact on provision of collective goods.6 On what terms should conversions be permitted? What should determine the price paid by a for-profit firm to gain control of a nonprofit's resources? An obvious suggestion is a process of competitive bidding. There is surely merit in this idea, but such a process can be costly, time consuming (Schaeffer 1996), and surprisingly complex. Consider the ambiguity of precisely what is to be transferred from the nonprofit to the for-profit. A sale would naturally include the items that appear on the organization's balance sheet, its assets and financial liabilities - but what of the organization's formal or informal "obligations" to provide collective goods? Suppose a nonprofit hospital that has been providing some charity care for poor and uninsured patients is considering sale to a for-profit hospital chain. Would the sale, if it took place, require the new owner to provide such charity care, and at the same level? If competitive bidding is used, with a requirement that the highest bid be accepted, it is very important to define terms carefully and to make sure that offers are truly comparable. This is one argument for preferring "complete" to "partial" conversions. Different suitors will undoubtedly prefer different terms for a joint-venture deal, making offers difficult to compare. Columbia/HCAhas, for example, participated in joint ventures in which it receives in addition to its ownership share a management fee. Clearly, a higher management fee increases the price it would willingly pay for its share. Even in the context of a complete conversion or outright sale, difficulties of specifying all the relevant terms of the contract, and in enforceable terms, are considerable. Conversion agreements have frequently specified that the for-profit buyer will maintain the level of charity care formerly provided by the nonprofit hospital (Claxton et al. 1997), but because charity care is notoriously difficult to define, such provisions are difficult to monitor and enforce. Another reason for not necessarily accepting the highest bid is the social interest in maintaining competitive pricing in product markets. In a community 6

Although there has been little research on the consequences of conversions in any industry, there is considerable literature comparing empirically the behavior of nonprofit and for-profit organizations in industries in which they coexist. Among the industries studied are day care (Knapp 1989; Badelt and Weiss 1990; Krashinsky 1993; Mauser 1993), university research (Blumenthal et al. 1996), nursing homes (Weisbrod and Schlesinger 1986; Weisbrod 1988; Hirth 1997), longterm psychiatric care facilities (Schlesinger and Dorwart 1984), and hospices (Christakis and Escarce 1996).

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with just two hospitals, hospital A may be in a position to offer the highest bid for hospital B, because the combined hospitals would be able to engage in monopoly pricing, an advantage that other potential buyers of hospital B would not have. Hospital A's advantage does not come from an ability to use resources more efficiently, but from being better positioned to extract payment from consumers. In this case, antitrust laws might rule out hospital A as a potential buyer, but the issue exists in less extreme situations. The point is that the highest bid is not the socially most efficient bid if it results from an expected exploitation of monopoly power. A key question for public policy is whether the postconversion provision of collective goods, such as charity care or medical research in the case of a hospital, is best handled through contractual agreements with the acquiring forprofit, or purchased using the assets transferred to a successor foundation. The latter approach appears to have certain advantages. Contractual mandates to provide such goods are likely to lead to extensive legal wrangling over precise definitions and measurement. Profit-oriented firms seek to minimize activities that generate financial losses. A for-profit hospital has an incentive to define charity care, for example, in such a way as to meet its legal obligations while departing as little as possible from what would otherwise maximize profits. Not obligating for-profits to provide collective goods should maximize bids, and may make competing bids easier to compare. A conversion should proceed only if the social value of the resources is higher in the for-profit sector. An open and competitive bidding process should elicit bids that are close to actual private valuations. Even the highest bid, however, is likely to be a lower-bound estimate of social value, for it would not reflect the social value of unprofitable collective goods such as indigent care. If a private purchaser were required to provide such services, the costs of providing them would be negatively reflected in its bid, whereas the positive social value of the services would not be. Moreover, expected tax payments would detract from the bid of a private for-profit bidder, even though, from a social perspective, tax payments have positive value. To approximate social value in the private for-profit sector, we should add to private bids the present value of future tax liabilities, as well as an adjustment for the social value of community obligations. A private bidder would subtract losses on obligatory community services - that is, their production cost minus any associated receipts - before identifying its maximum bid. We could therefore add to private bids a positive amount equal to expected losses due to community obligations. In particular cases this adjustment could be too large or too small. It would be too large if the community-service obligation was itself inefficient - that is, if the required services had a social value below the marginal cost of providing them. On the other hand, it would be too small if the social value exceeded the cost of production. This is reasonably clear concep-

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tually, but estimating the marginal social values of the required unprofitable services is typically extremely difficult in practice. Even more difficult is evaluating the social value of the firm in its nonprofit form. Theoretically it is the present value to society of the services that those assets would deliver over the remainder of their life, if they remain under nonprofit control, less any net subsidies the firm would use in delivering those services. Private-market valuations of the nonprofit's assets, either in total, as elicited through bids to purchase the firm and convert it to for-profit, or piecemeal, as obtained through appraisals of the value of individual tangible assets, are not directly relevant. These reflect the value of the assets if they were deployed in the for-profit sector, where they can be expected to provide different kinds of services or to different beneficiaries. Bids from nonprofit suitors provide at least some information about the firm's value in that sector. For comparison with bids from for-profits, these should be reduced by the present value of net subsidies that the nonprofit could expect to receive (just as the for-profit bids should be increased by the value of tax liabilities). Even rough valuations of the expected flow of collective goods, if the organization retained its nonprofit form, would be useful for comparison with the value in the for-profit sector. In addition to attempting to make such difficult comparisons of value directly, public policy should also concern itself with the process by which conversions are proposed. A necessary, though generally not sufficient, condition for a conversion to occur is that the nonprofit's leadership desires it. These decision makers are arguably best informed about what their organization can accomplish as a nonprofit and what would be lost if the nonprofit was to disappear or be replaced by a private firm. Ideally, they would not seek a conversion unless they saw it as the best way to advance the social objectives that the nonprofit was established to serve.7 They should, from a social-efficiency perspective, compare the financial resources that would be realized from a sale (and which could then be devoted to charitable purposes) with the value of what the organization could accomplish if it remained nonprofit. If the objectives of these decision makers, as they consider conversion and compare alternatives, are well aligned with social goals, then the invisible hand may yet work reasonably well. Unfortunately, nonprofit board members and top executives do not always have the knowledge and motivation to carry out their public responsibilities effectively.

7

We should not suppose that decision makers have perfect information about the firm activities. In a recent case of alleged serious fiscal mismanagement of a nonprofit hospital, one trustee admitted, "I'm a layman - what do I know?" A former official of the hospital added, "The board was like a bunch of sheep.... they would raise their hands yes to everything Ward [the CEO] asked" (Langley 1996).

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If the nonprofit decision makers are to act in their legal fiduciary capacity as agents for the public in promoting only efficient conversions, their decisions should not be biased by personal financial gain. The possibility of moving to a job with the new for-profit at higher pay does not necessarily bias an individual's decision, if the rate of pay in the for-profit is market based; but if a manager or trustee is rewarded significantly for facilitating a transfer of control and is also involved in deciding its terms, private reward may improperly influence the decision. For facilitating a conversion, officials of a nonprofit may be rewarded with a job with the purchasing firm at a wage far exceeding market opportunities - or more subtly, at a seemingly competitive wage but with various "golden parachute" provisions. There could also be lucrative consulting arrangements, or payments for agreements not to compete, as in the Columbia/ HCA offer for Blue Cross and Blue Shield of Ohio. It is also objectionable for officials of the original nonprofit to buy it themselves - as happened with Health Net - at least in the absence of a workable competitive-bidding process. The temptation to undervalue the nonprofit in these circumstances is simply too great. In many HMO conversions insiders were allegedly able to purchase ownership shares at low prices before the converted organizations were valued in the stock market; they then profited enormously when the organizations "went public" and a true market value was established. Hamburger et al. (1995) claim that in California in the early 1980s, directors and managers of nonprofit HMOs that converted to for-profits became millionaires "overnight" as a result of capital gains on stock in the new companies (see also Fox and Isenberg 1996). Leonard Schaeffer (who as CEO of California Blue Cross was himself the engineer of its conversion to WellPoint Health Networks) stated the point emphatically in a published interview (Iglehart 1995): Before the conversion of WellPoint, the value of every single company that converted to for-profit status was significantly underestimated... .Almost all of the value created went to the management and boards of these companies. .. . FHP International, Foundation Health, Pacificare, TakeCare, you name it. These are companies that today are led by multimillionaires who achieved that status by virtue of receiving stock that was dramatically undervalued at the time of conversion. Some states have begun to pay close attention to potential conflicts of interest involved in conversion proposals (Allen 1997; Matzke 1997). The IRS is also taking a closer look. Marcus Owens, the director of its Exempt Organization Division, has stated that sales, conversions, and joint ventures of hospitals would be getting more attention, focused on "the level of private benefit that might be occurring in the transaction," among other things (Internal Revenue Service 1997). One possible response to potential conflicts of interest is to prohibit payments of any kind - including compensation for employment - from a for-

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profit firm that buys a nonprofit to any high official of the acquired nonprofit. This idea could even be extended to conversions of organizational form without an outright sale; the board and top managers might be required to resign and to refrain from any financial association with the new entity. A somewhat analogous prohibition on senior federal officials' switching sectors already exists: They may not be paid by firms with which they had dealt in their governmental roles, for varying periods of as long as five years. Although we believe that the potential for conflict of interest is very real, such an absolute prohibition would probably be counterproductive. The prospect of a personal financial loss, and perhaps loss of prestige as well, might motivate managers and board members to oppose socially desirable conversions. In particular situations, it would be efficient for the leaders of a nonprofit to play similar roles in (or at least serve as consultants to) the new for-profit. These officials have knowledge and experience - specific human capital - concerning their organization's operations and its relationships with its customer base, the value of which could not be economically replicated by the firm.8 A final issue about the terms of conversion is whether the converted organization should be allowed to use the name of the former nonprofit. The national Blue Cross and Blue Shield Association agreed to that possibility in 1994, but voted to revoke the use of its trademark by BCBS of Ohio if its deal with Columbia/HCA were completed. In markets where consumers have difficulty assessing product quality, a trusted name can be a very valuable asset; whether the name is transferred may therefore significantly affect the offer price. If the name is not transferred and is therefore no longer used, there would appear to be a destruction of that value, which may seem inefficient. It is surely a loss of private value for the for-profit purchaser, but is it a loss of social value? Not if the surviving organization is to act differently in important ways, and the use of the name of the predecessor might convey that there has been no change. The social value of allowing the new firm to retain the name of the nonprofit is probably far lower than its private value to the organization, and it may not even be positive. Allowing the firm to retain the name has positive social value insofar as the name conveys accurate information, reducing uncertainty for buyers, and facilitates better matches between sellers and buyers (insurer and enrollees, or hospitals and patients). However, there is a negative social value if the new firm derives benefits from the brand name by virtue of misleading consumers into having greater confidence than is warranted by the firm's behavior.

8

Bradford Gray suggested to us the Empire Blue Cross case as one where it seems appropriate that the leaders of a nonprofit remain in place following a conversion of form. The conversion proposal appears to be well structured to avoid problems of conflict of interest.

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What should happen to the assets? Consideration of incentive effects has led us to conclude that conversion should not be a vehicle for subverting the nondistribution constraint. Thus none of the value of the nonprofit's assets should be used for the financial benefit of individuals closely connected with the organization. All of the proceeds of a sale should be transferred to an approved social purpose. For nonprofits organized for a charitable purpose, the law in most states and the common-law cy pres doctrine requires that the assets be dedicated to purposes as close as possible to the original ones (Hamburger et al. 1995; Kane 1997). For example, a foundation created from the sale of a nonprofit hospital might be dedicated to financing care for the indigent or promoting community health. Economic efficiency argues that they be directed to the use where they produce the most value, although identifying high-value uses for funds allocated to charity is difficult. Policymakers and regulators must prevent new foundations from becoming vehicles for avoiding the nondistribution constraint, with funds devoted to exorbitant salaries or other uses of little social value.9 Concerns that incentives for proposing conversions be efficient and that public assets not be unfairly appropriated for private gain both argue for separate control of the new organization and the one that receives the assets of the former nonprofit. If managers or board members of a purchasing firm also sit on the board of the new foundation created with the proceeds of the sale, the foundation is more likely to act in the firm's interests. Even without direct overlap in control, if the foundation holds a major ownership share in the for-profit organization (e.g., one of two foundations created in the California Blue Cross conversion was endowed with stock of the for-profit WellPoint), their fortunes remain closely entwined. To separate them as much as possible, the proceeds of a sale generally should be paid in cash rather than in equity or debt issued by the purchasing firm or successor for-profit. If equity shares of the for-profit must form part of the sale proceeds (because providing its full equity value in cash would be too damaging to the for-profit in the short term), the foundation should agree to sell them within a reasonable time frame. Concluding remarks Nonprofit and for-profit organizations operate under different rules and constraints - financial and other. Whenever individuals are free to choose under which set to operate, they will be influenced by the costs and benefits of the alternatives. Moreover, they may want to switch from one set of constraints to 9

Jaffe and Langley (1996) relate a story of a former board member of a small town hospital who became director of a foundation formed through its sale, at a salary of over $200,000 per year.

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another if exogenous changes - in, say, tax policy or government grants - alter the relative attractiveness of the respective constraints, or if changes within the organization refocus its objectives. Certain legal constraints, such as lower taxes and greater subsidies, favor the accumulation of assets by nonprofit organizations: Many nonprofits have substantial assets that were amassed through contributions, gifts, and grants as well as untaxed income from the sale of program services and investments. Other constraints favor private firms, however, such as access to equity capital. Forprofits are surely less restricted in the ways they can deploy assets and distribute surplus revenues. Conversions transfer assets from the more-restricted uses permitted for nonprofits to the less-restricted private enterprise form. If the assets of nonprofit organizations could be converted into a form that was not subject to restricted distribution, the incentives for conversion among successful organizations would be enormous - consider an art museum with collections worth hundreds of millions of dollars. Nonprofits would often be only transitional organizations, formed to take advantage of public and private subsidies and then eventually abandoned - converted to private firms - so that the assets could be used for private gain. Of course, if it became widely known that such transfers were permitted, any trust that consumers place in the public-spiritedness of nonprofits would be severely undermined, which would in turn diminish donations and the social role that nonprofits can play. Among the difficulties of determining whether a specific conversion is socially efficient rather than merely privately profitable are the following: How do we determine the social value of the nonprofit, in order to make comparisons to private bids? How do we specify which assets, liabilities, and obligations not on the balance sheet are being sold, and ensure that those obligations are met? How do we prevent conflicts of interest that encourage managers and directors of a nonprofit to undervalue its assets for private gain? Conversions clearly hold the potential for abuse - for inefficient change that serves little or no social goal but enriches insiders at public expense. Informational problems seriously impede establishment of rules to guide regulators. Insiders are generally better informed than regulators about the magnitude and distribution of both private and social benefits. We can be confident that agreements between the managements of a nonprofit and a for-profit will generate private benefits to the leaders and owners of both, but the overall social benefits are more doubtful. It does not follow, however, that conversions are inevitably inefficient. Changing circumstances can reduce the importance of the social mission that first led to the development and growth of nonprofits in some industry, and can make reallocating resources efficient. Important as entry of nonprofits may be, so too is it important that there be mechanisms for facilitating their exit.

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The best public policy would establish rules that discourage nonprofit officials from proposing conversions for the wrong reasons (private gain), yet do not unduly inhibit efficient redirection of resources into private control. How high public policy sets the barriers - for instance, the stringency of restrictions on financial arrangements between the nonprofit's insiders and the purchasing for-profit - should, as usual, reflect a balancing of marginal gains and losses. The potential losses from an overly restrictive policy - that is to say, social gains forgone by efficient conversions denied - are not yet well understood; nor, for that matter, are the potential losses from a permissive policy. A better understanding of the motives for and consequences of current conversions in health care is a natural, though surely challenging, target for further research. Equally important is applying that understanding to nonprofit organizations outside of health care, so as to anticipate prospective pressures and be prepared to deal with them. The potential for conversions to generate private benefits but social costs is great - and by no means limited to the health sector.

PART II

Industry studies

CHAPTER 8

Commercialism in nonprofit hospitals

Frank A. Sloan

Introduction Most U.S. hospitals are organized as private, not-for-profit organizations. Although the share of such hospitals is declining, as of 1994,60 percent of nonfederal, short-term general hospitals were nonprofits; only 12 percent were proprietary, and the rest were government hospitals (AHA 1995). Private nonprofit hospitals, measured in terms of GNP, constitute by far the largest category of nonprofit institutions in the United States. The hospital industry is undergoing massive change. Partly because of modifications in payment practices, demand for hospital inpatient care is shrinking, leading to hospital closures and mergers as well as some conversions to forprofit status. Hospitals are integrating not only horizontally but also vertically, the latter including combinations with other types of health-care providers and, mainly through contracting, the establishment of links to health-insurance plans. Entry of capitated health plans has introduced a dose of competition into the health-care sector, which in turn is adding to competitive pressures on hospitals and appears to have made them more commercial than heretofore. The changes that are occurring raise several important public-policy concerns. The social expectation is that even persons who are disadvantaged because of their health, low income, or other factors, such as race or ethnicity, have access to needed care of high quality. Some hospitals have engaged in teaching and research, supported in part by profits from patient service and explicit subsidies. By virtue of their ownership status, it is also expected that at least some nonprofit hospitals will engage in these noncommercial activities. Important for public-policy purposes is the question whether nonprofit hospitals are becoming less committed to such "noncommercial" activities and whether these activities cease almost entirely when nonprofits convert to for-profits. I wish to thank the participants in Northwestern University's colloquium on commercialism in nonprofit organizations for their initial feedback.

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Conversions of hospitals from nonprofit to for-profit status have attracted considerable attention of the media in the mid-1990s, as was discussed in Chapter 7. They seem to be important to the public even though conversions from either nonprofit or government to for-profit status constituted only about a quarter of the ownership changes occurring between 1990 and 1993 (Needleman, Chollet, and Lamphere 1997). To illustrate media interest: When Baptist Hospital in Nashville, Tennessee, was considering a switch from nonprofit to for-profit status in early 1996, the hospital claimed that it would no longer contribute about $30 million a year in free care and other community benefits if it relinquished its nonprofit status; it would, however, pay additional taxes. According to the hospital's administrator, "The question is, would this hospital function better if we didn't have this additional $15 million to $19 million burden?" (Bell 1996). Judging from the article's tone, readers were to answer "no." The potential benefit of the extra tax revenues to the various communities the hospital serves was not mentioned. To the extent that increasing commercialism in the hospital sector is judged to be undesirable, public-policy makers have a limited number of instruments for taking corrective action. States or communities can oppose nonprofit conversion. In most states, the attorney general's office can provide oversight of transactions involving transfer of a substantial share of assets from a nonprofit to a for-profit organization; actual authority of attorneys general varies widely among states (Butler 1997; Hollis 1997). Another instrument is certificate of need (CON); but since the mid-1980s, states have had the option of dropping CON, and some, especially those with relatively competitive health-care markets, have done so (Delaware Health Care Commission 1996). Moreover, CON only reviews entry, changes in facilities and services, and new investment that may accompany reorganization. Antitrust agencies may oppose mergers or acquisitions on grounds that they are anticompetitive, although failure to perform noncommercial activities is not a violation of antitrust law. Except for removing tax-exempt status or refusing to issue tax-exempt securities on its behalf, there is little government can explicitly do to change the behavior of a nonprofit (Morrisey, Wedig, and Hassan 1996). Removal of tax-exempt status is politically risky and hardly, if ever, occurs. This chapter addresses two fundamental issues. First, what are the forces that are pushing nonprofit hospitals into sameness with their for-profit competitors? Second, to the extent that nonprofit hospitals are eliminated and/or forced into sameness by market forces and public budget cuts, what will have been lost? Should public-policy measures be developed to slow or even reverse the trend in conversions to for-profit status that seems to be evolving? To add focus to the analysis, the chapter excludes consideration of teaching hospitals. These institutions are very complex, and the public-policy issues relating to medical education and unsponsored clinical research are particular to

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these organizations. A very small proportion of hospitals engage in much educational research. Also, this chapter excludes consideration of some activities that, if performed, may create positive externalities, such as contracting with essential community providers and reporting bad clinical practices to appropriate authorities (Gray 1997), or health promotion and screening initiatives (Young, Desai, and Lukas 1997). Such benefits are excluded from this study not to downplay their potential importance, but rather because there is no empirical evidence that nonprofits perform differently in these cases. The next section presents reasons various authors have suggested for the dominance of the nonprofit form in the hospital sector in this century. The following one further describes changes that have occurred in U.S. health care during the past decade and their impact on the hospital industry. The ensuing sections discuss (respectively) the new empirical evidence on profitability, pricing and cost shifting, uncompensated care, quality and innovation, capital funds, and investment. These sections emphasize recent work; descriptions of earlier empirical research can be found elsewhere (see, e.g., Institute of Medicine 1986; Sloan 1988). A final section offers discussion, conclusions, and implications for public policy. Explanations of why the nonprofit hospital is dominant Several explanations have been offered for the dominance of the nonprofit form in the U.S. hospital sector. Kenneth Arrow (1963) explained this dominance as a response to uncertainty and incomplete markets for risk in markets for medical care. Nonprofits, because they presumably are not merely profit seekers, would not fully exploit their market power. Thus, price would be lower and output higher than in the for-profit case. Quality of care might also be higher. Further, rather than being paid to shareholders, profits may be distributed in the form of "free" care, and cross-subsidize unprofitable care, unsponsored research, and medical education. The nonprofit form is more consistent with the fiduciary relationship between patients and providers, an extension of Arrow's argument, and between donors and recipients of donations. Implicit subsidies in the form of internal transfers of funds are more likely to occur in nonprofit organizations. (Although explicit subsidies may be preferred, society cannot be trusted to provide a socially optimal level of such subsidies; hence, it is better to hide them.) Even though the notion of local control is conceptually distinct from ownership form, in practice they are often related since the choice may be between a for-profit hospital company operated from a distant site and a freestanding local nonprofit hospital. Other explanations are less charitable to nonprofits. The nonprofit form facilitates cartelization by physicians in the community (Pauly and Redisch 1973). Physicians may find it easier to divide profits of a nonprofit than a for-profit

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corporation: In the latter case, physicians have to share profits with equity holders, and some profits are distributed to the community as tax payments (Clark 1980). A possibility suggested by Hansmann (1996) is that the nonprofit form has become increasingly anachronistic and is protected by entry regulation strongly biased against for-profits. Nonprofit hospitals have consistently earned profits (see issues of the American Hospital Association's Hospital Statistics); their "nonprofit" status refers to the way that hospital profits are used, not to the absence thereof. According to Hansmann's (1980) classification, nonprofit hospitals are "entrepreneurial nonprofits." One justification for the high degree of similarity between for-profit and nonprofit hospitals has been that competitive pressures from for-profits have forced the nonprofits to act as profit seekers. Without the pressure from profit-seeking competitors, it has been argued that nonprofits would have acted in a more socially responsible manner. Major changes in the U.S. health system since the mid-1980s Two major changes in the U.S. health delivery system since about the mid1980s have had and are having major impacts on the hospital sector, irrespective of ownership form: implementation of Medicare's Prospective Payment System and the growth of competitive medical plans. Implementation of Medicare Prospective Payment System Before the 1980s, hospitals were paid on a retrospective cost or charge basis. Under retrospective cost, the share of hospital cost attributable to services provided to insured patients was recovered after services were delivered. Hospitals with higher cost were paid more (see, e.g., Sloan and Steinwald 1980). An explicit payment to profit was sometimes made as a surcharge over cost. Under retrospective charge reimbursement, hospitals were reimbursed a percentage of billed charges; the remainder of the charge was collectable from patients. Generally, a hospital had both cost- and charge-paying patients. Depending on how the programs were structured, hospitals had little incentive to be efficient. Various prospective payment schemes were designed to encourage efficiency by fixing the payment per unit of output however defined, in advance of provision. The Medicare Prospective Payment System (PPS), first implemented in 1983, affected more hospitals than any of the prospective payment programs operated by individual states. PPS set the payment as a fixed price per discharge, with price varying by Diagnosis Related Group (DRG). (Outpatient cost continues to be reimbursed by Medicare on a retrospective basis.) In recent years, Medicare has accounted for around one-third of hospital revenue; yet this share of revenue sufficed to produce dramatic effects on treatment patterns of patients

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more generally and on overall hospital operations (see, e.g., Antel, Ohsfeldt, and Becker 1995). Conceptually, a program like PPS should have the following impacts: 1

Under retrospective cost reimbursement, a dollar saved by the hospital meant a fraction of a dollar lost in revenue, where the fraction depended on the share of the hospital's patients with such insurance. By contrast, under PPS, a dollar saved by the hospital results in a fraction of a dollar extra profit; thus, hospitals have a greater incentive to be efficient. Prior to PPS, profits could be earned by manipulating hospital accounts (Danzon 1982) rather than by gaining efficiency. 2 Absent competition from other hospitals, PPS may give an incentive to cut quality. Still, with nonprice competition on various dimensions of quality, quality may rise until profits are eliminated (Pope 1989). In fact, quality of care appears to have risen after PPS was implemented (Keeler et al. 1992). If quality competition is market driven rather than determined by professional norms, there is no reason to expect differential behavior by for-profits and nonprofits. 3 It might appear that profits would rise under PPS, but this depends on the extent to which nonprice competition erodes quality and how well Medicare price updates keep up with increases in factor prices paid by hospitals. 4 As demand for inpatient care is reduced, hospitals may expand outputs for which reimbursement is unchanged, such as ambulatory care, nursing-home care, home health, and hospice care. Various hospital services besides acute hospital inpatient care did indeed expand rapidly as the inpatient sector shrunk (Delaware Health Care Commission 1996), but this incentive was faced by hospitals of all ownership types. Growth of competitive medical plans The second important trend is the growth of competitive medical plans (CMPs). These include health maintenance organizations (HMOs) and preferred provider organizations (PPOs). Growth of CMPs has two important impacts on hospitals in general, plus a third development that is particularly important for nonprofit hospitals: 1

Demand for inpatient care declines dramatically, reinforcing the downward pressure on demand from PPS. In relatively mature CMP markets, rates of hospitalization are far below those where indemnity insurance prevails (see, e.g., Sokolov 1995) and have fallen more in markets dominated by CMPs, such as in California (Robinson 1996). This has resulted in excess hospital capacity as well as hospital mergers and closures. Interestingly, between 1983 and 1993, the for-profit

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sector in California shrank at a faster rate than did the nonprofit sector. At the same time, there were some conversions of nonprofit hospitals to membership in for-profit hospital systems. 2 The growth of HMOs in particular has increased vertical integration of inpatient care with other sites of care (see, e.g., Shortell et al. 1996). Beginning with California's selective contracting law (Zwanziger and Melnick 1988), which is now commonplace among states, insurers could direct patients to hospitals with which they had contractual relationships. Typically, hospitals are not owned by HMOs, but rather are paid a per-diem rate, fee-for-service, often at a discount, or a payment per case (ProPAC 1995, 79; Robinson 1995). Although quality may be a factor in HMOs' choices, price unquestionably is a factor. Thus, competition among hospitals has been transformed from exclusively nonprice competition (Robinson and Luft 1987) to competition on price and quality. 3 Enrollments in for-profit HMOs have far surpassed those in nonprofit HMOs in the 1990s (VHA and Deloitte & Touche 1996,14). Recently, several Blue Cross and Blue Shield plans, which traditionally were all nonprofits, have converted to for-profit organizations. (For an analysis of the public-policy implications of such conversions, see Chapter 7.) The main justification offered by insurers in public testimony before regulatory agencies is the need to raise equity capital. Since the hospital sector is shrinking, hospitals do not face this same motive to convert to for-profit status, although by consolidating, hospitals do realize internal efficiencies (Lynk 1995) and may be able to borrow funds at more favorable rates (Grossman et al. 1993). It would seem plausible that a for-profit HMO would expect the organizations from which it purchases care to behave like a for-profit too. Exogenous changes and the future shape of the nonprofithospital sector Economic research on hospital behavior can shed some light on how nonprofit hospitals have and are likely to respond to important changes in health-care purchasing practices. Also, such research can reveal whether the nonprofit hospital, as it currently operates, is worth preserving as an organizational form. This literature review emphasizes research published during the past decade. Hospital profitability Overall, profitability of hospitals, irrespective of ownership, as measured by total margin (total revenue minus total expense as a percentage of total revenue),

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1984

1990

1986

Figure 8.1. Trends in hospital total margins: NFP: not-for-profit; FP, for-profit; ALL includes public hospitals. (Source: Prospective Payment Assessment Commission 1995,56)

Table 8.1. Distribution of total margins by hospital ownership, 1993 Hospital group Nonprofits For-profits All

Percentile 25th

Median

75th

Percent with neg. margin

0.3 (1.2) 0.1

3.6 4.9 3.7

6.8 10.6 7.4

22.2 29.0 23.8

declined from levels attained immediately after implementation of PPS but has remained fairly constant since then (Figure 8.1). Nonprofit hospitals had positive total margins in all years, and in some had higher margins than for-profit hospitals. By the early 1990s, for-profit margins had climbed above nonprofit margins, and the differential appeared to be widening; even at its greatest extent, however, it was slightly more than two percentage points. Although for-profit mean and median profitability was higher than for nonprofits, there was more variation in hospital profits for for-profits than for nonprofits in 1993 (Table 8.1). In that year, 29 percent of for-profit hospitals had negative total margins versus 22 percent for nonprofits. This descriptive evidence is consistent with Hoerger's (1991) analysis. He conducted two tests of the hypothesis that nonprofit hospitals behave differently from for-profit hospitals. First, a profit-variability test determined whether

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profits of nonprofits exhibited less intertemporal variation than did profits of forprofit hospitals, as he expected. This would occur if nonprofits maximize utility subject to a profit constraint, as in Newhouse's (1970) model, or maximize income per physician on the medical staff, subject to a zero-profit constraint for the hospital, as in Pauly and Redisch's (1973) model. Second, he examined whether nonprofit profits are, as he supposed, less responsive to changes in such exogenous factors as Medicare payment levels. Both his hypotheses were supported by his empirical analysis. From this evidence, it appears that, for those institutions that survive, nonprofit hospitals will on average do what it takes to earn a nonnegative total margin, although for-profit hospitals do not like negative margins either. In the process of maximizing profits, for-profits may undertake riskier activities. One logical way to maintain profitability is to shift service mix away from unprofitable and toward profitable services. Unfortunately, direct national empirical evidence on changes in service mix by ownership form is not available. Even if it were, one would additionally need to know the relative profitability of specific hospital services. Some empirical studies have investigated diffusion of technology in hospitals; unfortunately, well-controlled empirical evidence is mostly available only for the pre-PPS period. A large variety of innovations have been examined, including process and (more often) product innovations (Romeo, Wagner, and Lee 1984; Sloan, Valvona, and Perrin 1986; Sloan, Whetten-Goldstein, and Wilson 1997). With rare exceptions, there were no statistically significant differences in adoption rates between nonprofit and for-profit hospitals. Both nonprofit and other hospitals face pressure to shift to more profitable services. Waters (1992) assessed profitability of cardiac catheterizations and coronarybypass surgery units in Florida during the 1980s. Particularly noteworthy were the procedures' contribution margins - additional to total hospital profits attributable to the service - which indicate that a few procedures may account for much of a hospital's total profitability. The best data on profitability were for cardiac catheterization units; these came both from Florida's Health Care Cost Containment Board (HCCCB) and from certificate-of-need (CON) applications filed by individual Florida hospitals. The mean contribution per patient to total hospital profit was over $1,200 (1990$). In 1989, the profit projected for the second year of operation in CON applications filed by hospitals was $420,000 (1990$). Not surprisingly, 104 CON applications were submitted by hospitals during the 1980s requesting permission to open cardiac catheterization units. Despite the efforts to constrain the growth of capacity, the number of cardiac catheterizations performed in Florida increased fivefold during the 1980s. Unfortunately, HCCCB did not collect comparable data on service-specific revenue and cost for the coronary-bypass surgery units. However, judging from CON applications, the margin was over three times that for catheterizations.

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This case study illustrates the resourcefulness of hospitals. There are other examples: For instance, because PPS did not cover mental health and rehabilitation, both nonprofit and for-profit hospitals made great efforts to expand into these areas. Those hospitals that will survive hospital downsizing may be expected to develop new, more profitable product lines as the need arises. Hospital pricing patterns: Cost shifting in the face of demand shifts? Various health-care experts have argued that when public agencies reduce the amounts they pay for inpatient care, hospitals respond by raising prices to privately insured patients. This behavior is called cost shifting (see, e.g., Morrisey 1994 for further discussion), although charge shifting may more accurately describe this behavior (Phelps 1986). Prerequisites for cost shifting are (1) sufficient market power (i.e., hospital ability to set price) and (2) unexploited market power - that is, the hospital cannot be profit maximizing before the price decrease by the public payer. Since for-profit hospitals plausibly are profit maximizers, there is a strong conceptual argument that they do not shift cost. Cost shifting and other forms of non-profit-maximizing behavior of nonprofits can be analyzed within the following framework. Analysts have often specified a utility function for the nonprofit hospital with profit and something else (X) as arguments (Pauly 1987). Profits earned by the nonprofit can be spent in pursuit of objectives of the hospital's management. The X may be quantity or quality of service, or uncompensated care. Because the nonprofit hospital likes X, it does not operate at the profit-maximizing level. However, if it suffers a decrease in product demand or an increase in factor prices, it may move toward the profit-maximizing price by reducing levels of X. To the extent that such cost shifting occurs in response to various pressures, one could say that these hospitals are becoming more commercial. Cost shifting is often confused with two-part price discrimination. Under price discrimination, a decrease in the price paid by a public payer would reduce the price charged in the market where the hospital sets price. Under cost shifting, by contrast, such a decrease would raise the private price. As noted above, to shift cost, the hospital must have market power that was unexploited prior to the negative shock. Under price discrimination, it is only necessary to have market power. Whether or not hospitals shift cost cannot be deduced, but rather must be decided by the empirical evidence. To the extent that CMPs reduce hospitals' market power, one would expect cost shifting to be declining, if in fact it ever existed. To noneconomist experts on health, however, the issue of nonprofit (and perhaps even for-profit) cost shifting is beyond question: They have no doubt that it occurs.

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Table 8.2. Hospital payment-cost ratios for Medicare, Medicaid, and private payers, 1980-93 Year

Medicare

Medicaid

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

0.96 0.97 0.96 0.97 0.98 1.01 1.01 0.98 0.94 0.91 0.89 0.88 0.89 0.89

0.91 0.93 0.91 0.92 0.88 0.90 0.88 0.83 0.80 0.76 0.80 0.82 0.91 0.93

Private 1.12 1.12 1.14 1.16 1.16 1.16 1.16 1.20 1.22 1.22 1.27 1.30 1.30 1.29

Viewing the time series of payment-cost ratios (Table 8.2), it would appear at first glance that hospitals do in fact shift cost. Through the 1980s there was a secular decline in the amounts paid by Medicare and Medicaid relative to cost, and a simultaneous secular increase in the ratio of payment from private sources to cost. Such evidence, however, is not conclusive. First, the information is for all hospitals, and there is no reason to believe that a for-profit hospital would engage in cost shifting. Second, and potentially more important, changes in revenue relative to cost may arise because of shifts to more profitable products rather than from price increases. Third, in the early 1990s, the payment-cost ratio for Medicaid patients rose appreciably, whereas the ratio for the private payers fell very slightly. Some of the more rigorous empirical studies of cost shifting have found empirical evidence that hospitals do shift cost (see, e.g., Dranove 1988); yet Morrisey's (1994) very comprehensive review of the empirical literature concluded that the evidence overall suggests very little cost shifting occurs. In a sense, this controversy is more of historical than of current interest. Even if hospitals could have cost-shifted at one time, there must be a limit to their unexploited market power. Also, with CMP growth and increased hospital dependence on public payers, it is likely that they will also no longer have sufficient market power - and both are needed for cost shifting to occur.

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Uncompensated care One public-policy concern is that an increase in commercial practices of nonprofit hospitals will place the poor and the uninsured at an even greater disadvantage than previously (Mann et al. 1995; see also Chapter 4). However, differences between for-profits and nonprofits in provision of uncompensated care and in provision of care to publically sponsored patients were very small, even before implementation of PPS and the growth of managed care. Sloan et al. (1986), using national data on hospitals for 1978-83, assessed amounts of charity care and bad-debt care provided by community hospitals of various ownership types. Charity care was defined as care rendered to patients whom the hospital adjudged unable to pay; bad-debt care was the value of care delivered to patients adjudged by the hospital as able to pay but who did not do so. For hospitals located in urban areas in 1982, Sloan and coauthors computed bad-debt care plus charity care as a percentage of hospital charges as follows: 3.7 percent for nonprofits; 3.0 for for-profits; and 8.6 for public hospitals. For rural hospitals, the corresponding numbers were 4.0,4.2, and 5.3 percent, respectively. Uncompensated-care data for 1994 showed nonprofits at 4.5 percent of revenues and for-profits at 4.0 percent (ProPAC 1996,84). Morrisey et al. (1996) compared uncompensated care provided by nonprofit hospitals in California in 1988 and 1991 to the tax subsidies such hospitals received. For all but 20 percent of the hospitals, uncompensated care exceeded the tax subsidies. Earlier research had also found the shares of revenue from Medicare and Medicaid to be similar between nonprofit and for-profit ownership types (Pattison and Katz 1983; Sloan and Vraciu 1983; Becker and Sloan 1985). Several more recent non-peer-reviewed studies have concluded that for-profit hospitals provide less uncompensated care, but at least some of these studies were conducted to support public advocacy positions of nonprofits (see Kuttner 1996a). Using a national sample for 1981, Norton and Staiger (1994) found that when for-profit and nonprofit hospitals are located in the same area, they serve an equivalent number of uninsured persons. However, for-profit hospitals indirectly avoid provision of care to the uninsured by locating more frequently where better-insured persons live. Young and coauthors (1997) examined changes in uncompensated care, as a percentage of hospital gross patient revenue (billed charges), for seventeen California hospitals that converted from nonprofit to for-profit status. They found that acquisition of nonprofit hospitals by for-profits did not lead uniformly to less uncompensated care among acquired hospitals. They concluded that their results are consistent with the prior research by Norton and Staiger indicating for-profit hospitals provide no less uncompensated care than do nonprofits, given their locational choices.

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Frank and Salkever (1991) modeled provision of uncompensated care by nonprofit hospitals. They considered two alternative models of nonprofit hospital behavior. In one, the "pure altruism" model, hospitals have profit and unmet need in the community as arguments in the utility function. In this model, increases in the supply of uncompensated care by other hospitals in the community "crowd out" provision of such care by the hospital in question (unless the income or endowment effect is very strong). In their alternative formulation, the "impure altruism" model, the nonprofit hospital competes for public goodwill by providing free care. Here crowding out is less likely because hospitals compete for patients who do not pay. Using data from Maryland nonprofit hospitals for 1980^, the authors obtained mixed results for both the pure and impure altruism models. In a market dominated by CMPs, it would seem unlikely that they, the new customers, would be particularly impressed by a hospital providing a lot of uncompensated care. Thorpe and Phelps (1991) evaluated the effect of change in New York State's hospital rate-setting program on provision of uncompensated care. As in other studies, they found evidence of crowding out. In particular, nonprofit hospitals provided less uncompensated care when public hospitals were present in their markets. New York and Maryland are at one end of the regulatory spectrum: New York was the first state to implement all-payer rate setting of hospitals, and Maryland was the only state to retain it. At the other extreme is California, where price competition among hospitals began. With data from that state, Gruber (1994) tested the hypothesis that increased competition among hospitals reduced hospital prices and profits, which in turn led to decreased provision of uncompensated care. He argued that the potential for shopping by PPOs and HMOs was likely to be greatest in those market areas that had ready substitutes available for a given hospital. Availability of substitutes was measured alternatively by a Herfindahl index of patient concentration and a distance-based measure. His empirical analysis of the 1984-8 period revealed a large decrease in prices and profits in the California markets with the least concentration of outputs, and a relative drop in provision of uncompensated care in these same markets. The result on concentration is consistent with Thorpe and Phelps's (1991) finding. In sum, the issue is not so much that nonprofits have played or play a special role in the provision of care to disadvantaged populations. Their past role can be debated, even with reference to the same empirical evidence. Rather the focus of policy should be oriented toward the future. Changes in hospital payment, increased competition, and cuts in the growth of public budgets will reduce provision of such care by all types of hospitals at the same time that the number of uninsured persons in the United States is rising.

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Quality of care Another variable is quality of care. It has been hypothesized that nonprofit hospitals provide higher-quality care than is demanded, and hence higher than forprofit hospitals are likely to provide (see, e.g., Newhouse 1970). The most rigorous large-scale empirical study of quality that permits comparisons between quality offered by nonprofit and for-profit hospitals is by Keeler and coauthors (1992), who assessed quality based on information from hospital charts. The sample included fourteen thousand Medicare beneficiaries hospitalized with one of five diseases in five states. Keeler and his colleagues found no difference in quality between nonprofit and for-profit hospitals on two quality indicators; public hospitals fared worse on both criteria. On a third measure, however, there was a statistically significant difference between the quality of care of nonprofit hospitals and that of forprofit and public hospitals, in favor of nonprofits. These authors appear to have been more persuaded by the results on the first two indicators, concluding that "nonprofit and for-profit hospitals provide similar quality overall" (p. 1712). They added that "[t]he slightly better quality of for-profit nonteaching hospitals makes up for the much higher percent of (high-quality) nonprofit hospitals" (p. 1714). Previous work by Hartz et al. (1989) had found that mortality was higher in for-profit than nonprofit hospitals, but they had used fewer covariates for their mortality adjustment. In their national study of 981 hospitals in 1983^, Shortell and Hughes (1988) found no difference in quality of care by ownership. On structural measures of quality, such as percentage of hospitals with Joint Commission of Hospital accreditation, or with cardiac care and intensive care, the two organizational forms are quite similar (Herzlinger and Krasker 1987). Capital funds One of the distinguishing features of nonprofit hospitals is that they are precluded from obtaining capital funds from the sale of equity. All their equity is generated either externally in the form of philanthropic contributions or internally in the form of retained earnings. Like for-profits, nonprofits have access to debt capital. Both also have some access to tax-exempt industrial revenue bonds, but only nonprofits can borrow in other tax-exempt bond markets. Historically, Blue Cross (in some areas) and Medicare paid nonprofit and forprofit hospitals differently, paying for-profits an explicit return on equity. Medicare no longer makes this distinction, and it is unlikely that many Blue Cross plans do so either. All cost payers cover payment for interest and depreciation expense.

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Wedig and coauthors (1988) found that, given this payback guarantee, hospitals highly dependent on revenue from cost-based payers took on more debt; hospitals could recover interest cost from such payers. In the same study, the effect of the share of revenue the hospital derived from cost-based sources was greater for for-profit than for nonprofit hospitals. Other than the effect operating through the cost-based payer share, there were no differences in hospital capital structure according to hospital ownership. Perhaps, as my discussions with persons in the hospital industry suggest was so at the time, for-profit hospitals were more adept at maximizing reimbursement. The system rewarded the maximization of reimbursement rather than the minimization of cost. Wedig, Hassan, and Sloan (1989), assessing the effects of variations in costrecovery policies of insurers on hospital location, found that for-profit hospital market shares were higher in states where payment policies were more generous. The converse was true for nonprofit hospitals: The nonprofits satisfied patient demand by being in areas where the for-profits were not willing to serve. In principle, access to voluntary contributions should be a competitive advantage for nonprofit hospitals. In practice, such donations are an unimportant source of funds for hospitals as a percentage of revenue. For example, in 1984, only 5 percent of total spending on hospital construction was funded by philanthropy (Levit et al. 1985). Dependence on philanthropic funds has diminished over time. Sloan and coauthors (1990) studied the decline in hospital philanthropy both theoretically and empirically. In their time series, real donations for medical-facility construction rose from $115 million in 1935 to a peak of $3.2 billion in 1965, then dropped to $1.0 billion in 1981 (1996$). One plausible reason for the decline is the growth of health-insurance coverage. However, as they showed, the direction of effect of increased coverage on donations cannot be determined theoretically. On the one hand, increased coverage crowds out donations by providing an alternative source of revenue. On the other hand, insurance also raises patient willingness to pay for hospital output, which the donor plausibly likes; thus, increased coverage allows a dollar's worth of donations to buy more output. The patient, in effect, matches part of the donor's gift. Lump-sum subsidies should reduce donations, but matching grants may increase them. (See Chapter 3 for further discussion of the varied potential effects of increased revenue from program services on revenue from donations.) Using both time series and cross-section analysis, the authors found strong evidence that increased insurance coverage crowds out private giving to hospitals. Although there has been some erosion in insurance coverage in recent years, this is slight when viewed over the entire century. Having access to philanthropy was a far greater competitive advantage for nonprofit hospitals in 1925, when there was essentially no health insurance, than in 1985, when the vast majority of Americans had some coverage.

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Given that the only source of private external equity to nonprofits is philanthropy, it is difficult to know what their cost of capital is. Several authors have argued that the cost of nonprofit equity equals the return on equally risky taxfree securities (Conrad 1984, 1986; Silvers and Kauer 1986; Herzlinger and Krasker 1987); but determining "equally risky" is not an easy task. One solution used by Sloan et al. (1988) was to take the /3, a measure of riskiness, for public for-profit companies; compute the unlevered (without debt) /3; compute a levered /3 for nonprofit hospitals with the debt-equity ratio for nonprofits; and then adjust for the fact that nonprofits do not pay the corporate income tax. In this manner they found the cost of equity capital to be from 2.5 to 1.1 percentage points lower for nonprofit than for for-profit hospitals. The weighted cost of capital (cost of debt and external equity capital) was from 1.0 to 0.5 percentage points lower for the nonprofits - not a very large competitive advantage. During the period analyzed, the weighted cost of capital for for-profit companies was in the 6-9 percent range (nominal estimates). Using a sample of California nonprofit hospitals, Morrisey and coauthors (1996) calculated that, on average, interest-rate subsidies for nonprofit hospitals in that state amounted to $437,000 per hospital in 1991, which was about one-quarter of the total tax subsidy such hospitals obtained. Corporate income tax and property income tax subsidies accounted for the rest. Lower cost of capital does not give nonprofits much of a competitive advantage that they might in turn use for the community's benefit. Investment Behavioral differences between nonprofit and for-profit hospitals should plausibly be reflected in investment behavior: 1 Their objectives may differ. To the extent that the "bosses" of nonprofit hospitals value such objectives as quality beyond that valued by the market (Newhouse 1970) or engage in conspicuous consumption of hospital inputs (Lee 1971), this should cause such hospitals to purchase more plant and equipment. 2 The constraints surely differ. Differences in tax and insurer policies have already been noted; but perhaps particularly important is the forprofits' access to equity markets, which contrasts with the very limited "market" for philanthropic funds open to nonprofits. 3 As Hoerger (1995) argued, lenders, because of information asymmetries, may be especially reluctant to lend funds to nonprofits. (This is the most speculative difference of the three.) Hoerger (1995) studied individual hospital investment decisions during the 1980s in California, Florida, and Tennessee. His most noteworthy finding on

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ownership was that cash flow, the sum of the hospital's accounting profits and accumulated depreciation, had a much greater positive effect on investment for nonprofit than for for-profit hospitals. This result is plausible because nonprofit hospitals cannot issue stock. Discussion, conclusions, and implications for public policy Not-for-profit hospitals have been transformed from the almshouses of the nineteenth century to some of the larger locally run enterprises in the communities they serve. In large part, the rapid growth of nonprofit hospitals in particular and acute-care hospitals in general reflects the massive infusion of funds from both private and public health insurance that occurred after World War II. Already by the 1970s, nonprofit and for-profit hospitals were much more alike than different. The nonprofit hospital of the 1990s fits Henry Hansmann's (1980) definition of the entrepreneurial nonprofit better than ever before. Hospitals of nonprofit and for-profit ownership are similar in provision of uncompensated care, in quality of care, and in adoption of technology. There is a greater difference in provision of uncompensated care by public hospitals on the one hand and either type of private hospital on the other. Conversions of nonprofits to for-profit hospitals do not appear to reduce provision of uncompensated care. These generalizations reflect averages. As the comparisons between uncompensated care and tax subsidies revealed, not all nonprofit hospitals pay their way. Those that do not, merit attention by policymakers; yet such hospitals may provide community benefits other than uncompensated care. Also, hospital conversions from nonprofit to for-profit status may often be in the public interest, or at least neutral; but sometimes, the main motive may be personal enrichment without demonstrable community benefit. The public sector has an appropriate role in scrutinizing such changes. Relatively few hospitals have made major commitments to medical education and biomedical research. This review has deliberately excluded such hospitals, although they are reflected in summary statistics for nonprofit hospitals. Society will need to decide among alternative mechanisms for funding such education and research. Keeping nonprofit hospitals afloat as a general strategy for supporting these worthy objectives would be a very inefficient way to accomplish this important social objective. More recently, during the 1990s, a major shift is occurring from a model of care focused on inpatient treatment of illness episodes to one that emphasizes primary care, prevention, and integration of a range of services. The hospital will no longer be the traditional hub of the health-care system (Shortell, Gillies, and Devers 1995). The concept of community is expanding to include care of whole populations. Whether or not hospitals will be able to adapt is still an

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open question, as is whether for-profits and nonprofits will differ in their survival abilities. To the economist, the fact that hospitals are organized in alternative ways provides a laboratory for studying effects of ownership type and organizational incentives on behavior. Interestingly, the major behavioral differences relate to hospital financial and location decisions. For-profit hospitals have been more careful to locate in market areas where families have the ability to pay for hospital care, and they have avoided states in which reimbursement has been low. Nonprofit hospital investment decisions are more influenced by availability of internal funds. In the future, hospital-location decisions will reflect the business strategies of integrated networks. To the extent that such networks find it profitable to serve locations that have been previously underserved, such as inner cities of major metropolitan areas, they will see to it that there is adequate supply of services. These networks will have no interest in serving individuals who have no health-insurance coverage. The public seems to have little concern about who owns their hospitals. The Kaiser Family Foundation (1995) conducted a survey of American's perceptions about for-profit and not-for-profit health care in 1995. Particularly relevant to the discussion here are responses to the survey's questions. Asked to compare nonprofit with for-profit hospitals on a number of criteria, respondents preferred nonprofits in two respects: "more helpful to the community," 65 to 31 percent; and "cost you less," 73 to 22 percent. However, for-profits were preferred in three other ways: "are more responsive to customers," 54 to 42 percent; "provide better quality care," 57 to 34 percent; and "are more efficient," 59 to 35 percent. Given the empirical evidence that shows very little difference, the citizens' perceptions about quality, cost, and efficiency seem wrong or at least exaggerated. The difference in helpfulness to the community may be real. In fact, when asked, "Which do you think is better for your community - a hospital run and owned by a local for-profit organization or a hospital run and owned by a for-profit national chain?" 70 percent said that the former would be more responsive. This seems to be a matter of local control rather than forprofitness. When asked, "Please tell me which type of health care organization you would trust to provide you with high quality health care at a reasonable price - would it be a for-profit insurance plan, HMO, or hospital, or a nonprofit health insurance plan, HMO, or hospital, or do you think there is not much difference?" almost half the respondents said "not much difference"; the rest were split evenly between the two ownership types. If local control is a primary benefit of the nonprofit hospital, the next questions is, What is the nature of this good, and who within the community benefits? Two likely stakeholders are hospital employees and physicians on the medical staffs of these hospitals. Benefits of local control to consumers of hospital

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care are less apparent, unless one counts the mere presence of a hospital as a consumer benefit. The issue of control appears to be at the heart of opposition by regulatory, physician, or community groups to conversion of nonprofit and public hospitals to for-profit chain status (see Chapter 7 and Kuttner 1996a,b). Many of the concerns are legitimate, such as who controls the foundations established at the time of the sale and whether hospital trustees or executives receive excessive inducements to promote it. Another issue is how funds controlled by the new foundations will be allocated. There is no empirical evidence on this. The forprofit chains may argue that it is the foundations that were established to fund uncompensated care, and that therefore the chains themselves have no continuing obligation to fund such care out of operating funds as they have done previously. Will the nonprofit hospital wither? It is not clear what the future holds for the nonprofit hospital sector. According to one journalistic report, "we will see either a growing convergence in the behavior of nonprofits and for-profits or a sharper delineation between institutions with a community purpose and those driven by the bottom line" (Kuttner 1996b, 450). More likely, pressure to preserve the bottom line will be felt by almost all hospitals. If nonprofits are to distinguish themselves by their community focus, they will have to do two things: define what this focus means in operational terms and secure sources of funding other than patient dollars.

CHAPTER 9

Universities as creators and retailers of intellectual property: Life-sciences research and commercial development

Walter W. Powell and Jason Owen-Smith

Introduction Over the past decade there has been a remarkable shift in the division of labor among universities, industry, and the federal government. In our view, this transformation is most pronounced in the life sciences and the commercial fields of medicine, Pharmaceuticals, and biotechnology. The post-cold war focus of federal science and technology policy on "competitiveness" has been noted by many observers, and the intensified interest in basic research and collaborative product development by large private corporations in various high-technology fields has been widely studied. However, the accompanying change in the mandate of research universities toward a greater focus on commercializing research findings is much less understood. Our goal in this chapter is to enhance the understanding of the ways in which the relationship between universities and the private economy has changed, particularly in the life sciences. We highlight the primary forces that have blurred the traditionally distinct roles of the academy and industry, illustrating these trends with data from the life sciences. We review several explanations for this transformation, and conclude with a discussion of its consequences both for public policy and for the institutional role of universities as generators and disseminators of basic knowledge. Throughout much of the post-World War II era there was a relatively clear distinction between basic and applied research, with the former the domain of the university and the latter the turf of business. The federal government, outside of defense-related research, supported the creation of an infrastructure for basic research and, through the National Science Foundation (NSF) and the NaWe thank Avner Ben-Ner, Allen Buchanan, Christian Freuh, Laurel Smith-Doerr, and Sarah Soule for comments on an earlier draft. Powell acknowledges the research support of the Aspen Institute Nonprofit Sector Research Fund and NSF grant 9710729.

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tional Institutes of Health (NIH), funded individual scientists as well. University research was basic in the sense that it aimed to understand phenomena at a fundamental level. The NSF defines basic science as research whose objective is a fuller knowledge or understanding of the subject under study, rather than a practical application thereof; but this focus, as Rosenberg and Nelson (1994) suggest, has never meant that basic research was inattentive to the pull of important technological problems and policy objectives. Indeed, Geiger (1986) has shown that the "knowledge-plus" focus of U.S. universities has been a "quiet" reality for much of this century, and not just a post-WWII phenomenon. Moreover, Ben-David (1977) has observed that U.S. universities have long had a more practical orientation than universities in the United Kingdom or Germany. Still, universities focused more on the "R" side of the R&D (research and development) continuum, while much of industry eschewed basic research because the payoffs were either too long-run or difficult to appropriate. The great bulk of industrial R&D was focused on shorter-term problem solving.1 To be sure, basic research flourished in a handful of large corporations, such as AT&T, Kodak, Du Pont, and IBM, whose dominant market positions cushioned research budgets from market pressures. However, recent changes in government regulation and intensified competition have ended the era of great corporate labs, and the centralized corporate R&D lab may never actually have been as widely employed as typically assumed (Rosenbloom and Spencer 1996). Dasgupta and David (1987,1994) argue that the realms of science and technology are separated more by their social organization and reward structure than by the actual character of their work. Despite the similarities in the methods of their work, scientists and technologists enter their respective realms "precommitted" to different norms and rules of the game. For scientists, priority of discovery is the goal, and publication the means through which new knowledge is shared in a timely fashion (Merton 1957). The public nature of scientific knowledge encourages its use by others, and in so doing increases the reputation of the researcher (Merton 1988; Stephan 1996). In contrast, patents are the coin of the realm in the technologist's world. Rewards are pecuniary, and the incentive to divulge new information quickly is not as potent. Our argument is that the separation of the realms of science and technology no longer holds in the life sciences. The formerly independent, if fragile, system is today fully interdependent as universities have become much more oriented to the commercialization of research. Chapter 1 cautions that "[n]onprofit organizations confront a dilemma, as does public policy toward them: how to balance pursuit of their social missions with financial constraints when additional resources may be available from sources that might distort mission." With 1

For an excellent historical survey of the relationship between universities and industry, see Rosenberg and Nelson (1994).

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respect to research universities, we argue that income-generating activities that were formerly ancillary are taking on much greater salience. This shift is not, we argue, driven by an urgent need for new sources of financing but due to changing incentives that favor increased efforts at the commercialization of research. This remaking of the institutional division of labor between universities and the private economy is both recent and profound. We begin our survey of the broad contours of this changed landscape by focusing briefly on key policy changes at the federal level. We then turn to the corporate sector, noting the significant alterations in the structure of the firm, particularly with regards to how access to new knowledge is organized. The role of universities is considered next, and we document the increasing commercialization of research, especially in the life sciences, and the new status of knowledge as intellectual property. We think it is important, however, to recognize that the relationship between university research and commercial technology development varies considerably across academic fields and industries; our analysis of the life sciences is not necessarily generalizable to other areas. We thus heed Mowery and Rosenberg's (1993,53) caution that "no single model or description of the constraints, advantages, and disadvantages of such collaboration is likely to be accurate for all university-industry collaborations." A changed landscape Government policy With the ending of four decades of rivalry and conflict with the Soviet Union, the rationale for federal science and technology expenditures has been reoriented toward programs that enhance economic "competitiveness" (NAS 1992; Cohen and Noll 1994; Slaughter and Rhoades 1996). There is a growing federal view that research universities can and should play a larger and more direct role in assisting industry and promoting national competitiveness. Universities are being urged by the federal government to seek a more direct partnership with business in the development and commercialization of new technologies. The shift in federal policy - from basic research to increased concern over its application - is reflected in legislation, funding plans, and joint agreements. Most notable on the legislative front were the 1980 Patent and Trademark Amendments (Public Law 96-517), also known as the Bayh-Dole Act. This legislation allowed universities, nonprofit institutions, and small businesses to retain the property rights to inventions deriving from federally funded research. In the words of Congress, "it is the policy and objective of the Congress to promote collaboration between commercial concerns and nonprofit organizations, including universities." The 1984 Public Law 98-620 expanded the rights of

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universities more broadly by removing restrictions in Bayh-Dole and permitting universities to assign their property rights to others.2 The StevensonWydler Act of 1980 (PL 96-480) and its 1986 amendments; the Cooperative Research Act of 1986 (PL 98-462); the National Competitiveness Technology Transfer Act of 1989 (PL 101-189); and the Clinton administration's 1993 "defense conversion initiative," in which formerly off-limits defense-related research was opened to commercialization - these have all followed the path laid by Bayh-Dole to remake federal policy to enhance the commercialization of research at universities.3 These legislative changes sparked a considerable upsurge in licensing, as well as rapid growth in the number of university-industry research centers (UIRCs), cooperative research and development agreements (CRADAs), federally funded research and development centers (FFRDCs), and industry-university research consortia. Accompanying these initiatives has been a significant change in funding policies.4 At the NSF, numerous programs have been developed to promote university-industry collaboration, and funding in some engineering and science and technology fields requires that NSF-supported centers have an industrial component. Stigler (1993, 172) suggests that the NSF has found it "easier to explain large-scale projects and research centers to Congress than to argue convincingly for the diffuse benefits of a broad-based funding of individual projects.. . ." The impact of these UIRCs is considerable: Cohen, Florida, and Goe (1994) estimate that 19 percent of university research is now carried out in programs that involve close linkages with industry. Cohen and Noll (1994) argue that the competitiveness rationale for federal research support has two strong consequences: 1

2

3 4

There is greater privatization of both the selection (the review process) and the results (intellectual property rights) of research. The review process is increasingly "privatized" by eligibility criteria that require corporate participation, by assigning industry responsibility for the evaluation of technical merits, and by including the feasibility of commercialization and marketing plans as key points of evaluation.

Jonathan Cole, Provost of Columbia University, writing in a 1993 Daedalus issue on "The American Research University," terms Bayh-Dole "prescient" and notes that "annual revenues from patents and licenses (at Columbia) have risen from roughly $4 million to $24 million over the past five years . .. and over the next decade, we could see these figures grow to as much as $75 million a year" (Cole 1993, 31). In congressional hearings reviewing the consequences of the Bayh-Dole Act, university presidents and officials testified to the success of the legislation in promoting technology transfer and generating jobs, particularly in biotechnology (U.S. Congress, Senate, hearings before Subcommittee on Patents, Copyrights, and Trademarks, April 19,1994). Lee (1994) provides a detailed survey of legislation fostering technology transfer. For example, the federally funded national laboratories are now expected to generate more of their operating budgets through the sale of technology (Schriesheim 1990-1; Roessner and Wise 1994).

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There is now increased collaboration between U.S. firms and research organizations, and federal research funds now go to a wider array of research organizations than just research universities. Business strategy

The embrace of the competitiveness rationale at the federal level reflected a widespread perception among policymakers that U.S. corporations were faring less well in international competition. Although the United States was widely regarded as the world leader in scientific research, U.S. industry in the 1980s looked vulnerable indeed. Universities and industry were chided for their failure to transfer basic research into commercial development. Within the large corporation, there was growing recognition that firms had become much less self-sufficient in their ability to generate the science and technology necessary to fuel economic growth (Von Hippel 1988; Nelson 1990). As a result, there is now much greater reliance on external sources of R&D (Badaracco 1991; Hamel 1991; Hagedoorn 1993; Saxenian 1994). The causes of this transformation are myriad, involving an indissoluble combination of corporations' need to access sources of expertise located outside organizational boundaries, pressures to compete with global rivals that do little research internally but are quick to exploit the developments of others, and the tremendous scale of investment required to commercialize new technologies (see discussions in Powell 1990, 314-18; Powell, Koput, and Smith-Doerr 1996, 116-22). In many rapidly developing areas of technology, research breakthroughs are so broadly distributed across both disciplines and institutions that no single firm has all the necessary capabilities to keep pace (Powell 1996). Consequently, in such fields as advanced television systems, biotechnology, computers, optics, and semiconductors, firms are turning to cooperation with former competitors, as well as to partnerships with universities and government institutes. Rosenbloom and Spencer (1996, 70) capture these developments aptly: "What was once a race has become more like a rugby match." They anticipate a "diminishing role for corporate laboratories as the wellspring of innovation," and suggest that the "seeds of new technological advance will probably sprout more often in university or government laboratories" (pp. 70-1). The private firms that are best able to exploit such new developments are those with both the most extensive external connections and the strongest internal capabilities for evaluating the quality of research done elsewhere (Powell et al. 1996). Many observers have noted that this transformation of corporate research is most pronounced in the biopharmaceutical field, where there is a complex intermingling of government and university research, small-firm initiative, and large-firm development and marketing muscle. Federal research funding has supported much of the basic science underlying the new biotechnology, and top

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researchers in universities and in the intramural branches of the NIH have made the pioneering discoveries. Science-based small firms, either spun off from universities or with extensive academic linkages, have played a key role in new product development. Alliances among universities, small startups, and established pharmaceutical corporations have proven to be viable vehicles for the commercialization of new medical treatments. Universities Changes in both federal policy and corporate practice have consequently reshaped the external environment and incentive structure of research universities. No longer are universities just the providers for industry of basic research knowledge and a trained labor force, skilled in the newest technologies; they have become, in the words of NSF Division Director Daryl Chubin (1994,126), "creators and retailers of intellectual property." High-quality research, Chubin suggests, has multiple components: a basis for scientific knowledge, innovative technology available for transfer, and the expertise embodied in faculty and research staff. Etzkowitz and Webster (1995,480-1) observe that "science and property, formerly independent and even opposed concepts referring to distinctively different kinds of activities and social spheres, have been made contingent upon each other through the concept of intellectual property rights." This commercialization of knowledge makes universities key contributors to economic innovation, both as, in Chubin's (1994,126) language, "resource and catalyst." Not only is university research now evaluated more extensively for its commercial application, but universities themselves are increasingly viewed as "engines of economic development" (Feller 1990). The successes of universityindustry affiliations have played a key role in the development of such hightechnology-based industrial districts as Silicon Valley, Route 128, Austin, Texas, and the Research Triangle in North Carolina (Smilor, Kozmetsky, and Gibson 1988; Rosegrant and Lampe 1992). Numerous analysts have observed that innovation has become dependent on a region's technological infrastructure (Romer 1986; Krugman 1991; Jaffe,Trajtenberg, and Henderson 1993; Feldman 1994; Feldman and Florida 1994). Thus the success of a relatively small number of universities in contributing to local economic development has changed the expectations for nearly all universities. Now every governor wants the next Silicon Valley in his or her backyard. In turn, some universities have decided they can play a more aggressive financial role than just being an incubator of new knowledge: They seek to share in the income that may be generated by their new discoveries. Hence, we are witnessing the growth of universities as venture capitalists (Matkin 1990). The progression from incubator of ideas, to patent licensing and technology trans-

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fer, to science parks, and finally to equity ownership is based in part on the recognition that in fast-developing fields patents do not easily "capture" intellectual property (Merges and Nelson 1990). Negotiating for equity in start-up companies is often easier for universities to do than licensing their research findings; but the most compelling factor to universities is the prospect of large financial returns. The life sciences represent the cutting edge of these developments, in part because of the large number of start-up companies created with the assistance or direct involvement of academic researchers (Zucker, Darby, and Brewer 1994). The biotechnology industry is remarkably clustered in but a few areas San Diego, the Bay Area, Boston, Seattle, and to a lesser extent, Philadelphia and Houston - with close proximity to major universities, research-oriented hospitals, and cancer-treatment facilities.5 Physical, intellectual, and economic integration between firms and universities is so pronounced that they constitute a common technological community (Powell 1996). The life sciences represent the leading edge We stress that the nature of industry-university-government relationships are largely idiosyncratic to particular disciplines. Indeed, one reason that the life sciences are rather unusual is that biotechnology represents a novel case of an industry that was developed inside the university. The initial discoveries were made by university scientists, who then also played a leading role in the introduction and development of the new ideas. Biotechnology has thus largely collapsed the distinction between basic and applied science: Fundamental new discoveries, such as gene therapy or the identification of a fat gene, have immediate scientific and medical importance as well as enormous commercial relevance. Of course, while the life sciences may be the leading edge of commercial ventures, there are novel efforts underway in all branches of universities to exploit their "assets" in a manner to enhance revenue generation. Athletics are the most visible example, but selling seats at poetry readings and all manner of professional education, conferences, and outreach programs are other signs of greater attention to commercial activities. We document the blurring of the division of labor between universities and industry, marshaling a range of evidence to demonstrate the convergence of the public and private sectors. We first present summary data on university patenting and on royalties derived from university licensing. We then look at the in5

Although university faculty played a key role in biotechnology's emergence, the continuing involvement of academic researchers does not appear to be geographically localized. In research we are doing, we find that networks of collaboration are not locally based (Koput, Powell, and Smith-Doerr 1997), and Audretsch and Stepan (1996) report that biotech scientist-firm linkages are typically nonlocal.

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creased role of industry funding of university research in the health-sciences fields, illustrating this trend with a snapshot of the burgeoning field of genomics. Next we examine the notable changes in the labor market for biological scientists, and see how a common scientific community has evolved that spans universities and industry. Finally, we briefly look at two universities at the forefront of research and its commercialization in the life sciences: Stanford and Johns Hopkins. Patenting One way to examine university commercialization efforts is to analyze universities' propensity to patent. Table 9.1 illustrates the limited activity of universities in the period 1969-73, but shows that by 1989-94 university patenting had increased dramatically. Note that all three patent classes where university efforts were most significant are in the life sciences. Henderson, Jaffe, and Trajtenberg (1995) have noted that from 1965 to 1992, total U.S. patenting grew by less than 50 percent; our analysis of NSF data for the period 1969-94 shows an increase on the part of universities of over 1,100 percent. Moreover, a much greater number of universities is now involved: In 1965,96 patents were issued to 28 universities; in 1992 nearly 1,500 patents were granted to 150 universities (Henderson et al. 1995). In short, university patenting has grown rapidly while industry activity has increased modestly, and the life sciences have been at the forefront of university efforts. A 1992 General Accounting Office report (GAO 1992) suggests that these changes in patenting propensity reflect greater university focus on commercially relevant technologies and increased industry funding of university research. More specifically, the increased drive to patent is a direct response to the BayhDole legislation that facilitated university retention of property rights to federally funded research. A GAO survey of thirty-five universities found that technology developed in whole or in part with NSF and NIH funding accounted for 73 percent of the $113.1 million that the universities received in license income in 1989 and 1990. The typical licensees were small U.S. businesses in biotechnology or pharmaceutical corporations. Licensing and corporate support ofR&D University revenues derived from patenting and licensing have been growing annually, reaching nearly $255 million in 1994, and a sizable percentage of licensing revenues are derived from life-science applications. For example, MIT is very active in this area: A recent survey (Guterman 1996) of technology transfer there reports biotechnology constitutes roughly half of MIT's exclusive licenses - despite its not having a medical school. The commercial benefits of

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Table 9.1. Top patent classes for university patenting Class

Description

1969-73 73 128 435 424 204 514 56 423 324 310

Measuring and testing Surgery Chemistry: Molecular biology and microbiology Drug: Bio-affecting and body treating compositions Chemistry: Electrical and wave energy Drug: Bio-affecting and body treating compositions Harvesters Chemistry of inorganic compounds Electricity: Measuring and testing Electrical generators and motors

56 32 31 31 28 27 26 25 23 23

/989-94 435 514 424 128 250 530 324 204 364 73

Chemistry: Molecular biology and microbiology Drug: Bio-affecting and body treating compositions Drug: Bio-affecting and body treating compositions Surgery Radiant energy Chemistry: Peptides or proteins Electricity: Measuring and testing Chemistry: Electrical and wave energy Electrical computers and data processing systems Measuring and testing

863 789 518 306 241 229 192 188 178 171

No. of patents

Source: NSF National Science Board, Science and Engineering Indicators: 1996, pp. 252-3.

licensing are obvious - successful product development by a firm generates royalties to a university and to the inventor in question - but the rationales for licensing a discovery are diverse, and create very different challenges for universities. Consider the following three motivations, each of which characterizes an important aspect of university licensing of innovative research: 1

2

A diagnostic test - such as for Wilm's tumor, which affects only a few hundred young children - has limited commercial value; however, it can be licensed broadly to speed its clinical development while freeing the faculty member to continue basic research. In contrast, some licensing is exclusive and entrepreneurial: Productive faculty convert discoveries into the platform for companies that they spin off from their university research; the university then licenses those discoveries to the companies. Such an arrangement pre-

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vents the loss of valuable faculty to industry. Indeed, in our research on the biotechnology industry, we have encountered numerous examples of faculty at leading research universities who have developed two or more companies while maintaining their university positions. At the same time, this process does involve a partial "loss" of faculty, insofar as their energy and creativity is shifted to firm-related work. 3 Licensing allows discoveries to be utilized as magnets to draw sponsored research into the university. Clearly this has been a powerful trend in the life sciences, generating enhanced funding for faculty, providing employment opportunities for graduate students, and promoting a new dialogue between business and industry - feedback that might otherwise be absent from both basic science and corporate product development. The first example of broad licensing allows a professor to continue his or her research; the second - involving exclusive licensing - enables a professor, but not necessarily the university, to have the best of both worlds, so to speak; and the third attracts corporate funding to the university. The growing industry role in health-related research is illustrated in Figure 9.1. Note that since 1980 both industry and federal support for health research has grown rapidly; around 1988, however, industry spending surpassed the contribution of government. To be sure, the great bulk of medical industry R&D is still done "in-house," but in the context of declining corporate-research spending across U.S. industries, the biopharmaceutical sector is a striking counterpoint. Figures for 1995 suggest federal funding for medicine and health on the order of $13 billion, and an industry contribution of $15 billion (NIH Economics Roundtable, Executive Summary, Jan. 1996). Looking from the viewpoint of a single university, we can see just how significant corporate support from the biopharmaceutical sector is. At the University of Arizona in 1995, the top fifty corporate sponsors of research and development gave $25 million to the university. Nearly a third of these sponsors are biotech or pharmaceutical companies (University of Arizona 1996). In addition, a ranking of all U.S. firms in terms of R&D expenditures as a percentage of sales shows that eight of the top ten spenders on R&D are biopharmaceutical firms, with two biotech companies - Genentech and Amgen - at the very top (NSF 1996, 121). Genomics is the broad label for one of the hottest fields in the life sciences. The race to map the sequence of the human genome has triggered a parallel race to determine gene function. The emerging area of functional genetics includes efforts to pinpoint genes for specific diseases, to correct genetic defects via gene therapy, and to discover tools (ranging from combinatorial chemistry to bioinformatics) to manage the flood of genetic information. Industry-university collaborations in this area are both commonplace and so complex that a week-

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-#- Federal Government ^r Other Government Industry •©. Private

CQ

1970

1980

1990

Year Figure 9.1. National support for health research and development, by source, 1960-93. (Source: Provided to authors by NIH Division of Planning and Evaluation, Planning and Policy Research Branch) ly scorecard is needed to keep track of who is working with whom. Knowledge is advancing at an explosive rate in this area, and appealing hypotheses for intervention in unmet medical needs are abundant, albeit highly uncertain. One attraction of genomics and related new technologies is that they offer a powerful means to accelerate the drug discovery process. Large pharmaceutical companies, fearful of being left behind as new technologies for rapid high-volume screening of new chemical entities are developed, have either acquired, taken equity positions in, or joined in collaborations with many of the leading small companies. The appeal of the smaller biotech companies is based on both their intellectual property related to genomics and their closeness to university-based research. Larger, established biotech firms, such as Amgen and Chiron, are heavily involved in genomics as well. For example, Amgen was willing to pay as much as $90 million, of which $20 million was up front, to Rockefeller University for the rights to a recently discovered gene that may play a key role in obesity. Chiron licensed the exclusive rights to a gene mapping and sequenc-

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ing technology developed at New York University that could vastly speed the analysis of whole human genomes. A recent report in an excellent industry newsletter (BioWorld Financial Watch, Sept. 25, 1995) notes that the most active players in genomics are the independent, "little" biotechs - firms such as Millennium and Sequana Therapeutics - that have "far-reaching collaborations with academic institutions." Included among their various partners are university researchers, research clinics and hospitals, nonprofit institutes, and medical foundations. This broad array of partners spanning institutions typifies the cutting-edge areas of life sciences, illustrating how the boundaries of the research community are being redrawn. Changes in the division of labor We have stressed that academics played a critical role in biotechnology's emergence, that many leading professors have formed companies to advance and commercialize their research, and that biotech companies are closely aligned with university research. However, researchers also routinely move back and forth between universities and biotech firms, professors take sabbaticals at companies, and most established biotech firms run postdoctoral fellowship programs. Cutting-edge research is now performed by intellectually and institutionally heterogeneous groups, and researchers at for-profit companies play a key role in the basic science. The 1993 Nobel Prize in chemistry went to Kary Mullis for work done at a biotech firm. Powell et al. (1996,140-1) present data that illustrate the research clout of biotech firms. Table 9.2 ranks leading contributors to the literature in molecular biology and genetics, as measured by citations per publication. There are two notable features of the list: the relative absence of universities and the presence of two commercial firms, Genentech and Chiron, as numbers 4 and 5, respectively. Many of the most critical publications, as measured by citations, are now coming from nonacademic organizations, and in some cases, private firms. In short, the labor market for life scientists has been greatly expanded, and the cross-traffic between universities and industry is now so extensive that it is fair to consider biotech firms and universities as part of a common technological community. Two universities at the forefront Further evidence of this blurring or redefinition of boundaries is apparent from a brief review of activities at two leading universities, Stanford and Johns Hopkins. Both play a preeminent role in life-science scholarship and its commercialization. Stanford has been notable for the key contribution its faculty played in the development of gene splicing, which made biotechnology possible, and in

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Table 9.2. Top ten most visible institutions in molecular biology and genetics, 1988-92 Institution

Cites per publication

No. of papers

Salk Institute Cold Spring Harbor Labs Whitehead Institute Genentech Chiron Institute Chemie Biologique Fred Hutchinson Cancer Center MIT Princeton MRC Lab Molecular Biology

41.6 40.8 39.7 33.1 32.8 31.8 27.1 25.8 24.0 23.7

403 359 392 225 200 261 413 1,060 369 430

Source: Powell, Koput, & Smith-Doerr (1996, 141), based on data from the Institute for Scientific Information.

the large number of linkages between Stanford faculty and biotech companies. Johns Hopkins has attracted attention for its novel efforts to exploit commercially the research prowess of its faculty and the inventive financial arrangements it has negotiated with commercial entities. In 1973, Stanley Cohen of Stanford and Herbert Boyer of the University of California at San Francisco (UCSF) created the first recombinant-DNA clone, thus making genetic engineering practical. They worked out a clear way to transplant genes from different organisms into bacteria, which then could be grown in large quantities. Boyer went on to play a founding role in the establishment of Genentech, the first widely known biotech company, and one that attracted enormous attention in October 1980 when it went public in a frenzied stock offering. Cohen remained at Stanford, where the university obtained a patent on its gene-splicing technique - a valuable piece of intellectual property that earned Stanford and UCSF $66.3 million each between 1980 and August 1996 (Puzzanghera 1997, 12A). Etzkowitz and Webster (1995, 489) remark that Stanford created the organizational arrangements that promoted the view of high-quality science and generating money as complementary. At Stanford's Office of Technology Licensing, Neils Reimers persuaded first Cohen and then Boyer to patent their work. Cohen (quoted in Etzkowitz and Webster 1995,489) reports having been somewhat reluctant at first: My initial reaction to Reimers' proposal was to question whether basic research of this type could or should be patented and to point out that our work had been dependent on a number of earlier discoveries by others.. . . Reimers insisted that no invention is made in a vacuum and that inventions are always dependent on prior work by others.

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Reimers later advised both MIT and the University of California on the setup of their technology-transfer offices (Matkin 1990). At Johns Hopkins Medical School, an internal venture-capital fund has been created to bankroll promising lines of research and move them toward commercialization. Adopting the view that the university can play the role of venture capitalist with greater acumen and not have to share the gains with outsiders, faculty compete internally for venture funds. Johns Hopkins has also "pushed the commercialism envelope" in other ways, such as licensing prior to discovery. For example, the Medical School approached Oncor Inc., a cancer-based biotech firm, and persuaded it to fund research in a newly established laboratory of a leading researcher in return for first rights to discoveries that might eventuate from the research. Moreover, of the more than $1 million that Oncor paid the university over a three-year period, about 20 percent was in Oncor stock. Johns Hopkins has aggressively pursued corporate funding of campusbased research. In the process of this commercial expansion, the university has also replaced Bethlehem Steel and Westinghouse Electric as Maryland's largest private employer. Key factors driving these developments The changes underway in life-science research are far-reaching. Most participants are surprised, even astonished, at the speed and extent of these transformations. The life sciences are going through a profound intellectual revolution, just at the time federal, corporate, and university policies are changing in response to new economic and political conditions. Consequently, developments in the life sciences are playing an important role in the process of creating new institutional mechanisms to respond to these changes. Expanding opportunities, not resource scarcity In contrast to many other areas of academic research, the life sciences do not suffer from declining resources. Recall that Figure 9.1 showed a steep rise in the outlay of both federal and industrial support for health-science research. The life sciences presently receive more than 55 percent of all federal research support. The NIH is now by far the largest supporter of academic research, and between 1981 and 1990, its budget increased by 50 percent (in constant dollars), a figure two-thirds greater than the increase in total federal outlays. At the end of the 1980s, the government began to fund the Human Genome Project at the rate of $3 billion over fifteen years. In fiscal year 1996, while most branches of government limped along on partial and continuing funding extensions, the NIH received a firm commitment from Congress and the president, with a 5.6 percent increase, the largest in the federal budget; and, more recently, the 1997 ap-

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propriations bill gave the NIH an increase of 6.9 percent to a budget of $12.7 billion (Marshall and Lawler 1996). Increased budgets do not, of course, necessarily keep pace with the costs of doing research, especially in fast-developing fields. Moreover, the number of life scientists competing for funds has certainly increased, intensifying the competition. Still, the overall financial picture in the life sciences looks promising in contrast to other areas of basic research. The motivations in this field are not driven by a lack of resources, we submit, but rather by the opportunity to expand the pool of available research funds: the chance to develop a new line of research more rapidly, to pursue a promising idea in order to speed the development of a new treatment that will either improve or save patients' lives. Indeed, there is growing evidence that commercial and basic funding go hand in hand. David Blumenthal (1992) and his colleagues (Blumenthal et al. 1996) report that scientists receiving support from biotechnology companies are the same researchers who also receive federal funds. Rather than a partitioning of the field into scientists with industry support on the one hand and those with federal monies on the other, we see the Matthew effect in operation: To those that already have, more shall be given (Merton 1968). At an institutional level, we find - not surprisingly - the same pattern. The universities most involved in the new biotechnology are among the wealthiest and most prestigious research universities. They are precisely where the centers of excellence in life-science research are located. Our research indicates considerable overlap between the universities holding the largest number of formal contractual agreements (including licensing, long-term research partnerships, and large-scale clinical trials) with dedicated biotechnology companies, and those with the most accomplished research programs in the life sciences. Table 9.3 lists the universities with the most collaborations with biotechnology firms, and shows that these schools are also those with the strongest graduate programs in molecular biology. We think this convergence is reflective of a change in the nature of knowledge, one that has not been sufficiently stressed, nor its ramifications fully recognized. Thoughtful commentators such as Drucker (1993) and Nonaka (1994) have argued that a transformation, equivalent in scope to the industrial revolution, is underway in which the leading edge of the economy is more and more dependent on the production of knowledge. We make a less grand claim, but one with broad implications. The life sciences represent an area in which established conceptions of knowledge and existing institutional arrangements no longer adequately fit with the current methods for the production and commercialization of science. We see this change in the collapse of the distinction between basic and applied science, in the growing diversity of sources of expert knowledge, and in the complex interdisciplinary and multi-institutional teams needed to pursue cutting-edge research. As Powell and Smith-Doerr (1994)

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Table 9.3. Universities with the most formal contractual agreements with biotechnology companies, 1988-95, and NRC/NAS ranking in molecular and general genetics, 1995 Institution

NAS/NRC ranking

Collaborations

Stanford University Harvard University MIT Johns Hopkins University University of California^

5 3 1 9 2,6,10

16 11 11 10 10

a

The University of California (UC) system is treated as a single entity because contracts from all campuses are signed with the Board of Regents. UC-San Francisco was ranked second, UC-San Diego sixth, and UC-Berkeley tenth in the NAS/NRC rankings. Sources: Powell, unpublished data derived from Bioscan, 1988-95; National Research Council/ National Academy of Sciences rankings of leading U.S. graduate programs by field of study, 1995.

have argued, knowledge is increasingly located in networks of relationships, and access to such networks is a key to competitive survival. Recognition of this change in the location and organization of expertise means that it is inappropriate and misleading to focus only on changes in the organization of universities, without examining how changes in universities dovetail with simultaneous changes in private-sector R&D, federal policy, and the evolving structure of science. In short, we must view cutting-edge science as the product of a coevolutionary system of interlinked institutions. Gibbons and colleagues (1994) describe a shift in the production of knowledge from a traditional disciplinary basis, which they term Mode I, to a more diffuse, interdisciplinary project, labeled Mode II. Well-understood extensions of existing knowledge, with eventual applied commercial applications, typify Mode I. Several of the earliest university commercial endeavors - for example, agriculture, chemical engineering, mining and metallurgy - are exemplars of Mode I. Gibbons et al. argue that Mode I knowledge is organized around established disciplines, where intellectual development is linear. Commercial applications occur "downstream," and innovations involve breakthroughs in scale. Mode II knowledge, they suggest, is exemplified by biotechnology, highenergy physics research in the areas of superconductivity, and the marriage of computers, software, and telecommunications being played out today on the World Wide Web. These forms of knowledge span disciplines, are more commonly organized through networks than collegial hierarchies, and are characterized by rapid, often nonlinear development. Consequently, the internal dynamics of science have generated a new system of knowledge production, in which greater interdisciplinarity and more collaboration are key features.

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Although the Mode I-Mode II distinction is a broad characterization, we find it is an apt description of the revolution in the nature and use of knowledge in the life sciences. Recall that the changes in the most active areas of university patenting were from harvesters and measurement devices to the life sciences (see Table 9.1). Remember also that leading biotechnology firms, as well as nonprofit research institutes, now play a significant role in producing and publishing cutting-edge research. At the same time, industry research in established pharmaceutical companies has become much more theory based, model driven, and deductive than earlier methods of trial-and-error search and inductive reasoning. Breakthrough research involves the collaboration of multiple disciplines and heterogeneous institutions. Consider the 1992 Oliver et al. paper in Nature that reports the sequencing and characterization of an entire yeast chromosome. (Yeast has many genes that are homologous to humans and has a fairly "simple" structure that makes it highly useful for inserting foreign genes for amplification.) This exceedingly laborious and important work involved 141 scientists from more than thirty-five nonprofit, public, and private institutions from around the globe. Alternatively, examine any one of a number of publications in Science on BRCA1, the gene that plays a critical role in familial breast and ovarian cancers. For example, the 7 October 1994 article, "BRCAJ Mutations in Primary Breast and Ovarian Carcinomas," has twenty-seven authors located at the NIH, a new biotech company, a new department of medical informatics at the University of Utah medical center, a Swedish university, Sloan-Kettering Cancer Center, and two departments at Duke University. These papers vividly illustrate the changing locus of knowledge, and how intellectual progress depends on collaboration across disciplinary and institutional boundaries. (Such cooperation between nonprofit organizations [here, universities] and for-profit firms was highlighted in Chapters 1 and 8, where it was identified as an important avenue for nonprofits' pursuit of commercial revenue and as contributing to the breakdown of the distinction between the two sectors.) We contend that the boundaries between universities and firms in the life sciences are crumbling. These new organizational arrangements blur the distinction between academic research and commercial development. Life-sciences research not only spans disciplines and organizations but increasingly fuses knowledge and property. Stephan (1994) has shown that the success of initial public offerings of biotech firms is significantly related to the reputation of university scientists affiliated with the firm. At the same time, the annual reports of university research offices look like documents prepared for the private sector, whereas biotech firm annual reports could pass as grant reports to the NIH. The strong precommitment to different norms and rewards, stressed by researchers in the economics and sociology of science (Dasgupta and David 1987, 1994; Merton 1957,1968,1988), also appears to be declining as the realms of science and technology become inseparable.

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As university management of intellectual property becomes more aggressive and far-reaching, and as universities become regarded as key contributors to economic growth, they become enmeshed in a wide array of political and economic relationships. This broader role of universities engages many more political constituencies and interest groups and, in turn, creates new expectations while making it much more difficult for universities to maintain their legitimacy. Nobel Laureate Philip Sharp, former Director of MIT's Center for Cancer Research, worries that the desire to harness the commercial potential of universities has led to earmarking, or the award of special-purpose funds by Congress without the use of a peer-review process. He cautions, "As universities become more identified with commercial wealth, they also lose their uniqueness in society. They are no longer viewed as ivory towers of intellectual pursuits and truthful thoughts, but rather as enterprises driven by arrogant individuals out to capture as much money and influence as possible" (Sharp 1994, 148). We focus first on how the new mandate for universities has triggered the earmarking of federal research funds to particular local institutions, so that political decisions threaten to reduce the influence of merit review. The pursuit of new revenues has also led to significant organizational changes in the structure of universities. There is growing evidence of an academic arms race, resulting in a division between the haves and have nots. Many commentators have questioned whether commercial activities compromise scientific impartiality by introducing the profit motive into research (Krimsky 1991; Brooks 1993). We stress a less direct, second-order effect of increased commercialization: the potential for university and faculty interests to be at odds with one another. Finally, we discuss how changes in the mandate of universities have led to disputes over the values and the very culture of university life. We illustrate these issues with a discussion of the different issues raised by patenting and publishing. Politics of funding The trend of shifting research funds away from scientific peer review toward the more overtly political field of congressional earmarking is suggested by the growth of earmarked funds noted in Table 9.4. The expansion of such funds has been dramatic, from $11 million in 1980 to $708 million in 1992, coinciding with the birth and development of biotechnology. Merit review plays no role in the earmarking process. Traditionally, earmarked funds were used for the construction of university facilities, but by 1992, 42 percent of earmarked funds went for university research. Put differently, Congress provided almost $300 million to university researchers in 1992 without any attempt at intellectual assessment (Pennisi 1993).

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Table 9.4. Congressional earmarking for universities and colleges: Total funds by year, 1980-93 Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Totals

No. of earmarks 7 0 9 13 6 39 38 48 72 208 252 279 499

Amount

NA

10,740,000 0 9,370,999 77,400,000 39,320,000 104,085,000 110,885,000 163,305,000 232,392,000 299,026,000 247,976,333 470,279,499 707,989,031 763,000,000

1,422

335,768,862

Source: NSF National Science Board, Science and Engineering Indicators: 1993, p. 139.

Debates over earmarking are typically loud and bitter. Critics argue that the process is dominated by special-interest politics and extensive lobbying, and results in lower-quality science while simultaneously denying merit-based funding to more worthy projects. Supporters of earmarking, such as former Boston University President John Silber, defend their large payments for lobbying activities, claiming earmarking represents a way to "level the playing field."6 Silber charges that the peer process is a "tight knit old-boys network," and "an oligopoly."7 Earmarking, Silber opines, "is the ante that gives places like Boston University a seat at the table, and the last thing those [elite] institutions want is an aggressive new player in their game." Boston University received a total of $56.5 million in earmarked funds in 1984,1988, and 1992, to build research 6

7

Boston University paid Cassidy and Associates, the most renowned academic lobbying firm, $7.9 million over the period 1981-94. Northwestern University, also highly successful in obtaining earmarked funds (portions of which went to support a biotechnology center), paid Cassidy and Associates $3.7 million during 1984-94 (U.S. House of Representatives 1993, 389, 198). Partially stemming from criticisms raised at the congressional earmarking hearings, the GAO conducted a detailed study of peer review at the NSF and NIH in 1993, finding little evidence of bias (Marshall 1994).

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centers in physics and engineering. In turn, BU's success in obtaining competitive grants increased by "647 percent" (U.S. House of Representatives 1993, 231). The grants also brought important economic benefits to the local community, in construction jobs and subsequent employment, a point BU, as well as other universities such as Northwestern, emphasized in their congressional testimony in support of earmarking. Organizational responses The pursuit of new sources of revenue, from either the commercial marketplace or the political arena, has led to a number of organizational adaptations within universities. The 1992 GAO report on university research noted that thirty-four of the thirty-five surveyed institutions, having substantially expanded their patent and licensing programs since 1980, had established a technology-licensing office, whereas in 1980 only twenty-two had had such an office. The spread of technology-transfer offices, the fees paid to lobbying firms, and the legal expenses associated with defending intellectual property are all costs associated with new forms of academic entrepreneurship. Earlier we noted that the commercial firms best able to exploit new technological breakthroughs are those with the most extensive external connections and the strongest internal capabilities for evaluating research done elsewhere (Powell et al. 1996). The same process appears to hold for universities, with several consequences. One effect is an increasingly sharp division between academic haves and have nots. Research funding is already highly concentrated. Schultz (1996,133) reports that 85 percent of federal research funding - about $13 billion in 1992 - goes to a hundred research universities, and 21 percent of that funding goes to just ten universities. These same universities are in the forefront of commercialization efforts. A second-order effect is found in the considerable efforts on the part of universities to develop institutional arrangements to foster external linkages (e.g., industrial liaison programs, contract research agreements, research parks, clinical trials programs) and internal administrative capabilities to facilitate them (e.g., offices of sponsored research, technology transfer, patent administration, institutional development, large legal departments). Matkin (1990) evaluates the technology-transfer offices of four research universities, finding marked differences in how their "commercialization arms" are organized. We know little at this point about the commercial efficacy of different forms of university organization, but we suggest that a third-order effect of enhanced commercial efforts is to change the calculus by which political and economic leaders evaluate universities. The various on-campus offices and off-campus programs set up to promote and process commercial endeavors are not inexpensive to operate. Intellectualproperty law is a burgeoning and expensive field, and patent applications incur

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considerable costs and time to file, and even more so to enforce. There seems to be a wholesale rush in this direction by all universities, triggering a form of status-based competition in which universities show the symbols, if not the fruits, of commercial efforts. However, even though many universities are attempting to develop internal competencies at commercialization, we suspect that the lion's share of the results will go to a small handful of universities with the strongest basic-science research portfolios. As the academic race for commercial support heats up, a winner-take-all market results (Frank and Cook 1995). Those universities not in the vanguard will find themselves comparatively much poorer, losing out in competitions for new facilities, up-and-coming faculty, promising graduate students, and research funding. Conflicting interests Commercial activities do more than generate revenues. Universities in the forefront of life-sciences research will undergo heightened scrutiny and criticism as they attempt to chart a course in unfamiliar waters. The reality, however, is that there is no turning back to a less complex and contradictory era. The emerging discoveries in the life sciences are so powerful and dramatic, and the medical and material rewards so considerable, that each new scientific discovery represents yet another commercial opportunity. There have been only limited efforts to assess the consequences of these developments on the internal culture of universities. Most attention has focused on the individual faculty members and whether the integrity of their scientific research is compromised by commercial efforts (NAS/NAE/IOM 1992). A few observers recognize that the new environment creates competing claims: research for knowledge, research for treatment, and research for competitive advantage (Trias 1996). Indeed, some university administrators argue that "conflicts of interest aren't bad; they're good." Craig Heller, Stanford's associate dean of research, argues that conflicts mean "you have an entrepreneurial environment. It has to be recognized and managed" (Puzzanghera 1997, 13A). Universities, aware of the potential conflicts between advancing knowledge and generating revenues, are struggling to develop rules of conduct that simultaneously - some would say incompatibly - safeguard faculty from commercial pressures, mandate disclosure of possible conflicts of interest, and provide incentives to faculty working in areas with commercial potential. What, however, protects faculty when the university represents its own interests in external commercial negotiations rather than those of the researcher whose work is being marketed? There are numerous disputes between faculty members who prefer an accessible, open license for their discovery, which would maximize the breadth of knowledge dissemination, and universities that seek a more lucrative, exclusive license. Who is the fiduciary when universities convert a profes-

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sor's discovery into equity ownership in a company, and that company is subsequently sued for patent infringement? A current legal case in California is illustrative of the possible conflicts between universities and their faculty. Two professors won a jury award of $2.3 million from the University of California at San Francisco (UCSF) after claiming it defrauded them by licensing their patents to other companies at a discount in exchange for sponsored research support from these companies. Thus for all the attention to possible faculty conflicts of interest, a parallel caution is needed regarding the growing opportunity for faculty and university interests to diverge. The broadest ramification of the new conception of knowledge as property may be its capacity to change the culture of academic life. In a back-page essay in Scientific American, a professor of pathology at NYU Medical Center observes that "when today's professors hit the big time, they have to read their professional literature and Business Week, write scientific papers and patent applications, teach, give seminars, and sit on the scientific advisory boards of various corporations" (Zolla-Pazner 1994,120). The author goes on to remark that: The academic scientistfindsherself taking a crash course in business and law. The demands of negotiating agreements and writing patents drain time and energy. Some research activities are redirected from basic science toward more immediately practical goals. The promise of continuing industrial support is seductive but inevitably tied to commercial products and the bottom line. The lab mayfinditself focused on an agenda set by the company. The basic research that sparked the initial effort may lie fallow. The spontaneity of scientific pursuit, so prized by those lucky enough to have investigatorinitiated government research grants, may be restricted. The speed with which the professor can share data or new reagents may be slowed. The result, in the worst scenario, would be deleterious for the lab, harmful for science, bad for society. We doubt that such a wholesale appropriation of a scientist's research agenda is likely, particularly when there is evidence that scientists who are successful in one arena, such as federal grants, also fare well in commercial areas; but the focus of research can be shaped in subtle ways by commercial exigency rather than scientific curiosity. Feller (1990) and Cohen and Noll (1994) argue strongly that academic research is now more directed toward questions whose answers constitute "patentable" or commercial outcomes. Feller goes on to suggest that faculty working on the "newer" scientific questions are more intensively involved in the postdiscovery stages of research; in one respect, this means that faculty now exert more control over the terms and means by which academic research moves to the marketplace. Many would regard this development as positive, but few would be satisfied if its consequence was that the merits of faculty research were judged according to its commercial significance. In an important new study, Packer and Webster (1996) analyze the emergence of a patenting culture in British universities, and stress that the making of claims for patenting departs notably from traditional conceptions of novelty

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in science. Patenting involves demonstrating to an imaginary person - the legal fiction of a "person skilled in the art" - that a discovery would not have been an obvious extension of existing knowledge or practice. The universe of patenting, Packer and Webster observe (p. 438), is a virtual one in which no one has "membership" status even when one participates in it. Patenting does not just involve different rules from academic publishing, it is a different game altogether. Writing papers and building an audience for one's ideas involves enrolling other academics in a collective project; patenting has more to do with controlling others. Put differently, patenting involves claims staking; publishing entails claims making. "Holding patents is not so much a means of enhancing the credibility of scientists in their research world but a means of defending prior investment in the area" (p. 441). For centuries, scientists have done their research virtually unfettered by patent constraints. Now, worries Stanford professor and Nobel Laureate Arthur Kornberg, "Every one of us working in a laboratory . . . have to wonder whether anything we do may have been protected by a patent and whether we will be sued for it" (Carlton 1995, B4). Conclusion We have argued that a profound blurring of the roles of universities and private industry is developing in the life sciences, and that this has broad consequences for research universities. We contend that these changes are, in large part, irreversible because they reflect a significant transformation in the nature of knowledge. We agree with Hicks and Katz (1996, 394) that "research collaboration among geographically separated institutions will become the normal way of conducting research - the rule, not the exception." We add that in the life sciences such collaboration spans the academy, private industry, nonprofit research institutes and hospitals, and government laboratories, and we see these institutions as coevolving in ways that make them organizationally more similar. These developments offer ample opportunities for universities to diversify their funding base and to contribute to both the advancement of life-sciences research and the development of powerful new medicines that will be of considerable benefit to society. At the same time, the ramifications of the growing parallels in the organization of the academy and industry, and the role of federal policy in promoting these trends, are poorly understood. Already Feller (1990) has observed that many academic research teams have the character of "quasifirms" as scientists eagerly pursue R&D programs aimed at commercial application. To the extent that the norms of open science are fragile (Dasgupta and David 1994), universities may well be endangering their distinctive reward systems. Changes in the reward system (such as tying salary increases or tenure to success at research commercialization) could result in a loss of legitimacy, or speed the movement of scientists to other institutions; either development

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would impair the educational mission of research universities. Moreover, the loss of researchers to industry could result in fewer basic-science discoveries by universities, harming their research function. As the cross-traffic between universities and industry increases, it becomes less apparent what will remain distinctive and appealing about a career of university-based research. We also caution that universities are not well equipped as organizations to deal with the growing status of knowledge as property. Matkin (1990, 382-3) contends that universities typically see the problems associated with commercialization as "isolated instances of bad judgement or bad luck, and call for ad hoc solutions," rather than comprehending that these problems are outcroppings of a deeper transformation. We add that of all the participants in the new highly linked universe of knowledge development and commercialization, it is universities whose established routines of operations will be most transformed. If practices fundamental to the traditional mission of universities are altered in a piecemeal fashion, without recognition of the deeper and more systemic changes we describe, the potential for distortion of the goals of universities is considerable. We also stress that changes in operating routines made to accommodate technological developments in the life sciences might have unanticipated consequences when applied to other sectors of the university. Given that the areas of knowledge that we characterize as Mode II - where intellectual breakthroughs have immediate commercial relevance - represent only a limited portion of university research, the life sciences may not represent a viable model for all university technology-transfer activities. Enhanced efforts at commercialization typically lead universities to devolve financial responsibility to lower levels, allowing individual research units autonomy and responsibility for their own funding. As this process unfolds, marketbased criteria become the dominant logic in resource-allocation decisions. Current trends clearly point in the direction of this more instrumental focus on resources, even though funding opportunities that are abundant today may be less plentiful in the future. In contrast to the long-term steady support for research provided by the federal government, future sources of funding are likely to be much more variable and dictated by commercial need. In the life sciences, we note that market criteria do not discriminate between medical and nonmedical goals. To date, the great bulk of biomedical research has focused on unmet medical needs; but there are many areas, such as obesity or small stature, where highly lucrative research applications might be based more on cosmetic considerations. The changes underway at research universities are the result of multiple forces: a transformation in the nature of knowledge and a redefinition of the mission of universities by both policymakers and key constituents. These trends are so potent that there is little chance for reversing them - nor necessarily a rationale for doing so. Nevertheless, without recognition of the confluence of

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forces that are spearheading increased efforts at commercializing research, university responses are likely to be incremental and inadequate. It must be clearly recognized that the conditions that have given rise to the commercialization of basic research in the life sciences are idiosyncratic to this field. Moreover, changes that entail the use of market-based criteria (e.g., more focus on patenting and licensing) to evaluate the "merits" of research may, in unanticipated ways, lead to a corrosion of the mission of research universities, undercutting public trust in them. Such developments could, then, erode the very features that have made U.S. research universities unparalleled contributors to both intellectual and commercial advance.

CHAPTER 10

Commercialism in nonprofit social service associations: Its character, significance, and rationale

Dennis R. Young

Introduction Overall, income from sales of services now constitutes the largest and fastestgrowing source of revenues for private, nonprofit organizations in the United States, proportionally larger than charitable contributions or income from governmental sources. Salamon (1992) estimates that fees and charges constituted some 51 percent of total gross income of nonprofit public-benefit organizations in 1989, and that such income accounted for 55 percent of the growth in nonprofit revenues between 1977 and 1989. Although reliance on income from sales varies widely among subsectors, there is little doubt that these trends are now pervasive throughout the U.S. nonprofit sector. This chapter investigates the nature of this development in selected segments of the social services subsector- in six national, social service "umbrella" associations encompassing youth services, health charities, and services for older Americans, as well as among affiliates of a seventh association in the field of community and recreational services. First, a conceptual framework is established that relates commercial income to the missions of nonprofit organizations I wish to thank the staffs of the national associations that provided information and data for this chapter, including Allan Finkelstein, Robert Fischer, and Edward Kagen of the Jewish Community Centers Association, John Garrison and Bea Lyons of the American Lung Association, John Seffrin and Dawn Hardwick of the American Cancer Society, Mary Rose Main and Florence Corsello of the Girl Scouts of the USA, Russell Weathers and Stewart J. Smith of Camp Fire Boys and Girls, David Liederman of the Child Welfare League of America, and Joan Wise, Steve Zaleznick, and Horace Deets of the American Association of Retired Persons. I especially want to thank my research assistant, Fatih Kocan, for his steadfast help with the statistical analysis. Thanks also to Laura Leete for her advice, and to Anne Standley for the support provided to me through the research program of the Mandel Center for Nonprofit Organizations. Finally, I am indebted to members of the project on nonprofit commercialism, especially Richard Steinberg and Helmut Anheier, for their candid criticism and helpful guidance.

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and to changes in their economic environments. Second, the variety and magnitude of commercial income sources, and the strategic issues associated with these sources, are described through case studies of the six national associations. Third, the commercial income of affiliates of the Jewish Community Centers (JCC) Association is statistically analyzed to determine its relation to other income sources, including external grants and contributions and membership fees, and to financial performance. These analyses raise several important public-policy questions concerning the regulation and taxation of nonprofit organizations. As nonprofit commercial income grows, how much of it should be taxed? If commercial activities can undermine the integrity of nonprofits or divert them from their social missions, what limits are required to maintain tax-exempt status? If commercial funding undermines the confidence of donors or otherwise discourages giving, how important is the loss of donated revenue and what can be done to maintain donor incentives? This study reveals that nonprofit social service associations endeavor to maintain consistency between mission and commercial activity and also to minimize tax liability, and are aided in doing so by missions framed in very broad terms. These organizations also try hard to avoid commercial initiatives that pose serious risks to their reputations. There is also evidence that donations are reduced as sales revenues increase. All told, the study suggests that although nonprofit social service organizations deal conscientiously with the challenges and uncertainties posed by commercial funding, tax and regulatory policies may require reexamination in light of the economic environment in which nonprofit organizations now operate. Conceptual framework Studies of enterprising behavior by nonprofit organizations indicate that commercial practices are related, directly or indirectly, to the promotion of organizational missions (Skloot 1988). Some scholars argue that reliance on particular income streams can co-opt or subvert missions, or displace organizational goals (DiMaggio 1986b); the present study, however, reveals that mission is an overriding consideration in decisions to undertake commercial activities, though the connection to mission is sometimes indirect and subtle. Indeed, missions of nonprofit organizations, especially national umbrella groups, are often articulated in very broad terms, so that mission relevance is difficult to specify with precision. Nonetheless, association leaders explicitly reference their missions in making decisions about commercial activity. Estelle James's (1983) model of nonprofit-organization behavior, refined by Schiff and Weisbrod (1991), illuminates how nonprofit commercial activities relate to mission. James distinguishes among nonprofit services that yield favored outputs, which are related to mission and valued by managers; neutral outputs, which are unrelated to mission and to which managers are indifferent;

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and disfavored outputs, which may impair the mission or are distasteful to managers (Young and Steinberg 1995). In this model, nonprofits may choose to produce favored services at a financial loss, and use financial surpluses from neutral or disfavored services to subsidize them. (See Chapter 3 and its discussion of preferred and nonpreferred outputs.) Commercial activities may contribute to mission in one of three ways: 1

Some activities constitute mainstream (favored) mission-related services that can be financed, at least in part, by user fees. For example, the Child Welfare League of America (CWLA) provides its member organizations with technical consultation. In so doing, CWLA's principal decision is what to charge, not whether to provide the service. 2 A nonprofit may undertake an (neutral or disfavored) activity solely to generate surplus revenue. Pure fund-raising strategies, such as renting out facilities for private parties or hosting bingo games, fit this description. Here, the nonprofit organization presumably designs its fee structure so as to maximize profits, and must decide if the activity generates sufficient profit to offset any indirect costs associated with damage to its reputation or image. (See the discussion of "ancillary" activities in Chapter 3.) 3 Some (favored or neutral) commercial activities, while optional, are explicitly intended both to generate surplus revenues and to contribute directly to mission. For example, the American Association of Retired Persons (AARP) receives royalties on licensed insurance programs that serve its members, and the Girl Scouts sell cookies - an activity said to provide girls with an experience that helps build character and impart business skills. In these cases, the organization must decide both whether it is worthwhile to offer such services and what to charge for them. Fees may be designed to ensure that operations break even or run a surplus, but not necessarily to maximize profits if doing so would substantially reduce mission-related benefits. (See Chapter 4.) All commercial nonprofit services may be thought of as falling along a continuum within the third category: services with both mission-related and financial consequences but also having a wide range of (positive or negative) weights attached to generating revenue versus mission-related benefits and costs. Mission-related benefits and costs include (1) direct benefits associated with providing the service to constituents of the organization, and (2) damage to the organization's reputation resulting from involvement in an activity that is viewed as being unsavory, in conflict with the organization's mission, excluding worthy beneficiaries who cannot pay, or causing other harm. As considered below, concern over reputation is particularly salient in connection with so-called causerelated marketing ventures undertaken with business corporations. These activities, which can provide nonprofits with considerable visibility to reach the

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general public through commercial channels, involve "a relationship which ties a company, its customers and selected products to an issue or cause with the goal of improving sales and corporate image while providing substantial income and benefits to the cause" (American Cancer Society, 1996a, p. 2). To determine its optimal policy for undertaking a given commercial activity or imposing a specific fee structure, a nonprofit would offset the aforementioned mission-related costs and benefits against indirect financial benefits and costs: (1) financial profits to the organization that it can use to promote its mission, and (2) financial losses from reductions of donated income that may occur in reaction to the undertaking of commercial activity. The latter effect, known as crowding out, has been studied in connection with both government and commercial funding of nonprofit organizations (see Steinberg 1993a; Kingma 1995). Crowding out occurs when donors feel that their contributions are less needed because of increases in other revenues, or where the character of such revenues make the organization seem less attractive. The foregoing theory establishes a number of prior expectations for empirical examination of the commercial activities of nonprofit social service associations. We expect: 1 the commercial initiatives of these associations to contribute in varying combinations both to generating net revenues and to accomplishing the organization's mission; 2 that commercial initiatives will be approached with caution because of potential risks to reputation and possible losses of other sources of income; and 3 that commercial initiatives will be encouraged by financial pressures and by the decline of other streams of income, such as grants and donations. (See also Chapter 6.) For the specific national associations examined here, some nuances may be added to these expectations. First, some of these associations put a particular value on membership, over and above the revenues generated from membership dues. For AARP and CWLA, membership rolls represent political clout, whereas for affiliates of the JCC Association, membership is a measure of the degree to which these organizations are succeeding in maintaining Jewish community life. Rather than maximize revenues from membership, these organizations try to enlarge membership for its own sake by keeping dues modest (Chapter 4). Hence, the net effect on commercial initiatives of changes in membership revenues is the result of two factors: (1) the inclination of nonprofit managers to generate new commercial income to compensate for any decline in membership revenues, and (2) the fact that membership growth from lower dues may increase the market in which the organization can sell its commercial services. Indeed, most commercial sales in these associations appear to be made

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to their own members. The relationship between membership income and commercial income is thus intrinsically ambivalent: If membership revenues slow, commercial activity may increase because managers will attempt to compensate for the loss, though they may fail if the (membership) market is shrinking. Alternatively, if membership income increases, managers may choose to reduce (unfavored) sales income, yet that income may nonetheless increase if the underlying (membership) market is increasing. We speculate that change in membership levels rather than the price of membership (dues) is the stronger driver of membership revenue, and hence that commercial sales and membership revenues will be directly rather than inversely related to one another. Finally, since the national associations that we examine (except for AARP) encompass semiautonomous organizational affiliates that operate in different local contexts, we expect the strength of the relationships postulated in the model to vary among differing contexts. For example, the degree to which the local managerial culture is entrepreneurial, or the local community is charitable or tolerant of commercial practices in nonprofits, may vary regionally, between large and small cities, or for different sizes and types of nonprofit organization. Association case studies Here we describe the commercial practices of six prominent national nonprofit social service associations - the character, variety and significance of commercial income as a source of revenue for these associations and how this is changing over time; the relationship of commercial initiatives to the missions of these associations; and the strategic and managerial issues association leaders face in undertaking commercial initiatives. The cases allow us to investigate several implications of the conceptual framework presented in Chapter 3 and elaborated above, including whether 1

reliance on commercial income is increasing as traditional revenue sources, such as donations and government funding, become more restricted; 2 commercial initiatives are being undertaken cautiously and in a manner sensitive to preserving associations' abilities to address their basic missions; and 3 there are particular tensions in such areas as partnering with business corporations, where associations are vulnerable to tarnishing their reputations among donors, or in the pricing of services, where associations may confront trade-offs between member benefits and revenue considerations. A general questionnaire inquiring about the nature, extent, and profitability of commercial activities was directed to the national executives of four youth-

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oriented associations and four health charities that were participating in a larger study of national association structure at the Mandel Center for Nonprofit Organizations of Case Western Reserve University in 1995-6. The instrument was also sent to three other national associations that appeared to have particularly interesting commercial practices. Of the eleven associations contacted, six responded and four actually filled out all or part of the survey form; the remaining two respondents provided reports or narratives instead. Officials of five of the respondent associations were interviewed in person, and all respondents provided follow-up correspondence and reports. The six associations do not constitute a scientific probability sample, and the surveys and interviews did not provide sufficient data for comparative statistical analysis. Still, the responses were relatively detailed and offer a rich picture of commercial practices. For easy comparison, the following vignettes are presented in successive pairs of similar types of association: two health charities, two youth-serving associations, and two associations that advocate for the interests of large segments of the American population - children and older people, respectively. American Lung Association The mission of the American Lung Association (ALA) is to promote research and public knowledge of lung disease and to advocate for its prevention, treatment, and cure. According to annual reports, the budget of the ALA national office has grown approximately 40 percent in current dollars between 1989 and 1995, from $33.3 million to $46.6 million. The composition of its revenues has changed as well: Revenue from donations and government grants has declined from almost 35 percent of revenues to just over 20 percent of the total, while revenue from sales has risen from 60 percent to 75 percent. The latter includes gross sales of supplies and services to state and regional affiliate Lung Associations, as well as external sales income composed largely of revenues from scientific journals and conferences. The latter component is responsible for the relative rise in sales income: External sales have increased from 13 percent to 26 percent of revenues between 1989 and 1995, while internal sales have remained flat around 48 percent. For 1995, the ALA reports commercial practices in all three of our conceptual categories: activities integral to its mission, those undertaken primarily to raise funds, and those that contribute both to fund development and mission. In the first category, the ALA publishes two medical journals on lung disease that earn small profits on gross revenues of $4 million in revenues. These revenues come substantially from advertising, on which the ALA pays Unrelated Business Income Tax (UBIT). The association also sponsors an annual international scientific conference on lung disease, which earns a profit that is used to offset

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the costs of the American Thoracic Society, the medical section of the ALA. In addition the ALA prepares and sells educational materials to its affiliate Lung Associations - an activity intended to break even but that in fact has yielded small profits or losses (under 5 percent of total national-office revenue) over the past six years. Activities undertaken primarily for fund-raising purposes include the leasing of mailing lists, which brings in $100,000 annually to the national association. The ALA also helps affiliates raise funds through gift annuities and planned giving, for which it charges fees to cover substantially all its expenses. Some of the ALA's more interesting commercial ventures, contributing both to mission and to fund-raising, involve partnerships with businesses. Golf-privilege cards, which may be purchased from an affiliate Lung Association and entitle bearers to discounts at local golf courses, generate $8 million per year. These cards both help the ALA financially and promote the benefits of healthful outdoor activity. A scan of the Web sites of affiliate Lung Associations reveals other such practices, including the sale of ski-privilege books by the Western Massachusetts Lung Association; of fitness passports to local health clubs and gyms and of restaurant-discount cards by the Lung Association of New York; and of smoking-cessation and weight-control programs, as well as carbon-monoxide and radon detectors, by the Lung Association of Ohio. At the national level, the ALA allows a pharmaceutical company to advertise its brands in national magazines along with statements of support for the ALA and its public-health work: Essentially, the company provides free advertising for the ALA and more than a million dollars per year in payments in exchange for the credibility it achieves by identifying with the ALA. In addition, the pharmaceutical company's sister brands support the ALA's "Children's ALA Christmas Seal Design Contest," bringing national attention to Christmas seals and, in turn, providing income for Lung Association affiliates. American Cancer Society The mission of the American Cancer Society (ACS) is to eliminate cancer as a major health problem and to diminish suffering from the disease, through research, education, advocacy, and service. Until recently, the ACS had limited its commercial involvement to the publication of two medical journals, for which it receives royalties of almost $1 million annually (0.2 percent of its $420 million in total revenue in 1995) under contract with a commercial publisher. ACS's publishing policies are now under active review (American Cancer Society 1996b), and financial performance has become one of several criteria considered in evaluating publication initiatives; others include whether publications accurately reflect ACS policy, are scientifically and clinically correct, and are distributed effectively to target (mission-relevant) audiences. A recent report of

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ACS's Publications Subcommittee recommended that "as a long run goal, the ACS publications program as a whole should either generate positive net revenue or be revenue neutral" (American Cancer Society 1996b, 6). Though publications remain integral to ACS's mission, the association is grappling with the degree to which they should be self-supporting or profitable. ACS's overall policy toward commercial revenue is clearly changing. According to its 1995 annual report, ACS is "forging a new breed of partnership with corporations, raising money for cancer-fighting programs while reaching out to new audiences with life-saving messages" (p. 11). This policy came to fruition in 1996, when the association undertook its first two major initiatives in corporate sponsorship - with SmithKline Beecham Consumer Healthcare (SBCH) and the Florida Department of Citrus (Freudenheim 1996b). The partnership with the Florida Department of Citrus (the state association of growers and producers) involves a nationwide education campaign through local grocery stores calling attention to the role of good nutrition in preventing cancer. The Department funds the campaign and also makes a $1 million annual grant to the ACS for research, education, and patient service programs. Under the SBCH arrangement, the ACS logo appears on boxes of NicoDermCQ nicotine patches and Nicorette nicotine gum, calling attention to ACS's education program on smoking cessation. SBCH also provides ACS with $1 million per year in unrestricted grants. ACS views these initiatives not as product endorsements but as partnerships to create a national awareness program on the issues of smoking cessation and proper nutrition (American Cancer Society 1996a). ACS leaders insist that the mission-related benefits of these efforts dominate any financial considerations, and that there is a good fit between the mission and the products of the corporate sponsors with which they work. Nonetheless, SBCH and the Florida growers clearly receive benefits equivalent to product endorsements from ACS. Girl Scouts of the USA The stated purpose of Girl Scouts is "to inspire girls with the highest ideals of character, conduct, patriotism, and service that they may become happy and resourceful citizens." This general mission is addressed through a variety of specific educational and recreational activities for girls of different ages, from preschoolers to teenagers, administered by local Girl Scout councils affiliated with the national organization, Girl Scouts of the USA (GSUSA). The national organization reports a number of commercial services considered integral to its mission, including a profitable national equipment service that supplies uniforms and other materials to participants, and various fee-bearing but loss-making programs and training events for councils. Affiliated councils also administer sev-

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eral mission-focused commercial activities, including fee-generating programs and activities that run losses; profitable "girl product sales" (products sold by Girl Scouts) including Girl Scout Cookies; and local equipment sales, the profitability of which varies by council. GSUSA establishes operational guidelines and standards for product sales by local councils. Any given troop (a local subgroup of a council) is permitted to participate in no more than two product-sales activities in a given year, and only one of these may be a cookie sale. (IRS rules for avoiding the UBIT on such activities require that they not be carried out on a continuous basis.) Commercial mission-relevant services represent substantial portions of Girl Scout organization budgets. Revenue from net national equipment sales contributed approximately 34 percent of the $36 million 1994 operating budget of the national organization. Meanwhile, net revenues from product sales constituted approximately 57 percent of the $413 million 1994 aggregate operating budgets of affiliated councils (GSUSA 1995). In the category of commercial activity intended primarily for fund-raising, GSUSA reports only income from rental of its facilities. The national organization rents its conference center in Briarcliff Manor, New York, to outside groups and uses the income to offset the costs of operating this center for its own training programs. Similarly, local Girl Scout councils generate income from the rental of their program sites to outside groups. Generally, facility rentals to outside groups are priced at prevailing market rates, although this service is also seen by Girl Scout officials as providing visibility and good community relations for the organization. Girls Scouts reports little involvement in cause-related marketing, although GSUSA does sponsor a prepaid telephone card and has participated in GIFTUSA, a service in collaboration with the Reader's Digest Association and its subsidiary, QSP, Inc., wherein people called an 800 number to order gifts of flowers, chocolates, perfume, jewelry, and other items. In this arrangement, QSP increased its sales, and a percentage of the profits benefited Girl Scouts. Some councils are also reported to involve themselves sporadically in their own coventures and cause-related marketing on the local level; but the national organization provides guidelines for such ventures, to which councils must conform. Although cause-related marketing has not yet become a significant financial factor in Girl Scout operations, GSUSA appears to be approaching this option seriously and cautiously as a possible way to diversify local council finances, which are now heavily dependent upon product sales. However, GSUSA guidelines put relatively strict bounds on councils' cause-related marketing, including limiting such projects to no more than one annually and stipulating the following for agreements with partner corporations:

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Girl Scouts is to be portrayed as a recipient of largesse or commendation, and not an endorser of corporate products. Exclusive relationships between Girl Scouts and a particular corporation are to be avoided. Girl Scouts is to have approval rights over all copy and artwork. Councils should dissociate themselves from materials urging the purchase of particular products. Promotion of prizes or incentives encouraging Girl Scout participants to purchase specific corporate products is to be avoided. The guidelines also recommend minimum payments made to Girl Scouts from any promotional activity. GSUS A also requires councils to obtain its permission prior to entering into any agreement that might be construed as a commercial endorsement. For example, GSUSA rejected an offer by a McDonald's fast-food restaurant to help a local Girl Scout council by advertising its cookie sales on a discount coupon for purchases at the restaurant. In contrast, GSUSA approved the proposal of a Philadelphia bank to run newspaper ads saluting Girl Scouting. Overall, net commercial income has been a fairly stable part of Girl Scouts' revenue over the past five years. Such income has declined from 49 percent to 45 percent of the national operating budget while increasing from 55 percent to 56.5 percent of affiliates' budgets. To date, Girls Scouts of the USA and local councils have not found it necessary to pay the UBIT on any of these revenues because this income has been offset by corresponding expenses or has qualified, by IRS rules, as related to the Girl Scout mission. Camp Fire Boys and Girls The stated purpose of Camp Fire is "[t]o provide, through a program of informal education, opportunities for youth to realize their potential and to function effectively as caring, self-directed individuals, responsible to themselves, and to others; and, as an organization, to seek to improve those conditions in society which affect youth" (1995 annual report). This broadly framed mission, like that for Girl Scouts, is manifested in specific service activities of local councils. Camp Fire reports an array of commercial activities similar to Girl Scouts, all characterized as integral to its mission. For the national organization, this includes the sale of goods associated with Camp Fire operations, such as uniforms, T-shirts, program books, and supplies. The national organization also provides technical assistance to local councils on such matters as governance, fund-raising, planning, and programming, for which councils pay an annual charter fee calibrated to the size of a council's operating budget. The charter fee

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covers use of Camp Fire's intellectual property, including its name, insignia, and program materials. The sale of merchandise and technical assistance services are reported as profitable for the national organization. Charter fees contributed 54 percent and net profit from merchandise sales 13 percent to the $3.9 million national budget in 1994. The national organization also receives fee revenue (2 percent of its budget) from its (mission-related) conferences and workshops. Affiliate councils also have two principal sources of fee revenue: They sell ancillary goods, including chocolate, and they charge user fees for services such as clubs, camps, child care, and other mission-related programming. These activities are all reported to be profitable. Program fees constituted about 30 percent of the $49.3 million affiliate operating budgets in 1994, and net revenues from chocolate sales alone represented approximately 8.5 percent. Camp Fire chocolate sales are very similar to Girl Scout cookie sales. They are said to contribute to a sense of belonging to the organization and to build life skills, and are undertaken in an episodic manner that avoids classification as taxable unrelated income. However, Camp Fire also acknowledges hazards of the chocolate sales, such as potential product-liability problems and reputational effects stemming from the sale of a product that is nutritionally questionable. While program fee revenues for Camp Fire councils have increased dramatically in recent years, by roughly two-thirds in current dollar value from 1990 to 1994, chocolate sales have declined by approximately 33 percent over that same period, continuing a downward trend in that revenue stream since 1983. However, the latter is apparently related to Camp Fire's operational difficulties with its chocolate-sales operations rather than to any explicit strategic decision to deemphasize it as a revenue source. The financial statement of the national organization also cites a small component of net rental income (1.5 percent of its operating budget). Some local councils have such income as well. Camp Fire reports no significant cause-related marketing activity, but the national organization has recently undertaken to explore potential partnerships with corporations. Child Welfare League of America Child Welfare League of America is a national membership association of more than nine hundred diverse public and nonprofit agencies in the United States and Canada "that are devoted to improving life for abused, neglected, and otherwise vulnerable children and young people and their families." CWLA serves principally as an advocacy, standard-setting, and technical-assistance organization. CWLA is substantially engaged in commercial activity, all of which is reported as integral to its mission, including a major publications operation, a consultation program, and a conference program. In each of these activities, CWLA

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leadership says it would like to run a profit, but only within the bounds of meeting service obligations. The publications and training programs are reported to break even, and the conference programs run a modest surplus. Consultation activity runs at an overall loss; however, some consultation is included free in basic membership fees. Gross consulting income represented approximately 15 percent of the 1994 budget of $8.5 million, gross publication sales 13 percent, and gross conference income 7 percent; CWLA also collected miscellaneous program service fees (0.5 percent). Membership fees charged to affiliates accounted for 32 percent of CWLA's total revenues, support from endowment was 5 percent, and most of the rest (28 percent) derived from grants and contributions. CWLA also reports 1.5 percent of its budget from cause-related marketing activities. These are not separately identified in its financial statements but presumably counted as (corporate) contributions or manifested as in-kind (nonfinancial) benefits (see below). Goods and services sold by CWLA are purchased by members and nonmembers at different prices. Members receive publications free of charge and discounts to attend conferences, whereas nonmembers are charged "full price" for these services. Some consultation is provided free to members, but most is paid for in addition to membership fees; nonmembers are charged for all consultation. In keeping with its service orientation, CWLA charges substantially less than prevailing for-profit consulting rates - a maximum rate of $1,000 a day, compared to private rates of $2,000 a day or more for equivalent value (as estimated by CWLA management). Overall, CWLA received approximately $1.2 million in gross consulting income in 1994 while spending slightly more than that on this program. CWLA, and many of its affiliates, actively engage in cause-related marketing, which CWLA claims provide financial benefits as well as valuable visibility for the organization in its efforts to promote child welfare. CWLA's leadership sees such benefits as hinging on affiliations with "quality" companies, and risks as connected to poor choices of corporate partners. For example, CWLA avoids companies whose products, such as tobacco or alcohol, are potentially damaging to children. Sometimes the risk is less obvious: CWLA cites its association with department store J. C. Penney's line of Pee Wee Herman clothes, just two years before that actor's arrest on a morals charge. CWLA's cause-related marketing ventures include: "Oshkosh B'Gosh: Tips for Tots for Parents," a program that distributes CWLA flyers in Oshkosh B'Gosh stores and advertises CWLA books in the store's catalogs; an arrangement with Aveda Hair Products in which CWLA flyers are distributed in beauty parlors featuring Aveda products, with cus-

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tomers asked to donate to CWLA as one of five designated charities; and Citibank Dollars under which people receive "CitiDollars" by using their credit cards and are given the option to donate these points to CWLA, also as one of five designated charities. CWLA affiliates engage in a wide variety of cause-related marketing activities with franchises such as Wendy's and Burger King, local supermarkets, and other businesses. In the state of Washington, an affiliate makes more than $200,000 a year selling "Washington Apples"; in California, an affiliate makes and sells a Monopoly® game of their own community; and in New York City, the Children's Aid Society holds a "Day at the Circus," for which it receives contributions. CWLA's commercial revenue streams have been reliable, modestly growing sources of income over the past decade. While total revenues in current dollars rose 140 percent from 1986 to 1994, from $3.6 million to $8.7 million, gross publication sales fluctuated between 13 and 15 percent of that total; gross consultation income rose from 12 percent of the total in 1990, when it was first separately reported, to 15 percent in 1994; and gross conference income (also first reported in 1990) varied between 6 and 8 percent of the total between 1990 and 1994 as well. CWLA pays only a few thousand dollars in UBIT, on revenues from magazine advertising and rental of mailing lists. Reliance on membership dues varied between 41 and 32 percent of total revenue over the 1986 to 1994 period, representing a growth in absolute terms but trending downward percentagewise because of overall revenue growth. Reliance on grants and contributions has varied substantially in recent years, oscillating in the 20-32 percent range between 1986 and 1994. American Association of Retired Persons Unlike the 501(c)(3) associations reported here, the American Association of Retired Persons is classified as a 501(c)(4) social-welfare organization by the IRS because of its strong emphasis on public-policy advocacy. AARP's purpose is to promote the interests of older Americans (age 50 and over) through advocacy, supportive services, and the provision of information and research. Although AARP has some four thousand local chapters and is considering ways to decentralize its operations, it operates primarily as a unified national corporation, and its chapters are not autonomous or separately incorporated. The association has also recently established a 501(c)(3) foundation that can accept tax-deductible donations for specific charitable purposes. AARP's operating revenues have grown steadily from $150 million in 1985 to $416 million in 1995 (Arthur Andersen LLP 1986-96). Approximately 32

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percent of AARP's 1995 operating revenue came from membership fees paid by individual members, varying from 32 to 39 percent over the period 1985-95. These fees are kept deliberately low ($8 per year) in order to make membership widely accessible. Members receive, free of additional charge, the organization's magazine, Modern Maturity, and its Bulletin covering current events. AARP attracted some $55 million in advertising revenue in its publications in 1995, but these revenues are said only partially to defer the total costs of its publications program, which also includes specialized newsletters for volunteers, older employees, and other subgroups, and a series of educational brochures on issues such as consumer affairs, crime prevention, and retirement planning, all available free of charge. AARP pays full postage on the proportion of its publications that represents advertising and receives a nonprofit postal rate for the rest. The association is also subject to UBIT on profits from its advertising revenues, but has not paid any tax because "applicable deductions for editorial costs offset the revenue derived" (AARP 1995, 11). AARP operates several service programs under its own auspices that it considers intrinsic to its mission and for which it charges fees. These include educational programs, such as preretirement and driver-improvement programs, as well as on-line information services. Other sources of AARP income are more explicitly fund-raising in character, including program and royalty fees (13 percent of total revenues) and administrative allowances from group insurance programs (23 percent of revenues) undertaken with corporate partners. These proportions have all remained relatively stable over the past decade as the overall budget has tripled. The group health-insurance program with Prudential Insurance Company of America offers Medigap coverage to association members. AARP helps market the program, monitors the insurance company, and serves as an ombudsman for member complaints; in exchange, AARP receives an allowance from Prudential of almost 3 percent of member contributions (about $102 million in 1994). AARP's program and royalty fees involve the licensing of its name to commercial providers who receive, in effect, AARP's "seal of approval" as an asset with which to market their services. AARP is also engaged in a number of start-up ventures, including a lifeinsurance program with New York Life Insurance Company, and an annuity program with American Maturity Life. In addition, AARP is entering the field of managed health care by licensing its name to health maintenance organizations (Freudenheim 1995). AARP also owns a taxable subsidiary called AARP Financial Services Corporation, which operates credit card and mutual fund programs (in partnership with Bank One and Scudder, Stevens & Clark, respectively) that generate net revenues on which corporate income taxes are paid. Currently, the payment of taxes on AARP's other service-income-generating programs is in dispute between AARP and the IRS over the issue of whether particular forms of income are taxable (AARP 1995, 12).

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A characteristic common to all of these program fee, allowance, and royalty arrangements with corporations is that they provide services of interest to AARP members with assured quality, availability, and reasonable cost. For example, Medigap insurance is made available with no underwriting and no preexisting-condition exclusion, and the group's automobile insurance has very restricted cancellation policies. These programs also generate net revenues targeted to specific AARP services, including the Grandparent Information Center and Legal Counsel for the Elderly. Hence, these activities both contribute to mission and generate profits to support other organizational services that do not pay for themselves. AARP's new foray into licensing of managed-care providers highlights some of the risks and potential conflicts of such arrangements. This initiative was prompted by the declining fee-for-service market for medical care and the growth of managed care. However, as the New York Times reports: AARP will be lending its name to businesses that at times limit or even refuse medical services, instead of just making sure that claims are paid. That could create a backlash in a constituency that has generally looked upon the association as a vigorous advocate for its interests. (Freudenheim 1995, C22) This new initiative, perhaps more than other AARP ventures, highlights the fine line the association, as all nonprofit organizations, must walk between advocating and promoting the interests of its members or other constituents and responding to commercial opportunities that promise lucrative financial returns. Review and assessment The six case studies reveal substantial reliance by these associations on - and their increasing interest in - commercial sources of income. The variety of commercial activity, the growth of fee income from sales of services, and the growing involvement in cause-related marketing arrangements with business corporations are particularly noteworthy. The vignettes reveal that the value received by the associations from commercial initiatives is twofold, as our conceptual framework suggests: both direct, mission-related benefits and surplus revenues that can be used to promote the organization's mission-related work. In causerelated marketing ventures, private corporations also benefit by obtaining access to the markets represented by the constituents of these associations and from a "seal of approval" that gives the companies privileged access to these markets. Thus, the associations trade on their reputational and membership assets to expand sales of products and services that become identified with their names, so as to promote their causes and raise funds. In so doing, they are becoming more sophisticated about the need to preserve and protect those assets by entering collaborations only with reputable companies and into activities that will not harm their constituents. Nonetheless, as cause-related marketing be-

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comes more prominent, nonprofits will continue to encounter tension and criticism, as recent AARP and American Cancer Society experiences have shown. In all cases, broadly framed organizational missions provide the touchstones that association leaders reference in assessing the advisability and design of particular initiatives. In almost all cases, commercial initiatives bear some direct logical connection to mission; for instance, health charities link with companies providing health-related products or services. Although these connections help sell products, they also commonly contribute to mission, directly through provision of valued services to constituents or increased visibility of a cause, and indirectly through net revenue generated for the nonprofits. Associations seek to avoid commercial initiatives in conflict with missions or posing risks for their constituents, though some of their recent initiatives are not without controversy. Nonprofit social service associations are still struggling with the fine line between commercialism and mission orientation, and the fineness of this line ultimately raises questions about whether changes in regulatory or tax policies are needed to ensure that these organizations continue to act in the public interest. Most of the associations (AARP, CWLA, GSUSA, Camp Fire) reviewed here look to their own members as the markets for the services they sell. In addition, national leaders of associations such as Camp Fire and GSUSA recognize that their affiliates have increased their reliance on commercial funding over time, in part because they have been less able to rely on traditional sources of local charitable donations such as United Way. The dynamics of decline in external sources of support and the cultivation of members as markets are issues examined more closely in the following analysis of the affiliates of the JCC Association. The Jewish Community Centers Association The Jewish Community Centers Association is a national organization whose affiliates are Jewish Community Centers and YM-YWHAs in local communities in the United States and Canada. These affiliates (hereafter called JCCs) provide health, recreation, and other community services. The JCC Association publishes annual Budgetary Trends reports (e.g., Kagen 1995) that provide details on the income and expenditure patterns of individual affiliate members.1 JCCs derive their incomes from several sources, including program income from fees and tuitions for nursery schools, day camps, child care and other ser1

Although affiliates are autonomous and vary in their accounting practices, they are all asked to provide the same data to the national organization. Because compliance is high, the data set is relatively uniform and complete, permitting examination of the factors associated with a JCCs reliance on income from sales, including the influence of donated and membership revenues.

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vices; basic membership fees; additional membership fees paid for health-club privileges; individual contributions; revenues from fund-raising events; investments; facilities rentals; grants from federated sources including United Way and Jewish federations; grants and contracts from government; foundations grants; and other miscellaneous sources. Over the years, the composition of JCCs' revenues has changed. While total revenue for these centers has grown substantially, most sources of income, including foundation and government grants, charitable contributions, and membership fees, have grown much less rapidly. The major component of revenue growth has been the increase in user fees charged for participating in programs, which have grown from just over 30 percent of the total in 1980 to more than 45 percent in 1994. Overall, internally generated income derived from sales of services and dues has increased from 60 percent to almost 80 percent of the total over this period, while external income derived from grants and contributions has declined from 40 percent to a little over 20 percent. Below, we offer a preliminary statistical model for explaining the changes in various components of commercial income (called "activity" or "service" fee income by the JCC Association) that JCCs received between 1993 and 1994. We hypothesize that: The level of commercial income in a given year depends on basic membership revenues in that year, external donative revenues in that year, the operating surplus or deficit in the previous year, and various environmental or "control" variables, such as organization size and geographic location, that may affect commercial revenues for a given JCC. It is difficult to estimate this model directly because commercial income, membership income, and external income are all correlated with the total revenues of the organization, leading to colinearity problems. Thus, it is helpful to transform the model into first difference form, by subtracting the equation representing this relationship in one year from that of the next year. Thus, for the years 1994 and 1993, our model is the following: Change in Commercial Income from 1993 to 1994 = Jc(change in basic Member Revenues from 1993 to 1994; change in External Income from 1993 to 1994; change in operating Surplus or Deficit from 1992 to 1993). Note that the control variables are presumed not to change between 1993 and 1994, and hence drop out of the equation. Nonetheless, in our analysis we repeated our estimation of this model for different subsets of JCCs, by size and location, to determine whether the management processes among those subsets

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vary in a manner that affects the parameters of decision making on commercial income generation.2 Various measures of the dependent variable Commercial Income were estimated, including 1 Program Fees, for services such as day care and summer camps; 2 Unrelated Income, encompassing revenues from special fund-raising events and facilities rentals; and 3 Total Sales, which is the sum of Program Fees, Unrelated Income, and fees for health-club services.3 The sum of these three components reflects the overall package of options available to a JCC that wishes to generate sales income. As noted, the foregoing model assumes that an executive of a JCC decides how aggressively to pursue commercial income strategies, contingent on the expected levels of other "exogenous" income streams (including regular membership dues as well as grants and contributions received from outside sources), and the JCC's financial performance in the previous year. An operating surplus from the previous year, or any increase in membership and external revenues, will reduce the pressure to generate commercial income; an operating deficit or a decrease in those revenues will increase the incentive to generate commercial income. Thus, we expect the signs associated with External Income and Surplus to be negative. Commercial income may reflect promotion of less favored activity, or instituting or raising prices, hence curtailing demand for preferred activities. All other things equal, our framework suggests that managers prefer not to pursue such policies and are inclined to increase commercial income only where it helps to compensate for expected losses in other revenue streams or to stanch operating losses (see Chapter 6). The matter of membership revenues is more nuanced, given the dynamics of membership fees. An increase in membership revenues reflects either an increase in the number of members, or an increase in membership fee levels, or both. If the number of members increases, this represents an enhanced base of customers to whom supplementary fee-based services can be sold. Most earned income services, such as day care, nursery schools, summer camps, or health clubs, are indeed sold primarily to individuals who are JCC members. Thus, we 2

3

The consecutive years 1993 and 1994 were chosen for three reasons: first, the reporting format for the data has changed over time, and these two years were recorded consistently with one another. Second, these are the most recent years for which these data were available. Third, the model presumes that allocation decisions are made on a year-to-year basis, with this year's decisions depending partially on last year's financial performance. Thus, analyzing changes in consecutive years most closely tracks the character of the decision-making process. Note that health-club fees are supplementary to regular membership fees. Many JCCs do not have health clubs, and they are an optional service to members where they do.

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may expect a positive relationship between membership fee income and commercial income. The net effect of an increase in membership revenues on commercial income will be the difference between the conventional negative influence (crowd-out) and the positive influence of an increased membership base. We need to justify the assumptions that membership revenues, external income, and surplus are indeed exogenous (i.e., essentially given to JCC managers and independent of their commercial revenue decisions). External donative income is most easily understood to be exogenous: These revenues are provided by governments, foundations, United Way, and local Jewish federations. Although allocations of these funds to individual JCCs may be influenced somewhat by the energy or creativity of their managements, they are probably much more heavily determined by the condition of the local economy, trends in giving and government expenditure, and competing demands on charitable funds. Membership revenues are conceivably more influenced by management and less clearly exogenous; however, memberships serve a different objective for JCCs than do program fees or other sources of internally generated funding. An overall goal of JCCs is to provide for the cultural needs of local Jewish communities. Maintaining Jewish identity, community traditions, and cohesion are overriding imperatives to maximize participation in JCC programs. Therefore, membership enhancement rather than revenue generation serves as the primary influence in centers' membership drives, despite pressures from some funders to increase member revenues; JCCs are thus disposed to keep membership fees low enough to maintain current members and attract new ones. For purposes here, membership fee policies are taken as given in management's general deliberations on revenue strategy, although this may not be entirely accurate. Finally, we have assumed that an operating surplus or deficit in a given year serves as a signal to a JCC executive as to whether sales activities should be pursued more or less aggressively in the next year. Since the previous year's deficit is historical fact and cannot be affected by current-year decisions, we can treat it as exogenous. Data on a sample size of eighty-one JCCs were available for the years 1992, 1993, and 1994. Both linear and log-linear regression models were estimated for the entire sample and for subsets of organizations in different regions of the United States and different-size cities. The JCC Association classifies the urban areas in which each tabulated JCC is located into one of four categories - intermediate, large intermediate, large, and metropolitan - using a combination of three factors: Jewish population size, total expenditure budget, and number of members. Hence the categories are as much an indicator of JCC size as of the size of the city in which it is located. We did separate analyses for the thirtyfive JCCs classified as large and metropolitan, and for the forty-six cases classified as intermediate and large intermediate, to see if the operations and management processes in larger-city JCCs were different from those in smaller ones.

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Each center was also classified by region of the country (and Canada) as defined by standard grouping of states (Lincoln Library of Essential Information 1966). We performed separate analyses for the thirty-six centers located in the New England and Mid-Atlantic states and for the forty-three centers located in the other U.S. regions to see if differences in managerial cultures or traditions manifested themselves by region. Although significant results were found for several different estimations, the most consistent and significant were obtained for the log-linear regressions using the forty-six JCCs in the smaller-city subset.4 These estimations, displayed in Table 10.1, highlight the following findings: Change in External Income is significantly and negatively related to change in Program Fees revenue, consistent with theoretical expectations. Elasticity is -31 percent for this relationship; that is, a 10 percent decrease in External Income is associated with a 3.1 percent increase in revenue from Program Fees, all else held equal. Change in Surplus is positively and significantly related to change in Unrelated Income, with a modest elasticity of 1.4 percent. The sign of this relationship is counter to expectations of our model. Rather than slacken Unrelated Income activities when they run surpluses, JCCs may be mildly inclined to pursue them further, perhaps to hedge against risk, accumulate capital for future investment, or for other reasons, as suggested by Chang and Tuckman (1990). A positive and significant relationship exists between Total Sales and Member Fees, and a significant and negative relationship between Total Sales and External Income. The elasticity of change in Total Sales revenue with respect to change in External Income is modest, approximately -2.5 percent. However, elasticity of change in Total Sales with respect to change in Member Fees is quite large: An increase in Member Fees yields a proportional increase in Total Sales almost twice as large. These results are generally consistent with theoretical expectations: Where significant, external income exhibits an inverse relationship with commercial income (as was also hypothesized in Chapter 3). Membership revenues, which probably reflect changes in underlying membership rolls, exert large direct effects on total sales income because services such as health-club privileges are 4

It is not obvious why these results emerge significantly for the smaller-city subset and, except for the membership revenue effect, not for the data set as a whole. Although there are no dramatic differences in the distribution of funding sources of JCCs in the smaller versus larger cities, the smaller JCCs may nonetheless feel more vulnerable to changes in external income from grants and contributions. Hence, a reduction in external income may be more likely to prompt compensatory action to increase sales income in these organizations.

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Table 10.1. Log-linear regression analyses offactors affecting commercial income in smaller-city Jewish Community Centers, 1993-4 Program Fees

Unrelated Income

Total Sales

External Income Membership Revenues Surplus

-0310* 0.818 -0.00904

0.00377 -0.0657 0.0138**

-0.0245* 1.95** 0.00723

Constant Significance (F) Adjusted R2 Sample size

0.479 3.005* 0.134 46

3.26** 5.01** 0.236 46

-3.19* 9.091** 0.384 46

Note: All variables are logged differences of 1994 values minus 1993 values, except for Surplus, which is the logged difference of (1993 Surplus) - (1992 Surplus). Surplus is measured as the difference between total revenues and total expenditures in a given year. *Significant at .05 level **Significant at .01 level

purchased by members. However, operating surplus is found to exert an unanticipated small direct effect on unrelated commercial income. The fact that commercial income is inversely related to external income suggests that policymakers need to examine whether new donor incentives can be created to maintain contributions in the context of increasing reliance on sales revenues. Moreover, since government grants and contracts are a component of external income for the JCCs, the analysis suggests that government also needs to examine how much its own direct funding cutbacks exacerbate reliance of nonprofits on commercial income. Conclusion The case studies of national associations and the statistical analyses of JCC affiliates support our conceptual framework for understanding the pursuit of commercial income by nonprofit organizations. In particular, new sales initiatives, imposition of fees for mainline services, and collaborations with business all appear to be driven by a combination of desires to promulgate favored (i.e., mission-related) services and to generate surplus revenues. It appears to be the rare initiative that does not contain elements of both of these motivations. Indeed, few if any of the commercial initiatives of the studied associations are easily characterized as undertaken solely for the revenue, or as "disfavored" in the sense of detracting from the organization's mission. Even where initiatives

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seem largely designed for their revenue-producing potential, associations generally go to some pains to demonstrate how these activities are supportive of their organizations' purposes, constituents, and capacities. In virtually every case, associations can identify some direct contribution that an initiative makes toward its mission. Moreover, the six national associations appear to exercise significant caution to ensure that their commercial activity damages neither the organizations' reputations nor their abilities to promote their work among constituents - the two principal assets upon which these associations rely. Indeed, it is these nonprofits' reputations that make them attractive to their corporate business partners. Our results suggest that nonprofits are moved to increase sales income by financial considerations. This is consistent with the theoretical expectation that nonprofit managers undertake sales initiatives or raise prices only reluctantly when the welfare of their enterprises is threatened by cutbacks in government grants or private giving. The JCC analysis specifically confirms the apparent substitution effects between external (contributed) revenue and reliance on income from sales. It must be noted, however, that the directionality of this crowd-out effect of contributions on commercial income requires further investigation. Though it seems likely that reductions in exogenous donated revenues lead to at least partially compensatory increases in JCCs' sales activity, it may also be the case that commercial venturing and the raising of fees and charges by the JCC affiliates lead charitable and governmental sources to reduce their grants to these organizations - a matter about which little is known. Some other financial considerations that might be expected to influence the undertaking of commercial initiatives appear to be relatively unimportant. In particular, UBIT appears only to be a minor concern for the six national associations; they pay little such tax, and appear to design their sales programs to avoid tax vulnerability (Chapter 5). Similarly, the JCC analysis suggests that financial performance, as measured by the previous year's operating deficit or surplus, does not influence commercial income generation in a major way. Finally, the JCC analysis also makes clear that considerable variation in practices exists among local nonprofits in their approaches to commercial income. In particular, important differences exist between larger- and smaller-city JCCs. The six national associations also exhibit a wide variety of commercial practices. In all cases, however, it is fair to conclude that commercial income is becoming more important over time as a source of revenue, and all of these organizations continue to examine their options and strategies for generating more such revenue.

CHAPTER 11

Zoos and aquariums

Louis Cain and Dennis Meritt, Jr.

Introduction Those who have not visited a zoo or aquarium since LB J was president will find a quite different place. The menagerie mentality, cages and tanks arranged for display purposes, has disappeared. The best zoos are no longer those with the most different kinds of animals. As part of the ecological awakening that culminated in the passage of the Endangered Species Act of 1973, and part of their historic mission of exhibiting animals, zoos and aquariums transformed their display space from cages and tanks to habitats designed to promote normal behavior. By helping to create an environment in which breeding could take place, this investment in new capital helped promote a second mission, one to which these institutions have rededicated themselves - species preservation. There have been other changes as well: To facilitate research, laboratories and libraries have been expanded. To provide education, classrooms have been constructed and teachers hired. All the while, zoos and aquariums have tried to remain financially accessible to low-income citizens. What has changed little since the founding of the American Zoo and Aquarium Association (AZA) in the 1920s is the mission of these institutions: to promote and advance zoological parks and aquariums; to aid in the exchange and importation of zoological specimens; to provide exhibits for scientific, educational and recreational purposes; and to aid in the preservation of wild life.1 What has changed are the weights attached to each of these goals and the means adopted to accomplish them. The Endangered Species Act of 1973 reflects a recognition that human action has imperiled the survival of an increasing number of species. By one estiWe thank Neal David, Joseph Feme, Craig LaMay, and Jan Schweitzer for their comments; Supriya Mathew and Gina Germane for their research assistance. 1 The earliest citation we could locate for these goals is Doolittle (c. 1932,100).

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mate, 20 percent of all species resident in rain forests will become extinct over the next quarter century. By another, it takes ten million years to replenish what is lost after a wave of extinction. As Edward Wilson has observed, "Humanity is now destroying most of the habitats where evolution can occur" (Wilson 1993, 29).2 As implemented, the goal of the federal legislation is to minimize the probability of extinction, but that legislation has been concerned primarily with wild populations. Zoos and aquariums, the institutions responsible for captive populations, have adopted an identical goal, yet they play almost no role in this legislation - nor in the resulting policies.3 All concerned have strong preferences for attempting to preserve species in the wild, but it will take more than habitat acquisition and protection to prevent extinction (see, e.g., Randall 1986; Williams and Nowak 1993; see also Tober 1981). It has been estimated that, in the next half century, at least fifteen hundred species will be so endangered that their survival will require captive propagation (Foose 1993, 163).4 Species such as Przewalski's Wild Horse and the California Condor survive today only in captivity.5 Consequently, zoos and aquariums have undertaken a coordinated program to preserve endangered species. In 1980 a report entitled "A Species Survival Plan for AAZPA" (Meritt 1980) was presented at the association's annual meeting.6 A Species Survival Plan (SSP) is a cooperative agreement among accredited AZA members and similar institutions internationally to preserve the gene pool of endangered species through controlled breeding for genetic diversity. Such plans have led to the development of a large computerized data base, the International Species Inventory System (ISIS), that tracks the animal collections of the major institutions (see Seal 1976). In short, once zoos and aquariums renewed their dedication to this mission, modern technology was brought to bear in a short amount of time. There is a heightened sense of urgency. Until the 1960s, scientists estimated the total number of animal and plant species at approximately three million. Advances in both taxonomy and statistics over the next two decades caused that estimate to be raised to ten million. This explosion in the number of species suggested the possibility that many more were endangered than originally believed. 2

The purpose of the Endangered Species Act of 1973 is to provide a means for conserving the habitats in which endangered species reside, as well as to conserve the species themselves.The U.S. first passed wildlife conservation laws around 1900; endangered-species conservation legislation was passed in 1966 and 1969 prior to the Act of 1973. 3 The entire spectrum of legislation in this area is discussed in Bean (1983). Federal monies have been allocated to purchase critical habitat, but the public funds that have been made available to zoos and aquariums have come largely from local governments. 4 Over the same period, it has been estimated that the efficient utilization of resources will enable zoos and aquariums to house approximately a thousand species (Conway 1986). 5 There are plans under way to reintroduce these species into their native habitat. 6 Prior to 1994, the association was called the American Association of Zoological Parks and Aquariums (AAZPA).

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The first official federal list of endangered species, the "Redbook," appeared in August 1964 and included only sixty-three vertebrate species. Captive propagation programs such as SSPs are a short-term solution to a surprisingly long-run problem: The primary objective of captive propagation, however, is the reinforcement, not replacement, of wild populations. Captive populations are not an end in themselves. Even if the worst occurs in the immediate future, we must be optimistic that in several centuries, perhaps as long as 500 to 1,000 years, the human population will stabilize and decline. It should then be possible to restore or even reconstruct ecosystems, but only if we have kept all the parts. (Foose 1993, 150) Each organism contains a genetically coded blueprint, one that we still do not understand all that well. The only way we have of retaining the information from, say, a rain forest is to protect it, to preserve it as it is. To quote Edward Wilson: The surviving biosphere remains the great unknown of Earth in many respects. On the practical side, it is hard even to imagine what other species have to offer in the way of new pharmaceuticals, crops,fibers,petroleum substitutes and other products. We have only a poor grasp of the ecosystem services by which other organisms cleanse the water, turn soil into a fertile living cover and manufacture the very air we breathe. (1993, 29) The transformation of zoos and aquariums from menageries to habitats is part of the attempt to resolve this uncertainty. Whereas exhibition was once primary, species preservation (including the attendant research and education) has become at least as important. That transformation involved a considerable investment in plant and technology, one that severely strained the financial constraint of many institutions. Zoological parks and aquariums are often cited as examples of merit goods, goods that the public demands but is unwilling to purchase at prices that cover costs.7 The principal reasons people go to zoos and aquariums reflect a different set of motivations than those of the people running them. Demand and supply was ever thus. The hypothesis of this chapter is that, to meet the increase in costs associated with the re weighing of their goals, zoos and aquariums have faced a tight financial constraint and have increasingly turned to commercial activity. As explained in Chapter 3, the revenue-generating activities are divided into those connected with the organization's preferred private goods (or PP-goods; e.g., animal exhibition, for which it can charge user fees) and the preferred collective goods (or PC-goods; e.g., species preservation, education, and research, for which it cannot). The PC-goods have been the motivation for the capital improvements that have been made, even though there clearly are important spill7

This follows from the definition in Musgrave (1959). See, for example, Netzer (1978), 16-18. It is clear that zoos are externality-producing collective goods; see Throsby (1994), 23.

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overs into the provision of the PP-good. As we shall demonstrate, there has been no change in the structure of demand for the PP-good. More money could be raised through increased admission fees (the sale of the PP-good), but zoos and aquariums have been restrained in their use of that approach lest they become inaccessible to poor families. (See Chapter 4 for more on such distributional goals.) The Reagan-era tax-rate reductions, which increased the price of charitable giving, led to a reduction in donations.8 Consequently, zoos and aquariums have turned increasingly to the sale of nonpreferred private goods (or NPgoods; e.g., stuffed animals, T-shirts, food), the sale of which has been growing in importance. Still, the PP-goods must not be neglected for they are what keeps these institutions in the hearts and minds of their consumers. In order to examine our hypothesis, we study zoos and aquariums that are members of the AZA.9 Because of the limits on what the statistics collected by the AZA reveal, we conducted two case studies: the relatively small Glen Oak Zoo, owned and managed by the Peoria (IL) Park District, which has an annual attendance that has remained at 125,000 for several years; and the large Lincoln Park Zoo in Chicago, with a reported four million visitors annually, which is managed by the nonprofit Lincoln Park Zoological Society and subsidized by the Chicago Park District.10 Most U.S. zoos are like Glen Oak. They are in the public sector, customarily part of a park district for budgetary purposes. Most have a private support group, a zoological or aquarium society, that provides supplementary funds. Although most can be characterized as "public," this merely describes features such as ownership or primary source of funds.11 There are no substantive differences between the goals or operations of public and private nonprofit zoos and aquariums. Glen Oak's goals and how it would like to accomplish them are substantially the same as Lincoln Park's. Statistical overview Zoo finance is complicated by the fact that there are usually multiple budget authorities to which a single institution reports. Animal care typically is as8

Many public subsidies are tied to private donations through some degree of matching arrangement. 9 As a first step, we sought and gained the endorsement and encouragement of the Board of Directors of the then-AAZPA. They were extremely supportive because no one, from any discipline, has ever attempted this analysis. 10 The zoo was owned and managed by the Chicago Park District until 1 January 1995, when management was turned over to the Zoo Society under a thirty-year operating agreement. 1 ! There are a few AZA members that are private, for-profit enterprises, but they are not included in this study.

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signed to the zoo or aquarium's budget, but maintenance and repair might be the responsibility of the park district in which the zoo is located. Development operations (membership, gift shops, and the like) are often the responsibility of a private zoo society. Our limited sample is based on annual reports and budgets from eighteen zoos and aquariums in the United States. There is great variety in the manner in which the information is reported, which limits the analysis.12 For assessment purposes we divided the fifteen-year period between 1975 and 1989 into three consecutive five-year periods. The zoos and aquariums represented in Table 11.1 were those for which we had both income and expense information for at least two years within two of these three periods. Hence this table represents only nine institutions, although its basic contour is unchanged if the information from the other nine is included.13 Table 11.1 is an attempt to sort out some common denominators. It was assembled as follows: The information for each institution was reconfigured into common categories (i.e., membership revenue) for each year. The revenue in each category was expressed as a percentage of the total. We then calculated, for each institution, the simple average of those percentages for each five-year period. The table reports weighted means of the average percentages over all institutions.14 Table 11.1 also provides a preliminary look into the question of whether organizational size mattered. The institutions have been divided between "large" (six) and "small" (three) institutions to see if there were any differences. We defined "large" as an institution with annual revenue (or budget) greater than $1.5 million.15 The growing commercialization hypothesis implies zoos have become more dependent on commercial revenue (sale of the NP-good) over time. There is a substantial decrease in the percentage of revenue derived from donations between the late 1970s and early 1980s. In all three groupings, fewer total dollars were received from donations in the late 1980s than a decade earlier. Given this decrease, all the other percentages increase between the late 1970s and early 1980s, with the exception of admissions (sale of the PP-good) in small zoos.

12

There may well be some sample selection bias: We believe the majority of U.S. zoos and aquariums operate at a deficit, yet of the ten institutions for which both revenue and cost data are available, only three reported an operating loss. The remaining eight sent us information on their (budgeted) expenditures. 13 A few, too few, institutions sent us information for earlier years. The data for the years before 1975 are consistent with what is reported in these tables for the period 1975-9. 14 The weights are the proportion of each zoo's total income or total expenses to the pooled total for all the zoos. ^ The choice of $1.5 million was purely arbitrary. There are two institutions with average revenues within 10 percent of that figure. Most were either in excess of $3 million or less than $1 million.

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Table 11.1. Overview of zoo finance 1985-9

1980-4

1975-9

All institutions Total revenue Donations Admissions Concessions Memberships Other Total expense

$4,972,366 0.2081 0.4520 0.2296 0.0601 0.0502 $5,224,022

$3,235,849 0.2849 0.4298 0.1962 0.0545 0.0346 $3,359,051

$1,868,628 0.5819 0.2936 0.0923 0.0112 0.0209 $1,876,734

Large institutions Total revenue Donations Admissions Concessions Memberships Other Total expense

$6,851,091 0.2143 0.4554 0.2227 0.0604 0.0472 $7,218,020

$4,450,736 0.2934 0.4328 0.1855 0.0548 0.0335 $4,643,504

$2,746,566 0.6024 0.2786 0.0887 0.0110 0.0193 $2,785,931

Small institutions Total revenue Donations Admissions Concessions Memberships Other Total expense

$1,214,917 0.1383 0.4139 0.3076 0.0566 0.0837 $1,236,025

$806,074 0.1913 0.3959 0.3143 0.0518 0.0467 $790,145

$551,721 0.4288 0.4059 0.1195 0.0132 0.0327 $512,939

Note: Dollar amounts are annual averages. Other numbers are proportions of total revenues.

The growth of expenses reflects commitments, particularly to increases in PC-goods, that zoos and aquariums made in the 1970s, when they would have anticipated the composition of their revenue stream to contain a larger share of donations than was realized in the 1980s. Though they might have anticipated that donations would not grow as fast as required revenues, it is doubtful they anticipated the drop that occurred. Both large and small institutions began selling memberships, which increased from slightly more than 1 percent of revenues to around 5.5 percent. Both increased the proportion coming from concessions by about 2.5 times. Large zoos and aquariums increased the portion coming from admissions, but this remained relatively constant for the small ones. To understand the search for replacement revenue, to see why all zoos and aquariums turned to sales of the NP-good as well as to raising the price of the PP-good, it is necessary to take a closer look at all potential revenue sources.

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Donations The decline in the share of total revenue coming from donations was true for both large and small institutions, although the small ones received approximately two-thirds the percentage of revenues from donations as large institutions (and no more than 15 percent of the absolute amount of donations) in each period. This is attributable, in part, to the fact that, among the zoos in our sample, local government subsidies were more often accounted explicitly by large zoos, but this does not explain the entire one-third difference. Small zoos have always been less dependent on donations than have large zoos, as the smaller percentage for these institutions attests. From our analysis of the Lincoln Park Zoo we find that its individual donations largely have been for capital purposes. The 1996 fiscal year, which ended on March 31, is the first complete year under privatization, and in that year reported contributions were 42.8 percent of revenue.16 With privatization, there was a major need to solicit donations to help build an endowment.17 Corporate donations are intermingled with corporate sponsorships (also accounted as donations) - the Smith Company building rather than the Mr. Smith building. This is largely an untapped area at Lincoln Park, as well as at other zoos and aquariums. Approximately 10 percent of the Glen Oak Zoo's revenue comes from donations. This is, in part, the result of an Adopt-an-Animal program that parallels one offered by Lincoln Park. In part, the donations are the result of the efforts of the Friends of Glen Oak Zoo, a support group that has helped provide capital funds and, in recent years, about $12,000 per year in operating funds through the solicitation of donations, but also through the sale of memberships and NPgoods at concessions stands. A generally unrecorded form of donation toward operating costs comes as food for the animals: Glen Oak receives occasional usable donations from grocers; Lincoln Park gets substantially more.18 Glen Oak provides an excellent example of a second type of unrecorded donation that goes toward capital costs. The zoo transformed its old lion cage into an education room and constructed a new, outdoor lion enclosure with volun16

17

18

This contrasts with a much lower percentage for large zoos in the most recent period reported in Table 11.1. During this time, the zoo was nearing completion of a major capital-fund drive. The accountants created estimates for the 1995 fiscal year in which "contributions" were an even larger percentage of larger reported revenues. Endowment income helps smooth the annual variation in ordinary income, especially for those institutions charging admission fees. An event such as privatization represents a "hook" to solicit such donations, but it was not fully realized by Lincoln Park. The zoo recently received a three-year grant to develop a planned-giving program. When Lincoln Park acquired koalas, it needed a source of eucalyptus. It receives a donation by means of which several species of eucalyptus are grown in Florida and airlifted to Chicago on a regular basis.

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teer labor (including the architect) and materials at (or below) cost. The total out-of-pocket cost was roughly $50,000, as opposed to $300,000 if, as would be true at a large zoo, the factors were purchased at market prices. Admission fees The Lincoln Park Zoo has never charged an admission fee. As part of privatization, the Chicago Park District pledged it will provide a subsidy to the zoo so it can continue to operate without one. The monetary value of this pledge in 1996 was $5.5 million, approximately a third of reported revenues; whether that will suffice to ensure free admission in the future remains to be seen.19 The Glen Oak Zoo, under its agreement with the Peoria Park District, is currently responsible for raising 56.7 percent of its budgeted revenues. Presently, 50 percent of its $600,000 annual budget comes from admission fees ($3.25 for adults and $1.50 for children), slightly higher than the 41 percent reported for small institutions in Table 11.1. To evaluate admission fees (i.e., sale of the PP-good) as a potential revenue source, we collected data from 111 nonprofit, AZA-accredited institutions that reported in 1994 and the 85 institutions in this group that had also reported in 1968. The average adult admission charge had increased from $0,210 in 1968 to $3,934 in 1994 - by a factor of almost 19. There are at least two reasons, besides general inflation, why prices jumped so dramatically over this period. First, the proportion of institutions charging admission has increased. A symposium at the 1965 AZA Annual Meeting debated the question of admission fees; the consensus was that a modest such fee - one that was not set to raise revenue - helped to minimize problems such as loitering and littering, yet kept the zoos and aquariums accessible to low-income families ("Symposium on Free versus Admission Zoos" 1965, Z26-33, Z73-5). The average adult admission in 1994 ($3.93) can be considered "modest" in comparison to alternative attractions. It also can be argued that the average adult admission overstates the true price: Zoos and aquariums customarily admit members without additional charge every day, have well-publicized "free days" (often a designated day each week), and admit school groups and the like without charge for educational programs.20 The symposium did not discuss what impact raising fees might have on revenues, nor how much it might cost to collect an average admission fee of $0.21. In any event, it is clear that many of the institutions that had been free in 1968 were charging admission in 1994. 19

20

For the following seven years, the Park District contribution will change with the CPI, then become frozen in nominal terms. Haeseler (1988,173) reports that, in a sample of thirteen zoos, free admissions accounted for an average of 29 percent of total attendance.

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Second, in the 1980s, zoos raised admission fees in an attempt to raise revenue, particularly to help defray the cost of constructing new habitats. The average adult admission fee in real terms (1982-4 = 100) increased from $0.60 in 1968 to $2.65 in 1994, an average annual increase of 5.9 percent over twentysix years. Although it is not completely clear why these institutions adopted a more aggressive pricing policy, the timing suggests that the absolute decline in donation dollars between the late 1970s and early 1980s may have been an important stimulus.21 The available data on attendance are also an overestimate of what an economist would like to have. The AZA reports the Annual Attendance claimed by each accredited zoo; in some cases this is only an educated guess on the part of the institution - many zoos (especially the free ones) do not have an accurate count. Nonetheless, even if accurate attendance figures were available, it would still be true that many of the attendees did not pay the full adult admission. Mindful of data limitations, regressions were run for 1968 and 1994, using this quantitative information as the dependent variable, to address the question of whether the structure of demand had changed in any way that would enable zoos and aquariums to rely more heavily on admission fees. The Price variable is the institution's adult admission rate. As noted, this is an overestimate of the average amount collected; in fact, we believe it to be more highly overestimated than the attendance data. For this reason, the estimated coefficient, showing the relationship between price and the level of attendance, will be biased upward. Other independent control variables include the Population of the metropolitan area in which the zoo is located and the median Income of families for that metropolitan area. Both variables are taken from the Census of Population for 1970 and 1990, respectively. Visitor surveys suggest that those most likely to attend zoos and aquariums are families with children.22 They also suggest that older people are unlikely to attend because of the amount of walking involved. Consequently, the percentages of the metropolitan population aged Under Eighteen years and those Over Sixty-Five are included. These also come from the two Censuses. Given that these institutions reputedly set price with reference to the goal of retaining access by low-income residents, a variable is included for the percentage of Low Income persons in the population. The data used are from the County and City Data Book and reflect the percentage of low-income residents in the central city defining the metropolitan area (reported as "low income" in the 1972 book [1969 data] and "poverty income" in the 1994 book [1989 data].) 21

22

A second important stimulus, to be discussed below, was a renewed effort to attract members, and free admission is one of the normal benefits of membership. A number of visitor surveys have been published in the Proceedings of the Annual Meeting of the AZA. In addition, we solicited such studies from all AZA-accredited institutions.

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The number of species and specimens, both of which are reported by AZA, are indicators of institution size, statistical measures of the depth and breadth of a collection. They are highly correlated, however, and only the Number of Specimens is used in our statistical analysis.23 There are some difficulties with this measure. For example, a zoo specializing in large mammals is likely to require a larger space, yet have fewer species and specimens than a zoo specializing in invertebrates. Casual empiricism (confirmed by the data in this case) suggests a strong, positive correlation between the size of an institution and annual attendance. According to the visitor surveys, the modal zoo visitor unit during the week is a mother and her children; the father is present on the weekend. Since these institutions represent one of the few places a family can take young children for an outing, the Number of Competitors is defined as the number of AZAaccredited institutions in the area.24 One dummy variable, Aquarium, was added as a reflection of the differences between zoos and aquariums; each institution that is exclusively an aquarium was noted. A multiplicative specification of the functional form has been selected; the variables appear in logarithmic form, with the exception of the three measured in percentages and the one dummy variable. One can interpret the coefficient of the logarithmic variables as elasticities. Further, it is assumed these institutions are providers of a strictly private (PP-)good: the opportunity to view animals. Almost all of them receive some type of subsidy, if only the ability to use public land on favorable terms; they are not dependent solely on admission fees for revenue.25 The results of the estimations appear in Table 11.2. The coefficient on Price has the expected negative sign and lies between -1 and 0 in both regressions, although it is not statistically significant in 1994. As noted earlier in this section, it is biased away from zero. The fact that zoos and aquariums operate in the inelastic portion of their demand curves suggests they do not set price to maximize profits.26 The price inelasticity of demand implies zoos and aquariums could raise additional revenue through an increase in price. Increases in Population lead to increased Annual Attendance. A 10 percent increase in population is associated with a 2.9 percent increase in attendance. 23

24 25

26

Similarly, both the number of full-time employees and the annual budget are highly correlated with the number of specimens. The number of specimens is the least correlated with annual attendance. Commonly cited alternatives to such a trip are visits to parks and shopping malls. In almost all cases, subsidies for operating expenses are independent of other revenue sources. Subsidies for capital expenses are often on a matching basis. Given that both price and attendance are overestimated, it seems unlikely that the "true" coefficient is in the elastic portion of the curve.

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Table 11.2. Estimates of the demand for zoos and aquariums 1968 -0.6650* (-2.5066) 0.2868** In Population (3.3302) 0.5680 In Income (0.7318) 0.0086 % Under 18 (0.2482) % Over 65 -0.1135** (-2.6576) 0.0067 % Low Income (0.0257) In Price

1994 -0.0838 (-0.7672) 0.2916** (3.7945) 0.2010 (0.3578) 0.0044 (0.1827) -0.0237 (-0.8433) -0.0050 (-0.4063)

In No. of Specimens Aquarium No. of Competitors Constant

Observations (Aquariums)

1968

1994

0.6099** (6.9672) -1.2633** (-4.7808) -0.0098 (-0.0906) 0.8861 (0.1272)

0.5138** (9.0958) -0.3598* (-1.4636) -0.1528* (-2.2641) 3.9288 (0.6714)

0.780 85 (5)

0.667 111 (8)

Note: The dependent variable is the logarithm of Annual Attendance; f-values are in parentheses *Significant at .05 confidence level, two-tail test. **Significant at .01 confidence level, two-tail test. Sources: AAZPA, Zoos and Aquariums in the Americas, August 1968 and 1970; AZA, Zoological Parks and Aquariums in the Americas, 1994-95; U.S. Bureau of the Census, Census of Population, 1970, vol. 1, and Census of Population, 1990, vol. 1; County and City Data Book, 1972 and 1994.

This may be a reflection of the fact that our best-known zoos and aquariums are in larger cities and attract more out-of-town visitors. Of the five institutions with a 1994 attendance in excess of two million, all are located in metropolitan areas with populations greater than two million.27 Since the 1994 regression includes several smaller zoos that either did not report or did not exist in 1968, the mean annual attendance for 1968 was, in fact, larger than that for 1994 (see Table 11.3). The coefficient on Income is positive in both years, although it is not statistically significant. Zoos and aquariums are normal goods. The hypothesis that prices have been kept low to keep the institution affordable by the poor suggests an income elasticity between zero and one, and this is what we observe. The three demographic variables add little; only one of the six coefficients is statistically significant. The percentages Under Eighteen and Over SixtyFive both have the expected signs, but that of percentage Low Income changes 27

There are ten institutions reporting attendance greater than or equal to 1.5 million. Of these nine are in areas of greater than two million in population, the exception being the Monterey Bay Aquarium. At the other extreme, of the eight institutions reporting attendance less than or equal to 100,000, four are in areas of less than 250,000 and three in areas of 250,000-500,000; only the Brandywine Zoo is in an area of more than 500,000.

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Table 11.3. Means of variables Variable

1968

1987

Price Population Income % Under 18 % Over 65 % Low Income Aquarium No. of Specimens No. of Competitors Annual Attendance

1.46 804,621.4 10,183.17 34.51 9.03 10.54 0.059 795.49 1.42 490,345.6

5.18 1,049,441.7 36,797.47 25.80 11.65 18.36 0.072 1,183.81 1.68 461,999.8

No. of Species Specimens/Species

211.35 3.76

217.01 5.46

Sources: AAZP\,Zoos and Aquariums in the Americas, August 1968 and 1970; AZA, Zoological Parks and Aquariums in the Americas, 1994-95; U.S. Bureau of the Census, Census of Population, 1970, vol. 1, and Census of Population, 1990, vol. 1; County and City Data Book, 1972 and 1994.

from positive to negative. The reason appears to be the result of a North-South differential: On average, Southern zoos have a smaller annual attendance and are located in metropolitan areas where the percentage of low-income families is larger. The coefficients on the variable representing the size of the zoo, Number of Specimens, have the expected positive sign and are statistically significant. Just as the more popular zoos and aquariums are in the largest cities, they also tend to be larger than the average. The five institutions with an annual attendance over two million report an average of over 4,109 specimens and 552 species, in comparison to an average of 1,184 specimens and 217 species for all 111 institutions. It is also worth noting the increase in the number of specimens per species, consistent with the shift from menageries to habitats (see Table 11.3). The coefficient on the variable Number of Competitors is negative in both years, but it is statistically significantly different from zero only in 1994. This is consistent with the hypothesis that the presence of substitutes in the area reduces attendance. At the mean 1994 attendance, one additional institution in an area will reduce attendance by approximately 65,000. The coefficient on the Aquarium variable is always negative and statistically significant in both 1968 and 1994. At the mean 1994 attendance, aquariums drew roughly 140,000 fewer people.

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A Chow (F-test) was run to test for a change in the structure of demand between these two years. As noted, even though these years bracket tremendous changes in the nature of zoos and aquariums, the conclusion is that there has been no statistically significant change in demand as measured by the set of variables in Table 11.2.28 Zoos are beginning to take advantage of the inelasticity of demand by charging higher admission fees, but, between these two years, there was no significant change in demand that would make such fees a more attractive revenue source. Memberships As Table 11.1 reports, revenue from this source has increased from 1.1 percent in the late 1970s to around 6 percent, but it remains a relatively small percentage of total revenue. Memberships are a mixture of donation and concessions. The normal membership package includes benefits such as free admission. Most zoos and aquariums offer NP-goods (a stuffed animal or T-shirt) as an incentive for making the initial commitment that are not offered for renewals. Memberships in the Lincoln Park Zoological Society generate (subtracting direct acquisition and retention costs) about sixteen cents per dollar the first year and about eighty-three cents per dollar thereafter for the zoo's general revenue fund. Both the Lincoln Park Zoological Society and the Friends of Glen Oak Zoo plan continued efforts to increase memberships, but report relatively stable membership over the past few years. Although some increase is possible, Lincoln Park believes this is a "mature" revenue source that is not going to be a source of significant revenue increase. Glen Oak suspects the stability of membership they have observed is the result of a Friends group that has not been as active or as effective as would be desirable. They believe they could increase their market penetration. Concessions The final category of revenue, concessions, represents the sales of NP-goods. As Table 11.1 documents, concessions now generate approximately 22 percent of the revenue at large zoos and almost 31 percent at small zoos. These percentages were considerably smaller in the late 1970s. Although the percentage has increased steadily for the large zoos, it jumped dramatically for the small zoos in the early 1980s, then remained constant. It appears to be the case that, for 28

The statistical test is based on the residual sum-of-squares (RSS) for the individual regressions versus a pooled regression. The RRSs are 17.961 for the 1968 regression and 31.685 for the 1994 regression; that for the pooled regression is 54.652. The resulting value is /MO,186 = 1 595. The critical value at the 5 percent confidence level is /M0,200 = 2.56.

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small institutions, the installation of carnival rides and boutiques selling T-shirts has proved to be a more profitable strategy than the organized appeals to the charitable impulses of local government, business, foundations, and individual consumers that have proved successful for the large institutions. Most of the financial information we received did not provide a detailed breakdown of what is included in the "concessions" category. Those few cases for which information is available suggest that greater diversification is taking place. One zoo reported that "retail sales" accounted for roughly 67 percent and "parking" for 30 percent of gross concessions revenue in the late 1970s, but that in the late 1980s "retail sales" were only 15 percent, "parking" was 45 percent, and "rides" were 40 percent. Another zoo, which reported that "rides" comprised nearly 50 percent of gross concessions revenue in the late 1970s, now reports "rides" at roughly 25 percent; the difference was that its "gift shop" had increased from 5 percent to 35 percent. It is clear that these institutions continue to search for creative ways to enhance their revenue and that this process involves the development of new sources of commercial revenue (NP-goods) as well as an extension of existing sources. Although gift shops generally have excellent potential as a revenue source, they need to be of sufficient size and strategically placed. Those at the Lincoln Park Zoo are not; but even so, "visitor services," which includes food service, souvenirs, parking, and the like, accounted for 5.8 percent of net revenues in fiscal year 1996. There is a need to move shops (and restaurants) toward the periphery, where they can be open even when the zoo is not. The public is underserved in an area where the yield (profit) is close to 20 cents on the dollar. Concessions account for 30 percent of the Glen Oak Zoo's gross revenues, which is about average for small zoos in Table 11.1. The space devoted to the year-round gift shop has been increasing, and its revenue has been on the rise. Food service and pony rides, available seasonally, also provide commercial income. Phase 1 of the zoo's master plan calls for construction of a new gift shop; phase 2 for construction of a new concession compound, in recognition of its revenue-generating potential.29 Moreover, a large area to the side of the outdoor exhibits is being developed for rental purposes with the expectation that corporations and other groups will rent it for evening functions.30 Another way in

29

30

In addition, phase 1 will construct outdoor habitats for those primates still in indoor cages. Phase 2 will address the center core, with the main highlight being a giraffe exhibit in which the animals can be seen at several different levels. Special events (e.g., a corporate "day at the zoo" with special tours) ordinarily are one-day events that, if successful, can net as much as $25,000 for a larger zoo, less for a smaller one. In the overall scheme, this is a relatively small amount, but such events are being encouraged, as are fee-based programs.

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which such spaces are being used by zoos and aquariums is as sites for outings by conferences meeting in the city.31 Like most small zoos, Glen Oak is aggressively pursuing new ways to generate revenue through commercial channels. Concluding remarks As is true of many other nonprofit institutions, zoos and aquariums increasingly have found it desirable to cast a broader net in their search for revenue. The cause has been the reweighing of organizational goals and the more costly means adopted to attain them. Costs have increased as zoos converted their plant and equipment toward space more compatible with their increased emphasis on the goal of species preservation (a PC-good in the context of the model presented in Chapter 3). While admission fees are a feasible source of revenue with respect to the customary mission of animal display (a PP-good), beneficiary user fees are not feasible with respect to species preservation. The inelasticity of demand we found for viewing animals implies that additional revenues to fund the collective good can be obtained by raising admission fees. Since the vast majority of these facilities are nonprofits, however, those fees typically are set not to maximize profit (or even revenue), but at lower levels to achieve more socially oriented goals, such as facilitating attendance by the poor. Private donations and public subsidies, the other potential sources of funding for collective goods, have decreased, thereby increasing the pressure to find new revenue sources. This has led zoos and aquariums to look to new and expanded commercial activities (NP-goods). These activities, from selling stuffed animals to leasing space for private parties, lie outside the stated goals of these institutions, but they are understandable as complementary with unrestricted donations as means to finance provision of PC-goods. What are the consequences? The increased reliance on concessions has not led zoos and aquariums astray as yet. Most of these institutions are headed by individuals trained in animal management, but there is a need for this group to develop a stronger sense of the institution as a business. Financial constraints undoubtedly will prove more binding in the future as these institutions play an increasingly active role in species preservation, but it is doubtful that this would evolve to where financial concerns dominate animal ones. Gift shops and restaurants will remain secondary interests, in many cases outsourced to private firms. Raising admission fees will remain a viable way in which to increase revenues, but, given the fact that so many of these institutions are in the public sec3

! Additional revenue-generating activities include music performances on the grounds (jazz and country are the most common, with at least one zoo offering opera) and the sale of liquor, wine, and beer.

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tor, there will be weekdays when admission will be free. Low-income families will be inconvenienced, but not priced out of the market. Of greater consequence is the question, What happens if zoos and aquariums are successful in preserving species? Are the profits from stuffed animals and hamburgers an equitable way to cover the costs of deceleration on the road to mass extinction?

CHAPTER 12

Commerce and the muse: Are art museums becoming commercial?

Helmut K. Anheier and Stefan Toepler

Introduction In this chapter, we examine the commercialization of art museums by looking at trends and patterns of revenue and expenditures as well as other financial indicators over time. Commercialization involves greater reliance on earned income relative to other forms of revenue, such as donations and government grants. In the case of museums, earned income includes fees, sales, and charges that are related or unrelated to the charitable purpose of the organization. We first explore possible reasons for, and characteristic elements of, commercialization, and then look for patterns that might help explain whether (and if so, why) art museums have become more commercial over time. For the main part of this analysis, we make use of the tax returns (Forms 990) of the largest U.S. museums at five different points in time between 1982 and 1992. Over the past three decades the museum field has undergone major changes, as museums slowly transformed from secluded temples of culture to more popular institutions with considerable public appeal (d'Harnoncourt et al. 1991, 54-5). Beginning in the 1960s, both the number of museums and the number of visitors to them increased considerably. Attendance at art museums rose from twenty-two million in 1962 to forty-two million in 1975 to seventy million in 1986 and to over seventy-five million in 1988 (Heilbrun and Gray 1993,170). The number of art museums expanded as well. Indeed, one out of two American art museums was founded after 1970: 13 percent were founded in the 1980s, and 37 percent in the 1970s, whereas 18 percent were created during the 1960s, and only 31 percent of all art museums were founded before that decade (AAM 1992, 64). We would like to thank Eric Crutchfield and Virginia Hodgkinson of Independent Sector for making the data for this study available to us, as well as the participants in the commercialism workshops held at Northwestern University. 233

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The general expansion of the field was accompanied by a concomitant change in the resource structure of museums. Until midway through the twentieth century, art museums predominantly relied on endowments and individual patrons to support their ongoing operations and acquisitions of new art objects. Since the 1960s, however, new funders - namely government, foundations, and corporations - have entered the field. This shift placed new demands on museums: The new funders, while supporting the general expansion of museum activities overall, were less inclined to help finance ongoing operations and current expenditures. Instead, they preferred to support special activities such as exhibitions and outreach programs or specific acquisitions. This frequently resulted in a mismatch between the broader array of museum functions and the usually more narrow range of objectives pursued by funders. Financially, this mismatch could make it difficult for museums to meet operating expenditures, which, over time, may lead to chronic underfunding of some core areas. As Temin (1991,179) remarked, some museums "appear to be in a state of perpetual deficit." Despite the growth in public and private donative support to the arts for much of the past three decades, museums have nonetheless faced often latent, sometimes overt, commercialization pressures. As one observer holds, "in the last fifteen years or so many of those charged with governing nonprofits are more market-oriented than mission-oriented. . . . Mission gets blurred or is so elastic it can be construed to accommodate whatever might be the latest incomeproducing technique.... The trend is now more than evident in the museum world" (Malaro 1994,113). This is not to say that museums have never engaged in commercial activities in the past. To the contrary, the Metropolitan Museum of Art in New York, for instance, opened a museum shop as early as 1908 (Weisbrod 1988,109), and started a mail-order operation in 1921. However, such early ventures remained the exception rather than the rule. In contrast to other arts organizations, such as theaters, orchestras, operas, or dance companies, where earned income typically accounts for half or more of total operating expenditures (DiMaggio 1986a, 84), most art museums, by virtue of their charters, could not easily raise earned income by charging higher admission (user) fees. Nonetheless, it now appears that museums have increasingly become interested in generating income from fees, charges, and sales. One indication of this growing interest is a burgeoning of marketing-related articles that has occurred in museum trade journals since the mid-1980s, both in the United States and abroad (Rentschler 1996; see also Blattberg and Broderick 1991). Another indicator is the expansion of museums shops, both on-site and off-site (typically in shopping malls). Moreover, many museums are either establishing, remodeling, expanding, or upgrading cafeterias and restaurants to make them more attractive to a wider clientele.

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The business professionalization of museums may also cause internal tensions between curators, the traditional guardians of art museums on the one hand, and museum directors and administrators responsible for the financial viability of the institution on the other. Historically, museum directors were chosen from the ranks of curators. Recently, however, this unity of artistic and administrative responsibility has been weakening, as business background and orientation have become primary qualifications for museum directorships. Increasingly, museums are experiencing difficulties recruiting art historians as chief executives willing to take on the fund-raising and financial responsibilities the position entails (Riley and Urice 1996). The commercialization trend of museums raises important public-policy questions. Critics argue that the increasing business orientation among museums may deflect their original mission and, in the long run, endanger the basis for their preferential tax treatment. This point is forcefully put forward by Marie Malaro, who states that "growing commercialism . . . is changing the whole emphasis of what museums do, and it has all sorts of very serious ramifications. . . . It calls into question . . . why is this organization a nonprofit and why should it retain many of its privileges" (NPR 1996b). Still, how pronounced is this commercialization trend? Is it a general trend or does it affect only some types of museums? What are the forces behind commercialization, and what forms does it take? To answer these questions, we first look at the funding environment in which museums operate. Commercialization pressures Compared to other areas of nonprofit activity, the reasons for a trend toward commercialization among art museums are less obvious. Unlike health care, for example - the most commercial field of nonprofit activity - museums have not become dependent on government as their major financial customer; after all, government does not reimburse museums for services rendered to visitors. Unlike science and technology museums, art museums do not directly compete with commercial theme parks and similar organizations that increasingly shift their focus from pure entertainment to "edutainment" (Mintz 1994). Since high culture is typically prone to market failure, competition between art museums and for-profit firms is typically absent. As mentioned in the preceding section, until the mid-twentieth century, virtually all museums depended for support, both in terms of operating costs and acquisition budgets, largely on individual private patrons. Foundations had no significant presence in arts funding until the late 1950s, when the Ford Foundation and a few other large grant makers established special programs to support the arts and culture. The federal government followed in 1965 with the estab-

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lishment of the National Endowment for the Arts (NEA), which in turn fostered similar programs at state levels. Moreover, the Institute of Museum Services was established in 1976 to provide direct operating support to all types of museum, albeit to a limited extent. The 1970s, and even more so the 1980s, saw considerable growth in support for the arts from a number of sources, particularly government, foundations, and corporations. This influx of new financial resources into the arts sector has been substantial: Private giving increased from approximately $0.5 billion in the mid1960s to about $10 billion (current dollars) in the mid-1990s (AARRC 1997). By the same token, NEA appropriations increased from less than $3 million in 1966 to a high of $176 million in 1992, leveraging substantial additional state and local funding. Total government support in the mid-1990s was estimated at more than $1 billion (Cobb 1996). How do the increases in government and foundation support to the arts since the 1960s relate to possible commercialization pressures among art museums? There are four major reasons why commercialization may have grown among museums as the overall funding base broadened: First, the availability of new resources frequently supported capital investments, specific acquisitions, and special projects rather than general funds toward operating costs. The result was a significant expansion of the museum field: Not only did the number of museums increase during this period, but existing museums expanded as well. The 1988 Museum Survey of the American Association of Museums reports that close to half (47 percent) of all art museums reported major renovations, and nearly 13 percent moved to new building sites (AAM 1992,76). Second, art museums are subject to so-called cost disease. Using the performing arts as an example, Baumol and Bowen (1966) suggest that the arts are a rising-cost industry, in which increases in labor cost are not easily compensated by gains in productivity. Art museums also fit that description. Because technological advances can substitute for labor only to a limited extent, museums may face income gaps over time. Of course, new technologies have had, and are having, considerable effects on different aspects of museum operations, but personnel costs remain a major part of operating expenses, particularly for larger museums. As Robert Buck, Director of the Brooklyn Museum, has put it: "We are nine-tenths salaries. To keep the actual operation going with the number of educators we need, the number of curators, the number of guards is enormous . . . , " and private patrons often prefer to support named collections and buildings rather than "secretary salaries and supplies" (NPR 1995). Third, the objectives of funders may not be in tune with the perceived financial needs of museums. In a study on the influence of funders on museum exhibitions, Alexander (1996) suggests that the goals of individual donors, foundations, corporations, and government agencies frequently run into conflict with

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those of the museum staff, most notably the curators. Some exhibition projects favored by curators fail to attract sufficient interest among private and institutional donors, which in turn forces museums to finance such exhibitions internally, at least in part. Moreover, staging exhibitions may be the most visible, but it is only one of five major activities museums perform: the other four - collection, conservation, research, and interpretation - are typically more difficult to support financially (Noble 1970). (At least the latter two are the collectivetype activities highlighted in Chapter 3.) For instance, foundation funding for "collection and conservation" amounts to an insignificant share of total foundation giving to the arts, and has even declined over the past decade (Weber and Renz 1993, 89). Accordingly, despite a greater availability of donative resources, museums may still face difficulties attracting outside funding for certain core activities, forcing them to develop, and manage more effectively, internal resources including commercial income. This, in turn, affects the managerial behavior of the museum administration. Indeed, noncuratorial staff with business training (and business-oriented attitudes) is becoming increasingly frequent in museum management and administration, changing them from "scholarly to managerial organizations" (Alexander 1996, 95). Fourth, it now appears that government support for the arts has reached its peak. After significant growth in the 1970s, appropriations for the NEA, which had been crucial in stimulating both private and other governmental spending, became relatively stagnant during the 1980s and early 1990s, then were sharply curtailed in 1996 (NEA 1996). At the level of state government, art appropriations continued to grow until the late 1980s, before declining in the recession of the early 1990s (NASAA 1992). Starting in 1994, however, state support began to rebound (Institute for Community Development and the Arts 1997). Thus, four factors - increased operating costs due to past expansions, inherent difficulties to control costs, the divergence between funding needs and available support, and recently declining government funds - may have led museums to follow the general trend toward greater commercialism that has been observed in other parts of the nonprofit sector. What are the different commercialization options that museums may have adopted over the past decade? Commercialization options There are several basic options museums can pursue to increase commercial revenue. These range from admission fees, museums shops, parking garages, and sale of reproductions, exhibition books, catalogs, and postcards, to blockbuster events around special exhibitions that focus on famous artists, popular genres, or en vogue periods. We briefly discuss some of the major commercialization options under the headings "Admissions" and "Ancillary Operations."

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Admissions The setting of admission (user) fees remains a major problem for art museums. Perhaps most important, there are equity considerations involved. From the beginning, public education has been the main rationale for the establishment of art museums, and their basic mission was to make the fine arts more accessible to social groups otherwise excluded from art consumption, thereby improving cultural tastes and promoting a general moral uplift (Zolberg 1986,184-5). In keeping with that mission, most art museums have traditionally not charged admission fees at all, fearing "that substantial entrance fees would prevent the relatively poor from partaking" (Heilbrun and Gray 1993,179).1 (See Chapter 4 for analysis of pricing policy and distributional goods.) Indeed, in a survey conducted by the American Association of Museums, only 36 percent of art museums reported charging any admission fee, the lowest proportion among museums in general (AAM 1992,133).2 Moreover, many museums that charge such fees prefer suggested contributions over fixed prices, thereby voluntarily restricting their ability to exclude customers neither willing nor able to pay full fees.3 Other museums, while charging principally fixed or suggested admission fees, waive them either on specific days or for specific groups, such as schoolchildren or senior citizens. In recent years, the fees and suggested donations have been increasing (Wade 1997). However, restrictions in setting fees do not necessarily apply to special exhibitions. Beginning in the late 1970s, museums have gradually come to rely on blockbuster exhibitions, that is, exhibitions with high popular appeal, to generate additional income. For example, according to its 1995 annual report, the Philadelphia Museum of Art yielded record income from admissions as well as from museum shop and restaurant sales through the greatly successful exhibition "From Cezanne to Matisse: Great French Paintings from The Barnes Foundation." In fact, museum finances have partially become subject to what has been termed blockbuster economics, whereby museums apply profits from the blockbuster toward deficits in their current operating budgets (Parker et al. 1991,61). This is precisely the kind of commercial revenue cross-subsidization that the model presented in Chapter 3 predicts. 1 A recent survey among nonvisitors suggests that admission fees are indeed a major subjective entrance barrier, especially among low-income groups and for those living outside major urban centers; see Kirchberg (1996). 2 The AAM survey in 1988 included both public and private museums. Since public museums are often free by charter, the percentage of nonprofit art museums charging entrance fees may actually be higher. The percentage of all types of nonprofit museums charging admission is close to 62 percent (AAM 1992, 134). 3 According to the AAM survey, of those art museums that have entrance fees, roughly 43 percent have fixed fees and 17 percent suggested fees. The remaining nearly 40 percent of museums with admissions did not indicate whether admissions are fixed or suggested (see AAM 1992, 133).

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Ancillary operations Some of the major activities museums have undertaken to increase commercial income are expansions of museums shops, licensing arrangements with commercial firms, arrangements with travel agencies, and solicitation of corporate sponsorships (Malaro 1994,113-14). Other activities include the expansion of restaurants and cafeterias, renting out of museum facilities for special events, and parking operations. Judging from the literature, however, the main thrust of commercial activity has been on retailing and merchandising, as museums not only increased store space but also moved off-site to shopping centers and malls. As of 1997, the Metropolitan Museum of Art, for instance, operates fifteen off-site stores in eight states and nine countries abroad. Similarly, the Art Institute of Chicago operates three off-site stores, and the Museum of Fine Arts, Boston, has five. Moreover, some of the largest museums have recently moved into the catalog business, following the early example of the Metropolitan, which led the way in 1921. The Art Institute of Chicago started its catalog business in 1982 with five thousand copies; ten years later it mailed over two million (Trescott 1994). It seems as if merchandising has become a major economic obligation, particularly for larger museums. Such sales operations, for instance, accounted for close to 46 percent of total revenue of the Metropolitan Museum in 1995, and for nearly 60 percent of the Museum of Fine Arts, Boston. However, revenues imply costs. In the case of the Boston museum, merchandising revenue did in fact become more expensive in recent years: Although total revenues increased by about 25 percent between 1991 and 1995, and merchandising revenue by 33 percent, merchandising cost jumped by 43 percent during the same period (1996 annual report). In other words, in examining commercialization trends among art museums, it is important to examine the weight of such commercial activities in the context of other cost and revenue categories over time (see Chapter 5). We follow up on this question in the next section. Are museums becoming more commercial? Are we experiencing a massive trend toward commercialization among American art museums? Before we answer this question, let's take a look at the data used for our analysis. Data sources The data are based on a multistage sampling procedure that begins with the IRS Business Master File. From this data set, the IRS selects the IRS Form 990 Tax Return File of Nonprofit Organizations, which includes all nonprofit organiza-

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tions filing Form 990, the principal tax-return form used for tax-exempt entities. This data set forms the basis for the IRS-SOI Sample, which includes organizations with assets of $10 million or more that file Form 990 tax returns, and then a random sample, based on asset size, from the rest of the nonprofit organizations in the IRS Form 990 Tax Return File. Assets sizes are grouped into seven classes ($10 million or more; $5 million to under $10 million; $2.5 million to under $5 million; $1 million to under $2.5 million; $500,000 to under $1 million; $250,000 to under $500,000; and under $250,000). The probability of being sampled is relative to the asset bracket of organizations. Nonprofit organizations in lower asset-size brackets are less likely to be sampled than those in upper asset brackets. The IRS-SOI Sample of tax-exempt organization formed the basis for the compilation of the data on American museums in this analysis. From the IRSSOI Samples for 1982, 1987, 1989, 1990, 1991, and 1992 we selected all art museums, which numbered in the range 190-200 for each period. Each sample represents the bulk of economic activity of American museums in the given year. Using 1992 as an example, the 198 organizations in the sample account for 60 percent of all donative income, 90 percent of assets, and 80 percent of all expenses for the total of all 2,003 art museums in the IRS Form 990 Tax Return File of Nonprofit Organizations (Hodgkinson and Weitzman 1996,247, tab. 5.7). With the help of these six annual samples, we generated a consolidated "panel" data set that included all museums that were part of either the 1992 or the 1991 samples plus two other additional prior periods. Thus, we excluded museums that were present neither in the 1991-2 samples, nor reporting on two pre-1991 periods. This yielded a sample size for the consolidated panel data set of 263 museums. With the help of the consolidated panel data set, it is possible to track changes in patterns and trends over time more precisely than would be the case in a cohort design, let alone cross-sectional analysis. Commercialization trends? Our data suggest that art museums have not become significantly more commercial in recent years. This does not mean, however, that no commercialization trend can be identified at all; in fact, as we shall see, half of all museums increased their share of either related business income or excluded unrelated business income, and every sixth museum increased unrelated business income between 1990 and 1992. However, these commercialization trends take place against the background of relative stability in the overall patterns of total museum revenue and expenditure. As Table 12.1 shows for the sum total of all 263 museums, the relative

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Table 12.1. Revenue sources for art museums, as share (%) of total revenue, 1982-92 Revenue category Direct public support Indirect public support Government grants Program revenue^ Membership dues Interest on savings Dividends Net rental income Other investment income Sales of assets Net income fund-raising Gross profit from sales Other revenue

1982 32.0 0.5 6.9 13.7 7.6 3.7 12.8 0.3 0.2 9.3 0.1 7.0 6.0

Total revenue (mil. curr. $) 778 71

N=

1987

1990 35.4 0.5 12.9 12.9 6.1 1.9 12.0 0.2 0.3 5.4 0.5 8.9 3.0

29.9 0.4 8.3 15.1 7.1 2.2 10.7 0.4 0.5 9.7 0.3 9.7 5.6 1,522 185

1,872 201

1991 34.4 0.5 12.6 12.2 5.6 2.0 10.8 0.3 0.1 9.4 0.4 8.1 3.5 2,107 199

1992 34.8 0.6 11.6 13.3 5.3 1.3 10.4 0.3 0.2 10.9 0.4 8.2 2.7 2,320 198

^Includes admission fees. Source: Consolidated data set based on IRS-SOI samples.

shares of revenue sources have changed little over the ten years between 1982 and 1992. Direct public support (i.e., private grants and donations), accounted for about one-third of total revenue for each period, and changes are usually within the 1- or 2-percentage-point range. The same can be said for program revenue (admissions, royalties, etc.) and sales: Between 1982 and 1992, these two revenue sources that are most closely linked to commercialization grew substantially in nominal dollars, but changed very little in relative terms (Table 12.1). Program revenue accounted for 13.7 percent of total museum revenue in 1982 and roughly the same share a decade later; gross profits from sales represented 7.0 percent of total revenue in 1982 and 8.2 percent after ten years. Government grants are the only revenue source that shows a general and significant increase between 1982 and 1992, moving up from 6.9 to 11.6 percent. Whereas in 1982, government grants represented about half of the relative size of program revenue, both sources are about equal in their financial weight by 1992. The financial size of the museums included in the sample increased substantially during this period: Between 1987 and 1992, total revenues rose by 65 percent from $1.5 billion to $2.3 billion (Table 12.1). This means that government grants funded the growth in museum revenue disproportionately to other

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Table 12.2. Expenses of art museums by major category, as share (%) of total expenses, 1982-92 Expense category Program services Management, general Fund-raising Payments to affiliates Total expenses (mil. current $) N=

1982 76.8 20.3 2.8 0.0 559 77

1987

1990 74.1 22.2 3.6 0.1

74.7 21.9 3.2 0.2 1,121 185

1,487 201

1991 74.6 21.9 3.6 0.0 1,645 199

1992 76.0 20.2 3.8 0.0 1,783 198

Source: Consolidated data set based on IRS-SOI samples.

sources. By implication, the expansion in total revenue was not the result of relative increases in commercial income. Although museums took in more revenue overall, including all forms of commercial income, only government grants grew both absolutely and relatively. For the period under consideration, this increase in government grants reflects the growing engagement of government in funding the arts. How can we explain this pattern of stability and the general absence of pronounced commercialization trends? The expenditure side of museum operations is one area to look for answers. Perhaps the structure of museum costs has remained relatively stable as well, making it less likely for museums to venture massively into new forms of revenue. Indeed, as Table 12.2 suggests, museums as a whole experienced virtually no change in the composition of major cost items: Program services, management and general administration, and fundraising costs still account for the same relative cost shares in 1992 as they did in 1982 and the years in between, even though expenditures rose from $1.1 billion in 1987 to $1.8 billion in 1992. No major shifts in expenditure patterns seem to have propelled museums to seek additional or alternative revenue from commercial market sources. A second possibility for the observed stability can be found in changes in the relationship between revenue and operating expenditure. We could assume that a relative decline in revenues compared to growing expenditures would push museums to pursue more commercial strategies over time. Indeed, setting the cost and income levels in 1982 to unity, we see that revenues increased slightly more rapidly than operating expenditures until 1989, but have lagged behind since then, with increases in expenditures outpacing growth in revenue. At the same time, the revenue-expenditure ratio declined from 1.62 in 1982 to about 1.32 for the period 1991-2, with the biggest drop occurring between 1989

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and 1990. In other words, whereas museums had, on average, $162 in revenue for $100 in operating expenditure in 1982, this buffer was cut in half a decade later. Even though 1992 revenue-expenditure ratios still show an aggregate revenue surplus, they nonetheless mean that museums have fewer dollars left for acquisitions and collections, as well as for investments in buildings and other capital expenditures. Moreover, museum curators have less funds available inhouse to stage exhibitions independent of special support from outside.4 Thus, although museums do seem to be facing a somewhat tighter financial situation, it is not one tight enough to pressure them to rethink, at fundamental levels, their revenue and expenditure patterns in view of the alternative of generating greater commercial income. A third reason for the stability in revenue shares can be found in the relationship between assets and liabilities over time. We could argue that current account categories remained stable because there was little change in assets and liabilities that would have propelled museums to restructure their revenue sources and expenditure patterns. As Table 12.3 shows, assets did increase substantially between 1987 and 1992, from $4.8 billion at the beginning of 1987 to $9.2 billion five years later; liabilities, however, grew even faster, more than doubling from $639 million in 1987 to $1.5 billion in 1992.5 Taken together, the trends in assets and liabilities mean that museums became more wealthy and more indebted at the same time, as the median values indicate: The median endof-year asset value (not shown in Table 12.3) jumped from close to $12 million in 1987 to $18.5 million in 1992. Likewise, median liabilities grew even more in relative terms, from $0.7 million to $1.3 million. Thus, although there is a general trend toward increased assets, they seem to have been increasingly financed through some form of liability: Asset-liability ratios declined overall by nearly 3 points from 8.8 to 6.2. Though most museums have accumulated more assets in recent years, and even more in terms of liabilities, our data show that this trend is most pronounced among the larger museums. What does this trend mean for commercialization pressures? For one thing, growing liabilities translate into payments at some stage, most likely reducing the amounts available for operating and capital expenditures. If this is the case, museums may have to seek additional sources to increase revenue even further in the future. However, we should keep in mind that during the same period in which museums grew in terms of assets and liabilities, only government grants showed a significant increase in their relative and absolute share of total revenue; all other sources remained stable in relative terms. With government grants 4

5

The finding that the financial "buffer" is crucial for museums is also supported by Alexander's (1996,60) study of thirty large art museums. She reports that about 80 percent of all art exhibitions are internally funded; only 20 percent involve outside support from foundations, corporate sponsors, or government agencies. Figures in Table 12.3 are adjusted for inflation by applying a price deflator for 1989 and onward.

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declining in the late 1990s, we should therefore expect that the picture of relative stability portrayed in Tables 12.1-12.3 may no longer prevail in the future. Thus, commercialization pressures among art museums are not only the result of likely government cutbacks; they are also closely related to a relatively long period of expansion of museum operations and holdings. Changes in income-producing activities Although the revenue and expenditure structure of museums has shown remarkable stability during the growth years between 1982 and 1992, there are signs that changes are under way. Before analyzing what these changes are, however, it is useful to consider the stability even in the types of income-producing activities in which museums typically engage. Table 12.4 shows that related business income declined somewhat, from 28.0 percent in 1990 to 26.4 percent in 1992; excluded business income grew more substantially from 21.6 percent to about 25 percent, whereas unrelated business income remained stable. Museums primarily engage in equal shares of related and excluded business income, and only to a very limited extent in taxable activities raising revenue unrelated to the charitable purpose of the organization. In fact, less than $2 of every $100 in museum revenue comes in the form of unrelated business income (UBI). As was pointed out in Chapter 5, however, reported UBI may understate substantially the actual income distribution of unrelated business activities. The composition of income-producing activities associated with commercialization also shows remarkable stability in terms of the various income categories (Table 12.4). Percentages have changed little over the three years from 1990 to 1992. Some areas often associated with a general trend toward commercialization have even experienced slight declines: Membership income in the form of dues and related charges dropped somewhat in relative terms, as did sales, both perhaps as a result of the 1991-2 recession. Other categories, namely fund-raising income and program services, show slight increases. Of course, these data are at a relatively high level of aggregation, since they encompass both increases and decreases in the various income-producing categories across a large number of museums. If, however, we look at these changes at the organizational level, we find that the relative frequency of increases in all forms of business income is higher than that for decreases. Table 12.5 indicates that slightly more than half of all museums increased their share of total revenue from related business activities during 1990-2, while about a third reported decreases in this income category. For the great majority of these cases, changes are less than 10 percent, or under 3 percent annually for the three years under consideration. That is, not surprisingly, museums rarely became drastically more commercial or less commercial in a single year; rather, they changed

Table 12.3. Assets and liabilities of art museums, 1987-92

Net assets, beginning of year (% of 1982) Excess/deficit for the year (% of 1982) Other changes (% of 1982) Net assets, end of year (% of 1982) Total assets, end of year (% of 1982) Total liabilities, end of year (% of 1982) Assets-liabilities ratio N=

1987

1989

1990

1991

1992

4,770,468,772 (100) 402,274,264 (100) (156,581,926) (100) 5,016,161,114 (100) 5,655,656,297 (100) 639,495,179 (100) 8.84 185

5,345,997,894 (112) 465,317,730 (116) (27,235,113) (17) 5,784,080,511 (115) 6,544,895,984 (116) 760,815,249 (119) 8.60 196

5,730,700,781 (120) 365,142,027 (91) (36,213,323) (23) 6,059,629^41 (121) 7,048,938,775 (125) 989,309,124 (155) 7.13 201

6,399,563,864 (134) 447,564,029 (111) 136,484,076 (-87) 6,983,611,967 (139) 8,373,676,594 (148) 1,390,065,302 (217) 6.02 199

7,204,921,033 (151) 527,087,798 (131) 6,357,254

Note: Figures are adjusted for inflation. Source: Consolidated data set based on IRS-SOI samples.

M) 7,738,366,076 (154) 9,221,135,696 (163) 1,482,769,682 (232) 6.22 198

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Table 12.4. Art museums' related, unrelated, and excluded income-producing activities, selected sources, 1990-2 Pet. of total revenue

Pet. of total revenue

Program services Unrelated Excluded Related Government Unrelated Excluded Related Membership Unrelated Excluded Related Fund-raising Unrelated Excluded Related

1990

1991

1992

1990

1991

1992

12.8 0.2 0.8 11.8 0.2 0.0 0.0 0.2 6.1 0.0 0.2 5.9 0.5 0.0 0.2 0.3

12.1 0.2 0.8 11.1 0.2 0.0 0.0 0.2 5.6 0.0 0.2 5.5 1.0 0.0 0.8 0.3

13.2 0.2 0.8 12.2 0.2 0.0 0.0 0.2 5.3 0.0 0.2 5.1 1.0 0.1 0.2 0.7

Sales 8.9 Unrelated 0.1 Excluded 0.5 Related 8.3 Other 3.0 Unrelated 1.5 1.1 Excluded Related 0.5 Income-prod. activs. 51.3 Unrelated 1.8 Excluded 21.6 Related 28.0

8.0 0.1 0.4 7.5 3.5 1.3 1.0 1.3 52.4 1.6 24.4 26.5

7.4 0.1 0.4 7.0 2.9 1.3 1.2 0.5 53.0 1.6 25.0 26.4

yv =

201

199

198

Source: Consolidated data set based on IRS-SOI samples.

gradually. A similar pattern holds for excluded business income, but with a substantially higher proportion (8.3 percent) reporting increases of 10 percent or more, reflecting the more frequent expansion of revenues from cafeterias, parking facilities, and the like. Table 12.5 also indicates that the pattern for unrelated income is very different from the other two revenue sources involving sales. Most museums - over three-quarters - did not change the relative proportion of UBI during the threeyear span, and those that did all reported increases of less than 10 percent. Although about twice as many museums increased as decreased their share of unrelated income, we should recall that the overall share of UBI is less than 2 percent of total revenue. Thus, even if museums increase unrelated business activity, the net revenue impact is small. Conclusion This chapter explored the commercialization of American museums. Specifically, we looked at the patterns and trends of commercialization, and the reasons that lie behind it. In the period under consideration here (1982-92), art muse-

Commerce and the muse: Art museums becoming commercial?

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Table 12.5. Changes in income-producing activities for museums, 1990-2 Share of business income (%) Change, 1990-2

Related

Unrelated

Excluded

Reduction > 10% 0.1% < Reduction < 9.9% No change 0.1% < Increases 9.9% Increase > 10% Total

4.1 31.2 14.1 46.5 4.1 100.0

0.0 7.7 76.3 16.0 0.0 100.0

4.7 30.0 16.6 40.4 8.3 100.0

Note: N = 169. Source: Consolidated data set based on IRS-SOI samples.

urns as a whole experienced a major expansion in terms of revenue, expenditure, assets, and liabilities. However, overall composition of museum revenue has been relatively stable, with few changes in the relative shares of various income sources. The one exception is government support, the only revenue source that showed disproportional growth during this period. Against this background, our analysis suggests that no general and pronounced trend toward commercialization of museum operations has taken place, although some indications of increased commercial activities are nonetheless identifiable. Museums seem to become slowly and gradually more commercial over time, if at all. This is especially true with regard to excluded and unrelated business income, the latter generally being negligible and of minute importance. The subtle commercialization trend that seems to be occurring now, however, does so on the heels of a major expansion of the museum field in the 1980s: Every second museum increased its related-business-income share of total revenue during 19902, though, for most museums, these changes are less than 3 percent annually. All in all, our analysis suggests that commercialization in the museum field is not as grave an issue at present as it is often perceived in the field and in the literature. How can we reconcile this difference between the general perception and what is borne out in the financial data? One explanation would be that commercialization on a grand scale is more prevalent among very large museums. Some forms of commercialization, such as blockbuster exhibitions or extensive retailing, require substantial financial investments; many smaller museums may be unable to afford the high start-up costs involved. Since larger museums and their activities have higher visibility in artistic and art-policy circles, increased commercial activities among these art museums may have invited generalizations to the field as a whole.

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However, there might also be other reasons for the perceived commercialization of the museum field - reasons not necessarily reflected in the financial data that formed the basis of our analysis. For example, Malaro (1994) points to the possibility that an increased internal business orientation, rather than the use of commercial means of income generation alone, is at the heart of the commercialization of art museums. Similarly, Alexander suggests that the influence of management on defining the mission of museums made them "less elitist, more popular institutions that are increasingly geared toward income and funding" (Alexander 1996,95). With the traditional balance of power between curators and administrators gradually shifting in favor of the latter, vital decisions are increasingly made in view of economic viability rather than based on artistic merit and quality. Seen this way, commercialization in the museum context does not necessarily mean that museums charge higher fees for their core activities or engage in new activities to increase sales, as is the case in other nonprofit industries; what it could mean is that museums change their core services to make them more attractive to a broader range of clients and funders. Based on our analysis, however, we can suggest that the rise of commercial museum management seems to coincide with the emergence of the second major shift in arts funding in less than four decades. The first, which took place in the 1960s and 1970s, involved a shift from individual philanthropy to foundation and government support. In the second, which has merely begun, museums are likely to put more emphasis on earned income from admissions, merchandising, and other ancillary activities. Art museums are embarking on this course somewhat hesitantly, and appear frequently torn between "commerce" and the "muse" as seemingly contradictory options. Nonetheless, many art museums are likely to face financial difficulties, as expenditures have risen faster than revenues, and increases in liabilities have outpaced those for assets. This would explain why commercialization has evolved as a major policy option and concern for cultural institutions in the latter part of the 1990s.

CHAPTER 13

The funding perils of the Corporation for Public Broadcasting

Craig L. LaMay and Burton A. Weisbrod

Introduction and perspective On November 5, 1967, President Lyndon Johnson signed into law the Public Broadcasting Act, creating the Corporation for Public Broadcasting (CPB). The purpose of the act, Johnson said, was to "renew the promise of the vision in the word 'television.'" Johnson described the new CPB as "the people's corporation. Fully independent. Broadly representative. Supported by public and private money. Free from interference by private interests, government agency, or political party" (Johnson 1967). "Public" radio and television are industries that illustrate well the interplay of outputs and mechanisms to finance them. The collective-goods aspects of their broadcast outputs are unusually large; the process of production and distribution of programs is such that the incremental costs of serving additional listeners or viewers is essentially zero, and it is costly, though not impossible, to limit listener and viewer access (Owen and Wildman 1992). These are the precise conditions of production under which financial problems emerge. With user fees to listeners being infeasible, dependence on contributions, gifts, and grants becomes great. Because grants from government have fallen in recent years, public broadcasting has had to pursue all of its principal finance options: It has moved aggressively to expand private donations, especially through "memberships"; and it has worked to increase revenues from each of its two potential sources of sales - user fees from its advertisers and "underwriters," and ancillary services that are complements of the broadcast process. Every potential revenue source - government grants, private donations, private sales, or anything else - represents a willingness to pay for some particWe thank Michael Janeway, James G. Webster, and Steven S. Wildman for comments on an earlier draft.

249

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ular output, and the ability of its provider to tap into that willingness. Thus the decision by a provider of public radio or television programming to reach out to a particular source of funds implies that programming will be of the type that appeals to that source. Decisions on the nature of programming cannot be made independently of the availability of funding for that package of service. The character of the services being produced and the success of a public broadcaster to generate funding for those services are inextricably entwined; depending on the nature of the "outputs," it can be easy, difficult, or even impossible to finance them through sales to "consumers" - in this case, listeners and viewers on one hand, and commercial advertisers on the other. The history of public radio and television makes clear that their goals were of a particular sort: (1) to provide programming that was "different" from what privately owned stations were providing, and (2) to broadcast them differently - without "commercial" interruptions. That is, the concept of public broadcasting rested on the belief that the private market, though extensive, had failed to provide certain kinds of outputs for which at least some people were willing to pay. How actually to generate the financial support, however, was and is the key problem. Potential revenue sources in public broadcasting The multiproduct framework, set forth in Chapter 3, for analyzing nonprofits' responses to cutbacks in government contributions, will guide our examination. As was explained there, any nonprofit organization can generate revenue from either of two basic sources, donations and sales. The collective-type character of radio and television broadcasting essentially precludes selling services to listeners and viewers or charging user fees. Some readers will immediately object that a license fee - a tax on television and radio receivers - has traditionally been the finance mechanism for most public broadcast systems in Europe. Such a fee accounts for 80 percent of the revenues of the world's most well-known and well-regarded public broadcaster, the British Broadcasting Corporation (BBC), and those revenues are substantial - approximately $2.5 billion of the BBC's $3.2 billion budget in 1996 ("Time to Adjust Your Set" 1995). However, the fee is on receivers, it must be remembered, not programs; thus although fees are technically possible they are inherently inefficient. Moreover, no matter where the fee is set, it will be too high for some people, thus excluding those viewers from watching programs despite the cost of serving additional viewers being zero. In the United States, the dominant system of broadcasting has always been private and for-profit, so license fees do not exist. For public broadcasters, then, remaining revenue options include donations from (1) government and (2) private sources; and commercial revenues in the forms of (3) user fees from orga-

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nizations purchasing access to broadcast time - that is, advertisers - and (4) sale of other, ancillary services that would be profitable. Government grants Government grants have been critical for public radio and television not only in the United States but throughout the world, and the fiscal pressure resulting from government cutbacks is also quite widespread. In Canada, for example, in 1994, before the latest round of budget slashing, nearly 80 percent of the Canadian Broadcasting System (CBC) budget came from the federal government; the rest came largely from the sale of commercial advertising time. In 1996 a cut of some 12 percent - $127 million - occurred, and by 1998, when the cuts already announced will have taken place, grants will have dropped by about 25 percent in current dollars, even as production and distribution costs increase (DePalma 1996). In the United States, the federal government has been considerably less central to public broadcast funding.1 In fiscal 1995, federal appropriations of $285.6 million constituted about 14 percent of CPB's $1.8 billion revenue from all sources ("The Struggle Over Federal Aid,. . ." 1996). A review of public broadcasting's income over nearly two decades, from 1972 to 1989, shows that tax-based income from all sources (federal, state, and local) declined from 71 percent in 1972 to 46.8 percent in 1989. The federal contribution to public broadcasting reached a maximum of 27.3 percent of revenues in 1980; since then, federal revenues have declined, as shown in Table 13.1. Historically, public broadcasting has argued that the federal appropriation is essential to leveraging all other revenue sources. The steady lessening of federal appropriations has forced public broadcasters to adjust by some combination of decreases in broadcast outputs and intensified efforts to increase revenues from other sources.2 Private donations Another potential revenue source, private donations, has limited promise. The familiar difficulty of relying on private giving applies to all collective goods; 1

2

For comparison purposes, government spending in the United States is $ 1.06 per capita for public television. Japan spends $17.71 per head for NHK, Canada spends $32.15 per head for the CBC, and the United Kingdom spends $38.56 per head for the BBC. Federal funding of public television has always commanded bipartisan support, and normally funding has come in the form of three-year authorizations and two-year appropriations. Appropriations do not always match authorizations: The actual appropriation for 1993, for example, was $253 million, well short of the $285 million Congress authorized. In 1993, Congress authorized substantial increases in federal funding for the years 1994-6: $310 million for 1994 (appropriation was $255 million); $375 million for 1995 (appropriation was $285 million); and $425 million for 1996 (appropriation was $275 million). In fiscal 1997, authorized funding dropped to $260 million, and in 1998, to $250 million; but the authorization for 2000 is $300 million.

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since the broadcasts are available without a user fee, obtaining private donations involves an act of altruism that runs headlong into free-rider behavior. It is no wonder that public television and radio stations estimate that only some 10 percent of viewers and listeners contribute (Rowland 1993, 182). Airtime revenues Revenue from the sale of broadcast time to private firms for commercial announcements - a form of user fee - constitutes the financial lifeblood of private, for-profit radio and television; historically, however, it has been anathema to public stations. While private broadcasters have focused on the sale of airtime to business interests, public broadcasters have avoided this market. Public radio's and television's goals seemingly precluded the kinds, frequency, and timing of commercials that are most attractive to business advertisers. There was some, but a limited, market for public stations' sale of commercial broadcast time insofar as stations developed a reputation for trustworthiness, perhaps because of their nonprofit character, and some private firms wished to "purchase" an identification with that nonprofit broadcasting organization, even if the sponsorship was constrained in its form, content, and time positioning (e.g., only before or after a program). This form of commercial revenue surely holds the greatest financial potential as public broadcasters search for revenue to offset loss of government grants, but it is also the most problematic. The more public broadcasters' finances come to mimic those of private firms, the weaker the nonprofits' ability to carve out a unique social role and, hence, to justify any special treatment through government grants, private donations, or tax exemptions and subsidies as nonprofit organizations. Taken together, private donations and the sale of broadcast time (in the form of program underwriting and corporate sponsorship) comprise more than half of all income for public broadcasting, as shown in Table 13.1. Between 1972 and 1989, private donations rose from 28.5 percent of CPB's annual income to 53.2 percent. The meaning of this change is not certain, but two arguments stand out. One is the argument made by former Public Broadcasting Service (PBS) President Lawrence Grossman, who has said that private donations, whether from individual subscribers or large corporations, help to make public television truly "public" - not dependent on government. In this view, declining taxbased support and rising public support may pose operational difficulties, but nonetheless serve to confirm and enhance public broadcasting's mission. The second argument is that private support by definition comes with strings attached, and that those strings affect public broadcasting's mission, perhaps adversely. Public broadcasters who seek program support from businesses and foundations do in fact make compromises in program content, and anecdotal

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The funding perils of the Corporation for Public Broadcasting

Table 13.1. Tax-based revenues and private revenues as sources of U.S. public-broadcasting income, 1972-89 (in millions of dollars) Federal

Nonfedera1

FY

Total

(%)

State & local tax-based (%)

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

59.8 55.6 67.1 92.3 130.1 135.3 160.8 163.2 192.5 193.7 197.6 163.7 167.0 179.2 185.7 243.0 247.5 263.9

(25.5) (21.8) (23.1) (25.3) (30.0) (28.1) (29.1) (27.0) (27.3) (25.2) (23.4) (18.2) (17.1) (16.3) (16.4) (18.8) (18.1) (17.3)

107.7 127.3 139.1 156.6 175.9 191.3 218.2 245.5 271.6 277.5 301.0 318.3 334.5 358.4 378.8 389.2 415.8 451.3

(46.0) (50.0) (47.9) (42.9) (40.6) (39.7) (39.5) (40.7) (38.5) (36.1) (35.6) (35.4) (34.3) (32.7) (33.4) (30.1) (30.4) (29.5)

Total Private 66.8 71.9 84.3 115.9 127.3 155.6 173.4 194.7 240.7 297.7 346.6 417.1 472.8 558.7 569.5 662.3 704.1 812.3

(%) (28.5) (28.2) (29.0) (31.8) (29.4) (32.3) (31.4) (32.3) (34.2) (38.7) (41.0) (46.4) (48.5) (51.0) (50.2) (51.2) (51.5) (53.2)

Sources (%) 234.3 254.8 290.4 364.8 433.3 482.1 552.3 603.5 704.9 768.9 845.2 899.2 974.2 1,096.3 1,134.0 1,294.5 1,367.4 1,527.6

(100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0) (100.0)

Source: Corporation for Public Broadcasting.

evidence says that many worthwhile projects are scuttled, others never proposed. In practice, broadcasters make a determination that a program is worthwhile, then identify sympathetic funders. Again, however, whether and how that process affects a public broadcaster's mission is difficult to measure, primarily because, in the United States particularly, public broadcasting's mission is famously ill-defined. Some years ago, a U.S. public-broadcasting executive, despairing over the steady schedule of British imports and nature programming, described the U.S. service as "English people talking and animals mating, and occasionally vice versa." Given this problem of vagueness, it is very difficult to know whether public broadcasting's mission would change, or whether any change would affect programming decisions, if public broadcasting's revenues remained the same but simply came from a different mix of sources, or even from sources that were entirely tax based. Even public broadcasting's most ardent defenders admit that the mission of the institution lacks clear and operational articulation (Rowland 1993,166-7). Further complicating this problem

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of mission and its implications for programming is that Englishmen and animals are also regular fare, though at a price, on several cable channels. Revenues from ancillary goods and services A final source of expanded revenue involves sale of ancillary goods and services, other than broadcast time. In every industry the inputs used in the production of its preferred, mission-related activity have some potential for use in other activities, and these can be a source of revenue for cross-subsidizing the mission-related effort. In this case the mission is to provide particular types of programs, without commercial interruptions and without commercial influence over program content. The potential for profitable production and sale of ancillary goods varies among industries, as was discussed in Chapter 3 and as was reflected by the variation, shown in Chapter 6, among industries in the extent of their unrelated business activity. Later in this chapter (see "Alternative financing for public broadcasting") we shall bring to bear some evidence on how public television is responding to its financial stringency, including the expansion of its ancillary activities. These four revenue sources - two involving donations (from government and private sources) and two involving sales (user fees for the mission-related output and revenue from ancillary outputs) - do not have equal potential for expansion. They also have unequal consequences for contributing to organization mission. Table 13.1 shows how the distribution of public-television revenues from government and private sources has changed over time. The dilemma of commercial activity The "special" character of public radio and television - which includes not only the programming but also the nature of commercials - creates at least the possibility that stations can find other salable services that may not be available to the private-enterprise sector. These nonprofit organizations - 629 public radio stations and 350 public television stations in the United States as of 1998 - have sought to sell "memberships," which bundle sale of the collective good, public broadcasting, with sale of such private goods as monthly program magazines and "premiums," such as "free" dinners and umbrellas with the station logo. Public stations have also moved aggressively into other ancillary commercial markets. They sell music cassettes and transcriptions of discussion programs; they sell advertising of business services in newsletters and membership mailings; they produce broadcast programs for sale to other stations; they contract with private firms to market "educational" goods such as books and computers. Most of these activities capitalize on the stations' reputations for "quality," trustworthiness, and public-serving, not profit-seeking, goals.

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There is nothing to prevent private broadcasters from mimicking the fundraising methods of public broadcasters, just as these nonprofits can mimic their private-enterprise counterparts. Private broadcasters are less likely, however, to have equal success in attracting donations of the premiums that public stations are giving to member-donors, or in attracting people to "join" as members, or in attracting volunteers to help with fund-raising. Both tax-deductibility considerations and differential attitudes toward donating money or time (volunteering) to nonprofit and for-profit broadcasters confront these two types of organizations with differential revenue-generating opportunities. It is not surprising, therefore, that private broadcasters have chosen not to pursue "memberships" with the same vigor shown by the nonprofit broadcasters (though some cable channels, such as the Discovery Network, market themselves in similar ways). Similarly, it is not surprising that public broadcasters have steered away from the sale of airtime to business interests. As this chapter will show, however, external financial pressures - particularly the decreased availability of unrestricted governmental funding - have presented nonprofit broadcasters with a dilemma. They can retain the focus on the twin-mission goals of "quality" - as they define it - and avoidance of the commercial funding techniques used by private broadcasters; they can, that is, restrict their activities to what can be financed through donated, presumably unrestricted, revenue. Alternatively, they can compromise one or both goals in some measure by increasing their reliance on commercial revenues. It is tempting for public broadcasters to believe there is no dilemma - that resort to new revenue-generating sources will not necessitate a compromise in quality. Achieving their goal of quality programming is an admittedly ambiguous concept, as both critics and supporters of public broadcasting emphasize; thus the impact on mission of emulating private stations' commercials is difficult to assess. One intermediate position has been widely adopted by public radio stations - "selling" what amount to personal, rather than business, "commercials" by mentioning donors' names and a brief message concerning their birthdays, anniversaries, and so on. We show, however, that a far greater compromise of the nonadvertising goal has been evolving at a rapid rate; indeed, some public broadcasters appear to have dropped completely the goal of avoiding commercials, although at this point still restricting their timing so as not to interrupt programs. Peering ahead, this chapter's examination of the growing commercialism of public broadcasters is intended to shed light on the question of whether they are becoming indistinguishable from private stations and are thus vacating their distinct historic position. Will the process of competition for revenues continue to blur the distinction, or will public broadcasting contract or even wither away? What is not clear is whether nonprofit broadcasters have sufficient advantages in the market for private donations - whether because of tax deducibility or al-

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truistic support - to sustain their current level and form of activity, or whether they can be sufficiently innovative in overcoming free-rider problems in ways that will sustain their social role. A key question is whether an exogenous drop in government grants causes even a partial, let alone a full, offsetting increase in private donations. Theory suggests that there will be only a partial offset, for a "crowding out" of private donations by public funding is a general phenomenon in markets for collective goods. To summarize our perspective, we see any organization as pursuing a policy that optimizes the balance of revenue from varied sources, taking into account the effect of each source on the organization's achievement of its goals. This process involves balancing an organization's multiple goals with one another and with the availability of revenues from each source. It also involves recognizing that the pursuit of revenue is a process that not only raises funds but can also affect achievement of the organization's goals. In short, revenue generation has both a direct effect on organization behavior, through its impact on the funds available to pursue the organization mission, and an indirect effect, through the compromises in organization outputs that may be required to obtain those funds. In the case of broadcasting, the unique mission of public, nonprofit stations, never entirely clear, is becoming even less so. This is particularly true in television, as the technology of cable has greatly expanded the variety of programming, appealing to smaller, specialized audiences. Still, survival is a powerful motivator, and nonprofit stations are clearly being driven at an increasingly urgent pace to seek funding to offset loss of government grants, and in the process are becoming more like the private broadcasters whose behavior they were established explicitly to avoid. To understand the dilemma confronting public broadcasting today - involving the trade-off between social mission and access to revenue - it will be useful to review its history. The goals of public broadcasting in historic perspective When President Johnson signed the Public Broadcasting Act, he set forth an objective for the new Corporation for Public Broadcasting: "It will have a single purpose: to demand the best in broadcasting and to deliver it for the betterment of our people" (Johnson 1967). Such an ill-defined mission provides little guidance to decision makers. It is difficult, indeed, for any public broadcasting station, or for the system nationally, to judge whether pursuing or forgoing any revenue-generating opportunity is or is not inconsistent with the social mission, even though it recognizes that the availability of support from any particular source is tightly entwined with decisions on how the funds will be used. The heightening debate over whether commercial advertising should be permitted on public TV - and if so, in what forms - illustrates the problem:

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Managers of some of the biggest PBS-member stations want the right to carry ads onair. Corporate underwriting already provides about 16 percent of public broadcasting's overall revenues, and those managers believe that they could replace much of the lost federal aid if the corporate donors got real commercials instead of restricted underwriter credits. . . . Most managers appear to oppose commercials, however . . . more than 80 public TV station leaders officially opposed advertising in September 1995; noticeably absent were executives from 20 of the 30 largest cities. ("Should Public Broadcasting Go More Commercial?" 1996) Advertising revenue opportunities are certainly more limited in smaller cities, but it is unlikely that there would be opposition to commercial advertising anywhere were it not that the social mission for public TV is so ambiguous operationally. In many ways, Johnson's 1967 remarks echoed those made only a few years earlier by President Kennedy's young chairman of the Federal Communications Commission (FCC), Newton N. Minow. Speaking before the annual meeting of the National Association of Broadcasters in 1961, Minow had chastened broadcasters for their seemingly single-minded devotion to the needs of advertisers and called television "a vast wasteland" (Minow 1961). The speech energized the nonprofit broadcasting community, then supported primarily by the Ford Foundation, and led the Carnegie Corporation of New York to launch an investigation into the prospects for a new kind of national television service. As the Carnegie Commission foresaw it, the service would be commercial-free and thus offer distinctly different programming than the three existing commercial broadcast networks. To describe this new service, the commission chose the term "public television." The choice was intended to imply something broader than "educational television," a service that already existed and that, in Carnegie's view, conjured up images of classroom instruction. As the commission defined it, public television would include "all that is of human interest and importance which is not at the moment appropriate or available for support by advertising, and which is not arranged for formal instruction" (Carnegie Corporation of New York 1967, 11). In its clear rejection of advertiser-supported programming, the commission was identifying the essence of U.S. broadcast television economics: When a viewer turns on a TV program, he or she is not the consumer but the product. The real consumer, insofar as financing is concerned, is the advertiser; the programs are merely bait. It was this system, Newton Minow had charged, that led to the incessant dumbing-down of all television programming (Minow 1961). By rejecting advertising, Carnegie reasoned, public broadcasting would be free to do better. At the same time, however, it recognized that some funding mechanism was necessary, and while it was not averse to government funding, "we all agreed that the federal government was a last resort," commission member Lee DuBridge said later. "If we could see any other way to get adequate fi-

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nancing, we would be glad to take it" (Robertson 1992). The funding source the commission recommended was an excise tax on television sets, similar to the license fee used in Europe. The initial tax would be set at 2 percent of purchase price, to rise to 5 percent over time (Carnegie Corporation of New York 1967,68-9). To augment funds from this new tax, the commission further suggested that public television seek an endowment of $25 million from "industry and private foundations" with which to insulate itself from political pressure.3 When President Johnson signed the Public Broadcasting Act into law, however, the excise tax was missing. It had been removed from the bill at the objection of the Electronics Industries Association, a trade group whose membership included manufacturers of television sets and radios. The financing problem in the age of TV abundance Public broadcasting was thus launched without a secure financial base and with a relatively small commitment of government funding. The largest single source of public-broadcasting revenues is the public itself, whose contributions ("memberships") account for about 21 percent of annual revenues (see Figure 13.1). Membership drives are a regular part of the programming, occurring several times a year. No other major public broadcasting service in the world uses such a revenue-raising device, and many people within CPB and outside it think the effort undignified. The issue of whether such fund-raising is appropriate or dignified is irrelevant to a profit-maximizing firm; for a public-television broadcaster with vague social objectives, however, such criteria can cause intense debate. This is particularly so when the broadcaster's collective-good nature (which precludes charging viewers) combines with the policy of sharply restricting commercial advertising (which limits revenue from selling broadcast time to private firms) virtually to eliminate conventional user fees as a revenue source. With little access to revenues from direct beneficiaries - viewers or advertisers - finance options are very restricted. The other potential forms, though - private donations, government grants, and sales of ancillary goods, which is discussed later - have the apparent attraction of insulating fund-raising from decisions on program quality and content; or so it seems. The linkage between revenue source and broadcast content has, over the years, been a volatile political subject. Its volatility has been fueled in part by the original Carnegie Commission's belief that, somehow, noncommercial programming would be better programming. Better than what the commission did not say; nor did it provide any clear test of social mission that would focus today's debate over what market niche remains for public television in the new technological world of cable and satellite TV, VCRs, video CDs, and the Inter3 The first private contribution to CPB was a $1 million gift from CBS.

The funding perils of the Corporation for Public Broadcasting

Subscri 21.50%

259

State Colleges & Universities 8.30%

Figure 13.1. All sources of U.S. public-broadcasting revenue, 1994. In 1994, the last year for which full data are available, U.S. public television's total income was reported at $1.38 billion, of which the total federal appropriation was $255 million; the rest came from membership subscriptions ($297 mil.), state and local governments ($294 mil.), businesses ($225 mil.), foundations ($78 mil.), and colleges and universities ($34 mil.). (Source: Corporation for Public Broadcasting) net. The public-policy question is whether that niche justifies public subsidization of a service that is watched by only a small minority of viewers. On average, public broadcasting's nationally broadcast programs earn Nielsen ratings of about a 2 (or about 2 million homes) during the weekday prime-time viewing hours between 7 P.M. and 9 P.M. - a figure that would drive private commercial broadcasters to ruin, but which is almost identical to the ratings earned by public broadcasting's cable competitors, such as the Discovery or Arts & Entertainment networks.4 The only specific programming recommendations in the 1967 Carnegie Commission report that come close to defining the source of 4

Public television's Nielsen rating varies with its national program schedule, and some programs, such as the 1991 documentary The Civil War, received Nielsen ratings of 20 and higher - on par with major network sports and entertainment events. For an average rating, see A. C. Nielsen's monthly reports, PTV Cumulative Audience Ranking by Station Market. Weekly Nielsen figures

are also reported in the industry trade magazine Broadcasting & Cable.

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private-market failure that might justify public television, publicly financed, were for children's programming and public-affairs programming that would go beyond the "bare reporting of incidents" (Carnegie Corporation of New York 1967, 96). Beyond that, there was little attempt to operationalize important questions about public broadcasting's mission: Who is the public? What are its "needs'? These questions have bedeviled both CPB and the federal government ever since. Complicating matters further, the communications core of public broadcasting's enterprise raises, in the United States, legitimate questions about the constitutionality of its receiving any government support. What does public financing really buy? Another common criticism of public broadcasting is that it is "inefficient" and "unorganized." In a significant sense it is, and was designed to be. This is another aspect of the vagueness of its social goal. Efficiency is a matter of achieving goals, and whether public broadcasting is or is not well organized hinges on how closely those goals are being realized. CPB is a private, nonprofit corporation authorized by Congress to develop noncommercial radio and television services. Public broadcasting, however, is an enormously decentralized and fractious enterprise. PBS itself is a station-owned cooperative organization established in 1969 to acquire and distribute, but not produce, programming. The nation's 350 public broadcasting stations are independently owned and operated by 175 different licensees, with each making its own decisions about programming and scheduling; PBS is not a network in the operational sense. By law, federal funding goes directly to CPB, which then allocates it either to individual radio and television stations or to fund programming. Almost half of CPB's 1995 expenditures - $143 million - went to the nation's 350 individual public television stations in the form of "community service grants." Another $44.6 million went to radio community service grants. A relatively small sum - $67 million - actually went to fund radio and television programming (CPB 1996). That funding may go to stations, to PBS or the Independent Television Service (ITVS), or directly to producers. Responses to diminished federal financing With each cut the pressure mounts to find alternative sources of revenue. The principal focus has been on increasing individual and corporate contributions. Such "donations," however, especially from corporations, have had a significant element of a sale, for these "sponsorships" often include on-air identification of the sponsor, as well as a listing in a catalog that is distributed to "members." Thus, in the context of the multiproduct nonprofit organization, public TV stations have been engaging in two principal fund-raising activities: Devel-

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oping new methods for generating individual donations, and selling the output that has the greatest private market value, commercial broadcast time - although the latter has stopped somewhat short of the forms of commercials accepted by private broadcasters. The differences in finance sources between private and public stations have decreased but not disappeared. Reform of public broadcasting's financing has become unavoidable as a result of the diminished federal government grants and, in many cases, weakened state and local support too. In 1990, PBS enlisted the Boston Consulting Group (BCG) to appraise its future. The resulting report, Strategies for Public Television in a Multi-Channel Environment, recommended that to secure donations, especially corporate donations, stations should move away from local programming and toward the "safely splendid." In BCG's view, local programming was not cost effective because it did not encourage individual memberships or attract corporate underwriters. Local stations, on the other hand, were good at raising money. In the end, BCG recommended against a centralized national television service, but urged that production resources be shifted toward national programming (Boston Consulting Group 1991). More recently, the report of the Twentieth Century Fund Task Force on Public Television urged in 1993 that federal funding of stations' operations be eliminated entirely and the resources earmarked for national programs. Once this was done, the task force said, federal funding should be increased. Specifically, "national funding of public television should come from new non-taxpayer sources of funding such as possible spectrum auctions or spectrum usage fees" imposed on commercial broadcasters. "Commercialism," the report said, should be resisted, particularly that which targeted preschool children, one of public broadcasting's core audiences (Twentieth Century Fund 1993, 3-6). Still another proposed response to diminished federal funding has been to privatize CPB (Carter 1992; Jarvik 1992). This would convert these nonprofit broadcasters into for-profit firms that might or might not survive in competition with private broadcasters. The public-policy issues go beyond the matter of whether public subsidies are efficient, as the analysis of conversions showed in Chapter 7: Whatever the motivation may be for converting - and whether we are considering public broadcasting, hospitals and HMOs, or any other segment of the nonprofit sector - conversions have many effects. As that chapter shows, they alter not merely the finance mechanism for an organization, but also its goals, the constraints on it, and hence the character of its outputs. Conversions also redistribute wealth, shifting assets that were financed in large part through government and private donations - in the present instance, to improve public broadcasting, vague though that term may be - into private ownership, raising a question of equity. Additionally, public broadcast channels are licensed as such and can make no such conversion independently; they must have the approval of the FCC. Finally, many public broadcast licensees - about one-third

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of the total of 175 - are colleges and universities, state or local educational authorities (Ward 1993,143). Many of these entities, some of them predating the creation of CPB, see educational service as their mission - up to and including classroom instruction - and believe that privatization is neither desirable nor likely (Davis 1996). Alternative financing for public broadcasting Our theme is that with diminishing federal funds, and further cuts almost a certainty, public broadcasters are turning their attention to finding new sources of revenue, thereby blurring the distinction between public and commercial broadcasting. It is not the first time that alternatives to government funding have received major attention. Over the years a variety of funding mechanisms have been proposed, beginning with the follow-up Carnegie Commission on the Future of Public Broadcasting (Carnegie Corporation of New York 1979). Its report urged a spectrum fee on commercial broadcasters as a supplement to general tax revenues, but the recommendation was ignored. More recently, in 1982, President Reagan's FCC Chairman, Mark Fowler, called U.S. commercial broadcasters' claims that they serve the public interest (as the statutory terms of their licenses require) a "fiction," and urged that instead of receiving free and exclusive use of their channels they pay a spectrum fee and be freed from government content regulation. The resulting revenues, Fowler said, could be used to support public broadcasting (Fowler and Brenner 1982,207). The decision to levy such fees, of course, lay with Congress, which did nothing. In 1996 this debate arose again, led by Senate Majority Leader Bob Dole, who held up passage of the Telecommunications Act when he realized that it gave broadcasters, without charge, additional spectrum for advanced digital broadcasting. Dole estimated the value of that spectrum at $70 billion, and suggested that for both economic and First Amendment reasons broadcasters pay for it, though he said nothing about where the resulting revenues might go (Minow and LaMay 1996). Several public broadcasters urged that a portion of them, along with revenues from the sale of several public broadcast television stations in small markets around the country, be used to create a $4 billion trust fund for public broadcasting (Boot 1995). The spectrum and trust-fund proposals are but the latest in a long line of alternative financing proposals advanced over the years. None of the earlier proposals - surtaxes on residential electricity and telephone bills; government matching of private contributions; taxes on license transfers when commercial stations are sold; and taxes on the advertising revenues of commercial broadcasters and cable operators - have come to fruition (Ward 1993, 150). Because they have not, public broadcasters have sought to generate their own sources of revenue. This process began in earnest in 1981, when the Rea-

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gan administration threatened to end federal funding entirely, and, in response, Congress amended the Communications Act such that "Each public broadcasting station shall be authorized to engage in the offering of services, facilities or products in exchange for remuneration." The door to commercialism, entering new markets where one or another form of output could be sold profitably, was open. Stations can now rent out their studio space, accept advertising in their program guides, and sell books, music tapes, transcripts, and classroom materials based on PBS programs. They do all of these, and more. PBS itself leases time on its satellite transponders through PBS Enterprises, a wholly owned, forprofit subsidiary that develops services for use with new communications technologies. PBS Video sells videocassettes of public-broadcasting programs. PBS has even created its own home video label - PBS Home Video - and allows all public stations to buy its tapes at 52 percent off retail, then resell them at considerable profit. With the expanded opportunities, together with the fiscal pressure resulting from cutbacks in government grants that encourages stations to pursue those opportunities, public broadcasters are developing an ever-widening array of commercial ventures to raise revenue for their preferred, mission-related outputs. In the fall of 1996, for example, CPB gave four "strategic business development consultation" grants to public radio and television stations, essentially to develop new commercial ventures. Station WHYY-FM in Philadelphia launched a book-club service linked to the highly popular NPR program Fresh Air with Terry Gross; WHRO-TV in Norfolk, Virginia, developed a World Wide Web consulting service for businesses; several small Illinois public television stations established a teleconferencing business for citizens, businesses, and government agencies in rural west-central Illinois; and television station KCET in Los Angeles created a Center for Professional Development to offer multimedia and Internet training to teachers and private industry (CPB 1995). The grants, awarded in November 1995, were the second round of the CPB Business Development Initiative; the first round gave grants to WPSX-TV at Pennsylvania State University to develop CD-ROM and other electronic publishing; to KTCA/KTCI-TV in Minneapolis-St. Paul to develop on-line, CDROM, and teleconferencing services; to KQED-TV in San Francisco to develop adult-learning services; and to KNPB-TV in Reno to create a retail operation similar to LearningSmith or the Store of Knowledge stores found in Boston, Los Angeles, and Chicago (CPB 1995). Many other public television stations are well ahead of the curve in finding new commercial revenue sources. WTTW-Chicago, for example, partners in the production of programs with MTV Networks, Lifetime cable, and Walt Disney's Buena Vista television unit. In Seattle, KCTS-TV has produced the highly successful syndicated science program for young people, Bill Nye the Sci-

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ence Guy, for the Disney Channel. WTTW in Chicago, WGBH in Boston, and KCET in Los Angeles have all launched chains of retail stores with for-profit partners that supplied the initial capital, either LearningSmith Inc. or Store of Knowledge Inc. Public radio stations are just as active in business innovation. In St. Paul, Minnesota, for example, the twenty-nine-station Minnesota Public Radio Network raises about $150 million a year from its mail-order-catalog business (Schatz 1996). The profitability of all these activities is not clear. WGBH, for example, reports that net income from its for-profit ventures amounts to no more than about 5 percent of its annual operating budget (Ward 1993,158). Reported profits on unrelated business activity, however, are likely to be huge understatements, as was explained in Chapters 3 and 5. Nonprofits, including public broadcasters, have the incentive to select ancillary business activities that use inputs jointly with their tax-exempt, mission-related activities, and then to allocate as much of the joint costs as possible to the taxed sector, thereby showing little or no profit in that sector. Indeed, for all nonprofit organizations, the total reported profit from unrelated business (UB) activity is actually negative. Real losses, however, are not credible, and even less credible is evidence that gross UB revenue is growing rapidly but losses are getting larger (Chapter 5). In public broadcasting, as elsewhere in the nonprofit sector, creative accounting in the allocation of costs and revenues between the organization's untaxed (missionrelated) activities and its taxed (i.e., UB) activities doubtless distort and understate the actual contribution of the UB activities to organization resources. Further, many people in public broadcasting doubt that these enterprises can be greatly expanded without risking congressional wrath and the hastened end of all federal monies. Many for-profit businesses have attacked nonprofits' increasing engagement in commercial business activities as constituting unfair competition (see Chapter 3). Public broadcasters have not been singled out for criticism, but their commercial expansion is particularly rapid, and so they are likely to be under growing challenge as political forces bring pressure on the IRS to restrict nonprofits' UB activities as well as to expand the scope of what is defined as unrelated (SBA 1983, GAO 1987, Emshwiller 1995). Despite concerns, public broadcasters have pushed on, more worried about congressional threats to eliminate funding. PBS predicts a $22 million revenue increase in 1997 from the sale of videotapes and other educational media, and a $10 million increase from the sale of satellite services. Additionally, PBS has entered into a $75 million "program partnership" with Reader's Digest. Another deal that PBS announced in March 1995, a $15 million investment from MCI to develop an on-line service, has so far not gone forward (Behrens 1996). Not only is public broadcasting entering a vast uncharted sea of commercial activity, but it is doing that increasingly in partnerships with private firms. The barriers between nonprofit and for-profit organizations are falling.

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It must be noted that this is true not only in the United States, but also in Europe, Canada, and Japan. Because of the growing number of channels available everywhere, the competition for talent, film, and major events, such as sports, has driven their price up well above the inflation rate. This is a particular problem for public broadcast systems dependent on a license fee for TV sets, because the fee is typically pegged to inflation or lags behind it. Public broadcasters have thus turned to new sources of revenue, including advertising, to make up the shortfall. The BBC, for example, in 1994 created BBC Worldwide, a division dedicated to developing commercial revenues. In 1995 the BBC launched two new commercial services outside Britain - BBC World, a news channel, and BBC Prime, an advertiser-supported entertainment channel; both were undertaken in partnership with private firms ("Time to Adjust Your Set" 1995). Corporate underwriting and advertising In the debate about how to finance public broadcasting, concerns about advertising - under whatever name it goes - have always been central. American broadcasting's earliest pioneers had been nonprofit institutions - most notably universities, churches, and labor unions - all of which viewed radio broadcasting as essential to their public mission and many of which believed advertising a necessary, if not entirely desirable, adjunct to that mission (Barnouw 1968, chap. 1). Today, advertising on public broadcasting is in the form of corporate underwriting of programs. That support accounts for about 17 percent of public television's total budget and about 30 percent of the national programming budget (Ward 1993, 149) (see Figure 13.1). In 1981, the role of advertising in public television was examined more carefully when Congress and the FCC authorized a Temporary Commission on Additional Financing (TCAF) in that year's Public Broadcasting Amendments Act. The TCAF project was an eighteen-month experiment in which ten public television stations around the country were allowed to broadcast advertisements under restricted conditions: Advertisements were to appear only between programs, never during (and then only for two minutes); and no advertising at all was to appear in company with children's programs. According to the FCC report issued after the experiment, the results were promising. Viewer contributions during the experiment either stayed constant or increased. Interviews done with ten thousand public-television viewers after the TCAF ended found that few discerned any harmful effects from limited advertising; and so long as advertisements did not interrupt programs, viewers did not object to them. Viewers also said they preferred advertisements to on-air fund drives (FCC 1984). Despite these findings, the FCC expressed concern that whatever benefits might accrue from advertising would be outweighed by its presumed invidious

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effects on the mission of public broadcasting. The commision also worried that accepting commercials would be a net money loser because it would require added production costs, renegotiated labor contracts, taxes on revenues not deemed "charitable support," and the loss of viewer support. As a compromise, it urged what it called "enhanced underwriting," a carefully regulated form of sponsorship, and not a terribly successful one (FCC 1984). Advertisers often conclude that underwriting spots are ineffective, and withdraw support. In 1991, for example, corporations provided a total of $17 million to be exclusive underwriters of twenty PBS programs; by 1993, there were only fourteen programs exclusively underwritten, with total support of $6.3 million (Window to the World Communications, Inc., Chicago, IL, personal communication, 1993). In 1994, PBS announced publicly that it would reconsider its underwriting guidelines with the intent of liberalizing them. Jonathan Abbott, a PBS senior vicepresident, told the Wall Street Journal, "We want to make sure we're a destination more companies are comfortable considering" (Jensen 1994, A3). Despite the narrowing difference between commercial television advertising and the forms adopted by public television, and however public broadcasting's underwriting guidelines are finally redrawn, its use of advertising will remain controversial. One of the most heated debates in public broadcasting today is the uncertain conflict between the revenue that advertising, in any form, can generate and the public-serving mission that requires financial independence. This debate is well under way in Europe, where advertising has increasingly found its way into public-broadcasting finance. Noting this, some of the large program-producing public broadcasting stations in the United States have urged Congress and the FCC to experiment further with liberalized commercial advertising as a revenue source (LaMay 1994, A25). Enthusiasm for advertising is not universal, however. Opposition can be summarized by the views of Sharon Percy Rockefeller, president of WETA in Washington, D.C.: "Commercials would be the death knell of public television. We already have a vast commercial broadcasting system in this country; we need the alternative. And it's the alternative because it's noncommercial. It's so obvious. We put programs on the air for the purpose of the content, not for the purpose of making money from commercials" (Mifflin 1996). "Experiments" cannot resolve the debate over the social efficiency of allowing nonprofit organizations, public broadcasting or other, to emulate the financial approaches used by private firms. One half of the experiment is eminently feasible: to determine whether, and to what extent, commercial advertising or some other measure can actually increase the flow of revenue. The "rub": How will the organizations' social mission be affected? That requires understanding what the mission is in ways far more operational than by reference to "the public interest." Without this, experiments will do little to resolve disagreements

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over the appropriate role for advertising or, for that matter, other fund-raising techniques. Concluding remarks The public-broadcasting sector of the nonprofit economy illustrates the tension between nonprofit organizations' social goals, which differ from those of private firms and are the basis for subsidies and tax-exemptions to nonprofits, and the increased commercialism of nonprofits, their use of revenue-raising techniques that emulate those of private firms. It is clear that, vague as public broadcasting's social goals may be, the organizations that comprise it do fit the framework in which some revenue-generating measures and some forms of output are preferred over others, and the use of commercial-type mechanisms that involve selling services - a nonpreferred approach - is responsive to exogenous changes in contributions, gifts, and grants. As government grants continue to decline, and as competition for private donations becomes more intense among all participants in the nonprofit sector, public broadcasting's mission will come under further scrutiny. This is true not only in the United States, but in public broadcasting systems worldwide. Typically, however, other public broadcasting systems have detailed public-service charters specifying programming and service requirements, as well as an organizational structure designed to meet them. U.S. public broadcasting has neither of these things, in part because it was created as a nonprofit alternative to a predominantly for-profit, commercial broadcast system. However, particularly with public television, it is no longer clear what "alternative" the service provides. As the United States moves toward digital broadcast television delivery, the question of public television's mission is likely to become even more confused. Digital transmission permits a broadcaster to operate six channels in the spectrum space currently used to operate one, and the explosion of new profitseeking channels will further segment the television audience while also increasing the competition among all programmers for the limited supply of existing video content. Further, the transformation to digital broadcasting will require all broadcasters to make huge capital investments in equipment and facilities. Many broadcasters, public broadcasters included, are expected to recoup some of that cost by using their extra channels for nonbroadcast operations such as Internet service or telephone paging. The manner in which public broadcasters respond to these new competitive and structural challenges will have a great deal to say about their mission in the multichannel marketplace.

PART III

Overview, conclusions, and public-policy issues

CHAPTER 14

Commercialism among nonprofits: Objectives, opportunities, and constraints

Estelle James

Introduction Earlier chapters in this book provide a comprehensive picture of growing commercialism among nonprofit organizations. Commercialism is defined to mean the degree of reliance on sales revenues rather than donations or government grants, the production of goods for sale that compete with goods produced by for-proflt organizations, collaborations and partnerships with for-profits, and, ultimately, conversion into for-profits. The book attempts to answer the questions: Is commercialism increasing? If so, why and so what? Should it be encouraged or discouraged by public policy? Is growing commercialism good because it allows nonprofits to flourish and grow, or bad because it makes them more like for-profits? Here I contrast the arguments set forth in this book with a contrary hypothesis about nonprofit behavior and why it appears to be changing. I review the evidence provided to see which view of the nonprofit world is most consistent with the facts, and discuss some of the public-policy implications. The book depicts nonprofit organizations as having different and more altruistic objective functions than for-profits, which lead them to engage in commercial activities marginally and reluctantly, in order to cross-subsidize their preferred noncommercial activities, when other revenue sources such as donations and subsidies are not available. In fact, this is a point of view that I have espoused in the past, and I believe it is consistent with long-standing behavior in some organizations, such as universities. However, the contrary hypothesis that I shall examine here is stimulated by empirical observations in this book, indicating that the most dramatic growth in commercialism has occurred in situations where institutional or legal constraints on sales revenues were lifted, revealing large new opportunities. NonEditor 's note: After the studies in the preceding chapters were completed, we invited Estelle James, a distinguished contributor to the literature on the nonprofit sector, to write an overview chapter presenting her perspective on our work.

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profits responded enthusiastically to the new opportunities, without much evidence of reluctance. It is unclear whether the large "potential profits" thereby generated were used to cross-subsidize loss-making, public-consumption goods or were simply plowed back as investments to generate more profit-making goods; the contrary hypothesis predicts that the latter effect will dominate in many cases. Declines in donations, in some industries analyzed in this volume, seem to be a consequence rather than a cause of the increased reliance on sales. These empirical observations suggest that constraints and large opportunities, rather than altruistic objectives and cross-subsidization, play an important role in explaining the limited commercialism of nonprofits in the past and its striking emergence in some industries in recent years. When constraints are removed and large new opportunities for profit-making present themselves, nonprofits may behave very much like for-profits. The theory of nonprofit organizations and cross-subsidization The starting point for my discussion is the assertion (which I call the conventional hypothesis) that nonprofits have nonpecuniary altruistic objectives. They exist to provide public (collective) goods and to distribute quasi-public goods in ways that are different from market distribution - that is, to redistribute real income via free or low-price access to goods and services that generate external benefits. These objectives lead to pricing policies that differ from those of for-profits. (See Chapter 3 for a theoretical discussion of possible differences.) How are these goods financed, given that consumers cannot be excluded from the consumption of public goods, and nonprofits do not want to rely on the price mechanism even in cases where it is technologically feasible? In part through donations, by recipients of the consumer surplus or the external benefits who receive a "warm glow" by acting altruistically. Donations, it is well known, are limited by the free-rider problem and by the difficulty potential donors have in monitoring the effects of their donations. Nonprofit status (i.e., the nondistribution constraint) helps solve the monitoring problem by reassuring donors that their contributions will, in fact, be spent on services rather than simply on increasing profits that are distributed to the firm's owners. The choice of nonprofit managers whose objectives coincide with those of the donors provides additional reassurance. Tax deducibility of donations helps solve the freerider problem, by decreasing the after-tax cost of the donations. Government subsidies to nonprofit organizations are important additional sources of revenue. When government grants and private donations decline, the nonprofit is forced to become commercialized, to survive. Commercialization is said to be nonpreferred by nonprofits, because it involves producing goods they dislike, or charging prices that limit the consumption of goods they do like (Chapter 4). Thus, when other discretionary funds are available, commercializa-

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tion stops below the profit-maximizing point. The theory of cross-subsidization hypothesizes that when other revenue sources become less available, nonprofits will become more commercialized in order to generate a larger profit, which they can use to finance their provision of preferred public and quasi-public goods. This book argues that commercialism has been increasing in the nonprofit sector over the past two decades for this reason, and examines in detail several industries dominated by nonprofits to document this claim. In evaluating a theoretical argument, it is useful to have a countertheory against which to test it. As a countertheory, then, we might hypothesize that pecuniary rather than altruistic objectives dominate the decisions of many nonprofits. These "false" nonprofits - which Weisbrod (1988) referred to as "forprofits in disguise" - may maximize profits that they then distribute in disguised form (as higher wages and perks), or they may maximize revenues that lead to power and prestige for their managers. They are lured into the nonprofit sector by the tax and subsidy advantages that they gain therefrom. If these advantages decline, the disadvantages (loss of access to equity capital) may dominate and lead to an exodus from the nonprofit sector. Further, nonprofit managers and donors may have different interests. If nonprofit managers are primarily interested in revenues, they may limit their commercial activities because they fear that donations will fall if they appear to be self-supporting. The operative factor here is not the disutility of commercial activities, but their negative impact on other sources of funds. If large new opportunities open up - for example, due to technological, institutional, or legal changes that enable the price system to work - the gain in sales revenue may far outweigh the possible loss in donative revenues, and nonprofits may eagerly embrace the new opportunities. We may then see commercialism increase dramatically and nonprofit behavior that is very much like that of for-profits. Thus, whereas the conventional, cross-subsidization hypothesis emphasizes the differences in objectives between for-profits and nonprofits, views commercialism as a source of disutility, and sees increases in commercialism as a response to declining donations and grants, the counterhypothesis emphasizes the similarities in objectives between nonprofits and for-profits, downplays the importance of disutility, sees donations as responding to sales rather than vice versa, and underscores the key role played by the removal of institutional and legal constraints in opening up new sales opportunities and expanding commercialism. The next section of this chapter examines the empirical evidence to see which of these views receives more support. The evidence The great value of this book is that it provides detailed empirical evidence from many industries that allow us to explain and evaluate the growing commercialism among nonprofits.

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In Chapter 6, one of the chapters that cuts across industries, Segal and Weisbrod ask: Did the slower growth rate of donations over the past decade cause increased reliance on sales revenues? Their first answer is positive. Using panel data (a pooled cross section with lags) from the Forms 990 of nonprofits for 1985-93, they demonstrate that (next year's) sales revenues increase significantly when the growth rate of donative revenues declines. However, as they note, this specification assumes that donations are exogenous. When they use a vector autoregression model that allows for simultaneous determination of donations and sales, they find that sales influence donations, rather than vice versa. When the data are disaggregated by industry, the correlation between sales and donations is positive for some - most notably hospitals and universities - and negative for others. On the whole, I find this unconvincing evidence of cross-subsidization based on preferred versus nonpreferred goods. Rather, the simultaneous-determination model is consistent with the idea that revenue-maximizing nonprofit managers will charge a lower price than they would if they viewed donations as exogenous; that is, their reluctance to rely on sales revenue may stem more from its expected impact on donations than on its disutility to them - a possibility noted in Chapter 3. The zero or positive relationship between sales and other revenue sources seems to exist primarily in multiproduct industries, where donations may be targeted to goods where price finance still does not work and cross-subsidization from the more profitable goods is not expected. Chapters 7 and 8 describe in detail the decline in economic and legislative advantages for nonprofits that have led to increased commercialism in the health industry. Initially nonprofits had a secure place in this industry, justified by the expectation that they would provide charity care, better-quality service, and other socially useful activities through donations and cross-subsidization. Health care has long been given as a key example of an industry where consumer information is limited, trust is a substitute, and nonprofits were more likely to be trusted by consumers than were for-profits. As a result, the industry has been dominated by nonprofits, which have enjoyed numerous tax and subsidy advantages. For example, according to the Health Maintenance Organization Act of 1973, only nonprofits were eligible for federal subsidies, and nonprofit hospitals have long benefited from special tax exemptions. However, direct federal subsidies to HMOs ended in the early 1980s, and the tax advantages of Blue Cross and Blue Shield and hospitals gradually eroded over time, especially during the 1980s. Even more important - and possibly explaining this change in public policy - the growth of health insurance, through private coverage, Medicare, and Medicaid, ensured that most people could pay for medical services. In other words, institutions developed that enabled price finance to work, even for the poor, thereby diminishing the redistributive rationale for nonprofits. The advent

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of medical insurance, which was strongly supported by hospitals, makes crosssubsidization and the provision of charity care by nonprofits less critical. Not surprisingly, donations fell drastically in response to insurance, evidence that as institutions change so that the good in question can be privatized, donors will take their money elsewhere. This diminishes the comparative advantage of the nonprofit sector. Total revenues of hospitals increased, however, implying that the gains from insurance and sales far outweighed the loss from donations. (Consistent with this observation, for-profit hospitals tend to avoid areas where uninsured people live, whereas nonprofits are more likely to survive in these areas). In recent years, employers and government have sought cheaper and more predictable health-care arrangements. Competition among both nonprofits and for-profits - in the context of prospective payment systems, the setting of price limits by Medicare and Medicaid, the increasing use of HMOs and preferred providers, and negotiations between insurance companies and hospitals - meant that although costs were covered, there was little surplus left for discretionary spending and cross-subsidization. As a result of these forces, numerous studies show that (with the exception of the small group of teaching hospitals) nonprofit and for-profit hospitals coexist and behave in very similar ways with respect to quality of service, degree of uncompensated care (minimal), and efficiency. Indeed this coexistence and similarity, largely stemming from a common reliance on third-party price finance, may have led to the diminution of public-policy privileges for nonprofits described above. Consequently, the rationale for remaining nonprofit appears to be disappearing - that is, the disadvantages of the nonprofit form (lack of access to equity capital) outweigh the advantages - and we are currently observing a wave of conversions, asset sales, and contracting-out arrangements, from nonprofits to for-profits, among the Blues, HMOs, and hospitals. Nor have I seen much evidence of reluctance as to conversion in these organizations; in fact, the managers are often major beneficiaries - evidence for the countertheory. The other major change in balance between nonprofits and for-profits has occurred in the biotech area, where the lines between nonprofit-university research and for-profit applications have become increasingly blurred. Chapter 9 describes the many changes in federal policy that set the stage for these developments. Legislation in 1980 allowed universities to retain the patent rights to discoveries stemming from federally funded research, a right that had previously been denied to them. After 1984 these property rights could be transferred (sold) to others, including for-profits. Legislation in 1986 permitted universities and firms to collaborate without fear of antitrust litigation. In 1989 the opportunities for licensing of university research and other intersectoral collaboration were further expanded. In 1993 defense-related research was opened up to com-

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mercialization. New NSF programs encourage or require university-industry cooperation. Corporations are used to evaluate the technical merits of proposals, including the feasibility of commercialization and marketing as key points in the evaluation process. In this case, as in the health industry discussed above, public-policy changes probably were not exogenous; rather, they were probably an endogenous response to changing economic circumstances. After the cold war ended, and as international trade and capital movements expanded, public policy toward research has been driven by the belief that U.S. corporations were losing out in global economic competition, and that we could avoid this by developing new technologies, which requires a shift from basic to applied research. In the past, with the United States dominating the world economy, it was expected that domestic firms would capture most of the benefits of basic research; but as other countries have grown in economic power, this assumption is no longer valid. Instead, Japan, Korea, and other emerging countries may be expected to appropriate some of the benefits of our basic research. Under these conditions the U.S. government has less incentive to invest in basic research, and more incentive to shift its focus to the applied level, where the benefits are narrower and more likely to be captured by domestic firms; and this is exactly what has happened, as legal constraints changed to permit and encourage applied research. Fortuitously, the computer and biotech (genetics and Pharmaceuticals) industries were on the verge of major breakthroughs, poised for commercial development of scientific discoveries. As research in these industries generated huge potential profits, universities seized upon the new opportunities for pecuniary benefits. The result: a proliferation of alliances between industry and the academy, an upsurge in licensing, cooperative R&D agreements, and joint research consortia. Nineteen percent of university research and a much larger share in the biotech area is now carried out in close linkage with industry. Key faculty members move back and forth between industry and university laboratories, and small start-up firms, spun off from universities, are often led by present or past faculty members. Universities get an increasing share of their income from patents, licenses, royalties, equity in these start-up companies, and research agreements with private industry. A large and growing share of university research is now financed by private rather than public sources. In the life sciences, private support is greater than public support; but in this case public and private funding sources appear to be complements rather than substitutes. For example, the upsurge in university patenting and university share of total patents that has occurred over the past decade has attracted private funds, but most of the discoveries originated in NSF- and NIH-funded research projects. Three key points are especially worth noting: First, the changing university behavior is due to changing public policies - in particular, the removal of con-

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straints that closed off key avenues of commercialization to nonprofit universities, at a critical moment in time, permitting large new opportunities to open up. Second, these changing public policies are themselves an endogenous response to changing perceptions of the (domestic) economic benefits from basic versus applied research. Third, the universities responded enthusiastically. Though some concerns have been raised about the conflict between the academic value of free and open information versus the commercial motive for keeping information secret, on the whole universities (particularly the life-science parts of universities) aggressively pursued for-profit alliances and modes of behavior once the legal barriers came down. There is little evidence of disutility here, nor any indication that private funding of the life sciences allowed other university resources to be allocated elsewhere, as a form of cross-subsidization (e.g., profits from applied biotech research likely has not found its way to humanities libraries). I regard this as further evidence for the counterhypothesis. In contrast to health and higher education, in other industries commercialism is moving at a much slower pace and with fewer changes in underlying economic conditions and legal constraints. Chapter 12 finds that, among art museums, sales revenues have increased, but only in proportion with other revenues. As government and foundations have supported capital investment, special exhibitions, and outreach programs, the maintenance and normal operating expenses that they generate must be covered from elsewhere, and museums have turned to admission fees and sales from auxiliary operations for this purpose. Still, the proportion of revenues from sales has remained roughly constant, as commercial and donative sources have increased at similar rates. Chapter 10 describes complementarity between membership contributions and sales, but possible substitution between sales and donations, in the socialservice industry. Although many managers of social-service nonprofits feel a pressing need to generate additional resources because government funding for these activities has been cut, commercial activities are approached with caution owing to a possible loss of reputation and donations. Are these activities frowned upon because they generate intrinsic disutility, or because they may reduce other funding sources; that is, does a utility-maximizing or revenuemaximizing objective shape the nonprofits' behavior? We cannot respond with certainty, given the possibilities of cross-subsidization on the one hand and negative interactions among funding sources on the other hand, as Chapter 3 noted. However, we do observe that to minimize crowd-out, managers look for commercial activities that are a natural outgrowth of their primary missions: The American Lung Association and the American Cancer Society accept sponsorship from companies selling products that seem consistent with good health, AARP endorses (for a fee) insurance companies that are said to provide good service to senior citizens, and so on.

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We also observe that membership fees for social-service nonprofits are kept low - to increase member numbers and hence the organization's political clout and its market for commercial sales. In this case, membership fees and sales revenues are complementary because most sales are to members. Again, this behavior is consistent with maximization of either revenue or utility. Econometric evidence provided in Chapter 11 seems most consistent with the utility-maximization and cross-subsidization hypotheses. Zoos charge prices below the profit-maximizing levels; that is, they operate in the inelastic part of their demand curves, to keep admissions high and reach low-income groups. Sales of nonpreferred, ancillary goods (animal rides, souvenirs, food, parking) by zoos has grown as donations have decreased since the 1970s. Although similar behavior might be predicted for revenue maximizers in the face of strong and increasing crowd-out, zoos generally seem to fit the conventional model. Further evidence both of cross-subsidization and the importance of constraints is found in Chapter 13 on public broadcasting. Initially public TV was not supposed to engage in commercial activity; indeed, freedom from the demands of advertisers was its raison d'etre. However, since 1981 public broadcasting stations have been permitted to sell services and products, as new legislation removed old constraints and opened the door to commercialism. Rules on corporate sponsorship have eased, and further easing is under consideration. Simultaneously, government grants to public broadcasting have declined. As a result of these forces, we observe growing partnerships with for-profits, fundraising and membership drives, sales of broadcast time to corporate sponsors, and provision of auxiliary services (CDs, transcripts). It is difficult to disentangle whether the removal of constraints or the increased financial pressure for cross-subsidization is the greater motivating force for commercialism; probably the two interacted, creating greater opportunity and greater need at the same time. As in the social-service industry, public broadcasters fear that advertising and other forms of commercialism may crowd out public and private donations, and they shape their sponsors' messages and other sales techniques to minimize this negative effect. I suspect we shall see much more commercialism in this industry as legal restrictions continue to be lifted. As in the health and education industries, changing public policy in public broadcasting may be seen as an endogenous response to changing technology and institutions - in this case the advent of cable TV, which enabled the price mechanism to work better, hence undercutting the rationale for government grants and private donations to public TV. In the days before cable, pricing could not be used because exclusion of viewers was not technologically feasible, and commercial TV was financed by advertisers interested in maximizing consumption of their products. Strong preferences for a particular type of pro-

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gramming by small groups of people were ignored by these advertisers because it would not increase their sales. Public broadcasting, financed by government grants and private donations, was supposed to overcome this market failure. After the advent of cable TV, this small group could finance its preferred type of programming by paying a high fee to a cable producer, undercutting the rationale for grants and donations. Cable TV allows strong specialized tastes to be catered to, since it converts a nonexcludable good into an excludable good for which intensity of preference can be registered via the price people are willing to pay. Thus, the economic rationale for subsidizing public TV and for limiting its commercialism has declined in the past two decades, and the subsidies and constraints have likewise declined. The quest for organizational survival has led public TV to seek other (nonprice, noncable) financing sources, and these are likely increasingly to rely on commercialism directed toward a niche audience. In sum, the industries where commercialism has been most rampant, as manifested in partnerships, mergers, and conversions, are also industries where (1) institutional or technological change has made exclusion and price financing more feasible and/or (2) tax and subsidy advantages to and constraints upon nonprofits have been lifted since the early 1980s. The removal of constraints makes it possible for nonprofits to act more like for-profits; the reduction in tax and subsidy advantages makes it advantageous for nonprofits to convert to forprofit status; and the feasibility of price finance enables both legal and behavioral conversion between the two sectors. Indeed, we observe all these instances, particularly in the health industry and the university-biotech arena. Moreover, these occurrences are all consistent with the counterhypothesis, which views many (but, of course, not all) nonprofits as quite willing to react opportunistically to changing incentives and constraints in order to maximize revenues or disguised profits, rather than as being driven by nonpecuniary altruistic objectives reluctantly to undertake commercial activities. Furthermore, in all these cases public policies may be viewed as an endogenous response to changing economic conditions and institutions that make it desirable and feasible to shift the balance from public to private goods. At the same time, less dramatic increases in commercialism observed in museums, social-service organizations, zoos, and public broadcasting are more consistent with the conventional hypothesis that nonprofits commercialize and cross-subsidize when they are driven to do so by a reduction in public or private donations. In these cases, underlying institutions and constraints have not changed so as to produce discontinuous changes in behavior. Commercialism in these industries continues to be slowed by the disutility it creates and by the fear that sales revenues may drive out donations: It is impossible to disentangle these two effects.

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Why do we care about commercialism among nonprofits? Why is it worth writing a book about this topic? Should special privileges given to nonprofits be withdrawn as nonprofits become more like for-profits? To answer these questions it may be useful to recount the reasons why public policy creates a special legal category for nonprofits and gives them special tax and subsidy advantages in the first place. Tax and subsidy advantages: Why do they exist and should they be removed? Historically, most nonprofits were religious organizations that started schools, hospitals, and mutual-benefit organizations to serve their members better and maintain their loyalty. From a political-economy perspective, they may have received special tax treatment because of their political power and (especially in the United States) because of our legal strictures to maintain a separation between church and state. As society became more secular, so too did these organizations; but they remained concentrated in areas (education, health, social-service charities) where externalities are thought to exist and where the price mechanism could not be relied upon to achieve optimal results. Indeed, this book asserts - but does not prove - that nonprofits exist to provide public goods and to expand consumption of quasi-public goods to groups that otherwise could not afford to purchase them. Subsidies and tax privileges to nonprofits may be given to encourage donations and to overcome the free-rider problem that exists where exclusion and pricing are not possible. In other countries direct government payment for these services is common, but in the United States indirect subsidy via tax advantages is more likely - possibly because as a heterogeneous society we cannot reach a consensus on which goods and services to subsidize. Thus we decentralize that decision and subsidize via matching grants to organizations that receive "votes" in the form of donations. Public policy earmarks these privileges only for organizations that agree not to distribute their revenues to private owners in the form of dividends or capital gains, because the government cannot observe the detailed behavior of many decentralized organizations. Just as the nonprofit form may be taken as a proxy of trustworthiness by private donors, so too it may be regarded as less likely to abuse its subsidies (thereby causing a political scandal) by public donors. However, organizational form is only a second-best proxy for what we would really like to observe. Indeed, if "for-profits in disguise" are enticed into the field by the existence of tax privileges and subsidies, it may be a third-best proxy.

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Given this background, increased commercialism of or sales by nonprofits enables them to pursue their altruistic mission better by providing revenues, which should please both public and private donors. However, balanced against this are a number of problems it creates or new situations it underscores. First, it may signal that the service provided by nonprofits can now be financed by the price mechanism, due to new technologies and institutions, so public and private donations are no longer needed. In this case, private donations are likely to diminish over time, as donors shift their money to other areas where they are less dispensable. Since donations are diminishing, tax exemption for philanthropy does not pose a new public-policy problem, but other tax privileges may merit reconsideration. If benefits can be captured by prices, why should incomeand property-tax exemption be offered? Second, the increased emphasis on sales revenues may attract more "forprofits in disguise" into the sector - and may lead "real" nonprofits to hire new types of managers, with training, background, and objectives similar to those in the for-profit sector. These managers may be equally likely as for-profit managers to cheat the consumer or donor with respect to output characteristics that are not readily observable. In effect, true nonprofits may be turned into "forprofits in disguise" as a result of the managerial selection process, without full cognizance of this fact by the organization and without a deliberate decision having been made. Further, the psychological theory of cognitive dissonance suggests that attitudes follow behavior - so even if values were not pecuniary to begin with, they would gradually become so as managers are expected to meet monetary goals and are evaluated according to their success in doing so. In that case, the generation of commercial revenues may become an end in itself, and nonprofit status is no longer a reliable signal for trustworthiness or for the desire to "do good" - which were the rationales for tax privileges and public subsidies in the first place. Additional policy questions are raised in this volume about the justification for and possible abuse of income-tax exemptions for nonprofits when auxiliarygood production is large. Chapter 5 shows that nonprofits with unrelated business income (UBI) report lower general and administrative expenses on their Forms 990 than those without UBI. This suggests that a large share of their general expenses are attributed to their unrelated business (UB) activities, thereby sheltering the UBI from taxes even though these activities are not supposed to be tax exempt. One might expect that, for similar reasons, buildings with large depreciation potential would be treated as costs of the UB rather than of the nonprofit. (The nonprofit does not need these costs to shelter its regular income, which is automatically tax exempt.) These costs may be true joint costs that cannot be disentangled between the nonprofit and UB, or they may be costs that could in principle be disentangled but cannot readily be monitored. In the latter case, this attribution means that the government gets less tax revenue from

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the UB activities than it "should," and other firms or households must be taxed more as a result. Nonprofits also benefit from property-tax exemption. Chapter 5 shows that nonprofits tend to engage in commercial activities disproportionately in states where these tax rates are high, giving them a large comparative advantage over for-profits. For example, property used partially for UBI generation, particularly property without large depreciation potential, may be counted as nonprofit property that is exempt from property tax, thereby enabling nonprofits to undercut for-profits producing similar goods, distorting the choice of organizational form, and further reducing tax revenues. In general, when one organization engages both in profit-making and nonprofit activities, producing both public and private goods, it is natural to try to segment the income and cost flows between the two so as to maximize the value of the tax exemptions. This is particularly problematic for public policy if the nonprofits cannot be counted on to use the resulting revenues, via crosssubsidization, for socially useful purposes. Since the value system in nonprofits may itself change as commercialism increases, for the reasons given above, it may be that such exemptions should gradually be withdrawn once the commercial activities of an organization exceed a specified point. (When) Should special constraints apply to nonprofit behavior? Besides these questions as to the tax privileges of nonprofits, this book raises questions about whether and under what circumstances special legal constraints should apply. This issue is most clearly exemplified by the case of biotech research at universities, where constraints on commercial behavior were previously strong but have recently been substantially weakened. The rationales for the constraints were, presumably, the potential conflict between profit-making behavior and public-good-maximizing behavior, and an unwillingness to rely on nonprofit status alone to resolve this conflict in the public interest. In the past, when federally funded basic research was carried on at universities, results could not be patented and were regarded as open information, published in scientific journals and freely discussed at scientific meetings, as soon as (or even before) they were validated. In contrast, privately funded applied research was more likely to be carried on at industrial laboratories, and results were patented before they were made public. As the constraint on university patents was removed, the line between these two types of research has become blurred, and the public-private good conflict has reemerged. Patents are a compromise between the efficiency value of making information readily accessible once it is exists and the need to provide incentives to incur the costs that generate this information in the first place. The institution of patents may increase research funding, but it also directs that funding into

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areas where benefits can be appropriated and marketed within a reasonably short time, even if other areas such as basic research are more promising from the long-run, global perspective. Government grants to universities, together with the nonprofit university value system, solved the investment problem without patents and therefore allowed the efficiency gains from more open access and a broad, long-run perspective. Increased scarcity of government grants (relative to demand) combined with removal of constraints on patenting rights introduced this conflict into academia. Although the commercialization of scientific discoveries via patents makes more resources available for research, it directs the nature of the research toward the short and medium term, and runs the risk of limiting the utilization of research results. Moreover, under the new set of incentives, the allocation of university resources is likely to be strongly influenced by the profitability of outputs. For example, disciplines with commercial prospects may be given priority over those without, rather than basing these judgments on educational criteria. A larger share of university resources and faculty time may be devoted to the business rather than to the science of research and development. Faculty members whose research may lead to profitable patents or licenses, or collaborations with private industry, may be more likely to be hired and tenured than others; therefore, they have an incentive to concentrate on these areas. Although access to grants has always been a factor in resource-allocation decisions at universities, the grants supposedly were awarded according to basic scientific merit; but now commercial profitability plays a stronger role. In effect, the removal of constraints on the commercial activities of universities has shifted the trade-off between public and private research goods in favor of the latter. Have we chosen the right mix? Is this shift in values good for academia and for the economy in the long run? This is the public-policy issue raised as legal constraints are lifted and commercialism increases. Conversions: How can society's interests be protected? The most extreme form of commercialism occurs, as Chapter 7 showed, when nonprofits convert to for-profit status, as has been occurring most notably among HMOs, hospitals, and the Blues in the health industry. Presumably conversion occurs when the advantages of for-profit status outweigh the advantages of nonprofit status. This may be socially desirable if price finance is now so widely feasible that a public good has been turned into a private good, if access to equity capital is important in order to expand facilities, and if donations are no longer a large potential source of revenue. The danger is that the decision makers may take into account only the gains to them personally, rather than the gains and losses to society as a whole. For example, if a group of insiders purchases at a low price nonprofit assets that have been accumulated out of tax-

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exempt donations over the years, and if they cut the public services of the new organization in order to maximize their profits, this may be a case where society as a whole has lost. Alternatively, if a foundation is set up with the proceeds of the asset sales, and management is turned over to people without a social commitment but who earn high salaries and perks, this may be another example of a social loss. Several instances of this sort are reported in this volume. Conversions thus raise issues around who should be permitted to buy and under what procedures (e.g., Should competitive open bidding be required?), how the nonprofit's assets should be valued, how society should be compensated, and who should manage the compensation funds. Conclusion Over the past two decades subsidies to many nonprofit organizations have fallen while the need for their services has grown due to government cutbacks. The growing commercialism among nonprofits is often attributed to these two factors: The conventional theory of nonprofit behavior spelled out earlier predicts that they will rely increasingly on sales revenues to cross-subsidize their preferred public goods as public and private donations fall. This volume provides several empirical examples from the museum, social-service, zoo, and public broadcasting industries consistent with this hypothesis. Though commercialism can lead to abuses of tax privileges (e.g., through cost shifting), these may be minor and correctable in comparison with the gains in nonprofit services. However, in the health and university-biotech industries, where the most dramatic examples of commercialism have occurred, including extensive partnerships with and conversions into for-profit firms, the driving force seems to have been more basic changes in underlying institutional and economic conditions. Moreover, perhaps as a consequence of these underlying changes, the whole set of legal privileges and constraints faced by nonprofits has changed in these industries. Widespread medical insurance permits full pricing for hospital services, and special legal privileges for nonprofits thereafter decline; global competition puts greater emphasis on applied over basic research, and this leads to the removal of legal proscriptions on the rights of universities to patent the results of federally funded research. These basic changes alter in a discontinuous way the incentives of organizations to enter or stay in the nonprofit sector and the behavior of those organizations that do remain. In particular, we see little evidence of a reluctance to commercialize or of the use of sales revenues for cross-subsidization in these cases. It appears that marginal and global changes in commercialism may have quite different causes and effects. A diminution in other revenue sources or an increase in perceived need may explain marginal changes in commercialism, given the underlying set of economic, institutional, and legal constraints - con-

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sistent with the cross-subsidization hypothesis. However, they do not explain discontinuously large changes in commercialism. These may be due, instead, to dramatic changes in constraints and the opening up of new sources of sales revenues; the disutility from profitable activities and the cross-subsidization of loss-making activities become far less important to nonprofits under these circumstances. This suggests that pecuniary objectives may never have been far from the surface. When faced with large new opportunities for commercialism, many nonprofits seem quite willing to shed their altruistic cover and assume the values and behavior of for-profits. Given that sales revenues appear to crowd out donations, tax exemptions for contributions automatically become less important under these circumstances. However, public-policy issues are raised concerning: 1 the use of an organization's legal status to determine eligibility for income- and property-tax exemptions and other privileges in situations where nonprofits and for-profits produce similar goods and/or share similar values; and 2 the conditions for converting from nonprofit to for-profit status once assets have been accumulated out of tax-exempt revenues. In both cases the policy goal should be to ensure that public resources are indeed being used to provide public rather than private goods and to promote social rather than personal welfare - even though these categories are admittedly ambiguous and imprecise.

CHAPTER 15

Conclusions and public-policy issues: Commercialism and the road ahead

Burton A. Weisbrod

Introduction Should anyone care, we asked in Chapter 1, whether the nonprofit sector becomes increasingly commercial? The answer is yes, many people should care: taxpayers, who are affected by the subsidies to nonprofits; consumers of these organizations' services; governmental policymakers, as stewards for the public interest; owners of private firms, which are affected by nonprofits' activities; and nonprofit managers and directors, who are responsible for their organizations. We have surveyed the landscape of the nonprofit sector, examining why revenue-generating sources are changing, what forms they are taking, and what the consequences are of their use. We turn next to an overview of our findings, focusing on the building blocks of our analyses: goals (or mission) and constraints. That discussion, w.iich constitutes the majority of this chapter, is followed by a section identifying a number of issues that call for targeted research, and another on what our findings imply for the development of sound public policy toward the nonprofit sector and its financing. In short, we now take stock of what has been learned and what its implications are - for research and for public policy. A final section peers into the future of the nonprofit sector in light of its search for revenue. What has been learned about nonprofits9 commercialism? Overview The causes and consequences of commercialization are not abstract issues. Nonprofit organizations' commercial activities are bringing revolutionary changes I thank Jeffrey Ballou, Louis Cain, Estelle James, Laura McLean, and Dennis Young for helpful comments on an earlier draft. 287

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in traditional behavior, and in the process they are blurring the distinction between nonprofits and private firms. Prior chapters have identified many forms of nonprofits' commercialism, but new examples appear almost daily. A recent account involves major museums, such as Chicago's Art Institute, Shedd Aquarium, and Field Museum of Natural History: They have begun holding afterhours cocktail parties, "competing with establishments on the other end of the cultural spectrum: bars" and giving rise to their characterization as "meat markets" (Caro 1997). Revenue is produced through admission fees and drink sales, but the question of whether such activities undermine the museums' culturalpreservation and educational missions remains. In the hospital industry, a quite recent instance of aggressive marketing of profit-making activities is the decision by the largest nonprofit hospital in Nashville, Tennessee, "to build and operate a $15 million, 18-acre office and training-field complex that it will rent to the Houston Oilers [professional football team]," which moved to Tennessee in the fall of 1997. The hospital's chairman proudly reported that "Baptist Hospital will be on national T V . . . . When a player is hurt, a golf cart will rush onto the field with Baptist's name all over it." The CEO unabashedly spotlighted the market-oriented philosophy: "We are the pioneers of a nonprofit hospital competing with investor-owned hospitals" (Langley 1997). Commercialism by nonprofits should not just be dismissed as inefficient and counterproductive. It offers real advantages, despite the problems it poses. We have found evidence of significant scientific advances resulting from cooperation between universities and private-sector firms (Chapter 9). We have also found evidence, in the higher-education, hospital, and museum industries, that increased commercialism in the form of unrelated business activity is efficient in the sense that it imposes little marginal cost, given the resources already available for production of mission-related activities (Chapter 5); thus, it would appear to be inefficient to discourage, let alone prohibit, use of those resources even for business activities that are unrelated to tax-exempt missions. Earlier chapters have documented not only the many fascinating new forms of profit-oriented activities in various industries, but also the complexity of determining whether use of those finance mechanisms, which mimic private enterprise, is consistent with social missions. Our analytic framework (Chapter 3) implies that nonprofits select particular revenue-generating activities deliberately, reflecting such variables as their ability to take the labor and capital used for their central, mission-related activities and use them to produce other, ancillary outputs. Choices also reflect the flexibility of the IRS in deciding which activities will be taxed as being unrelated. Thus, forms of money-raising activities can be expected to evolve over time, in response to changes in technology or in IRS administrative practices, in addition to further cutbacks, should they occur, in government support.

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Nonprofits can be expected to increase efforts to push outward the margins of the kinds of revenue-producing mechanism they use, continually probing IRS regulatory restrictions. These restrictions have a number of dimensions, including 1 whether an activity will be subject to taxation as an unrelated business, 2 what accounting methods nonprofits may use to calculate their taxable income - including the rules on how nonprofits are permitted to allocate joint costs so as to minimize their tax liability (Chapter 5)1 - and 3 which activities are regarded as inconsistent with the nonprofit's mission and, hence, as justification for withdrawal of tax-exempt status. With nonprofits' commercialization bringing both revenue needed to finance their unprofitable, collective-goods mission and behavior that may be inconsistent with that mission, difficult choices result. The dilemma is real. Although our analyses generally reflect concerns about the balance between the drive for revenue and adherence to social goals, the precise nature of sacrifices that nonprofits make to raise revenue is seldom clear-cut. Increased commercialization is not ideal. The more important question, though, is whether its many forms, encompassing user fees and various ancillary outputs, are preferable to the alternatives. Those could include greater dependence on government - through grants, tax subsidies, or tax encouragement of private donations - or diminished output of collective goods. Mission: Its vagueness and its effects on nonprofits If it were entirely clear that certain commercial activities were in conflict with nonprofits' pursuit of their tax-exempt missions, the IRS would be revoking taxexempt status far more often. What is more commonly observed, however, is ambiguity as to the effects - ambiguity that reflects the typically broad scope of mission. Thus, we have found that in light of such mission vagueness, it is understandable that nonprofits typically claim there is no conflict - that commercial sales activities are not simply generating money but are simultaneously advancing organization mission. The Girl Scouts, for example, hold that sale of cookies is not merely a commercial activity to raise money, but an exercise through which young girls gain experience that helps build their character and impart business skills (Chapter 10). What, then, are the limits to the goods and services that might be sold in pursuit of that mission, or of AARP's mission of promoting the interests of older Americans (age 50 and over) through advo1

The issues are actually more complex. A nonprofit would wish not merely to minimize taxation, but to maximize aggregate revenue net of both taxes and any disutility from engaging in nonmission-related activities (as discussed in Chapter 3).

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cacy, supportive services, and the provision of information and research (Chapter 10)? The contrast with a profit-making firm is stark. The relative simplicity of gauging a firm's profitability stands in sharp contrast to the complex, multidimensional social goals that, whether attained or not, often characterize nonprofits. The complexity is not a weakness of nonprofits but rather a source of considerable difficulty in identifying and measuring their success or failure, and, thus, in making them "accountable." As our research proceeded it became increasingly apparent that mission vagueness is fundamentally important in predicting and evaluating nonprofitorganization behavior: It makes the operational definition of an "unrelated" business activity inherently problematic; it explains why nonprofits can undertake an ever-widening array of revenue-enhancing activities that the organization can argue are related to mission and that the IRS finds difficult to term "unrelated" and, hence, taxable. Mission vagueness permits managers and trustees to alter behavior in response to changing financial constraints while - at least arguably - continuing pursuit of the same goals. Means and ends are easily confused when goals are vague, and the wider the scope of mission, the greater is the challenge to organization leadership, prospective donors, and regulators to determine whether a profitable commercial activity is mission related. Narrowness of mission focus is not inherently desirable, nor is wide scope inherently undesirable. Breadth permits latitude for organizations to adjust to changing external conditions, and such flexibility is necessary for efficient use of resources. Drawing a distinction, however, between vagueness of mission and flexibility of resource use is both difficult and important for two reasons: to predict nonprofits' responses to exogenous changes in regulatory, financial, and technological constraints, and to assess the accomplishments of nonprofits in achieving their goals. Broad mission scope poses a severe regulatory challenge: to determine when the "border" is being crossed between a true mission-focused activity and a mere money-raiser. This is evident throughout our industry studies (Chapters 8-13). It is also explicit in the admission of the hospital CEO, cited above: "No question," he reportedly admitted; in the selection of revenue-generating activities, "we push the envelope" (Langley 1997). A question posed in many chapters is whether such aggressive commercialism is causing nonprofits to sacrifice subtle elements of their social, collectivegood, mission - for which the subsidies and tax exemptions are given - in the interest of generating revenue. In the case of university-industry research collaboration, universities have agreed to delay or even avoid publication of research findings in order to protect proprietary secrecy, actions that conflict with

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their traditional objective of full dissemination of knowledge. We have seen repeatedly how broad goals make it difficult to determine whether a commercial activity that garners revenue brings any adverse side effect with regard to mission. Without that determination, the true extent of nonprofits' contributions cannot be identified. Nonprofits' pursuit of mission: Effects on private firms To assess the overall contribution of nonprofits it is not enough to focus on those organizations. In addition to the impact of their commercial activities on their own revenues and on achievement of their organization goals, there are effects of those activities on other sectors of the economy - private enterprise, for one. We have seen that nonprofits are expanding into activities that compete with private firms. This may or may not be socially efficient, but it is clearly adverse to the firms. Such competition varies greatly among industries: Food pantries and homeless shelters use technologies that offer few opportunities for commercial expansion, but museums can open retail shops (Chapter 12), and public television stations can air announcements for commercial firms (Chapter 13). In the hospital industry, where the competition for patients who pay is especially keen, the legitimacy of subsidies to nonprofits is increasingly being questioned in light of evidence that their provision of medical care to the indigent closely resembles that of for-profit hospitals (Chapter 8). In the mapmaking industry, the nonprofit National Geographic Society has been charged with having an unfair advantage in its nascent cartographic competition with the forprofit firm Hammond Maps (Hays 1997). We have also found evidence, for various industries, that nonprofits' tax advantages, although ostensibly given to support mission-related activities, really extend beyond them to unrelated activities. Thus, most of nonprofits' taxable activities actually go untaxed, as nonprofits are typically successful in allocating enough joint costs to the taxable activities to eliminate reported profit (Chapter 5). Thus, even when nonprofits expand into commercial activities that are clearly unrelated to their missions, they generally have cost advantages over private-enterprise competitors. Nonprofits' commercialism is not inevitably detrimental to private enterprise. Sometimes the effects are favorable, involving not competition but collaboration. For example, as Chapter 9 documented, universities are increasingly engaging in scientific research in cooperation with for-profit biotechnology, chemical, and pharmaceutical firms. Clearly, both the universities and the firms expect to benefit from joint ventures or other collaborations. In such cases, the issue is not any adverse effect of nonprofits' commercialism on their private partners, but of effects elsewhere in the economy.

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Nonprofits' pursuit of mission: Effects of commercialism on governmental tax revenues One cause of social concern is that the gains to nonprofits and private firms may be at the expense of third parties: For example, government tax receipts may fall because nonprofits find ways to sell their tax advantages to private firms. One instance of such "tax arbitrage" across sectors occurred in higher education when, as we recounted in Chapter 1, a nonprofit college sold all its buildings to a private firm and then leased them back, thereby "selling" their depreciation. Such an allowable expense has no value to a nonprofit organization, which pays no tax on its profit, but depreciation is a valuable deduction to a private firm that can use it to reduce taxable profit. Such a sale of nonprofits' tax advantages is not necessarily socially undesirable, for it is a source of revenue for nonprofits. However, unrelated business income is also a source of revenue, and yet Congress has seen fit to tax it. The issue is what the limits should be on how nonprofits may use their resources, including tax advantages, to expand income. Currently, there is a more general public policy against transactions that have no justification other than to reduce taxation - which explains why the IRS disallows them, even when nonprofits are involved. Nonprofit organization goals and outputs How problematic any form of commercialism is cannot be determined without assessing the organization's "outputs," its success in achieving its social goals. Because this is so difficult, it is common for the IRS to examine procedural evidence rather than the harder-to-measure outputs. It may explore, for example, whether charitable assets are being used for private or "noncharitable" purposes; but this input-oriented indicator, while useful, tells little about what the organization is accomplishing overall. Similarly, it may attempt to distinguish pursuit of social mission from officers' pursuit of personal gain, but this too is difficult. Clearly, there are potential conflicts, but they are hard to observe and do not directly reflect outputs. Charges of overcommercialization, such as those made by critics of Nashville's Baptist Hospital - "When marketing and personal glory dwarf charity care [in a nonprofit hospital], the mission has changed," and "A nonprofit hospital shouldn't cross the line to spend millions of dollars for blatant advertising and promotion" (Langley 1997) - cannot be assessed until there is better understanding of nonprofits' outputs. Until operational measures of nonprofits' outputs in various industries are developed and standardized, the debate will continue over how to operationalize such allegedly negative influences as the pursuit of "personal glory" and "blatant advertising" on a nonprofit's outputs.

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Similar issues, involving new and expanded commercial activities, have been seen in every industry we examined - hospitals (Chapter 8), universities (Chapter 9), social-service agencies (Chapter 10), zoos (Chapter 11), art museums (Chapter 12), and public broadcasting (Chapter 13). The bold pursuit of profit has brought to the surface of the debate not only tax-related questions but, more broadly, the consistency of commercialism with a nonprofit's social, collective-good goals. Our earlier evidence that missions are often stated in extremely broad terms implies that debate will continue to grow over whether a particular nonprofit's commercialism has gone "too far." The IRS, with very limited resources for enforcement, can be expected to rely heavily on organization self-reports, with each nonprofit deciding how far it can go in terming its activities related, and only occasional IRS disputation. However, whether commercialization is, on balance, enhancing or impeding achievement of nonprofits' social goals involves much more fundamental matters than the size of the IRS budget for enforcement. The vagueness of many mission statements implies an inevitably large element of judgment to define which specific activities are or are not "substantially related" to the mission. Revenue and cost constraints Revenues limit what any organization, nonprofit or other, may do, and the nature of those limitations is not simple if revenue sources are interdependent and responsive to the organization's decisions. We have seen that nonprofits may be concerned, for example, about the effects of their decisions to increase revenue from one source or another - user fees or ancillary activities - on their revenue from yet another source - contributions, gifts, and grants (CGG). Such increased self-help could lead either to decreased or increased CGG, depending on whether prospective donors favor or oppose those efforts. Because of such revenue interdependencies, a nonprofit would not necessarily maximize its total revenue by trying to maximize revenue from each individual source; an increase in revenue from one source could diminish revenue from another source even more. There are still other fiscal interdependencies and associated constraints. Decisions to produce more of certain salable outputs can affect both revenues and also costs. Thus a nonprofit might be enabled to expand its mission-related outputs not only by increasing revenue but also by decreasing costs, and increased production of some ancillary activity could reduce production costs for the organization 's mission-related outputs (Chapter 3). Resource interdependencies can take other, complex forms. Increased commercial activity intended to generate revenue to expand production of missionrelated collective goods and services can affect the types of manager employed, the types of director selected, and thereby the organization's decisions on how

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it pursues its mission. This can be seen in the nonprofit National Geographic Society's recent restructuring and greatly expanded emphasis on commercially profitable activity. In order to increase revenue for its expeditions and educational activities, it is producing full-length feature films, developing commercial cable television partnerships with NBC, and producing, in the fall of 1997, the first National Geographic Road Atlas. To do this it is bringing in new management, not from other nonprofits but from private business. The effects on the quality of research scholarship for the magazine articles are uncertain, but there is already evidence of pressure to diminish the time allotted for field research (Hays 1997). Whether the trade-off is socially efficient cannot presently be resolved, but the balance clearly is changing. All these interdependencies among revenue sources, costs, and organization behavior add a significant dimension to understanding nonprofits' financial constraints. It has long been understood by economists and argued by nonprofits' leadership that private donations are affected by changes in the individual income-tax law, such as reduction in marginal tax rates or increases in requirements for itemizing deductions for charitable giving (Clotfelter 1990). What has scarcely been noted, however, is that those effects can be expected to trigger additional forces, especially commercial activity, so that the final effects on nonprofits' revenue may be quite different. Our evidence is that there is great variability among industries in their offsetting of losses in contributions, gifts, and grants by increasing commercial activity from "program services" (Chapter 6), and this suggests that nonprofit-organization behavior is more complex than has been commonly recognized. At this point, however, little is known about the causes of this behavioral heterogeneity across industries. Opportunities to expand commercial markets profitably may differ greatly, as may organizational willingness to adopt or increase user fees or enter new ancillary markets. Potential conflict between revenue source and goal attainment Both forms of commercialism, user fees and ancillary activities, have the potential to generate revenue, and both involve private goods, which can be withheld from any consumer. The key difference is that those persons served by ancillary goods are of no special concern to the nonprofit's mission, whereas user fees are charges made to consumers who constitute at least a portion of the organization's target population. We have highlighted the potential conflict between pursuing revenue via user fees and achieving a nonprofit's mission when that mission is to reach some specific population, such as the poor or all schoolchildren (Chapter 4). It is certainly feasible to impose charges on patients at a research hospital, where care is related to the clinical research activities, or on undergraduate students, who constitute an undergraduate college's target population, or on museum visitors, whose education is at least one element of

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the nonprofit's mission. However, barring perfect price discrimination, we have shown the danger that user fees will price out of the market at least some members of the target population. We have seen how increasing revenue through user fees, as through the institution of admission fees at museums and zoos, troubles nonprofits because of the negative effect on attendance and, hence, on their education mission (Chapter 11). In this way too, efforts to relax resource constraints can have adverse side effects on the achievement of organization goals. We have emphasized, moreover, that the organization's view of which activities are and are not central to its objectives may differ from the distinction made by the IRS, under the tax law, between related (untaxed) and unrelated (taxed) activities. Were it not for the links between goals and the revenue-related activities used to attain them, a nonprofit would act as a profit maximizer in those product markets where they seek simply to raise revenue. The model presented in Chapter 3, however, implies that nonprofits may not wish to maximize profits in such markets because they view the activities themselves as inconsistent with the mission; in at least some industries, such as zoos and public television, it seems clear that admission fees and sale of broadcast airtime are intentionally restricted because of a sense that generating more revenue from those sources would be inconsistent with mission. At the same time, however, it remains very difficult to distinguish such goal incompatibility from the effects of revenue interdependencies in which some form of commercial activity is disliked by prospective donors, causing them to decrease contributions (Chapter 14). In such situations a nonprofit that did seek to maximize profit in commercial markets, in order to subsidize its collective-goods outputs, would not act to maximize profit in each specific market where it can charge prices. The organization, recognizing negative marginal effects across markets, would balance the effect of increasing profit from one commercial activity against the loss in maximum attainable profit from other sources. Behavioral differences among industries Many of the goals, constraints, and interrelationships we have identified as characteristic of nonprofits appear to differ systematically across industries.2 Even if we have accurately assessed the basic forces operating on nonprofits - that is, if we have identified the essential character of their objective functions, the nature of trade-offs among revenue sources, and the production-cost interdependencies - there can be large differences in their effects among industries.

2

They may also differ between small and large nonprofits, between younger and older nonprofits, or in other ways not explored here explicitly.

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In fact, not only can there be differences, they can be expected. For example, the potential for realizing profit from ancillary activities, which do not contribute directly to the organization's mission but can generate profit to be used to augment mission-related activities, will depend on the production technology used for the pursuit of mission. That technology, which varies among industries, is likely to differ widely in its profit potential: For example, a nonprofit dedicated to perform ballet would appear to have far fewer opportunities for ancillarygoods profit than a hospital. Such differences in technology may help to explain the substantial variation we found among industries in the effects of changes in revenue from donations on commercial activity from "program service revenues" (Chapter 6). For some industries we found strong negative relationships between receipt of revenue from donations and subsequent revenue from program services, as the simple crowding-out hypothesis suggested. For other industries, however, there was no relationship; in still others, a positive one. One possible explanation is that data available from the IRS Form 990 return, the principal current data source, do not distinguish the two sources of commercial revenue, user fees and revenue from ancillary activities. A second complexity is that the simple crowding-out relationship may actually operate in all industries, yet be offset by interdependences among revenue sources or by cost interdependencies. Tax-related constraints: Joint-cost allocations between taxed and untaxed activities As we observed earlier (see "Nonprofits' pursuit of mission: Effects on private firms"), it appears that when nonprofits do report engaging in activities that are unrelated to their tax-exempt mission - and most do not, although the ranks are growing rapidly - they generally allocate so much cost to the taxed activities as to eliminate all tax liability. This is true despite our evidence that costs are heavily "joint." In this way, the actual incremental cost of the unrelated business activity is essentially zero. From an examination of the relationship between a nonprofit's taxed and untaxed activities it is a short step to recognizing the effects of nonprofit commercial activity on private firms. Although the specific effects on private enterprise of the nonprofit sector's commercial expansion have not been a major focus of this volume, our examination of cost allocations between nonprofits' taxed (unrelated) and untaxed (related and excluded) activities has shed some light on them. As a result of the joint-cost allocations, unrelated business (UB) activities, which presumably have no justification except to generate profit for crosssubsidizing the mission, are reported to be negative by some two-thirds of nonprofits that file Form 990-T returns reflecting taxable activity. Moreover, these "losses" are so great that they exceed the modest profit reported by the others, so that aggregate nonprofit-sector profit from all organizations reporting UB

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activity is negative! It is striking to note that while nonprofits are reporting increased total UB activity over time, they are also reporting increased losses. These findings appear to be the result of accounting cost allocations, not genuine unprofitability. In contrast with data reported on Form 990-T returns showing that costs of UB activity increase more than revenues, we found, in aggregate data and in the hospital and higher-education industries, that actual costs do not increase at all; by this reckoning, UB activities are extremely profitable. Thus, the generally negative profits reported by most UBIT filers make clear that a great deal of UB activity carries no tax liability. Cost allocations between nonprofits' untaxed and taxed activities are not merely technical issues; they have broad consequences on resource-allocation neutrality across ownership sectors. Altering constraints: Converting a nonprofit to afor-profit What we have termed "the ultimate commercialism" is the conversion of a nonprofit organization to for-profit status (Chapter 7). A conversion may or may not imply a change in organizational goals. It does so insofar as nonprofits pursue goals that involve provision of goods and services that are socially valuable but privately unprofitable, whereas for-profit firms do not - a view that finds expression and evidence in many chapters. On the other hand, whatever social policy may intend, nonprofits may actually differ little from private firms. This is argued for the hospital industry (Chapter 8); for conversions of hospitals and HMOs to for-profit status, where private gain to nonprofit organization executives seems to have motivated at least some recent activity (Chapter 7); and more generally, in an overview (Chapter 14). Our analysis of conversions demonstrated the difficulty of discerning when a conversion is a reallocation of resources from a less efficient to a more efficient use, and when it represents merely a private benefit to insiders. Private gain does not preclude social efficiency; neither, though, does it ensure it. Since this basic issue of distinguishing efficient reallocation of resources from simple redistribution of wealth is the same across all nonprofit-organization industries, the current prominence of conversions in health care - hospitals and HMOs - suggests that conversions may occur, with the same attendant problems, in other industries. Which industries will be the next to move aggressively to convert nonprofits to for-profits is not clear, just as widespread conversions were not foreseen for the hospital and HMO industries even a decade ago. There are two questions, not dealt with in this volume but nevertheless important: First, from an efficiency perspective, which industries will experience the threat of extinction of nonprofits unless they have greater access to capital? Second, from a wealth-distribution perspective, which industries offer the greatest potential opportunities for private gain from conversion? Speculation suggests that capital-market constraints on nonprofits may become increasingly severe in

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nursing homes, where an aging population will present opportunities for profitable expansion into regional, if not national, chains. Regarding opportunities for private benefit, the massive wealth in nonprofit colleges, universities, and museums continues to offer financially tempting targets.

Assessing our analytic framework The framework adopted in Chapter 3 focused on nonprofits' choices among outputs and among revenue sources that determine organization budget constraints, as well as on the interdependencies among outputs and among revenue sources. It proved to be useful as a base for structuring industry studies and posing research questions. Still, as with any relatively simple characterization, its small number of variables cannot capture fully the great variety of behaviors exhibited by the more than a half-million charitable nonprofit organizations. The goals-constraints structure assumed that nonprofits have goals that are clear enough to constitute meaningful objectives. That is often not the case, however, as we have repeatedly noted. In the absence of the functional equivalent of stockholders pursuing profitability, nonprofits' objectives may or may not be translatable into terms analogous to profit maximization. Moreover, because of mission vagueness, the actual goals pursued by a nonprofit may reflect managerial preferences, and, through a managerial sorting process, those preferences can be expected to reflect the (revenue and other) constraints faced by prospective managers. Thus, an organization's constraints and its actual goals may not be independent.

Implications for research Though we have learned much about the forces influencing nonprofits' increasing commercial activities, some important matters remain unclear. This section points to the principal directions that our work has identified for future research. The search for generalizations as to nonprofits' behavior remains a challenge. So, too, is the identification of differential patterns of behavior across industries. The following five dimensions, involving elements of nonprofit-organization goals and fiscal constraints, deserve increased research attention. Whether the interest is in predicting nonprofits' behavior or in developing wise public policy, it is important to increase understanding of the following: Nonprofit-organization objective functions 1 The breadth and multiplicity of goals of individual nonprofit organizations, and the differences among industries in the trade-offs being made among goals;

Conclusions and public policy issues: The road ahead

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2

the importance to various nonprofits of not simply providing certain goods or services but of reaching particular target populations; and 3 the degree of willingness to engage in production and distribution of ancillary goods in order to raise funds for subsidizing production of their mission-related goods, as well as the willingness to charge user fees and to adopt commercial approaches to expand donations.

Budgetary constraints 4

The opportunities - technological and market - available to various nonprofits to enter private-goods markets and compete successfully with private firms and other nonprofits, or to benefit from joint ventures with private firms; and 5 the interdependencies among nonprofits' various revenue sources and among costs of producing various mission-related and ancillary outputs.

Chapter after chapter focused on the importance of revenue constraints from various sources, but the framework did not deal explicitly with uncertainty about the promise of each prospective source. That is, the revenue constraints limiting what a nonprofit can do are not fully predictable. As a result, nonprofits' decisions on how much to pursue each of a variety of revenue sources may reflect not only the expected revenue from each alternative but the differing uncertainty as well. A particular source of revenue may appear to be quite uncertain yet turn out to be quite stable or otherwise predictable; alternatively, a source that seems highly predictable may turn out not to be. Study is needed, therefore, of uncertainty, both as anticipated and as realized. Government grants, for example, have come to be increasingly uncertain, as anticipated in an era of cost cutting and rethinking of the role of the federal government. In fiscal 1996, to illustrate, legislative delays caused funding agencies such as the National Science Foundation and the U.S. Geological Survey virtually to discontinue grants to university scientists for at least four months. According to one account, "field studies and laboratory experiments were being canceled. . . . Admissions to graduate programs [were] also being affected because of the uncertainty regarding the amount of funds available for research assistantships" (Menke 1996). Eventually appropriations restored the funding. Still, the general questions regarding uncertainty are as follows: 1

Do nonprofits perceive various revenue sources as differentially reliable? 2 Have some sources actually proven to be more dependable than others? 3 How do nonprofits respond to differences in predictability of revenue from alternative sources?

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With respect to all the issues in this section, there is need to learn more about their importance and influence not only for the nonprofit sector as a whole but also for individual industries. Disaggregation is very much needed, given our findings of distinct interindustry behavioral patterns that are as yet poorly understood. At the same time, while there are limitations to a one-size-fits-all model of nonprofits, there are also disadvantages to emphasizing their diversity, for that limits identification of common characteristics and, hence, the ability to generalize across industries. An industry perspective also highlights the influence of competition on nonprofits' commercial activity. It would be useful to learn whether greater competition, whether from other nonprofits, private firms, or government agencies, sparks commercial activity of nonprofits. Implications for public policy Our analyses of nonprofit commercialization do not lead inexorably to proposals to introduce major reform into the nonprofit sector, its activities, or its revenue sources. Nevertheless, they do suggest some directions for change. It is apparent that public policy affects the ways nonprofits are financed, the kinds of output they produce, and the mechanisms through which outputs are distributed. The instruments of public policy are far more complex than is commonly recognized, going far beyond tax deductibility of donations, tax exemption of nonprofit-organization surplus or profit, and outright subsidies. Public policy also encompasses incentives for nonprofits to produce profit-generating products, regulations that affect the use of accounting procedures that minimize or eliminate taxable profit, and rules that affect commercial alliances with, or conversions into, private firms. In this section we highlight a number of ways in which our findings link with public policy toward nonprofits. Our findings that revenues from donations, user fees, and ancillary activities are likely to be interdependent - a change in one affecting the availability of revenue from one or more of the others - have major implications for publicpolicy development. A government policy that alters the availability to nonprofits of one source of revenue can have unintended and unexpected side effects. To illustrate: As Congress and the administration consider cutting government grants for the arts and the humanities, as well as for antipoverty programs, the debate has focused on whether private donations will offset governmental cuts. The interdependence of government grants and private donations to nonprofits is certainly relevant to these organizations' budget constraints. However, our analysis has focused on another revenue interdependence: the effect of such a decrease in government grants on nonprofits' pursuit of commercial activity in the forms of increased user fees or production of ancillary goods. We have found some evidence that reduced donations (from all sources) lead to increased

Conclusions and public policy issues: The road ahead

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commercial activity. Industry disaggregation, however, disclosed substantial variation among industries, with reduced donations being associated with increases in commercial revenue in some industries but with decreases in others (Chapter 6). Such varied responses of nonprofit organizations to cuts in contributions, gifts, and grants were not obvious a priori, but in light of our analysis they are not surprising: Interindustry differences in organizational goals (including preferences for and aversion to particular activities), in interdependencies among costs, and in technologies and market demands that present varying commercial opportunities, can each influence responses to an exogenous change in revenue from any particular source. Recommendations on improving data about nonprofits Sound public policy toward nonprofits requires information about performance. Data with which to analyze nonprofit-organization behavior and changes over time are very limited. IRS Form 990 returns - the major source of data, which we utilized in a number of chapters - do not, and cannot be expected to, cover the entire range of issues on which information is needed. That form, valuable as we have found it to be, is inadequate in several respects. It needs to be supplemented with data on organization output and on physical quantities of inputs, to aid in the assessment of nonprofits' efficiency and social contribution. The following recommendations are made regarding data development and reporting: The IRS Form 990 return should be reconsidered, with the goal of eliminating questions that have proven to be of little use to the IRS, researchers, or public policy makers, and adding others, especially focusing on "outputs." Agreement on what constitute outputs and how to measure them is elusive; but without it, the goal of nonprofit accountability is unattainable. Thus: A process should be initiated in which researchers, nonprofit-sector leaders, government officials, and private-sector representatives of industries affected by nonprofits' commercial activities develop consensus measures of nonprofit outputs, including the distribution to target groups. Outputs should be industry specific, and selected to identify measures evidencing success or failure. Makers of public policy should confront the fact that a growing fraction of nonprofits are reporting unrelated business income, as well as the fact that extremely little taxable income results. Public policy should reflect better understanding of the growing complexity of nonprofit-organization activities, as more of them produce outputs clearly unrelated to their exempt purpose. To advance this process:

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Data from the Form 990 return and the Form 990-T return should be coordinated and published. The Form 990-T data, though confidential, can be aggregated in ways that would preserve confidentiality yet expand understanding of the connections between related and unrelated activities. Nonprofits compete with private firms and government agencies in many industries. Unless nonprofits' activities are viewed in an industrywide context, there will be little basis for determining in what ways they either accomplish goals not attained by other types of organization, or affect decisions of those organizations. Data on nonprofit-organization activities should be supplemented by analogous data for the private-enterprise and governmental organizations in the industry. This is not to say necessarily that this should be a responsibility of the IRS, let alone that it should be related in any way to the Form 990 return, but only that industrywide data are needed to assess the role of nonprofit components. Recommendation on public policy toward nonprofits' commercialization Public policy directed at nonprofits and their financing has effects that extend far beyond the nonprofit sector. Changes in personal income-tax rates or in government grants, for example, have more complex consequences than have generally been realized. Reductions in tax rates or grants initially reduce nonprofits' revenues, which can cause nonprofits to alter their commercial activity; this, in turn, will have additional effects on nonprofits' revenue if donations respond to commercial activity. In addition, changes in commercial activity can alter the way a nonprofit's mission is seen and pursued by its leadership, as we have already noted. Because such reverberative effects have significant implications for the direction of public policies affecting nonprofits: When cuts are considered in federal and state government support for colleges and universities, hospitals, the arts, and so on, attention should be directed to side effects. Such cuts - in grants, contracts, or tax subsidies - may drive nonprofits to increased commercialism. In the process, private firms would be affected by the extended competition; and government (at various levels) could be affected insofar as commercialism drives nonprofits into alliances with private firms in ways that reduce tax payments. Recommendation on encouraging private contributions The principal revenue alternative to commercial activity is increased contributions, gifts, and grants. There is, in short, an alternative to the choice between

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increased commercial activity and retrenchment: The drive for commercial revenue can be redirected. Worthy of attention, though not devoid of problems, are changes in tax laws to encourage private donations. Ways to increase private donations should be explored. Mechanisms worth examining include making it easier to take tax deductions for charitable giving, instituting limited tax credits, and permitting taxpayers to earmark a portion of their tax payments for specific nonprofits.

Recommendation on regulating conversions of nonprofits to

far-profits Conversions of nonprofits to for-profits deserve greater public-policy attention. They are sometimes necessary, as is capital mobility more generally, to encourage efficient use of resources. At the same time, conversions should protect assets built up with the assistance of charitable donations and government subsidies, and should avoid wealth transfers beyond what are needed to motivate efficient reallocations. Should there be a rush of nonprofits in asset-rich industries other than health care that seek to change to for-profit enterprises, and thereby become free of the nondistribution constraint, the same public-policy issue would arise: How to balance concerns about efficient resource use against concerns about equity toward donors and avoidance of unfair enrichment of insiders. There is no basis for predicting where pressures for conversions may arise next, just as there had been little recognition over the past decade of the impending sea change in the nonprofit health-care sector. At the same time, it is noteworthy that the vast wealth in nonprofit colleges, universities, and museums presents tempting opportunities for private gain through conversions. Thus: Public policy toward conversions should include development of better mechanisms to distinguish efficient resource reallocations from self-serving private gain. These should include requirements for arms-length transactions and the functional equivalent of open competitive bidding. Attention should also be directed to identifying industries likely to see major efforts to convert.

Recommendation on relating public policy to the diversity of nonprofits One of our major conclusions implies that great caution is required before implementing any sweeping reforms for the nonprofit sector as a whole. Industry components of the nonprofit sector differ greatly in their dependence on donations relative to commercial revenue, and in the revenue opportunities available

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to them. Any simple "solution" to the nonprofit-sector finance problem can have vastly varying effects across the wide expanse of nonprofit organizations. Thus, guidance for flexible public policy toward nonprofits seems justified by our findings: Avoid "sweeping" reforms of nonprofitfinancemechanisms. Because of differences among industries in nonprofits' access to capital, access to user fees, the suitability of their technology for the production of ancillary goods, and their ability to overcome free-rider problems, any broad reform is likely to have quite different effects among industries having nonprofit components. Commercialism: The road ahead For decades the nonprofit sector has been small enough, and its methods of raising revenue innocuous enough, to be largely out of sight. Success has changed this; with growth has come visibility. The increased public awareness of nonprofits reflects growth in their numbers, in their share of the gross domestic product, and in their use of commercial revenue-raising instruments traditionally identified with private enterprise. In light of nonprofits' receipt of public subsidies, demands for restricting their activities and for holding them more accountable for demonstrating their social contribution and its value are increasingly evident. Attacks on their tax exemptions, a widening array of penalties ("intermediate sanctions") now available to the IRS for various regulatory violations, and decreases in government funding, or shortfalls relative to "need," all demonstrate growing public concern. Because nonprofits often see their role as performing many elements of the unfinished job of governments, they tend to see their missions as forcing them to become more creative and imaginative in generating revenue. Competition for resources, however, drives all organizations - nonprofit, for-profit, and governmental - to search for new markets, and markets new to one type of organization are likely to be already occupied by one or more others. When nonprofits seek opportunities to raise revenue by producing goods or services they can sell profitably, they enter the domain of the private, for-profit firm. There, the drive for profit demands attention to costs and revenues and, hence, to avoidance of activities that, however desirable they may be from a societal perspective, do not generate profit. What happens when nonprofits' pursuit of revenue drives them to act like private firms? The answer, as previous chapters have shown, is not simple. There are dangers of goal displacement, as the social mission slips from sight in the drive for revenue. Aggressive marketing and merchandising produce almost inevitable conflict, sometimes forcing organizations to choose between "capitalist appetites and . . . integrity" (Farhi 1997, 13). Peering ahead, it is likely that:

Conclusions and public policy issues: The road ahead

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missions of nonprofits engaged in commercial activities will grow more ambiguous through time. New demands on senior management to pay attention not only to nonprofit but also to for-profit goals, the adoption of new structures such as joint ventures that create mixed missions and messages for participating entities, and the tendency of senior management to look at activities from the perspective of their contribution to revenues may create an environment in which nonprofits must work especially hard to keep their charitable mission in daily focus. Increased responsibility will likely fall on the Boards of Directors of commercial nonprofits to insure that a dilution of charitable mission does not occur. . . . (Howard P. Tuckman, personal communication, 1997) Whether the future finance bases and commercial activities of the nonprofit sector as a whole, and of specific industries within it, will be extensions of historical paths is not predetermined. Much depends on nonprofits' success in finding new sources of revenue. Barring unlikely changes in government grants or tax-law encouragement of private donations (of money and labor), increased user fees and, especially, expanded commercial activities are the most promising revenue sources. If nonprofit-organization commercialism continues to increase in magnitude and in scope, nonprofits will become even more entwined with private enterprise and less distinct from it.

APPENDIX

IRS Forms 990 and 990-T for nonprofit organizations

Appendix: IRS Forms 990 and 990-T

307 OMB No. 1545-0047

990

Return of Organization Exempt From Income Tax Under section 501 (c) of the Internal Revenue Code (except Mack lung benefit trust or private foundation) or section 4947(a)(1) nonexempt charitable trust Note: The organization may have to use a copy of this return to satisfy state reporting requirements.

This Form is Open to Public Inspection

A

For the 1996 calendar year, OR tax year period beginning , 1996. and ending D Employer identification number Pleas* C Name of organization B Check if: use IRS I I Change of address label or print or E State registratiion number Number a nd street (or P.O boxif mail is not delivered to Street address) ^oom/suite [~1 Initial return type. CD Final return See Q Amended return Specific City, towr . or post office, state, and ZIP+4 F Check • • if exemption application Instruc(required also for is pending tions. State reporting) ) < (insert number) OR • Q section 4947(a)(1) nonexempt charitable trust G Type of organization—• • Exempt under section 501 (cK Note: Section 501 (cH3) exempt organizations and 4947(a)(1) nonexempt charitable trusts MUST attach a completad Schedule A (Form 990. I If either box in H is checked "Yes," enter four-digit group H(a) Is this a group return filed for affiliates? D Yes • No exemption number (GEN) • (b) If Yes," enter the number of affiliates for which this return is filed;. . • J Accounting method: O Cash O Accrual D Other (specify) > (c) Is this a separate return fileo by an organization covered by a group ruling? I I Yes I I No Check here • Q if the organization's gross receipts are normally not more than $25,000. The organization need not file a return with the IRS; but if it received a Form 990 Package in the mail, it shoulo file a return without financial data Some states require a complete return. Note: Form 990-EZ may be used by organizations with gross receipts less than $100.000 and total assets less than $250,000 at end of year. Revenue, Expenses, and Changes in Net Assets or Fund Balances (See Specific Instructions on page 9.) 1 a

Contributions, gifts, grants, and similar amounts received: ' la

Direct public support

1b

b Indirect public support c Government contributions (grants)

I 1c

d Total (add lines 1a through 1c) (attach schedule of contributors) (cash $ 2

noncash $

) .

Program service revenue including government fees and contracts (from Part VII, line 93)

3

Membership dues and assessments

4

Interest on savings and temporary cash investments

5

Dividends and interest from securities 6a

6a Gross rents b 7

6b

Less: rental expenses

c Net rental income or (loss) (subtract line 6b from line 6a) Other investment income (describe •

8a Gross amount from sale of assets other

^ securities

than inventory b Less: cost or other basis and sales expenses. c G a i n or (loss) (attach schedule) .

.

.

8c

.

d

Net gain or (loss) (combine line 8c, columns (A) and (B))

a

Gross revenue (not including $ contributions reported on line 1a)

9a

b

Less: direct expenses other than fundraising expenses

9b

c

Net income or (loss) from special events (subtract line 9b from line 9a)

9

Special events and activities (attach schedule)

10a b c 11 12

Gross sales of inventory, less returns and allowances Less: cost of goods sold

10b

Gross profit or (loss) from sales of inventory (attach schedule) (subtract line 10b from line 10a) Other revenue (from Part VII, line 103) Total revenue (add lines I d , 2, 3, 4, 5, 6c, 7, 8d, 9c, 10c, and 11) .

13

Program services (from line 44, column (B))

14

Management and general (from line 44, column (C))

15 16 17

Fundraising (from line 44, column (D)) Payments to affiliates (attach schedule) Total expenses (add lines 16 and 44, column (A))

18

Excess or (deficit) for the year (subtract line 17 from line 12)

19 20 21

Net assets or fund balances at beginning of year (from line 73, column (A)) . Other changes in net assets or fund balances (attach explanation) . . . . Net assets or fund balances at end of year (combine lines 18, 19, and 20) . .

.

For Paperwork Reduction Act Notice, see page 1 of the separate instructions.

Cat. No. 11282Y

1 9 9 0 (1996)

308

Appendix: IRS Forms 990 and 990-T

Page 2 All organizations must Statement of and section 4947(a)(1) Functional Expenses Do not include amounts reported on line 6b, 8b, 9b, 10b, or 16 of Part I.

complete column (A). Columns (B), (C), and (D) are required for section 501(c)(3) and (4) organizations nonexempt charitable trusts but optional for others. (See Specific Instructions on page 13.)

(B) Program services

(C) Management and general

(D) Fundraising

Grants and allocations (attach schedule) (cash $ 23

noncash $

Specific assistance to individuals (attach schedule)

24

Benefits paid to or for members (attach schedule).

25

Compensation of officers, directors, etc. .

26

Other salaries and w a g e s

27

Pension plan contributions

28

Other employee benefits

29

Payroll taxes

30

Professional fundraising fees

31

Accounting fees

32

Legal fees

33

Supplies

34

.

Telephone

35

Postage and shipping

36

Occupancy

37

Equipment rental and maintenance

38

Printing and publications

37

. . . .

39

Travel

40

Conferences, conventions, and meetings .

41

Interest

42

Depreciation, depletion, etc. (attach schedule)

43

Other expenses (itemize): a

.

Total functional expenses (add lines 22 through 43) Organizations completing columns (B)-(D), cany these totals to lines H-15

44

Reporting of Joint Costs.—Did you report in column (B) (Program services) any joint costs from a combined educational campaign and fundraising solicitation? • D Yes ; (ii) the amount allocated to Program services $ If "Yes," enter (i) the aggregate amount of these joint costs $ (iii) the amount allocated to Management and general $ ; and (iv) the amount allocated to Fundraising $

D No

Statement of Program Service Accomplishments (See Specific Instructions on page 16.) Program Service What is the organization's primary exempt purpose? • Expenses All organizations must describe their exempt purpose achievements. State the number of clients served, (Required for 501 (c) (3) and orgs., and 4947(a)(1) publications issued, etc. Discuss achievements that are not measurable. (Section 501{c)(3) and (4) organizations (4)trusts; but optional for and 4947(a)(1) nonexempt charitable trusts must also enter the amount of grants and allocations to others.) others.)

(Grants and allocations

$

(Grants and allocations

$

(Grants and allocations

$

(Grants and allocations $ e Other program services (attach schedule) (Grants and allocations $ f Total of Program Service Expenses (should equal line 44, column (B), Program services).

Appendix: IRS Forms 990 and 990-T

309 Page 3

Balance Sheets (See Specific Instructions on page 16.) Note:

45 46

Where required, attached schedules and amounts within the column should be for end-of-year amounts only.

51a b 52 53 54 55a b

59

47b

Pledges receivable Less: allowance for doubtful accounts . Grants receivable Receivables from officers, directors, trustees, and key employees (attach schedule) Other notes and loans receivable (attach 51a schedule) 51b Less: allowance for doubtful accounts . . Inventories for sale or use Prepaid expenses and deferred charges . Investments—securities (attach schedule) Investments—land, buildings, and 55a equipment: basis Less: accumulated depreciation (attach 55b schedule) Investments—other (attach schedule) . . 57a Land, buildings, and equipment: basis . .

56 57a b Less: accumulated depreciation (attach schedule) 58 Other assets (describe •

(B) End of year

(A) Beginning of year

45

Cash—non-interest-bearing Savings and temporary cash investments .

47a Accounts receivable b Less; allowance for doubtful accounts . 48a b 49 50

description

49

54

57b

Total assets (add lines 45 through 58) (must equal line 74) .

60 61 62 63

Accounts payable and accrued expenses . Grants payable Deferred revenue Loans from officers, directors, trustees, and key employees (attach schedule) 64a Tax-exempt bond liabilities (attach schedule) b Mortgages and other notes payable (attach schedule) 65 Other liabilities (describe • ) 66

65

Total liabilities (add lines 60 through 65)

Organizations that follow SFAS 117, check here • • and complete lines 67 through 69 and lines 73 and 74. 67 Unrestricted 68 Temporarily restricted 69 Permanently restricted Organizations that do not follow SFAS 117, check here • D and complete lines 70 through 74. 70 Capital stock, trust principal, or current funds 71 Paid-in or capital surplus, or land, building, and equipment fund . . 72 Retained earnings, endowment, accumulated income, or other funds 73 Total net assets or fund balances (add lines 67 through 69 OR lines 70 through 72; column (A) must equal line 19 and column (B) must equal line 21) 74 Total liabilities and net assets / fund balances (add lines 66 and 73)

68

73

310

Appendix: IRS Forms 990 and 990-T Page 4

Reconciliation of Expenses per Audited Financial Statements with Expenses per Return

Reconciliation of Revenue per Audited Financial Statements with Revenue per Return (See Specific Instructions, page 18) a b (1) (2) (3) (4)

Total revenue, gains, and other support per audited financial statements . . • Amounts included on line a but not on line 12, Form 990: Net unrealized gains on investments . . $ Donated services and use of facilities $ Recoveries of prior year grants . . . $ Other (specify):

(1) (2)

(3) (4)

Total expenses and losses per audited financial statements . . • Amounts included on line a but not on line 17, Form 990: Donated services and use of facilities * Prior year adjustments reported on line 20, Form 990 . . . . * Losses reported on line 20, Form 990 . 1 Other (specify):

Add amounts on lines (1) through (4) • c d

Line a minus line b Amounts included on line 12, Form 990 but not on line a:

(1) Investment expenses not included on line 6b, Form 990 . . . I (2) Other (specify):

•

c d

Add amounts on lines (1) through (4)^ Line a minus line b • Amounts included on line 17, Form 990 but not on line a:

(1) Investment expenses not included on line 6b, Form 990. . . (2) Other (specify):

I

Add amounts on lines (1) and (2) • Add amounts on lines (1) and (2) • Total expenses per line 17, Form 990 Total revenue per line 12, Form 990 (line c plus line d) • (line c plus line d) • List of Officers, Directors, Trustees, and Key Employees (List each one even if not compensated; see Specific Instructions on page 18.) (B) Title and average hours per week devoted to position

75

(C) Compensation (If not paid, enter -0-.)

(D) Contributions to employee benefit plans * deferred compensation

Did any officer, director, trustee, or key employee receive aggregate compensation of more than $100,000 from your organization and all related organizations, of which more than $10,000 was provided by the related organizations? • If "Yes " attach schedule—see Specific Instructions on page 18.

(E) Expense account and other allowances

CD Yes

CH N o

Appendix: IRS Forms 990 and 990-T

311

Form 990 (1996)

Page 5

Other Information (See Specific Instructions on page 19.)

78a b 79 80a b 81a b 82a b

83a b 84a b 85 b

c d e f g h 86 b 87 b 88 89a b c d 90 91 92

Did the organization engage in any activity not previously reported to the IRS? If "Yes," attach a detailed description of each activity . Were any changes made in the organizing or governing documents but not reported to the IRS? . . . If "Yes," attach a conformed copy of the changes. Did the organization have unrelated business gross income of $1,000 or more during the year covered by this return?. If "Yes," has it filed a tax return on Form 990-T for this year? Was there a liquidation, dissolution, termination, or substantial contraction during the year? If "Yes," attach a statement Is the organization related (other than by association with a statewide or nationwide organization) through common membership, governing bodies, trustees, officers, etc., to any other exempt or nonexempt organization? . . . If "Yes," enter the name of the organization • _ and check whether it is • exempt OR • nonexempt. Enter the amount of political expenditures, direct or indirect, as described in the instructions for line 81 181a I Did the organization file Form 1120-POL for this year? Did the organization receive donated services or the use of materials, equipment, or facilities at no charge or at substantially less than fair rental value? If Yes," you may indicate the value of these items here. Do not include this amount as revenue in Part I or as an expense in Part II. (See instructions for reporting in Part III.) l»2b| Did the organization comply with the public inspection requirements for returns and exemption applications? Did the organization comply with the disclosure requirements relating to quid pro quo contributions? . . Did the organization solicit any contributions or gifts that were not tax deductible? If "Yes," did the organization include with every solicitation an express statement that such contributions 84b or gifts were not tax deductible? 50i(c)(4). (5), or (6) organizations.—a Were substantially all dues nondeductible by members? 85b I Did the organization make only in-house lobbying expenditures of $2,000 or less? If Yes' was answered to either 85a or 85b, do not complete 85c through 85h below unless the organization received a waiver for proxy tax owed for the prior year. Dues, assessments, and similar amounts from members 185c 85d Section 162(e) lobbying and political expenditures Aggregate nondeductible amount of section 6033(e)(1)(A) dues notices . Taxable amount of lobbying and political expenditures (line 85d less 85e) . . 135ff Does the organization elect to pay the section 6033(e) tax on the amount in 85f? If section 6033(e)(1)(A) dues notices were sent, does the organization agree to add the amount in 85f to its reasonable estimate of dues allocable to nondeductible lobbying and political expenditures for the following tax year?. . . 501(c)(7) organizations.—Enter, a Initiation fees and capital contributions included on line 12 L?6a_ Gross receipts, included on line 12, for public use of club facilities 86b 501(c)(12) organizations.—Enter: a Gross income from members or shareholders 87a Gross income from other sources. (Do not net amounts due or paid to other sources against amounts due or received from them.) 187b At any time during the year, did the organization own a 50% or greater interest in a taxable corporation or partnership? If "Yes," complete Part IX 501(c)(3) organizations.—Enter: Amount of tax paid during the year under: section 4911 • _ _ _ _ _ ; section 4912 • ; section 4955 • 501(c)(3) and 501(c)(4) organizations.—Did the organization engage in any section 4958 excess benefit transaction during the year? If "Yes," attach a statement explaining each transaction Enter: Amount of tax paid by the organization managers or disqualified persons during the year under section 4958 • _ Enter: Amount of tax in 89c, above, reimbursed by the organization • _ List the states with which a copy of this return is filed • The books are in care of • Telephone no. • ( L Located at • ZIP + 4 • Section 4947(a)(1) nonexempt charitable trusts filing Form 990 in lieu of Form 1041—Check here . . . and enter the amount of tax-exempt interest received or accrued during the tax year . . • 1 92 I

• D

312

Appendix: IRS Forms 990 and 990-T Page 6

Analysis of Income-Producing Activities (See Specific Instructions on page 22) Unrelated business income

Enter gross amounts unless otherwise indicated. 93

(A) Business code

Program service revenue:

(B) Amount

Excluded by section 512. 513. or 514 (C) Exclusion code

(D) Amount

(E) Related or sxempt function income

f 9

Fees and c o n t r a c t s from g o v e r n m e n t agencies M e m b e r s h i p dues and assessments

94

.

.

.

95

Interest on savings and temporary cash investments

96

Dividends a n d interest from securities

.

.

.

Net rental income or (loss) from real estate:

97 a

debt-financed property

b

not debt-financed property

98

Net rental income or (loss) from personal property

99

Other investment income

100

Gain or (loss) from sales of assets other than inventory

101

Net income or (loss) from special events

102

Gross profit or (loss) from sales of inventory .

103

Other revenue: a

104 Subtotal (add c o l u m n s (B), (D), a n d (E)) . . 105 Total (add line 104, c o l u m n s (B), (D), and (E))

Note: (Line 105 plus line 1d, Part I, should equal the amount on line 12, Part I.) Relationship of Activities to the Accomplishment of Exempt Purposes (See Specific Instructions on page 23.) Explain how each activity for which income is reported in column (E) of Part VII contributed importantly to the accomplishment of the organization's exempt purposes (other than by providing funds for such purposes).

Information Regarding Taxable Subsidiaries (Complete this Part if the "Yes" box on line 88 is checked.) Name, address, and employer identification number of corporation or partnership

Please Sign Here Paid Preparer's Use Only

Percentage of ownership interest

Nature of business activities

Total income

End-of-year assets

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and bplief, it is true, correct, and complete. Declaration of preparer (other than officer) is based on all information of which preparer has any knowledge (See General Instructions on page 8.) Signatu

Type or print name and title. Check if Preparer's SSN selfemployed • LJ

Firms name (or k yours if self employed) m • and address f

©

Appendix: IRS Forms 990 and 990-T

990-T

313

Exempt Organization Business Income Tax Return For calendar ye«r 1996 or other tax y e v beginning 1996, and ending • See separate instructions.

•I address changed B Exempt under section D

501 (

D

4O8(e)

)(

)or

OMB No 1545-0687

(and proxy tax under section 6033 (e)) ,19

.

D Employer identification number

Name of organization

(Employees' trust, see instructions for Block 0

Please Number, street, and room or suite no. (If a P.O. box. see page 5 of instructions. Print or Type City or town, state, and ZIP code

on page S.j

E Unrelated business activity codes (see instructions for Block E on page 5.)

C Book value of all assets at end of year

F Group exemption number (see instructions for Block F on page 5) • D 501 (c) Trust D Section 401 (a) trust 6 Check type of organization. • D 501 (c) Corporation H Describe the organization's primary unrelated business activity. • I J

D Section 408(a) trust

During the tax year, was the corporation a subsidiary in an affiliated group or a parent-subsidiary controlled group? . If "Yes," enter the name and identifying number of the parent corporation. • Telephone number • ( The books are in care of •

.•

•

Yes • No

Unrelated Trade or Business Income 1a b 2 3 4a b c

14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34

Gross receipts or sales I c Balance • Less returns and allowances Cost of goods sold (Schedule A, line 7) Gross profit (subtract line 2 from line 1c) Capital gain net income (attach Schedule D) Net gain (loss) (Form 4797, Part II, line 20) (attach Form 4797) Capital loss deduction for trusts Income (loss) from partnerships (attach statement) . . . Rent income (Schedule C) Unrelated debt-financed income (Schedule E) Interest, annuities, royalties, and rents from controlled organizations (Schedule F) Investment income of a section 501(c)(7), (9), or (17) organization (Schedule G) Exploited exempt activity income (Schedule I) Advertising income (Schedule J) Other income (see page 6 of the instructions—attach schedule) TOTAL. (combine lines 3 through 12) . | 13 [ | | | | Deductions Not Taken Elsewhere (See page 7 of the instructions for limitations on deductions.) (Except for contributions, deductions must be directly connected with the unrelated business income.) Compensation of officers, directors, and trustees (Schedule K) Salaries and wages Repairs and maintenance Bad debts Interest (attach schedule) Taxes and licenses Charitable contributions (see page 8 of the instructions for limitation rules) . Depreciation (attach Form 4562) I 21 22b Less depreciation claimed on Schedule A and elsewhere on return Depletion Contributions to deferred compensation plans Employee benefit programs Excess exempt expenses (Schedule I) Excess readership costs (Schedule J) Other deductions (attach schedule) TOTAL DEDUCTIONS (add lines 14 through 28) Unrelated business taxable income before net operating loss deduction (subtract line 29 from line 13). Net operating loss deduction Unrelated business taxable income before specific deduction (subtract line 31 from line 30) . . Specific deduction Unrelated business taxable income (subtract line 33 from line 32). If line 33 is greater than line 32, enter the smaller of zero or line 32 34

For Paperwork Reduction Act Notice, see page 1 of separate instructions.

Cat No 11291)

l 9 9 0 - T (1996)

Appendix: IRS Forms 990 and 990-T

314

Page 2

Form 990-T (1996)

36

Organizations Taxable as Corporations (see instructions for tax computation on page 9). Controlled group members (sections 1561 and 1563)—check here • . See instructions and: Enter your share of the $50,000, $25,000. and $9,925,000 taxable income brackets (in that order): (1) 1$ L_J (2) \* L _ J (3) 1$ I I Enter organization's share of: (1) additional 5% tax (not more than $11,750) I* I (2) additional 3% tax (not more than $100,000) I* _L Income tax on the amount on line 34 Trusts Taxable at Trust Rates (see instructions for tax computation on page 10) Income tax on the amount on line 34 from: D Tax rate schedule or • Schedule D (Form 1041) . . . . • Proxy tax (see page 10 of the instructions). . • Total (add line 37 to line 35c or 36, whichever applies)

35c

38

Tax and Payments 39a Foreign tax credit (corporations attach Form 1118; trusts attach Form 1116) . 39a 39b b Other credits, (see page 10 of the instructions) c General business credit—Check if from: • Form 3800 or • Form (specify) • d Credit for prior year minimum tax (attach Form 8801 or 8827) . . . e Total (add lines 39a through 39d) 40 Subtract line 39e from line 38 41 Recapture taxes. Check if from: • Form 4255 • Form 8611 . . 42 Alternative minimum tax 43 Total tax (add lines 40, 41, and 42) 44 Payments: a 1995 overpayment credited to 1996 44b b 1996 estimated tax payments c Tax deposited with Form 7004 or Form 2758 d Foreign organizations—Tax paid or withheld at source (see instructions) e Backup withholding (see instructions) 44f f Other credits and payments (see instructions) 45 Total payments (add lines 44a through 44f). 46 Estimated tax penalty (see page 3 of the instructions). Check • • if Form 2220 is attached . 47 Tax due—If line 45 is less than the total of lines 43 and 46, enter amount owed • 48 Overpayment—If line 45 is larger than the total of lines 43 and 46, enter amount overpaid . . . • f Refunded • 49 Enter the amount of line 48 you want: Credited to 1997 estimated tax • Statements Regarding Certain Activities and Other information (See instructions

40

45 47 49 on page 11.)

1

At any time during the 1996 calendar year, did the organization have an interest in or a signature or other authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account) If "Yes," the organization may have to file Form TD F 90-22.1. If "Yes," enter the name of the foreign country here • 2 During the tax year, did the organization receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If "Yes," see page 12 of the instructions for other forms the organization may have to file. 3 Enter the amount of tax-exempt interest received or accrued during the tax year • $ SCHEDULE A—COST OF GOODS SOLD (See instructions on page 12.) Method of inventory valuation (specify) • 6 Inventory at end of year. . . . 1 Inventory at beginning of year 2 Purchases 7 Cost of goods sold. Subtract line 6 3 Cost of labor from line 5. (Enter here and on line 2, Part I.) 4a Additional section 263A costs Do the rules of section 263A (with respect to (attach schedule) property produced or acquired for resale) apply b Other costs (attach schedule) to the organization? 5 TOTAL—Add lines 1 through 4b

Please Sign Here Paid Preparer's Use Only

Under penalties of perjury, I declare that I have examined this return including accompanying schedules and statements, and to the best of my knowledge a belief, it is true, correct, and complete Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Signature of officer

Preparer's L signature W Firm's name (or yours, if self-employed) and address

Check if self employed • I I

Preparer s social security number

Appendix: IRS Forms 990 and 990-T

315

Page 3

Form 990-T (1996)

SCHEDULE C-RENT INCOME (FROM REAL PROPERTY AND PERSONAL PROPERTY LEASED WITH REAL PROPERTY) (See instructions on page 12.) 1 Description of property

(D (2) (3) 2 Rent received or accrued 3 Deductions directly connected with the income in columns 2(a) and 2(b) (attach schedule)

(b) From real and personal property (if the percentage of rent for personal property exceeds 50% or if the rent is based on profit or income)

(a) From personal property (if the percentage of rent for personal property is more than 10% but not more than 50%)

(D (2) (3) (4)

Total

Total

Total deductions. Enter here and on line 6, column (B), Part 1, page 1 . . •

Total Income (Add totals of columns 2(a) and 2(b). Enter here and on line 6, column (A), Part I, page 1.) . •

SCHEDULE E—UNRELATED DEBT-FINANCED INCOME (See instructions on page 13.) 2 Gross income from or allocable to debt-financed property

1 Description of debt-financed property

3 Deductions directly connected with or allocable to debt-financed property (b) Other deductions (a) Straight line depreciation (attach schedule) (attach schedule)

(1) (2) (3) (4)

4 Amount of average acquisition debt on or allocable to debt-financed property (attach schedule)

5 Average adjusted basis of or allocable to debt-financed property (attach schedule)

6 Column 4 divided by column 5

7 Gross income reportable (column 2 x column 6)

(1)

%

(2)

%

(3)

%

(4)

%

8 Allocable deductions (column 6 x total of columns 3(a) and 3(b))

Enter here and on line 7, Enter here and on line 7, column (A), Part 1. page 1. column (B), Part 1, page 1.

•

Totals Total dividends-received deductions included in column 8

• SCHEDULE F—INTEREST, ANNUITIES, ROYALTIES, AND RENTS FROM CONTROLLED ORGANIZATIONS (See instructions on page 14.) 2 Gross income 1 Name and address of controlled organization(s) organization(s)

3 Deductions of controlling organization directly connected with column 2 income (attach schedule)

4 Exempt controlled organizations (a) Unrelated business taxable income

(b) Taxable income computed (c) as though not exempt under column (a) sec 501 (a), or the amount in divided by col. (a), whichever is larger column (b)

(1)

%

(2)

%

(3)

%

(4)

%

5 Nonexempt controlled organizatic ns (a) Excess taxable income

a), whichever is large r

6 Gross income reportable divided by Column (b)

(D

%

(2)

%

(3)

%

(4)

%

column 5(c))

or

Enter here and on line 8, column (A), Part 1, page 1. Totals

7 Allowable deductions column 5(c))

Enter here and on line 8 column (B), Part 1, page 1 .

Appendix: IRS Forms 990 and 990-T

316

Page 4

Form 990-T (1996)

SCHEDULE G—INVESTMENT INCOME OF A SECTION 501(c)(7), (9), OR (17) ORGANIZATION (See instructions on page 14.) 1 Description of income

2 Amount of income

3 Deductions directly connected (attach schedule)

4 Set-asides (attach schedule)

5 Total deductions and set-asides (col. 3 plus col. 4)

(1) (2) (3) (4)

Enter here and on line 9, column (B), Part 1, page 1.

Enter here and on line 9, column (A), Part 1, page 1. Totals

•

SCHEDULE I—EXPLOITED EXEMPT ACTIVITY INCOME, OTHER THAN ADVERTISING INCOME (See instructions on page 1 4 )

1 Description of exploited activity

business income from trade or

Enter here and on line 10, col. (A), Part I, page 1 Column totals

3 Expenses directly connected witr production of unrelated business incom

4 Net income (loss) from unrelated trade or business (column 2 minus column 3). If a gain, compute cols. 5 through 7

5 Gross income from activity that is not unrelated business income

6 Expenses attributable to column 5

7 Excess exempt expenses (column 6 minus column 5. but not column 4).

Enter here and >n line 26, Part II, page 1

Enter here and on line 10, col. (B), Part I, page 1

.

SCHEDULE J—ADVERTISING INCOME (See instructions on page 15.) ^^^B Income From Periodicals Reported on a Consolidated Basis 2 Gross advertising income

1 Name of periodical

3 Direct advertising costs

4 Advertising gain or (loss) (col. 2 minus col. 3) If a gain, compute cols. 5 through 7.

6 Readership costs

5 Circulation

m&

(1)

,

(2)

««,

'daft »n

(3)

iiiil

(4)

Column ine(5))

7 Excess readersh p costs (column 6 minus column 5, but not more than column 4).

totals

(carry

to

Part

II, •

Income From Periodicals Reported on a Separate Basis (For each periodical listed in Part II, fill in columns 2 through 7 on a line-by-line basis.)

(5) Totals from Part I Enter here and on line n , col (A), Part I, page 1

Enter here and on line 11, col, (B), Parti, page 1

Column totals, Part II

SCHEDULE K—COMPENSATION OF OFFICERS, DIRECTORS, AND TRUSTEES (See instructions on paqe 15.) 1 Name

2 Title

3 Percent of time devoted to business % % % %

Total—Enter here and on line 14, Part II, page 1

•

4 Compensation attributable to unrelated business

References

Abelson, Reed. 1998. "Charities Use For-Profit Units to Avoid Disclosing Finances," New York Times, February 9, pp. A1, A12. Alexander, Victoria D. 1996. Museums and Money: The Impact of Funding on Exhibitions, Scholarship, and Management. Bloomington and Indianapolis: Indiana University Press. Allen, Richard C. 1997. "The Massachusetts Experience," Health Affairs 16(2): 85-8. Altman, Lawrence K. 1997. "Drug Firm, Relenting, Allows Unflattering Study to Appear," New York Times, April 16,pp.Al,A12. "The AMA's Appliance Sale." 1997. Editorial, New York Times, August 14, p. A14. American Association of Fund-Raising Counsel (AAFRC). 1995. Giving USA 1995. New York: AAFRC Trust for Philanthropy. 1997. Giving USA 1997. New York: AAFRC Trust for Philanthropy. American Association of Museums (AAM). 1992. Data Report from the 1989 National Museum Survey. Washington, DC: AAM. American Association of Retired Persons (AARP). 1994. Partnerships for the Future, Annual Report, Washington, DC. 1995. "Statement of the American Association of Retired Persons Before the Senate Finance Committee's Subcommittee on Social Security and Family Policy of the United States Senate," Washington, DC, June 20. American Cancer Society (ACS). 1995. Annual Report, Atlanta. 1996a. "An Open Letter from the American Cancer Society," September. 1996b. "Strategic Publishing Plan White Paper," Atlanta, February 20. American Hospital Association (AHA). 1995-6. Hospital Statistics. Chicago: AHA. American Lung Association (ALA). 1990-5. Annual Reports, New York. Antel, J., R. Ohsfeldt, and E. Becker. 1995. "State Regulation and Hospital Costs," Review of Economics and Statistics 77(3): 416-22. Applebome, Peter. 1997. "Rising College Costs Imperil the Nation, Blunt Report Says," New York Times, June 18, pp. Al, A17. Arenson, Karen W. 1995a. "Large Charities Pay Well, Survey Finds," New York Times, September 5, p. A7. 1995b. "Law Would Tighten Limits on Political Advocacy by Charities," New York Times, August 7, p. A9. 1995c. "A Small College's Tax-Exempt Status Challenged," New York Times, September 26, p. A14. 1996. "Struggling Campuses Will Try Off-Peak Pricing Experiment," New York Times, September 28, p. Al. 317

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Arrow, Kenneth. 1963. "Uncertainty and the Welfare Economics of Medical Care," American Economic Review 53(5): 941-73. Arthur Andersen LLR 1986-96. "American Association of Retired Persons, Consolidated Financial Statement." Washington, DC: Arthur Andersen LLP. Asinof, Lynn. 1997. "In Paying College Costs, Parents Discover They Can Negotiate about Financial Aid," Wall Street Journal, April 16, p. Cl. Audretsch, David B., and Paula E. Stepan. 1996. "Company-Scientist Locational Links: The Case of Biotechnology," American Economic Review 86(3): 641-52. Badaracco, Joseph. 1991. The Knowledge Link. Boston: Harvard Business School Press. Badelt, Christoph, and Peter Weiss. 1990. "Specialization, Product Differentiation and Ownership Structures in Personal Social Services: The Case of Nursery Schools," Kyklos 1:61-81. Barnouw, Erik. 1968. The Golden Web: A History of Broadcasting in the United States, 1933-1953. New York: Oxford University Press. Baumol, William J. 1967. "Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis," American Economic Review 57: 415-26. Baumol, William J., and William G. Bowen. 1966. Performing Arts - The Economic Dilemma: A Study of Problems Common to Theater, Opera, Music and Dance. New York: Twentieth Century Fund. Bean, Michael J. 1983. The Evolution of National Wildlife Law, revd./expd. ed. New York: Praeger Publishers for the Environmental Defense Fund. Becker, E., and Frank A. Sloan. 1985. "Hospital Ownership and Performance," Economic Inquiry 23(1): 21-36. Becker, T. J. 1995. "Opening Door to Synergy," Chicago Tribune, May 16, §5, pp. 1,7. Behrens, Steven. 1996. "PBS Predicts Budget Gains," Current, February 12, p. 1. Bell, Julie. 1996. "Hospital Firms Court Baptist: It's an Option for Non-Profits," Nashville Tennessean, March 15, pp. IE, 4E. Ben-David, Joseph. 1977. Centers of Learning: Britain, France, Germany, and the United States. New York: McGraw-Hill. Ben-Ner, Avner. 1986. "Nonprofit Organizations: Why Do They Exist in Market Economies?" in Susan Rose-Ackerman (ed.), The Economics of Nonprofit Institutions: Studies in Structure and Policy. New York: Oxford University Press, pp. 94-113. Ben-Ner, Avner, and T. Van Hoomissen. 1991. "Nonprofit Organizations in the Mixed Economy," Annals of Public and Cooperative Economics 62(4): 519-50. Biddle, Wayne, and Margot Slade. 1983. "Ideas and Trends: Bennington's Mutual Aid Idea," New York Times, April 10, §4, p. 9. Birnbaum, Jeffrey H. 1982. "Charity That Delivers Surplus Food to Needy Is Split by Accusations," Wall Street Journal, October 25, pp. Al, A20. Blattberg, Robert C , and Cynthia J. Broderick. 1991. "Marketing of Art Museums," in Martin Feldstein (ed.), The Economics of Art Museums. Chicago and London: University of Chicago Press, pp. 327-46. Blumenthal, David. 1992. "Academic-Industry Relationships in the Life Sciences: Extent, Consequences, and Management," Journal of the American Medical Association 268(23): 3344-9. Blumenthal, David, Nancyanne Causino, Eric Campbell, and Karen Seashore Louis. 1996. "Relationships between Academic Institutions and Industry in the Life Sciences - A n Industry Survey," New England Journal of Medicine 334(6): 368-73. Boot, Max. 1995. "Competing with Big Bird," Wall Street Journal, 23 October, p. A27. Boston Consulting Group. 1991. Strategies for Public Television in a Multi-Channel Environment. Washington, DC: CPB.

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Index

Abbott, Jonathan, 266 academic medical centers, see hospitals Adelphi University, 8 admission fees, see user fees advertisers, public broadcasting and, 252-4, 256-8 allocation mechanisms, see distributional objectives American Association of Retired Persons (AARP), commercial activities of, 197, 198, 207-9, 277,289 American Cancer Society (ACS), commercial activities of, 31, 201-2 American Economic Association, 62 American Heart Association, 30 American Lung Association (ALA), 200-1, 277 American Medical Association (AMA), 2, 62 American Museum of Natural History, 20 American Zoo and Aquarium Association (AAZA), 217-18 Amgen, 178, 179 ancillary activities, 11,48,61,63, 171,296 aversion to, 53, 108 mission and, 15-17,21,54-5, 84, 294-5 see also specific nonprofit type antitrust laws, 8, 142 Apollo Group, Inc., 132 aquariums, see zoos and aquariums Aramony, William, 8 Archaeological Society of Central Oregon, 49 Arrow, Kenneth, 153 Art Institute of Chicago, 239, 288 art museums, 233-5, 237^44 admission fees, 234, 237-8 ancillary outputs, 239 "blockbuster" exhibitions, 238

336

commercialization pressures, 235-7 cross-subsidization and, 211-8 data analysis, 239^6 government role in funding, 234,235-6,237,241-2 income: activities to produce, 244-6; increases in, 240-4 as labor intensive, 236 management and, 235, 237 mission, 234,238 public policy and, 235 restaurants and shops, 1,18, 234, 238-9 see also specific museum arts organizations, 15-16,27,38-9, 95,97,99,118,119,125,126 asset distribution, conversion to for-profit and, 146 AT&T, 42 athletics, nonprofits and, 6 aversion premium, 87, 88,90, 93, 124 bad debts, in hospital care, 161 Bakker, Jim, 8 Baptist Hospital (Memphis), 152, 288,292 Baumol, William, 3,236 Bayh-Dole Act, 171-2 Baylor College of Medicine, 57 Beatrice Foods, 135 Behavioral Systems Southwest, 132 Bennington College, 18, 136 bidding, in nonprofit's price determination, 141-2 biopharmaceutical research, 173 biotechnology research, 173-85, 276 "blockbuster economics," 238 Blue Cross and Blue Shield, 130, 131, 137, 140, 145, 163;.see also health insurance/insurers Blumenthal, David, 183 bonoficing, 52, 53

Boston University, 187-8 Bowen, William, 3, 236 Boyer, Herbert, 181 Bristol-Myers Squibb, 57 British Broadcasting Corporation (BBC), 250 British Museum, 58 Brookings Institution, 34 bundling, product, 69,73 buyer influence, 31-2 cable TV, public broadcasting and, 258-69,278,279 California, University of, 6-7, 8, 15, 181, 182,190-1 Cambridge University, 57 Camp Fire Boys and Girls, commercial activities of, 204-5 Canadian Broadcasting System, 251 capital, weighted cost of, 65 catalog businesses, 234 CATO Institute, 34 causality, tests of, 113, 124 cause-related marketing, 203, 2067,209-10 certificate of need (CON), 31, 152, 158 Channel One, 56 charge shifting, 159; see also cost shifting charity care, 161, 162; see also social service organizations Child Welfare League of America (CWLA), commercial activities of, 197,198,205-7 Chiron, 179-80 church-based organizations, see religious nonprofits coevolutionary arrangements, A2-A Cohen, Stanley, 181 collaboration, 5-7, 48-9, 52, 61 compensation and, 134 among nonprofits, 4 2 ^ price discrimination and, 116 see also specific nonprofit type

337

Index collective goods and services, see outputs collectiveness index, 111 colleges, see education nonprofits Columbia/HCA, 37, 131, 141, 145 commercialization of nonprofits, 1-5,16,26-7, 108-9,112, 273-80, 304-5 aversion to, 53,92-3 competition and, 36-7,44-5 donations and, 56-9, 105-27, 198 issues needing further study, 298-300 public policy and, 44-5, 102-3, 166-8,198,235,280-4, 300-4 removal of constraints and, 273-9 tax issues and, 196, 292, 293, 302 technology and, 276,278-9 see also specific nonprofit type commercial share, as commercialactivity measure, 91,96 compensation, 101, 134 executive, 1,8 competition basis for, 26 nonprofit-for-profit, 4-5,25-7, 37-40,155,162,275,288, 291 nonprofit-nonprofit, 26-36: collaborative ventures and, 42—1; commercialization and, 36-7,44-5; exclusively nonprofit marketplaces, 27-34 organizational form and, 40-2, 44-5 public policy and, 44-5 unfair, 4, 87, 264, 291 competitive bidding, in nonprofit's price determination, 141-2 competitive medical plans (CMPs), 155-6 concessions, zoo and aquarium, 229-31 conflicts of interest, 144-5,189— 91,273; see also nonprofit mission, commercialization and constraints, 4-5, 282-3, 287 budgetary, 299-300 on conversion to for-profit, 297-8 on costs, 2 9 3 ^ market-imposed, 134 removal of, 273-9 on revenue, 14-16,293—1 tax-based, 296-7 see also specific nonprofit type consumers, influence of, 31-2, 227; see also target populations

Consumers Union, 30, 37 Contra Costa County Earth Day, 49 contract failure, 73 contributions, gifts, and grants (CGG),9, 112 in basic nonprofit model, 55-9 corporate sponsorships, 12 commercial activities: effect on, 93, 196; crowding out/in by CGG, 60, 106-7 endogenous, 55,113 program services and, 106-26, 296 public policy and, 302-3 as revenue source, 13-14, 272; constraints of, 14-16 see also specific nonprofit type; revenue conversion to for-profit, 129, 132-3 abuse of, 147 asset distribution and, 146 constraints on, 297-8 effect on society, 2 8 3 ^ , 285 managerial control, transfer of, 132 mission and, 19, 135,297 organizational form and, 133-4 partial vs. complete, 139 public policy and, 135,138-18, 152, 283-*, 303 reasons for, 18-19,133-8, 146 tax issues and, 134-5, 140 valuation, social vs. market, 139^5 see also specific nonprofit type cooperation, nonprofit-for-profit, 5-7 Cooperative Research Act, 172 cooperative research and development agreements (CRADAs), 172 corporate sponsorships, 12, 252-4 Corporation for Public Broadcasting (CPB), 256-8, 261, 263; see also public broadcasting corporations, see for-profits Corrections Corporation of America, 132 cost disease, 3,236 cost shifting, 91-2, 98-9, 159-60 costs of capital, weighted, 65 complementarities, 88, 90,92-3 constraints on, commercialization and, 293—4 interdependence among, 17, 60-1,113-14 see also joint costs cream skimming, 79-80 cross-subsidization, 273, 279 crowding out/in, 60, 106-7, 1201,198,216,277,285

Daughters of the American Revolution (DAR), 39 day-care centers, 27, 134 Diagnosis Related Groups (DRGs), 72-3,154 Diamondopoulos, Peter, 8 Discovery Network, 255 distributional objectives and mechanisms, 66-74, 77, 79, 108, 220, 238; see also nonprofit mission; target populations Dole, Bob, 262 donations, see contributions, gifts, and grants Dow Chemical, 6 DuBridge, Lee, 257-8 Duke University, 57 "earmarking," 186-7 Economic Recovery Tax Act (ERTA) of 1981,102 economies of scale, 38-9 economies of scope, 107 Edison Project, 132 Educational Testing Service, 30, 37 education nonprofits, 27,51, 132 commercial activity in, 1,4,6, 8, 10; and donations, 14-15, 56-7,107,276-7 tax issues and, 18,95,97,99 tuition, 68, 107 see also intellectual property, universities and eligibility requirements, raising revenue via, 69,71-3 endangered species, zoos and aquariums and, 217-19 endorsements by nonprofits, 2, 202,209 exogenous donations, 55, 109-10, 111 fairness, 76; see also competition, unfair fees, see user fees federally funded research and development centers (FFRDCs), 172 Field Museum of Natural History, 2,288 financing, see revenue fixed-effect model, 112, 121-2 food banks, 135 Ford Foundation, 30 for-profits, and nonprofits, 4, 273 affected by, 291-2, 296 competition, 4-5, 25-7, 37—W), 155, 162,275,288,291 cooperation/collaboration, 5-7, 238-9 as subsidiaries, 1, 263 see also conversion to for-profit "for-profits in disguise," 11-12, 48,65,66,273,281

338

Index

Fowler, Mark, 262 funding, see revenue fund-raising, 28,55-6, 86,109-10, 197; see also specific nonprofit type; contributions, gifts, and grants; revenue genetic engineering, 180-2 genomics, 178 Genotech, 178 Giamatti,A. Bartlett,6 gifts, see contributions, gifts, and grants gift shops, 229-30, 231 Girl Scouts of the USA, commercial activities of, 197, 202-4, 289 Glen Oak Zoo, 220, 223, 224, 229, 230 goals, nonprofit, see nonprofit mission government interaction with nonprofits, 3, 7-8,73 research support by, 172, 182, 186-8,283 university-industry collaborations and,171—3 see also specific nonprofit type; contributions, gifts, and grants; public policy; tax issues Grainger causality, 124 grants, see contributions, gifts, and grants Greater Richmond Partnership, 37 Grove City College, 14 Habitat for Humanity, 70 Hammond Maps, 291 Harvard University, 6, 57 Health Care Cost Containment Board, Florida, 158 health-care nonprofits, 1,4, 11-12 charities, 200-2, 210 competition and, 37-8,40, 1556 conversion to for-profit, 130-2, 136-8, 152 perceived quality of care and, 167 taxation and, 95, 97,99 see also health insurance/ insurers; hospitals; Medicaid; Medicare health insurance/insurers, 156, 208 cross-subsidization and, 274-5 for-profit conversion of, 130-2, 136-8,283,297 organizational form and, 40,42, 156 uninsured patients, 161-2, 164 see also health-care nonprofits

health-maintenance organizations (HMOs), see health insurance/insurers Health Net, 130 Heller, Craig, 189 Heritage Foundation, 34 Heyman, I. Michael, 12 Hill-Burton Act, 137 HoechstA.G.,6 holding companies, 40-1 hospitals, 27, 158, 166-8 capital funds, 163-5 coevolutionary arrangements and, 4 2 ^ commercialism in, 151-3, 167— 8; care and, 154-6, 161-2, 163; cross-subsidization and, 274-5,284; public policy and, 166-8 conversion to for-profit, 131, 132,152 investments, 165-6 nonprofit status, reasons for, organizational form and, 40-2 pricing patterns in, 159-60, 162 profitability of, 156-9 and research, 59-60, 153, 166 see also health-care nonprofits Human Genome Project, 182 human-services nonprofits, 95,97, 99 hurdle rate, 86 income, see revenue income tax, see tax issues Independent Sector, 117 Indiana University, 10 industry-university collaborations, see intellectual property, universities and Institute for Museum Services, 236 intellectual property, universities and, 6,56,169-71, 174-5, 182-91 business strategy, 173—4 conflicts of interest, 189-91 constraints on, 282-3 cross-subsidization and, 275-6 funding, politics of, 186-8 licensing and corporate support ofR&D, 176-80, 183 in life sciences, 175-82 organizational adaptations and, 188-9 patenting, 176, 190-1, 282-3 public policy, 171-3 at Stanford and Johns Hopkins, 180-2 Internal Revenue Service (IRS), 117 Code §501(c)(3)/(4), 4, 30,49, 91,207

determining taxability, 61-2, 105, 107-8,116,203^,205, 264,288,290,292,295 as regulatory agency, 50-1, 63, 123, 136, 144,264,288-9, 293,304 Form 990,44,55,91,110,117, 120,233,239^0,274,280, 296,301-2,307-12 Form 990-T, 99, 100-1, 296-7, 302,313-16 Form 1023,49

Statistics of Income (SOI) Division, 117,240 see also tax issues intertemporal price discrimination, 67,70 investments active, 41 of nonprofits, 53, 85-90, 92102,165-6,208 passive, 40-1, 53, 88, 89 Jewish Community Centers Association (JCCs), commercial activities of, 198,210-15 Johns Hopkins University, 180-2 Johnson, Lyndon, 256 joint costs, 90, 99, 102, 296-7 Joint Council on Economic Education, 30 joint ventures, 41-2, 132, 141, 264, 265, 305; .«?