Organizational form and output quality

This paper re-examines the relationship between a firm's organizational form, not-for-profit versus for-profit, and its output quality. The Arrow-Hansmann theory of hidden action on the part of providers predicts higher quality for not-for-profit suppliers. This prediction has a puzzling lack of support in the empirical literature. We propose a theory that resolves the empirical puzzle and generates additional testable implications. The theory starts with the traditional assumptions of hidden action and supplier altruism. It then incorporates two additional features of real-world markets: hidden information on supplier ability to provide high quality and a variation across buyers in the degree of informational asymmetry. The central prediction of the theory is that quality has a higher variance across for-profits than across not-for-profits. Preliminary evidence from the US market for hospital care is consistent with this prediction.