Team Incentives and Organizational Form

Conventional wisdom regarding nonprofit firms is that the absence of a profit motive renders them inefficient. However, the costs and product quality realized by profit‐taking firms is determined by how well those firms deal with a variety of internal incentive and information problems, and this should be equally true for nonprofits. This article analyzes the team incentive problem in nonprofit organizations. Holmstrom (1982) showed that the introduction of a budget‐breaker into a team permitted the creation of incentives to provide efficient effort when it is otherwise impossible. A similar result obtains for a nonprofit team, but the role of principal differs from that found in profit‐taking teams. It is shown that any of: donors, government regulators, or Trustees can fulfill this role in a nonprofit team. One implication of this is shown to be that nonprofit firms may indeed pay employees less than otherwise identical employees earn in identical jobs in profit‐taking firms.