THE PROFITS OF NONPROFITS: UNFAIR COMPETITION IN THE COMPUTER SOFTWARE AND AUDIOVISUAL INDUSTRIES
At the 1986 White House Conference on Small Business, "unfair competition" by governmental and commercial nonprofit enterprises (CNEs) was judged to be the third most important concern of the small business sector. Because of special legislative privileges enjoyed by the commercial nonprofit sector, small firms are often at a decided disadvantage when nonprofits engage in commercial activities. CNEs provide many of the same goods and services as for-profits, but because they have nonprofit status, they pay no federal, state, and local income, property, and sales taxes; they recieve special treatment from the federal government regarding unemployment insurance, minimum wages, securities regulation, and antitrust; they have preferential bankruptcy and copyright laws; they enjoy exemptions from many governmental regulations; and they can mail at subsidized postal rates. CNEs are not regulated by the Federal Trade commission, even though they often operate businesses nearly identical to those which are. They also benefit from direct taxpayers subsidies-many government grants and contracts are specifically reserved for nonprofits.
This article covers some important economic issues regarding unfair competition in the computer software and audiovisual industries, two industries where unfair competition appears especially intense. The analysis shows why unfair competition is so critical for small firms: CNEs drive many for profits out of the market and deter others from entering. Since small firms are the major source of innovation and job creation in the U.S. economy, "unfair competition" has undesirable economic effects.
The audiovisual (AV) industry's major customers are schools, libraries, colleges and universities, businesses, and government agencies which use films to educate, communicate, and train. Little is known about the industry's structure and composition, except that it consists of a large number of geographically dispersed small companies. It has been estimated that 95 percent of firms in the AV industry had annual revenues under $5 million and total industry sales were between $300 and $400 million in 1981.(1)
The microcomputer has had a major impact on instructional techniques in the last decade. Development, promotion, distribution, and sales of software for instructional use is a rapidly growing field serving the same customer base as the AV industry. In many cases, software firms are small operations which develop programs for specific applications, e.g., class scheduling or accounting systems for schools. An important characteristic which the AV and microcomputer software industries share is that both experience intense competition from the commercial nonprofit sector, particularly from tax-exempt educational institutions and government agencies.
A case can be made that the initial entry of educational institutions into the media market was unplanned and purely a matter of chance. Consider, for example, the founding of the Instructional Media Center (IMC) at Michigan State University which rents and sells AV instructional materials in direct competition with private firms.(2) From modest beginnings, the IMC at Michigan State quickly expanded into a commercial operation.
Higher education did not face budget exigencies in the late 1960s and early 1970s, so the marketing activities of IMC at MSU might be viewed as an effort to provide a service to the academic community on a self-supporting basis. IMC's commercial activity was (1)Senate Committee on Small Business, Governmental Competition with Small Business, 1981 Hearings before the Subcommittee on Advocacy and the Future of Small Business, 97th Cong., 1st Sess., 1981, p. 128. (2)Betty Decter, "Marketing Your Own Instructional Materials," Instructional Innovator (February 1982), p. 10. limited by an explicit restriction stating that only educational materials developed "in house" by MSU faculty could be sold. The operation has been, at least from the perspective of IMC, a major success, with sales increasing steadily.(3)
The economic climate for education at all levels changed with the recession of the early 1980s and threats of budget cuts. Education officials and administrators sought alternative sources of revenue to offset budget cuts, and the succesful commercial ventures established earlier by educational institutions, such as IMC at Michigan State, provided an excellent prototype. Entrepreneurial activity was vigorously pursued, as evidenced by the program developed by the Montclair, New Jersey school district which was faced with a reduction of $600,000 in federal funds for the 1981-82 school year. The school board of Montclair approved the following commercial activities: . Expanding the school district's data-processing center and paying someone to sell data services to 31 surrounding school districts. . Publishing books and pamphlets on educational topics written by the district's administrators and teachers, printed in its shop, and promoted by its public-relations people. . Bidding on federal government contracts for such things as military-educational materials, sex-education pamphlets for parents, and running desegregation workshops nationwide. . Establishing an education center for the district's emotionally disturbed students and taking in tuition-paying students from adjacent districts. . Operating a public restaurant as a vocational training program at a planetarium built with a foundation grant.(4) (3)Ibid., p. 12. (4)William E. Geist, "Facing U.S. Cuts, Montclair Tries New Ways to Raise School Funds," New York Times, June 12, 1981.
Although nonprofit commercial activities may have started for a variety of reasons, ranging from serendipity to design, they have become sources of revenue to offset declining support from the public sector.
PREDATORY PRICING IN THE AV
AND SOFTWARE INDUSTRIES
Economic theory indicates that, if CNEs maximize profits, they will price their goods and services competitively, even though they enjoy a cost advantage arising from their special legislative privileges and from subsidies. Nevertheless, there is ample evidence that CNEs engage in "predatory pricing," i.e., they charge lower prices than their private counterparts. Often, the promotional materials developed by CNEs stress that their prices are "breakeven" or "at cost." If this pricing behavior was conducted by a foreign competitor it would be called "dumping." In some cases, CNEs offer goods and services at a purely nominal price or even zero price.
Cost and Pricing Advantages of CNEs
All organizations engaged in commercial activity must charge prices which cover the costs of production if they wish to remain viable in the long run. The production cost of CNEs, however are much lower than those of for- profits. Taxes are an important, direct cost of doing business, as are postal charges, so that nonprofit status confers a distinct advantage in the market place over competing for-profits. In addition, private firms must recover all the costs of production and sales before earning a profit, but for many CNEs operating costs are also heavily subsidized. Equipment may have been obtained through government grants; for CNEs that are agencies of state or local governments, such as colleges and universities or schools, much of the "overhead" may also be paid by the taxpayer.
AV centers at institutions of higher learning may have space for offices and production facilities, telephones, utilities, and other services provided at no explicit charge so that even cost recovery prices do not have to reflect these expenses. Moreover, many CNEs can set prices at levels that private competitors would regard as predatory and still cover costs simply because the CNE's costs are subsidized.
Examples of Predatory Pricing
In Fairfax County, Virginia, the county library system lends videotapes to patrons at no charge. Private companies which rent the same tapes to customers require payment of membership fees as well as daily rental charges. Thus, the tax-supported library competes directly with private firms and pursues a predatory pricing policy--no commercial entity can provide services at zero price. This practice is widespread, for "...many public libraries loan films at little or no charge. College and university film rental libraries rent 16mm film (and occasionally videotapes) at costs lower than commercial distributors."(5)
Predatory pricing is also illustrated by the activities of WGVC-TV, a public television station licensed to Michigan's Grand Valley State Colleges. In anticipation of reductions in taxpayer funding for the station's operations, WGVC solicited video production business by direct mail. All of the equipment owned by WGVC and offered for commercial use, including a mobile unit, minicams, and studio facilities, was obtained either wholly or in part with state or federal funds.(6) In fact, in 1981, the station manager informed West Michigan magazine that WGVC had become one of the best-equipped studios in the region for television and field production.(7) This equipment was originally purchased for non-commercial (5)Andrea Pedolsky, ed., In-House Training and Development Programs (Detroit, Michigan: Neal-Schuman Publishers, Inc., 1981), p. 268. (6)See the following articles in the Grand Rapids Press: "GVSC Reports $445,118 Given for Education TV," April 1, 1971; TV Station Heads Out," June 28, 1976; "Shortage of Local Programming is a Sizable Problem at Channel 35," April 22, 1979; "Federal Grant to Help TV35 Buy Minicams," September 27, 1979. (7)PBS in Focus in West Michigan," West Michigan, June 1981, p. 38. purposes, that is, for student training and the production of local programs. In addition, 36 percent of WGVC's annual operating budget is tax-supported (divided about equally between state and federal funding).(8) Thus, taxpaying firms in western Michigan are, in effect, subsidizing this nonprofit competitor which charges only one-third to one-half the commercial rates for the same services.
Many CNEs price their services only to recover costs or part of their costs. The Occupational Curriculum Laboratory at East Texas State University is one of "four centers within the Texas Curriculum Network funded by the Texas Education Agency...[which] is currently developing and disseminating competency-based materials for both secondary and postsecondary programs."(9) The OCL's product catalog notes that "Complimentary copies are not available because the OCL operates on a cost recovery basis."(10)
Similarly, the National Dissemination and Assessment Center, Los Angeles (NDAC-LA), located at California State University, Los Angeles, is "funded by the Office of Bilingual Education to provide support services to all other bilingual programs at state, post-secondary and school district levels." An NDAC-LA promotional brochure indicates "a growing inventory of texts, booklets, visuals...which may interest and help you." A cover letter accompanying the brochure indicates that all materials are "available at cost plus mail charges." In addition, the brochure indicates that the "printing and reproduction capabilities of the Center cover all possibilities, the only limitation being cost."(11) (8)Toni Morris, "Cuts May Tune in Viewers to Needs of Public TV," Grand Rapids Press, March 19, 1981. (9)Publications 1982/83: Occupational Curriculum Laboratory (Commerce, Texas: East Texas University, 1982), inside front cover. (10)Ibid., p.21. (11)"Out of the Woods...Over the Bridge...Into Tommorow With Bilingual Education" (Los Angeles: National Dissemination and Assessment Center, California State University, Los Angeles, 1980), pp.1-2; letter accompanying brochure dated January 28, 1980, signed by Charles F. Leyba, Director.
The Oklahoma State Department of Vocational and Technical Education established a "productivity division that links vocational education with a pressing need of American business and industry--developing a work force that understands its role in productivity." Two state employees "travel throughout the state to provide orientation, training, and other services in a variety of settings. They have at their fingertips an array of materials and approaches to meet the individual training needs of employers--seminars, workshops, quality circles, case studies, analytical problem solving, lectures, films, videotapes and slide-tape programs... The only cost to companies using this program through the productivity division is for the materials used."(12)
Rationales for Predatory
Pricing by CNEs
Several reasons may be offered to explain why CNEs practice predatory pricing in the market for audiovisual instructional materials and for microcomputer software programs. First, political considerations can induce CNEs, which receive subsidies directly from the taxpayer, to offer goods and services at prices below market or, indeed, at zero price to benefit politically powerful groups of consumers (who often have above-average incomes). Libraries may offer videos and films at nominal or no charge as a way of transferring income to constituents who benefit and who are likely to provide political support for such programs.
A second reason that CNEs may practice predatory pricing relates to the quality of goods and services offered. In many cases the product produced by the CNE is of lower quality than that provided by the private sector. At educational institutions, for example, faculty may donate text- or scriptwriting time even though they are not (12)Dale Cotton, "Oklahoma's Productivity Division," Voc Ed (May 1982) pp. 1-40. professionals in the field; an administrator with no credentials in broadcasting may be selected to record or narrate the material; and students with no previous experience may be recruited for acting, artwork, filming, and other production services.
Classroom experience does not necessarily provide the skills required to develop high quality educational resources as is illustrated by the production of educational software for microcomputers. Apple SWAP, a nonprofit clearinghouse for educational programs for the Apple microcomputer, notes that of the more than 8,000 programs submitted in 1980-81 by educators from half the states and seven foreign countries, only 15 percent were deemed useful and accepted into its library for public access.(13)
Similarly, Dr. Gerald Gleason, a professor of educational psychology at the University of Wisconsin, Milwaukee writes in a critique of microcomputers in education that
[A] major source of programs [is] educators. The teachers probably have not had any formal training or experience in programming techniques, and this is likely to be reflected in their products. Again, some of these programs may be useful and effective, but most will not meet the quality standards we should expect.(14)
For-profit firms have a strong incentive to provide high quality materials; the marketplace has little tolerance for shoddy merchandise because competition will drive low-quality products from the market. If competition drives firms that produce poor quality products out of business, why are CNEs not subject to the same forces? In part, this question may be answered by noting that CNEs operate differently from private firms which, as standard practice, usually give the purchaser the opportunity to preview audiovisual materials before they are purchased or rented. The sale catalogs of CNEs, however, typically (13)Brook, op. cit. (14)Gerald Gleason, "Microcomputers in Education: The State of the Art," Educational Technology, March 1981, pp. 7-18; see especially pp. 11-12. give the user only two options: rental or purchase. Consider the policies stated in Cornell University's Audio-Visual Resource Catalog:
Preview for Purchase. Preview prints are available on the same basis as rental films listed in this catalog. If the previewed film is purchased within sixty (60) days of the preview date, any paid rental fee will be deducted from the film purchase price. Return of films is the user's responsibility.(15)
The citation above pertains only to films; with regard to slide sets, the restrictions are even more stringent: "Requests for previewing purchase slide sets cannot be honored..."(16) Rental is not even an option with Cornell's audio tapes, "because of the high costs of handling orders relative to the purchase price, it is impractical to rent audio tapes."(17) Thus, CNEs often limit the opportunities for prospective customers to evaluate the quality of the materials to be rented or purchased; costs are imposed on customers who do screen materials in advance. Despite inferior quality, a consumer may prefer the CNE's product because the price difference is disproportionately larger than the difference in quality.
Moreover, educators who buy and rent AV materials for instructional purposes may have a natural bias toward the product of an educational institution. Even when the consumer is not an educator, there is a bias toward nonprofit organizations in general. Along with the special legal privileges which CNEs enjoy, nonprofits have acquired a "pro bono publico" [for the good of the public] image. Marc Lane, author of the Legal Handbook for Nonprofit Organizations, asserts that "even if we put aside possible tax advantages, the nonprofit entity has an...advantage [relative to private firms] owing to the public image of nonprofit status.(18)
A third reason that CNEs charge lower prices than their for-profit competitors (15)Audio-Visual Resource Catalog, 1980-81 (Ithaca, N.Y.: Cornell University, Media Services 1980), p. 1. (16)Ibid., p. 87. (17)Ibid., p. 123. (18)Marc Lane, Legal Handbook for Nonprofit Organizations (New York: AMACOM, 1980), p. 273. is to protect this "pro bono publico" image. Because of their wellknown tax and cost advantages granted by legislative fiat, any CNEs that charged the same prices as a private firm for similar goods and services would appear to be operating to make a profit. Thus, one means of affirming to the public that CNEs are, in fact, nonprofit organizations is to charge lower prices than their for-profit competitors. Lower prices, however, do not necessarily mean that the CNE's profits are zero; only that they are below the level that would be earned if, other things equal, prices were closer to those charged by private firms. Predatory pricing offers a means for the CNE to share some of the benefits derived from its special privileges with its customers for public relations purposes.
Finally, the manager of a CNE has no strong incentive to maximize profits, because the manager's income is not directly related to profitability. In educational institutions, especially at state schools, salary levels are not tied to profits, but are set by administrators or by civil service regulations. Moreover, if CNEs were to charge the same prices as private firms, employees of CNEs would have to be much more aggressive in marketing their products and services because they would no longer have the advantage of belowmarket prices to entice customers. A relaxed pace of work is an important component of the perquisites enjoyed in the public sector and in other organizations which are not profit oriented. Predatory pricing may be regarded as a means of obtaining this perquisite.
THE RATIONAL FOR
AV products and instructional software cannot reasonably be regarded as public goods. Films, slide sets, videos, and computer programs have the characteristics of private goods and the fact that private firms are actively engaged in the production, promotion, and distribution of these products confirms their status as private goods. Profit-seeking firms do not provide public goods without taxpayer subsidies. Thus, even though "free-rider" or public goods problems have justified governmental or nonprofit involvement in education and other activities, the public good rationale does not apply to the commercial activities of educational institutions.
Another basic rationale for nonprofit involvement in these industries is the "thin market" argument which, in effect, says that "There are too few customers for this product to entice a for-profit to provide it." Without subsidized production by a nonprofit, there would be no product. But unfair competition cannot occur in a thin market, because for-profit firms, by definition, will not enter such a market.
The thin market argument might be valid in cases where audiovisuals deal with highly technical materials which reflect the specialized research equipment and professional staff at the producing educational institution,(19) but would have to be stretched considerably to apply to all the audiovisuals that are offered by most educational institutions. For example, the catalog of the Audio-Visual Center at Indiana University lists 6,388 titles of motion pictures in active use.(20) The films are classified under hundreds of subject headings ranging from "Ability--Testing" to "Zoos," and materials are available for every age group and educational level. The thin market rationale does not apply to these films, all of which are in high demand, because audiovisual materials which have a low demand [i.e., the "thin market" films] are not even listed in this catalog: "Many films for which there is little demand or where replacement materials are not available are retired to the reference library. The reference library (19)For example, see MIT Video Short Courses for Continuing Education (Cambridge, Mass.: Massachusetts Institute of Technology, Center for Advanced Engineering, 1980), p. 52. (20)1980 Catalog Educational Motion Pictures (Bloomington, Ind.: Indiana University, Audio-Visual Center, Office for Learning Resources, 1980), p. 5. currently consists of more than 2,200 titles which are available for use by writing the Audio-Visual Center."(21)
Private sector concern about competition from nonprofits is direct evidence that nonprofits compete for customers and sales. Thus, the notion that nonprofits entered the market for audiovisual educational materials and computer software to provide services that the private sector avoided because there was insufficient demand is not valid. For-profits are not concerned about nonprofit entry into markets where commercial firms do not operate. CNEs may benefit those who cannot afford the products of private firms, but if it is in the public interest to reduce prices charged to lower-income individuals, the burden should be shared by the public at large rather than disproportionately by the small business sector. In cases where CNEs do underprice private firms, it is not clear that the true price is any lower than the private firms' once the hidden costs of the subsidies are taken into account. Predatory pricing by CNEs might help the poor, but direct cash transfers would surely be more efficient. Moreover, the consumers of AV materials are not low-income individuals but, in many cases, educational institutions that benefit primarily the middle and upper classes, and corporations and government agencies.
A more likely interpretation of events is that some nonprofits started out to satisfy a perceived need that was not being met by profit-seeking organizations and found it worthwhile, once in the market, to expand their offerings to compete with products and services already provided by the private sector. All that is required for this scenario to be plausible is that economies of scale exist--in other words, unit costs decline as output rises.
There is ample reason to believe that economies of scale are present in the AV industry. For example, printing costs do not double if the number of (21)Ibid. entries in product catalogs double, nor do promotional postage costs. Moreover, in a very thin market, the demand may be so limited that the costs associated with serving the market are prohibitive, even for a subsidized nonprofit. To realize the benefits of economies of scale and thereby lower costs, nonprofits that began operations to serve a thin market exclusively can find it beneficial to expand their product line and services to break even or to attain a scale of operation that is economically viable.
It is difficult to assess quantitatively the damage that unfair competition has inflicted on small firms. No statistics are available on the number of new enterprises not formed, on the number of existing firms driven out of business, or the revenues lost by existing firms because of unfair competition. Indeed, a case can be made that even managers of for-profit firms might not realize the damage done by unfair competition. Suppose that a for-profit operates in a rapidly growing market where sales double each year; the annual growth rate would be 100 percent. If a nonprofit enters the market and takes, say, half of the new business, the for-profit experiences a growth rate of only 50 percent. With a growth rate of 50 percent, the manager of the for-profit might respond that nonprofit competition was unimportant. Only if the forprofit manager knew the amount of business lost would the full effect of the harm caused by the unfair competition be known.
There is, however, nonanecdotal evidence that shows unfair competition is severe. Recognizing that "data do not exist to quantify the nature, extent and impact of competition between [nonprofit and for-profit sectors]," the U.S. General Accounting Office sent a questionnaire about unfair competition to 1,738 randomly selected firms in six industries.(22) (22) U.S. General Accounting Office, Competition Between Taxable Business and Tax-Exempt Organizations (GAO/GGD-87-40 BR) (Washington, DC: GAO, 1987), p.1 and pp.30-36.
The GAO study found that nonprofits actively compete in all six industries but that the intensity of competition varies across industries. For example, 90 percent of the respondents in the research and testing industry, and nearly two-thirds of the respondents in the audiovisual industry reported at least one nonprofit competitor, but more than half of the travel agents (55 percent) and tour operators (57 percent) reported no nonprofit competitors.(23)
More agreement was found in response to a question about whether competition from tax exempt organizations has increased or decreased between 1980 and 1985. At least 90 percent of respondents in all six industries indicated that nonprofit competition was the same or greater in 1985 as in 1980, and more than half reported that competition was more intense in 1985 than in 1980.(24) The sources of nonprofit competition mentioned most frequently include public and private colleges and universities, state and local governments, religious organizations, business and professional organizations, hospitals, research organizations, YMCAs and YWCAs, recreation or fitness clubs, and humane or animal welfare organizations. The widespread concern expressed by private sector competitors in this industry indicates that unfair competition by nonprofits is significant, too substantial to be the result of nonprofits serving only thin markets or providing public goods.
Further research into unfair competition is warranted, since governmental enterprises compete with the private sector in the provision of hundreds of goods and services, and (23) This result in contradicted by a survey taken by the National Tour Association, Inc. (NTA), a trade association that represents tour operators. An NTA "Member Viewpoint" survey "indicated that 89 percent of the Association's tour operators are adversely impacted by nonprofit competition," and NTA's "Board of Directors has formally designated unfair competition by nonprofit organizations as the association's top priority issue for 1987." See Tuesday (A Periodic Publication of the National Tour Association News Bureau), vol. 7, February 24, 1987. (24) General Accounting Office, Competition Between Taxable Business, p.35. the private, nonprofit sector accounts for nearly 10 percent of GNP--more than either national defense or welfare expenditures--and is one of the fastest growing sectors of the economy.(25) (25) See James T. Bennett and Thomas J. DiLorenzo, Unfair Competition: The Profits of Nonprofits (forthcoming), Chapter 2.
The economic implications of unfair competition are clear. As the commercial nonprofit sector expands, small firms are crowded out of the market. Since small businesses create most of the new jobs in the economy, there are adverse effects on employment and economic growth. Unfair competition also reduces tax revenues as taxpaying businesses are replaced by tax-exempt ones. Consequently, there are likely to be pressures for general tax increases to make up for the shortfall. By not paying taxes on their commercial activities, CNEs will inevitably shift the tax burden to individual taxpayers and for-profit businesses.
Another general implication is that, because of the absence of direct profit incentives and their relative isolation from competitive pressures (due to their legislative privileges), CNEs are likely to be managed less efficiently than private competitive firms. Thus, overall productivity may suffer, even though CNEs themselves may offer "replacement jobs" for those that are lost in the small business sector.
Finally, it must be emphasized that competition per se is not the issue; there is nothing inherently wrong with nonprofits engaging in commercial activities. But when CNEs do not operate under the same tax and regulatory rules as other commercial enterprises, they impose costs on the owners, managers, and employees of for-profits and on taxpayers. There is a relatively simple way of allowing nonprofits to compete with for-profit businesses and, at the same time, eliminating unfair competition: nonprofit commercial activities should be undertaken through for-profit subsidiaries that are subject to the same tax and regulatory rules governing commercial firms. (25)See James T. Bennett and Thomas J. DiLorenzo, Unfair Competition: The Profits of Nonprofits (forthcoming), Chapter 2.…