Abstract
We investigate the classic strategy choice between low cost and high quality when quality is not directly observable and legal liability about quality is uncertain. In addition, we investigate how for-profit and nonprofit organizations differ in their responses to a changing risk of quality liability. Our theoretical analysis predicts that nonprofit organizations, because of their lesser dependence on profits and greater dependence on support from donors and local communities based on perceived quality, will adjust their investment in quality more aggressively than for-profit organizations in response to exogenous changes in the risk of quality liability. This difference in responsiveness will be greater for organizations with better reputations for quality. We find support for these predictions using data on hospital medical expenditures, state medical malpractice awards, and tort reforms in the United States for 1997–2006.
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