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Nonprofit and foundation behavior in competitive markets for grants

ProQuest Dissertations and Theses, 2011
Dissertation
Author: Lewis Haughton Faulk
Abstract:
This dissertation analyzes competition for foundation grants in the nonprofit sector. First, I examine how inter-organization competition and foundation activity in local grants markets affect organization behavior through institutional pressure on (1) firm fundraising expenses, (2) program expense ratios, and (3) revenue diversification. Second, I explore the impacts of nonprofit program expense ratios and fundraising expenses on foundation grantmaking. This analysis focuses on the relative "prices" of donations to competing nonprofit organizations, represented by these expense ratios, and the impact prices have on foundation grant decisions relative to the impact that nonprofit marketing has. Finally, I examine whether greater competition in grants markets increases the importance of program expense ratios and firm marketing behavior for grant selection. Overall, this dissertation contributes to our understanding of organization behavior and foundation influence in grant-seeking markets and competition's role in the distribution of charitable grants.

viii TABLE OF CONTENTS Page ACKNOWLEDGEMENTS v LIST OF TABLES x LIST OF FIGURES xi SUMMARY xii CHAPTER

1 Introduction: Competition for Charitable Resources in the Nonprofit Sector and Why it Matters 1 2 Literature Review 8 2.1 Theory on the Existence of Nonprofits in Market Economies and its Relation to Nonprofit Competition 8 2.2 The Role of Foundations in Nonprofit Professionalization and Financial Behavior 15 2.3 Inter-Organization Competition a nd Nonprofit Finance Behavior 18 2.4 Contract Failure and F oundation Grant Selection 22 2.5 Financial Efficiency Measures and the Relative “Price ” of Donations 25 2.6 The Overall View of Nonprofit Grant Markets 30 3 Integrated Theory, Hypotheses, and Models 33 3.1 The Influence of Foundation Activit y on Nonprofit Financial Behavior 33 3.2 The Impacts of Competition on Nonprofit Financial Behavior 34 3.3 Foundation Grant Decision Hypotheses 37 3.4 Hypotheses on the Moderating Impact of Competition on Grant Selection 39 4 Data and Methodology 42 5 Analysis 63

ix 5.1 Descriptive Statistics 64 5.2 The Impact of Foundations on Nonprofit Fundraising and Overhead 66 5.3 The Effect of Competition on Organization Behavior 69 5.4 Organizational Determinants of Foundation Grants 72 5.5 The Impact of Market Factors on Grant Success 74 5.6 The Moderating Impact of Competition on Grant Success 76 5.7 Sensitivity Analysis 83 6 Conclusions 85 APPENDIX A: Full Models 92 REFERENCES 102

x LIST OF TABLES Page Table 1: Summary of Sample I ndustry Subsector Statistics 46 Table 2: 12 Georgia Regions 47 Table 3: Inter-Organization Comp etition and Foundation Activity 48 Table 4: Inter-Organizati on Competition and Foundation Activity by Subsector 48 Table 5: HHI by Subsector within the Metro Atlanta Region 49 Table 6: Organization Level Summary Statistics 52 Table 7: Study Hypotheses 53 Table 8: Grantee vs. Non-Grantee Descriptive Statistics 65 Table 9: Organization Fina ncial Behavior Models 68 Table 10: Explaining Foundation Grant Distribution 73 Table 11: Competition and the Importance of Program Efficiency and Fundraising 77 Table 12: Competition and the Importance of Program Efficiency and Fundraising Supplemental Model 81 Table 13: Organization Financia l Behavior Full Models 92 Table 14: Explaining Foundation Gr ant Distribution Full Models 94 Table 15: Competition and the Importance of Program Efficiency and Fundraising Full Models 96 Table 16: Competition and the Importance of Program Efficiency and Fundraising Supplemental Full Model 99

xi LIST OF FIGURES Page Figure 1: 12 Georgia Regions 47 Figure 2: Inter-Organizat ion Competition (HHI) 49 Figure 3: Inter-Organizat ion Competition (N) 50

xii SUMMARY

This dissertation analyzes competitio n for foundation grants in the nonprofit sector. First, I examine how inter-organiz ation competition and foundation activity in local grants markets affect organization behavior through in stitutional pressure on (1) firm fundraising expenses, (2) program expens e ratios, and (3) reve nue diversification. Second, I explore the impacts of nonprofit program expense ratios and fundraising expenses on foundation grantmaking. This analys is focuses on the relative “prices” of donations to competing nonprofit organizations, represented by these expense ratios, and the impact prices have on foundation grant de cisions relative to th e impact that nonprofit marketing has. Finally, I examine whether greater competition in grants markets increases the importance of program expense ra tios and firm marketing behavior for grant selection. Overall, this di ssertation contribute s to our understandi ng of organization behavior and foundation influence in grant-s eeking markets and competition’s role in the distribution of ch aritable grants.

1 CHAPTER 1 INTRODUCTION: COMPET ITION FOR CHARITABLE RESOURCES IN THE NONPRO FIT SECTOR AND WHY IT MATTERS

Nonprofit organizations co mpete with each other and with for-profit and government organizations in a variety of ways . Nonprofit organizations in similar service areas and geographic markets regularly compet e with each other for charitable donations, volunteers, and other scarce philanthropic or public revenues. N onprofits sell private goods and provide public goods, competing in markets with both for-profits and government agencies. In industries such as health, residential care, daycare, and education, nonprofits compete with for-prof it firms and government agencies for human resources, clients, market share, market visibility, and fees for service, contracts, or other funding (Brown, 2010; Kearns, 2006). Inte r-organization competition among nonprofits is perhaps most pronounced in the pursuit of charitable resources , including foundation grants. Since more nonprofits apply for f oundation funding than can be funded at the amounts requested, there are winners and lo sers in the grants marketplace. The nonprofit sector has grown rapidly in recent decades. From 1970 to 2000, the nonprofit sector’s contribution to the U.S. GD P rose from 3.1 to 4.2 percent (Boris and Steuerle, 2006). From 1998 to 2008, the numbe r of 501(c)(3) public charities grew 60.5 percent, with their expenses growing 92.6 percent (45.8 percen t, adjusting for inflation) (Wing, Roeger, and Pollak, 2010). Over the sa me period, the growth in the number of grantmaking foundations matched the growth in charities, and tota l grantmaking grew by

2 84 percent (Wing, Roeger, and Pollak, 2010). Meanwhile, all private contributions (which include foundation grants) only grew by 32 percent (6 percent, adjusting for inflation) from 2000 to 2009, which did not match the growth in nonprofit outputs or the growth of the general economy over that time (Wing, Roeger, and Pollak, 2010). The combined effects of these trends have led to increased competition for charitable revenues in the sector and placed a larger emphasis for managers on the role of foundation grantmaking as a percentage of overall charitable financial support. While nonprofits as a whole depend on fees for services more than on charitable giving, charitable contributions typically make up over 40 percent of total revenues in subsectors such as the arts, environment, international, public and societal benefit, and religious (Boris and Steuerle, 2006, 77). Around 90 percent of nonprofit managers report using foundation grants as a funding source or actively soliciting foundation grants (Blackbaud, 2010; Association of Fundraising Professionals, 2009). Meanwhile, nonprofit subsectors that depend on charitable contributions in greater amounts have shown the largest growth in the last decade (Wing, Roeger, and Pollak, 2010), placing an even greater strain on charitable support. Leaders in the grantmaking community have been concerned about growth in the charitable nonprofit sector and increased competition for funding. Many grantmakers view competition among similar nonprofits as a wasteful duplication of services (Cordes & Rooney, 2004; Golden, 2001). At least anecdotally, foundations have responded to greater competition by targeting more specific fields of interest, focusing their grants on organizations with proven records of accomplishment and encouraging collaborative projects (Chetkovich & Frumkin, 2003; Golden, 2001; Irvin, 2010). If true, this avoids

3 spreading grants too thinly among similar service providers and decreases the risk of losing charitable return on the donations, but it potentially stymies many small or newly formed nonprofits in their efforts to grow their program operations. Such targeted grantmaking could also contribute to a less ideologically diverse sector by affecting entry and exit in nonprofit markets (Chetkovich & Frumkin, 2003). Already, foundations tend to make grants to established and more financially secure organizations (Ashley and Faulk, 2010), making it more difficult for smaller or transitioning organizations to receive funding that could make them more financially stable and capable of serving their missions. If greater competition for funding increases this pattern, greater segmentation of the sector will occur, with established organizations garnering foundation funding and foundations not funding many deserving charities. Since foundation funding could professionalize, improve, or expand the services nonprofits provide, more selective funding patterns in competitive environments could under-serve some segments of the community. Foundations become more selective in competitive grants markets for many reasons. Like general donors, foundations are sensitive to the relative “price” of donations, evaluated primarily through nonprofits’ financial efficiency measures (Ashley and Faulk, 2010). Foundations are interested in the mission-related and broader social impacts of their gifts and do not want to fund an organization that may go out of existence in the near future. Financial benchmarking of potential grantees allows foundations to assess the risk that organizations will not deliver on their promises. In this way, grants are social “investments” rather than gifts, and foundation representatives commonly evaluate them as they would financial investments. In the US, financial

4 benchmarking also commonly takes place due to the availability of financial data from yearly IRS 990 Form information returns for 501(c)(3) charitable nonprofits, the category of nonprofits which foundations predominantly fund. Financial benchmarking generally includes efficiency measures, such as program expense ratios (i.e., the proportion of total expenses going to programs) and fundraising expense ratios (fundraising expenses as a proportion of fundraising returns). Watchdog organizations such as the Wise Giving Alliance commonly use these metrics, and general donors typically emphasize charitable efficiency in their own giving choices (e.g., see http://www.bbb.org/us/Charity- Standards/; Pallotta, 2010). We know from previous research outlined in the literature review that financial measures influence general donations. However, few empirical studies explain foundation grant decisions specifically. Similarly, a small segment of the literature suggests that competitive market pressures improve nonprofit financial efficiency. Yet, no studies test a specific relationship between competition for grants and nonprofit financial efficiency or the relative importance of financial efficiency across different grant markets. Similar to for-profit competition, nonprofit competition could increase efficiency through improved product quality and lower prices for nonprofit services, such as through eliminating wasteful practices. Alternatively, competition could lead to socially inefficient fundraising expenses as nonprofits vie for the same pool of funds, limiting the overall impact that charitable resources have in communities. From a general perspective on competition in the sector, the implications of competition on nonprofit efficiency are important for taxpayers, policymakers, and government actors. The government gives public charities tax exemptions and their

5 donors tax deductions, thus subsidizing nonprof it activity. Therefor e, the public and government have an interest in the effici ent operations of the nonprofit sector that extends beyond foundations’ and do nors’ concern with the effici ency of their grantees. If competition leads foundations to disperse thei r funds more widely but in lower, less effective grant amounts or if competition lead s to inefficient fundraising, there would be social costs to having duplicative service pr oviders in nonprofit markets. In such cases, federated fundraising campaigns in which nonprofits combine th eir resources to attract a pool of funding which they then divide c ould achieve scale economies and be more socially efficient than nonpr ofits spending more individua lly to get the same return (Rose-Ackerman, 1982). Alternatively, comp etition among similar organizations could increase efficiency by forcing competitors to develop innovative service delivery practices and more efficient administrati on. Additionally, competition could lead to greater efficiency by causing gr eater service differentiation and market segmentation as individual nonprofits seek pa rticular niches and capture unique funding streams (Barman, 2002; Chektovich and Frumkin, 2003; Rose-Ackerman, 1982). 1

From a foundation perspective, if comp etition leads foundations to increasingly select organizations with str ong finances and proven records rather than spreading their grants more thinly, individual foundations may be able to justify thei r grant decisions and ensure the sustainable impact of their gift s. However, they may also inadvertently contribute to an environment where nascen t or innovative organizations fail and new social demands go unmet. Because of the managerial emphasis on foundation funding

1 However, greater market segmentation could lead to monopoly-like behavior as specific firms capture unique niches and funding streams.

6 and because of the heavy costs of competing for foundation grants, foundations may actually drive up administration costs and diminish nonprofit efficiency. Foundations may simultaneously increase professionalism and organizational capacity as organizations build their fundraising, tracking, and reporting operations. We currently lack empirical evidence examining foundation impacts on these organizational behaviors. In this dissertation, I examine these issues through three sets of research questions. First, I explore how both the level of foundation presence and inter-organization competition in local grants markets affects nonprofit financial behavior and efficiency. I test how foundation influence and competition among grant-seeking nonprofits impact organization (1) fundraising expenses, (2) administrative expenses, (3) fundraising expense ratios, (4) program expense ratios, and (5) levels of revenue diversification. If higher levels of foundation activity increase nonprofit administrative costs to manage grant application, implementation and reporting processes, foundations could increase organizational capacity but reduce program efficiency in these markets. Likewise, regardless of foundation activity, if competition between similar nonprofits increases fundraising expenses for the same pool of charitable funding, competition would generate inefficiencies and social costs. However, competition could lead to social benefits. Lower fundraising expenses and higher program expense ratios in more competitive markets could indicate greater market segmentation and efficiency gains from more targeted fundraising. Meanwhile, greater revenue portfolio diversification could indicate that competition leads to greater nonprofit financial stability. Second, I explore the impacts of nonprofit program expense ratios and fundraising expenses on foundation grantmaking. I ask (1) whether the relative “prices”

7 of donations to competing nonprofit organizations, represented by program expense ratios, impact foundation grantmaking decisions and (2) how prices affect grantmaking compared to the impact of nonprofit marketing, as demonstrated through fundraising expenses. If foundations, like private donors, reward nonprofits with higher program efficiency, foundations will create institutional pressures for nonprofits to be more efficient in their program operations to maintain comparative advantages in the grants marketplace. If foundations award grants to organizations with greater fundraising expenses, however, greater marketing investments, instead of efficiency, would lead to comparative advantages in these markets. Finally, I examine whether greater competition in grants markets increases the importance of (1) program expense ratios and (2) organization marketing behavior for grant selection. If grant price sensitivity is stronger under greater competition, competition could drive program efficiency. If fundraising expenses drive grant selection in more competitive markets, foundation grantmaking may be more efficiently targeted in these markets, but aggregate fundraising expenses by nonprofits competing for the same grant pools could be socially inefficient. Overall, this dissertation contributes to our understanding of organization and foundation behavior in grant-seeking markets and competition’s role in the distribution of charitable grants. Chapter 2 reviews the literature and pertinent theory. Chapter 3 develops theoretical arguments and research hypotheses for the research questions above. I discuss the data and methodology in chapter 4, the findings in chapter 5, and the conclusions and implications in chapter 6.

8 CHAPTER 2 LITERATURE REVIEW

2.1 Theory on the Existence of Nonprofits in Market Economies and its Relation to Nonprofit Competition The literature holds little consensus on wh at drives the formation and growth of nonprofit organizations or how competition aff ects the sector. While a coherent body of economic theory explains why and how for-profit firms operate in market economies, nonprofit studies lack a si milarly cogent framework for analyzing nonprofit organizational behavior. Instea d, several disparate theories propose explanations on the existence of nonprofit organizati ons. Each comes from a different perspective of the role of nonprofit organizations in society and cont ributes differently to how we may better understand the nature of competition and collaboration among nonprofit organizations and between nonprofits and other organizations in the economy. Public goods theory, also called demand heterogeneity theory, argues that the market and government do not meet the dema nd for collective, pub lic, or quasi-public goods. Nonprofits step in to supply u ndersupplied goods and services. Markets undersupply goods and services because thes e goods are non-excludable or non-rival (Steinberg, 2006). Since indivi duals cannot be excluded from enjoying the benefits of these goods, they have littl e incentive to pay and a fr ee-rider problem results. Government can tax to overcome free-riding, but if the average or “median” voter does not prefer the provision of a good or service, politicians wi ll be unlikely to supply it

9 because government resources and attention will be allocated toward providing goods and services with greater voter demand (Steinberg, 2006; Anheier, 2005). Therefore, nonprofits provide the undersupplied collective goods and services through the private contributions and voluntary efforts of individuals who prefer or demand higher levels of those goods. Even though the free-rider problem still exists and nonprofits do not have the power to tax individuals, they can overcome free-riding behavior through various fundraising strategies, creating private incentives for donating to collective causes (Olson, 1965). Nonprofit organizations therefore step in to “meet a diverse demand for collective goods” in democratic societies, from arts, education, and healthcare to environmental protection and community development, providing goods and services that would otherwise be underprovided by the market or government (Weisbrod, 1988, 25). Under the demand heterogeneity theory, nonprofits exist not to compete with existing organizations but to fill in where collective goods and services are undersupplied. This theory alone does not predict competition between nonprofits and other organizations for clients or market niche. Instead, nonprofit competition should center upon organizational resources, such as human capital, volunteers, and external funding. However, individual nonprofits exist because enough people demand the services they provide and are willing to support the organization through donations and time. Therefore, nonprofit density in any market increases as new organizations attract and maintain support from donors and volunteers who have similar preferences for goods and services. Since the mix of demands and preferences in communities changes over time, nonprofits will compete primarily with other nonprofit organizations for

10 philanthropy. However, if demand for collective services increases and the government decides to directly provide the services, nonprofits may begin to compete with government agencies for funding or niche, and nonprofits may begin to compete with for- profit organizations for government contracts if government decides to indirectly supply the services. In this way, an increase in demand for services that nonprofits provide and the provision of those services by government “crowds out” some nonprofit activity (Anheier, 2005, 123). Weisbrod’s public goods or demand heterogeneity theory does not readily explain the ongoing competition between nonprofit organizations and other organizations in the same industries because the theory explains that nonprofits act more as gap fillers than competitors. The market would clear over time as heterogeneous demands for collective services are met, and particularly when demands for services increase, causing for-profit and government suppliers to enter the market. Hansmann introduced a separate trust- related or contract failure theory, however, that adds to Weisbrod’s theory and helps us better understand ongoing competition and particularly why nonprofits would continue to exist in service markets where for-profit organizations operate. Hansmann argues that the free market undersupplies many goods and services because of high levels of information asymmetry between the producers and consumers. Third party payers have difficultly evaluating the quality of these goods and services, such as daycare, hospital or nursing care, and therefore profit-seeking firms are likely to cut service quality to increase profits (Anheier, 2005). Since the non-distribution constraint prohibits nonprofit organizations from distributing residual income as profits to stakeholders, nonprofit managers lack a profit incentive and are trusted to provide higher

11 quality goods and services under scenarios of high information asymmetry between buyers and sellers (Brown, 2010; Anheier, 2005). Under this theory, consumers, donors, and government prefer nonprofits to for-profit organizations for services, donations, and contracts. Therefore, the trust or contract theory adds to the demand heterogeneity theory by explaining why nonprofits compete with for-profit firms in supplying some goods and services (Anheier, 2005). In addition to nonprofits competing among themselves for general resources, nonprofits directly compete with for-profits for service markets and government funding in some fields. Therefore, we expect nonprofits to push for-profit providers out of particular market niches where high information asymmetry leads clients and government to prefer nonprofit providers. However, both nonprofits and for-profits will exist in industries where information asymmetries are not as high for clients who pay for the services they directly receive, such as in healthcare and other segmented markets. Therefore, even with comparative advantages in certain client markets, nonprofits will continue to compete with for-profits in the same industry for human resources and for client markets where information asymmetries are not as great, such as clients paying for elective surgeries in the healthcare industry. This theory also helps us better understand why government would choose to collaborate with nonprofit organizations for indirect service provision through government grants or contract arrangements because nonprofits would be trusted over for-profits to deliver on their promises that cannot be easily monitored. These theories originate from a demand-side perspective to explain how nonprofits form to meet unmet demands. Supply-side theories, such as stakeholder and

12 entrepreneurship theories, focus on the motivation of those who start nonprofits to explain their existence. Like trust theory, stakeholder theory explains that nonprofit organizations overcome information asymmetries where buyers do not trust for-profits to provide goods and services at the quality level demanded (Anheier, 2005; Ben-Ner and Van Hoomissen, 1993). However, stakeholder theory also acknowledges that, in some cases, individuals prefer to provide the good they consume for themselves to ensure the level of quality they want, to be the suppliers and demanders. This will be especially true when particular groups demand a very specific level or quality of the good or service. For instance, groups of parents with education preferences for their children that existing schools do not provide may choose to form a cooperative school (Anheier, 2005) or an independent charter school. Adding the supply-side perspective to the trust theory, stakeholder theory improves our understanding of nonprofit competition by explaining certain situations where nonprofits with similar missions will exist in the same community or service market. Since these organizations will only differ based on particular stakeholder preferences or ideology, competition between these nonprofits will be high for external funding (such as foundation or government grants), human services, clients, and market visibility. Extending the supply-side argument for nonprofit organizations, entrepreneurship theories (Young, 1983; Rose-Ackerman, 1996) argue that individuals who start and lead nonprofits derive utility from non-monetary rewards of nonprofit work, either from achieving the mission of the organization or from other motives, such as religious motivation to serve others. Therefore, individuals or groups of individuals with preferences to create their own organizations and approach social missions in unique

13 ways drive the supply of nonprofit organizations. This explains why so many nonprofits with similar services and missions exist. These theories predict a larger supply of nonprofit organizations, and greater competition for funding, than public goods or trust theories. Interdependence theory argues that nonprofits and government complement each other and that government largely supports the work done in the nonprofit sector through grants, contracts, and public-private partnerships (Anheier, 2005). Based on this theory, nonprofits can only provide a limited amount of services due to voluntary failure, or the insufficiency of philanthropic resources to supply public goods under situations of increasing demand. As public demand for their services grows, they increasingly rely on government to fund and support their work, leading to competition between nonprofits for valuable government grants and partnerships. Overall, each of these major theories provides different insights into the nature of nonprofit competition. As Anheier and Ben-Ner (1997) point out, these theories complement more than contradict each other. Particularly by combining stakeholder and entrepreneur perspectives with public goods and contract failure theory arguments, we expect a greater supply of nonprofit organizations than can be supported (i.e., demanded) by charitable donations. Because new and small nonprofits often rely solely or mostly on donated volunteer time, we expect many more organizations than would be demanded by financial resources to exist, especially in subsectors that have low barriers to entry, do not require large physical or capital assets, or have high exit thresholds due to low operating costs.

14 Meanwhile, others argue that for-profit theory regarding competition and market structure works for nonprofit organizations as well. Tuckman (1998) applies Porter's five competitive forces to nonprofit competition and demonstrates how entry and exit, power of buyers, power of suppliers, the presence of substitutes, and rivalry among competitors similarly impacts nonprofit organizations, even in markets, such as donation or foundation grant markets, where nonprofits compete exclusively against nonprofits. Lakdawalla and Philipson (2006) characterize all nonprofits as for-profits with lower costs due to tax subsidies and the altruistic motivation of their employees. They argue that for-profit theory holds for nonprofits by treating them as for-profits with lower costs. Extending this argument, Harrison and Laincz (2008) show consistency of for-profit models in nonprofit industries. Harrison and Laincz (2008) find a key difference for nonprofits, however, showing much higher survival rates for nonprofit organizations than for-profits generally. While new nonprofits form at around the same rate as for-profits, only 17 percent of nonprofits fail after 10 years compared to 80 percent of for-profits (Harrison and Laincz, 2008). As Harrison and Laincz explain, this results in much higher net entry rates for nonprofits than found in for-profits. This finding is consistent with Rose-Ackerman’s (1982) argument that low nonprofit entry barriers will allow ideologically driven entrepreneurs to start new organizations even in saturated markets. While new entrants will attract new donors into markets through additional fundraising and marketing, each organization’s share of overall donations will fall as the number of organizations in a market rises (Rose-Ackerman, 1982). Therefore, high net entry rates in the nonprofit sector translate into increased competition for donations over time.

Full document contains 124 pages
Abstract: This dissertation analyzes competition for foundation grants in the nonprofit sector. First, I examine how inter-organization competition and foundation activity in local grants markets affect organization behavior through institutional pressure on (1) firm fundraising expenses, (2) program expense ratios, and (3) revenue diversification. Second, I explore the impacts of nonprofit program expense ratios and fundraising expenses on foundation grantmaking. This analysis focuses on the relative "prices" of donations to competing nonprofit organizations, represented by these expense ratios, and the impact prices have on foundation grant decisions relative to the impact that nonprofit marketing has. Finally, I examine whether greater competition in grants markets increases the importance of program expense ratios and firm marketing behavior for grant selection. Overall, this dissertation contributes to our understanding of organization behavior and foundation influence in grant-seeking markets and competition's role in the distribution of charitable grants.