November 08, 2005
Why Nonprofits?
Posted by geoffrey manne

Why do promoters ever choose to form nonprofits? (The obvious answer -- the substantial tax benefits -- only begs the question:  Why do we subsidize the formation of nonprofit organizations? If the tax benefits disappeared, would we still have nonprofits?  We certainly had them before the tax benefits were being doled out). I'm not so sure that the accepted story -- basically, nonprofits are more honest because of their nonprofit-ness, and this is valuable where output is hard to observe -- is all that compelling.

The traditional economic answer -- attributable to Henry Hansmann -- is a signaling story: Customers will prefer to purchase goods or services from organizations operating under the nondistribution constraint where they find it difficult to judge the quality or quantity of the contracted-for good or service.  The constraint signals to prospective customers that the firm’s managers are unlikely to abuse the ignorant customers for profit because they are legally prohibited from gaining personally by increasing profits.  Promoters will choose the nonprofit form, then, where the gain from increased customer revenue outweighs the costs of the form (both from the nondistribution constraint as well as the concomitant absence of owners and control-market discipline).

But there is still gain to be had, of course. Nonprofits can and do pay high salaries to managers, and maybe they even maximize profits like for-profits do. Moreover, in large part the return to the operators of the firm may be non-pecuniary.  To the extent that nonprofit managers are motivated by ideology, the firm’s success may be its own reward.  But less charitably, the tenuous agency relationship (who, exactly, is the principal?), the absence of a control market, and the relative importance of non-pecuniary compensation (in a world where explicit compensation must be "competitive" and largely unmoored from profits) reward those who have a comparative advantage in extracting utility from non-pecuniary compensation.  In other words, nonprofits are attractive to the idealists as well as the shirkers and perk-takers; the moralists as well as the manipulators. 

So I have 2 sets of questions: 

  1. Why should the more optimistic conclusion be presumed to prevail over the pessimistic one? Why is the nonprofit form much of a signal when there is reason to expect that manipulators are as likely as altruists to be running the place? In this regard the Malani/David piece I linked to before (suggesting (with Christine's methodological caveat) that nonprofits don't actually signal their status) is interesting. Or does it really all come down (as Hansmann concluded) to norms? Is the signal ultimately reliable because the non-idealistic are excluded by operation of charitable norms?  And if so, do we have a good theory of why this would work, of how such norms are inculcated and spread? I mean, isn't "it's the norms, stupid" a pretty flimsy foundation on which to rest a massive and tax-favored sector of the economy?
  2. Is there any appreciable difference between the types of people who tend to work in nonprofits and in for-profits?  Other than the true idealists (if they can be distinguished from the manipulators), does the pool of prospective nonprofit managers (the better perk-takers and shirkers) look different than the pool of for-profit managers (the lesser exploiters)?  What, exactly, would characterize someone with a "comparative advantage in extracting utility from non-pecuniary sources?" This might just be, in Armen Alchian's famous phrase, folks who prefer "thicker carpets and prettier secretaries." Are they any more or less likely to be undesirable managers? I note quickly that, while shirking and perk-taking are always roundly criticized, there is no reason why non-pecuniary compensation must be less efficient than cash. Shirking and perk-taking can substitute for cash compensation and preventing them entails a cost, so the optimal level of shirking/perking is certainly not zero.


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