Many people mistake the organizational form of “nonprofit” for being free from economic considerations. If the organization is not driven by a profit motive, it must act ethically and in accordance with the organization’s mission statement. In a sense, people see nonprofits as an escape from the regular rules of life in a market economy.
However, nonprofits also have a vested interest in organizational survival. The flawed belief that without profit, people will no longer act in their self-interest, drives operational inefficiency. Many believe that since the organization is not trying to obtain money beyond operating costs (which itself is a dubious assumption), that the actions of the people within the organization will be focused solely on achieving the organization’s stated goals. However, as discussed earlier, there is an incentive to delay achieving these goals due to not wanting to be unemployed or take a pay cut.
This problem takes the form of a principal-agent problem because the organization’s advisors and its donors may have different interests than the employees and those who manage a nonprofit. Generally, people donate to a firm because they think it will achieve a goal they care about. However, since it is difficult to monitor whether these grants have been used effectively, measures need to be in place to encourage action.
I would like to link the two methods of financing nonprofits and suggest a method to improve their performance at the margin. The two main funding mechanisms are grants and award money.
Grants are paid in advance and can be specified. Most grants fall into this category. Generally, grants are favored by bureaucracy because most of them are perpetual and not tied to success, which can be fleeting. Often, grants work well in situations involving repeat players. Grants seem to work better when an organization’s purpose is diverse and staying power is important. Two types of nonprofits that seem to do well with grants are general purpose think tanks and direct aid organizations. General purpose think tanks come up with ideas that mostly follow a specific ideology. It’s not necessarily clear what success is defined as, which means that trying to tie success to a reward can lead to underutilization of good ideas. Since many think tanks are based on the idea of being a reliable authority, having authority is important. In the context of direct aid, staying power is equally important. When dealing with a problem like providing a food pantry, some regularity can be important to help the greatest number of people. Overhead, for example, is definitely something to consider; It can be expensive organization building and reforming to achieve the same goal. However, just because grants are preferable in some circumstances does not mean that they are well-equipped to deal with easily measurable success and generally efficient use of inputs.
One of the best ways to encourage an efficient use of inputs is through profit and loss Prize money can, in an important sense, act as a “commission”. [read “price”] For those who are deeply interested in achieving a goal. People who are trying to win prizes are less likely to spend more than the prize money to achieve the goal. This discourages spending that may not make much of a difference, while giving newcomers a better shot at winning, allowing for diversity of inputs and incorporating more local knowledge into what is likely to succeed. If one person can rally a team to achieve the goal of building 1,000 houses for the homeless, it is more likely to be accomplished. This reward system has worked well in trying to achieve major social goals. For example, Robin Hanson describes how outcome financing should be the best strategy when innovators have access to capital and a specific goal in mind. If science research is best accomplished through this market process, it should also pursue specific goals that would be better served this way. Nonprofits are often funded by individuals and donors. Using escrow or rewards can serve as a method to solve this principal-agent problem and result in better results.
If the nonprofit is focused on a specific measurable goal, awards are used less often as a means of achieving results. Collective action requires a focus on good solutions rather than dominant groups to kickstart new approaches to problem solving.
Isadore Johnson is a campus free speech advocate, an economics and philosophy student, and the regional coordinator for Students for Liberty.