_{Image: “USAID/Georgia’s Disability Advocacy Project” by USAID_IMAGES is licensed under CC BY-NC 2.0.}

2.1 Chapter Introduction

As discussed in the previous chapter, the nonprofit sector in the United States is incredibly large, with over 1.5 million registered organizations and another estimated 1 million informal groups. How did this come to be? Why does the nonprofit sector look the way that it does? And, perhaps more significantly, why does the nonprofit sector exist in the first place?

Over the last fifty years, nonprofit scholars have been developing theories that describe, define and shape the nonprofit sector, as well as explain its roles, responsibilities and behaviors. This chapter will present the main theories of the nonprofit sector and relate them to actual organizations. 

2.2 The “Four Failures”

Compared to for-profit businesses or government agencies, nonprofit organizations have their own strengths and weaknesses. Nonprofits are distinct organizational forms that are seen to exist for many reasons, with the leading theories sometimes described as the “Four Failures”:

• Market Failure.
• Government Failure.
• Contract Failure.
• Voluntary Failure.

Market Failure

Market Failure is a broad term often used in economics, political science, public administration and nonprofit studies. It defines a situation in which the market (business sector) fails to produce demanded goods and services. This failure leads to an inefficient distribution of goods and services by the “free market.” Richard Steinberg ^[1] argues that businesses may: fail to produce goods or provide services demanded by the public; over-restrict access to certain goods (such as by pricing too high); or fail to meet consumer expectations around the quantity or quality of the good/service.

In the case of the nonprofit sector, market failure is particularly relevant when goods or services for critical needs – such as health care, education, food or job training  – aren’t available to those that can’t afford “market prices.”

While it may seem that market failure happens simply because businesses can’t “make a profit,” there are other reasons the market may fail.  Different types^[2] of market failure include:

• Information asymmetries, which occur when the parties to any transaction have different levels of information about the quality of the product/service. This can lead to exploitation, such as when someone selling a car knows there is a significant issue with the engine and fails to provide this information while encouraging you to buy it. Government often intervenes to prevent information asymmetries through regulations that protect consumers, such as requiring certain disclosures by the seller or by establishing “lemon laws.”
• Externalities, also called “spillover effects,” which occur when benefits (positive) or costs (negative) impact someone who is not directly involved in a transaction. For example, a firm exposes the community to pollution while making its product. Government may also intervene in these cases through regulation (such as regulating or fining polluters), but nonprofit organizations may also get involved by holding organizations accountable to the law, either through political pressure or through litigation.

• Free-Rider problem, where individuals will not participate in the provision of (pay for) a good or service unless they are compelled to do so. This is especially the case when they can receive the good without having to pay for it (for example, driving down a road, enjoying a park or listening to public radio).^[3] Government intervenes in this case by compelling people to pay for the good or service through taxation. These types of goods are called non-excludable public goods and make up many of the goods and services government and nonprofit organizations provide. However, students know about the free-rider problem personally when they are working on a team project and one group member chooses not to contribute but expects to receive the same grade!
• Monopolies, where the market is concentrated on one provider, often allowing the provider to charge whatever they would like for a product. Monopolies can be particularly problematic if they are providing goods or services that are needed by the public, such as medical care or electricity. Government often regulates monopolies by placing a cap on what they can charge, or may even break them up into smaller organizations.

Traditionally, market failures are one of the main reasons government intervenes with taxes and regulations. If people won’t voluntarily provide funds for a public good (free-rider problem), government will tax the public in order to provide them, such as collecting taxes to fill potholes in the road or build a new bridge. If buying a car is risky because you don’t know about the maintenance history (information asymmetries), states might pass a “lemon law” to protect your rights in the event the car breaks down shortly after purchase, allowing you a full refund. Government may fine polluters for dumping into a local river (externalities). Government may also set price caps for public goods provided by a monopoly, such as a public utility.

Government Failure

Yet, sometimes government failure also impacts the availability of public goods and services. Government failure may exist because government is unwilling or unable to provide that public good or service. One theory to explain government failure asserts government is only interested in producing goods that are desired by the majority of the public (also called the median voter theorem).^[4] This leaves some goods and services under-provided by both market and government.^[5] In the nonprofit context, this might include goods and services as diverse as arts organizations or mental health services. More broadly, it could include advocacy organizations working to protect public goods like forests, parks, clean air and public waterways.

_{Image:  “Median Voter Theorem,” Chegg.com,}

In both market and government failure, the public cannot access goods and services. This is where nonprofits step in, “filling the gaps” left behind by the inability of government and the market to provide for the public.^[6]

Contract Failure

Contract Failure, on the other hand, is a distinct form of market failure that relates to information asymmetries. The public recognizes that a nonprofit organization is mission driven, not profit driven, and therefore may expect a better service than one provided by a for-profit business or government agency.^[7] In this case, the public is more willing to select a nonprofit provider over other types of organizations because nonprofits are considered more trustworthy by the public.

Voluntary Failure

The last of the “four failures” is called Voluntary Failure. That is, no matter how much money is donated, or time given by volunteers, the nonprofit sector is insufficient to solve problems on its own. This failure requires that the public sector (government) shore up the nonprofit sector through financial support. Lester Salamon^[8] considers four reasons for voluntary failure:

Philanthropic Insufficiency: Simply put, the nonprofit sector is not, on its own, able to generate or organize the resources necessary to “get to scale” and be large enough to solve society’s problems. This is partially due to the free-rider problem, but also relates to how private donations are simply not adequate to provide for all desired public goods and services.

Philanthropic Particularism: This is the criticism that nonprofit organizations select only sub-groups to serve rather than the wider public. For example, groups may only serve individuals of a particular religion or ethnic group, or may serve only the people in a particular neighborhood, or their specific interests or profession. This can lead to favoritism or, in worst case scenarios, bias and discrimination.

Philanthropic Paternalism: Traditionally, those who run nonprofit organizations and other community groups tend to be those who already have access to a community’s resources. This can leave a power imbalance between those who are serving and those who are being served, which may lead to organizations believing they “know what’s best” for beneficiaries and giving beneficiaries no control over resources spent on their behalf. This may also mean that those in charge choose programs, activities and services that they personally perceive as valuable (from a position of relative privilege), while potentially ignoring the real needs of those they mean to serve.

Philanthropic Amateurism: Many organizations are led by individuals who do not have management expertise or experience. This is partly due to paternalism, where good intentions and outdated assumptions lead to ill-managed programs. It’s also due to the lack of training and development in the nonprofit sector as a profession where specific skills and expertise are needed.

2.2 Interdependence Theory

Due to the Four Failures, nonprofit organizations and government are mutually dependent on each other for providing services that the public needs and demands. Nonprofit organizations (due to voluntary failure) are dependent upon government for the financial resources necessary to do their work, and the government (due to government failure) is dependent on the nonprofit sector to “fill the gaps” left by its own limitations and constraints. Sometimes the government may not directly produce a service, but rather they provide for one through the allocation of funds through grants and contracts to the nonprofit sector. This can be called interdependency theory.

2.3 Social Origins Theory

_{Image: “Sepak Takraw from Schagen’s World Map (1689)” by oschene is licensed under a CC BY-NC-SA 2.0 license.}

One final theory that I’d like to include in this chapter (there are many others) is Social Origins Theory^[9]. This theory provides a good framework to understand the variation in nonprofit sectors in different countries. For example, most higher-income countries have a substantial social safety net for citizens in need. In these countries, the nonprofit sector doesn’t have as many human services organizations as we do in the United States. In countries that lack basic services, such as schools and medical care, the nonprofit sector may be focused on those activities. In countries that limit free speech or advocacy, there may be few, if any, organizations engaged in advocacy or activism.