There Are Two Kinds of Doctors
Which kind are you?
An old joke that I believe I first heard on Russ Robert’s podcast EconTalk (Mike Munger was probably the guest) is said by academic PhDs: “I’m a doctor, but not the kind that helps people”.
Similarly, I think there are two types of nonprofits in this world: those that help people (the good kind), and those that help themselves (the bad kind). Both suffer from the same poor incentive structure. As Arnold Kling likes to say (my paraphrasing), “Profit-seeking firms are directly responsive to customers and indirectly responsive to owners and employees. Nonprofit-seeking firms are directly responsive to donors and somewhat to employees and indirectly responsive to explicit beneficiaries (presumed customers in this case).”
In the case of profit-seeking firms, we can measure their value to society very clearly through the profit/loss statement. For nonprofits it is much murkier. However, not all nonprofits are created much less run equally. Like I said, there are good ones and bad ones. While this distinction can just be a relative measure, often it is pretty stark.
The good nonprofits are not just relatively less bad where bad means socially destructive. Often the good ones really are doing good in this world. Keep in mind that good and bad is in terms of how we would define it in economics. Before you dismiss this, realize it is or at least can be an all-encompassing measure.
To correctly assess the social value of a firm (profit-seeking or otherwise) we want to know if it is using resources properly. A for-profit firm that is incurring losses is destroying resources. This cannot go on indefinitely without turnaround—the market will correct it by putting it out of business (assuming government doesn’t bail it out). If one were to argue that a for-profit is actually destroying resources despite showing a profit because it isn’t fully paying for the resources it uses (e.g., carbon use that isn’t capturing the externalities), the solution is simple: Add that to the profit/loss equation (e.g., a carbon tax).1
Similarly, a nonprofit can be examined in this framework by adding to the cost-benefit analysis any non-financial aspects one deems important. For example, spiritual benefits can certainly be considered. If a church’s food pantry work is not just about feeding the hungry but also to connect parishioners with those suffering, add that as a benefit.
No, this isn’t a straightforward effort, and it leaves plenty of room for debate. But having that debate through attempting to quantify and capture costs and benefits is a very useful exercise. Waving ones hands at it claiming “you simply can’t evaluate it” is not.
In fact one should be suspicious the more protest a nonprofit supporter puts up against any attempt at a cost-benefit analysis. To me that is a signal they either cannot stand up to scrutiny. At the very least it shows an unwillingness to do what should be required. “Just trust us” is a very poor substantiation.
Yet “just trust us [and let us verify with platitudes and generalities]” is the currency of the realm. So it is left up to us to do the heavy lifting to separate good from bad. Fortunately, we can begin to see the difference looking at a number factors.
Good nonprofits generally have the following characteristics:
They are close to the people they aim to help.
They are well regarded by knowledgeable outsiders in terms of outcomes—making progress toward goals we want achieved.
They don’t pivot to new needs much less propagate/invent new causes to preserve themselves.
They don’t pay very well—their employees all the way up to the top aren’t getting rich.2 [pay attention to the footnote here]
They are generally low prestige.
They have clearly defined, limited goals.
They exhibit frugality behind the scenes—their back offices, board meetings, and activities for staff are not lavish.
They have fundraising needs driven by spending that is obvious and mission specific.
I have a lot of experience and engagement with nonprofits of all stripes. Beyond casual witness to those around me, I have experience with many as a volunteer, board member, and outside money manager. While I’ve never directly experienced anything that I would call fraud, I have often seen meaningful contradictions between intentions and results.
One group of nonprofits that deserve careful attention is the case of nonprofits that exist to fund other nonprofit entities rather than people or causes directly. Foundations often fall into this group, and they span both spheres of good and bad nonprofits.
Foundations are particularly susceptible to mission creep and manipulation—both by staff and benefiting entity(s). Both of these are principal-agent problems. The staff version is fairly obvious (e.g., the staff using funds for personal benefit). The benefiting entity version is hard to see, and the foundation can be an innocent party to it. Unfortunately, I find in many cases they are a party to the conspiracy keeping in mind they usually all believe they are doing the Lord’s work.3
Determining whether a nonprofit is good or bad is both art and science meaning reasonable minds have more room to disagree. In the case of for-profit firms only the economically innumerate don’t understand that the greater the profit the greater the social good—where reasonable minds can only debate the externalities (positive as well as negative. Bryan Caplan’s recent book Pro-Market and Pro-Business and his upcoming book Unbeatable: The Brutally Honest Case for Free Markets should help in this matter.
In the case of non-profit firms we have to make a lot more assumptions. This is where reasonable minds can widely differ. Perhaps my list of good characteristics is a helpful starting point here.
[Note: I have left alone a discussion of tax treatment here leaving that for a future post. That discussion is really more about our abysmal tax policy and not a central feature of non-profit analysis despite how central tax treatment is for nonprofits.]
Substacks referenced:
Easier said than done. Remember, ESG = CRAP.
There can be exceptions here as in the case of very large foundations. However, I don’t have a lot of tolerance for what is found in many cases. I can speak most directly to investment management where the excesses are obscene—good money management is not just available at much lower prices than what we find; it is likely antithetical to expenses paid. Low-fee investment isn’t just a great barometer for individual investors. Similarly, for executive pay at very large nonprofits I have skepticism. Although their next best alternative might be in the for-profit world where they could command large salaries and benefits, a lot of that is risk-compensation. Not only do they not face the same risk profile in the non-profit world, we don’t want them compensated as insulation from risk taking in nonprofits. We want more conservative behavior when they are stewards of a nonprofit.
Upton Sinclair — “It is difficult to get a man to understand something when his salary depends on his not understanding it.” & Richard P. Feynman — “The first principle is that you must not fool yourself, and you are the easiest person to fool.”