Many people mistake the organizational form of “nonprofits” as being free from economic considerations. If the organization is not run by a profit-motive, it surely will act ethically and in accordance with the mission statement of the organization. In a sense, people view nonprofits as exempt from the regular rules of life in a market economy.

However, nonprofits also have a vested interest in organizational survival. The faulty belief that without profits, people will no longer act in their self-interests, drives operational inefficiencies. Many think that since the organization is not trying to obtain money beyond operating expenses (which is in itself a dubious assumption), that the actions of the people within the organization will solely focus on achieving the organization’s stated goals. However, there are incentives for delaying the achievement of these goals as a result of not wanting to become 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 administrating a nonprofit. Typically, people donate to a firm because they think it’ll achieve a goal that they care about. However, since it is hard to monitor whether those donations are used effectively, there needs to be mechanisms in place to encourage action.

I want to juxtapose two methods of funding nonprofits and suggest a manner to improve their effectiveness on the margin. The two major funding mechanisms are grants and prize money.

Grants are given in advance and are able to be specified. Most donations would fall into this category. Typically, grants are favored by bureaucracies because of the fact that much of them are in perpetuity and are not tied to success, which can be fleeting. Oftentimes, grants work well in situations involving repeat players. Grants seem to work better when the purpose of an organization is diversified, and staying power is important. Two types of nonprofit that seem to do well with grants are general purpose think tanks and direct aid organizations. General purpose think tanks come up with a set of ideas that mostly follows a specific ideology. It’s not necessarily clear what success is defined as, meaning that trying to tie success to a prize may result in underutilization of good ideas. Since a lot of think tanks are premised on the idea of being a reliable authority, staying power is important. Staying power is similarly important in the context of direct aid. When dealing with a problem like providing a food kitchen, some form of regularity can be important in helping the greatest number of people. Overhead, for example, is certainly something to consider; it can be expensive forming and reforming organizations to achieve the same goals. However, just because grants are preferable for some situations, doesn’t 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 profit and loss. Prize money, in an important sense, can serve as a “commission” [read “price”] for those who are deeply interested in achieving a goal. Those trying to win the prize are unlikely to spend more than the prize money is worth in pursuit of the goal. This discourages spending that isn’t likely to make much of a difference, while giving newcomers a better shot at winning, which allows for a diversification of inputs and incorporates more local knowledge into what is likely to be successful. If one person can put together a team to achieve a goal of building a thousand houses for the homeless, then it’s more likely to get done. This prize system has worked well in trying to achieve major social goals. For instance, Robin Hanson describes how funding for results should be the best strategy when innovators have access to capital and a particular goal in mind. If science research is best done through this market process, then it should also follow those specific goals would be better served in this way. Nonprofits are often funded by individuals and donors. Using escrow or prizes may serve as a method of solving this principal-agent problem and can result in better outcomes.

If nonprofits are focused on a specific measurable goal, prizes are underutilized as a method for achieving results. Focusing on good solutions, rather than on influential groups may be what’s necessary to kickstart new approaches to solving collective action problems.

 

Isadore Johnson is a campus free speech advocate, an economics and philosophy student, and regional coordinator for Students for Liberty.