Charities and Companies: A Tale of Two Incentive Structures

Wall Street taken above steam stack road works.
Image via Wikipedia

The comparison between for profits and not for profits is complicated, and the way we understand their differing incentives is of vital importance.

Companies have a simple goal, simple metrics for understanding success, and clear incentives to produce results. The actual process of making money is very difficult but to understand when a company is doing well all one really needs to do (at least in a mature company) is to look at its books. If it’s making a steady and growing profit, good. If it’s continually losing money it’s clearly failing. Lose enough money and the shareholders will try to do something about it or the business will simply go bankrupt.

Non profits, meanwhile, are messy entities. They have complicated goals – as differing as giving food to the hungry and education to the least educated – and measuring how they’re doing is difficult. Moreover, without shareholders closely monitoring their cashflow their incentives are also strange. The service they provide to donors is ultimately to make them feel like they’re doing good – and that may not be identical with fulfilling their charitable goal to the fullest.

We deal with this mismatch of incentives and outcomes – of getting charities to serve the needs of the needy – by trying to get an informed donor community. As we’ve mentioned numerous times on this blog Give Well, Charity Navigator and Philanthropedia all try to highlight the very best of the charities – and also the very worst – so that donors will start shifting resources to where they’re most helpful. What this should do is bend the incentives towards a high bang for your buck on meeting charity goals.

Now with this in mind, there’s the additional question as how a donor should think when compared with an investor. Because of the weakness of feedback the nonprofit sector does not operate like an efficient market – that is, unlike Wall Street there should be a huge amount of “arbitrage opportunities” in charities. The “price” of a nonprofit (which in this case would be its donations) should not be as informed as a publicly traded stock which allows for bargains. While there are still strong arguments for diversification in donations (to reflect some doubt on our ability to evaluate charities) there is still compelling logic to placing most of our donations in a small number of excellent charities.

Added 4/21/10: My cousin reminds me that nonprofits are not all charities. There are many excellent organizations from religious, educational and entertainment oriented (which may, as this podcast suggets, simply be subsidizing rich people through museums, operas and the like) which qualify as 501(c)(3)s. In these cases too the incentives problem persists. As Tyler Cowen has pointed out, museums are often very visitor unfriendly because being arcane and subtle fits donor preferences for high art. Places that rely more on visitor receipts will respond by being easier to enjoy oneself in.

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Filed under Organizational Models

2 responses to “Charities and Companies: A Tale of Two Incentive Structures

  1. Pingback: Ramban,Esther Duflo and the Power of Incentives « Teens for the World Blog

  2. Pingback: A Hayekian Challenge For Charities « Teens for the World Blog

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