The Non-Profit Problem

An entrepreneurial person identified a problem – people were wasting the blown glass beads worn on popular bracelets when the bracelet itself broke. In some cases, the glass was broken as well, but regardless, the glass is beautifully crafted and intricate. Surely there is another use for it, they must have wondered. The decorative nature of the glass inspired them to create a business that takes these broken beads and affixes them to ornate vases, then to be sold at the market. It’s a wonderful example of human creativity in solving this wasteful habit. The business became so popular that they received a large bulk order! But they didn’t have enough broken beads to fill it. The business has since broken its own beads to affix to the decorative vases to fulfill these large orders, effectively creating its own waste to reuse.

In economics, we would identify this as an incentive problem. A famous example is the New York City rat problem. Suppose the local government informs its citizens that it will pay a reward for every rat a person brings into the animal control station. Over time, more and more rats are turned in, the program is a rousing success. That is, until officials realize people have been breeding rats to collect the reward. Worse yet, if the city abruptly halts the rat reward system, those individuals breeding rats may simply release them into the wild. At the end of the day, New York City may have more rats than the day they instituted this program.

In either example, the problem is not the intent of the original idea, but the resulting incentives that idea created when confronted with increased scale or scope. The entrepreneur wanted to reduce the waste they saw in the world around them, but through their success, found that they did not possess enough broken glass to meet increasing demand. The city leader simply wanted fewer rats in the streets but found that the carrot incentivized production once capture was no longer an option. Even the best intentions falter at an increased scale.

Yet another entrepreneur wants to help end homelessness. Through generous charitable donations, this person is able to provide roofs and shelter to many downtrodden individuals on the streets of their hometown. After much success, the entrepreneur is approached with an expansion opportunity. They will be able to grow their non-profit to assist the homeless in two more towns across the state. But funding quickly becomes a problem. For the operation to grow, the donor base must as well – and likely more quickly than will the service to the homeless. This non-profit, like many before it, must now focus on donations primarily, rather than the good it hopes to do in the community.

The term non-profit is a misnomer. While it is true that these firms do not pursue profit in their areas of service, they necessarily must pursue profit in their operations. It is this disconnect that causes some non-profits to wilt at large scales where traditional firms succeed. The plight of the non-profit comes down to economizing, which explains how human beings prioritize and act in a context of scarce resources. Goods which can be economized are economic goods. In simple terms, this concept helps to explain how people make decisions when they are faced with a limited selection of disparate items. For a family, this addresses the decisions made at the grocery store (which meat to buy, how many bananas, etc.) or whether to purchase a new car or go on that fun summer vacation. For firms, this helps to explain how many units of “Good X” to produce, supplier negotiations, and how many employees are on staff. And for the college student, whether to eat ramen noodles or go to sleep.

The point is, people and businesses economize on what is scarce to them. It is a subjective consideration that weighs the potential decisions, the available opportunities, and the implications of each – all while inherently considering price and budgetary constraints. Applied to the traditional firm, economizing is what allows efficiencies at scale to materialize. In making difficult decisions under the constraint of scarce resources, the traditional firm will economize in the production of its goods or services directly. This, combined with the assumption that people typically want more money, is the profit motive. Firms economize in their production process, discover relevant efficiencies, and continue to scale upward in the search of more cash flow. Functionally, it’s the domino effect of scarcity that allows firms to discover how to make a profit and pursue greater sizes and scales.

Non-profit firms economize as well. However, recall that non-profits do not pursue profit through the service they are providing. Rather, non-profit firms pursue profit through their ancillary operations. Generally speaking, these firms seek profit through fundraising and not products or services as they describe them to the public. This is not necessarily a bad thing at a small scale. The vase seller was exceptionally successful at first, and the firm helping the homeless was certainly effective within its local community. The issue arises when these firms attempt to increase their scope.

Because nonprofits pursue profit through ancillary operations, they economize on those operations by definition. It’s a slight distinction, but it’s the proverbial straw that breaks the camel’s back, or better yet, the hammer that breaks the blown glass bead. For non-profits to economize, their relevant scarcity and constraints are primarily in their class of donors. This rather than in the direct application of the product or service they provide to a community. What this leads to is a group of firms who develop an efficiency in fundraising rather than an efficiency in their respective charities. We shouldn’t think of this as an issue in being able to provide, obviously, as a non-profit gains donors, it increases its capacity to do charitable service. But as the firm develops, it becomes really quite good at gathering donations and increasing capacity, but can become comparatively poor at providing the relevant charity to its now much larger community. Continue this trend upward in scale and it soon becomes obvious why many national charities struggle in efficacy.

The scaling problem non-profits face is really a problem of where these firms discover their efficiencies. Traditional firms discover these directly in the production process necessarily due to the effect of scarcity in their resources. The firm economizes on its primary function to its consumer, while the non-profit economizes on its ability to raise funds, which, generally, has nothing to do with its primary mission. Faced with the challenge of scaling up, non-profit firms are inherently disadvantaged because they are required to develop and improve the efficiency at which they gather donations in order to grow, rather than developing and improving their production processes.

Despite what their classification would lead you to believe, non-profit firms are, in fact, profit-motivated – just not in the area that helps the people they hope to serve.