Contracting Out through Nonprofits. The nonprofit sector includes
many hospitals, museums, human service organizations and, in the United States,
many uni~fersitiesT.h e double market-failure rationale has been most clearly used to
explain the role of nonprofit organizations in the economy (although using somewhat
different language). Nonprofits typically provide public goods (the first market failure)
in a context where potential contributors (governments or private individuals)
do not have the information to assess whether their contribution is actually used to
produce the public good (the second, or principal-agent, market fiilure). Henry
Hansmann argues that, as a result of the principal-agent problem, in such circumstances,
profit-making firms are able to divert funds to owners because contributors
have neither the incentive nor the information to monitor diversion. In addition, because
of the dificulty of monitoring performance (i.e., information asymmetry), the
profit-making firm may provide inferior goods at excessive prices. In other words,
donors may ''trust" nonprofits because they are not allowed to make a profit. Perhaps
donors also see certain nonprofits as having a strong sense of mission that leads
them to maximize the output of desired goods. Against this must be set the possibility
that nonprofits, given the lack of information, may transfer or dissipate (for example,
through higher salaries or less work) the excess of revenue over cost~.l~~
Hansmann's analysis compared nonprofit contracting to provision via profit-
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making firms, not to direct government supply. Yet nonprofit organizations can be
"_ thought of as being somewhere between market supply and direct government supply.
Why m~ghnt onprofit supply be preferable to direct government provision? One
advantage is that the nonprofit form allows for voluntary contributions-those who
value the supplied good can make additional contributions to expand its supply. Another
is that it allows for great flexibility in the mix of services provided, a feature especially
important where the recipients of the services have heterogeneous prefere
n c e ~ .O' ~f c~o urse, the relative independence of nonprofit firms sometimes makes it
difficult for the government sponsor to select the exact set of services that will be
supplied. Indeed, it may be difficult for government to stimulate the creation of nonprofits
where they do not already exist.