The Nonprofit Theory Revisited The Advantages and Challenges for the Third Sector Rasmus Bøgh Holmen Master Thesis for the Economic Theory and Econometrics Degree February 12 Department of Economics University of Oslo © Rasmus Bøgh Holmen February 12 The Nonprofit Theory Revisited – The Advantages and Challenges for the Third Sector http://www.duo.uio.no Press: University Print Centre at the University of Oslo II Illustrating Quotes My view is that nonprofits organizations are largely a way of solving informational problems. Managers of nonprofit organizations lack the incentive of profit that might otherwise tempt them to misrepresent their products or services (Weisbrod 1988, page vii). In spite of the limitation imposed upon them, nonprofits may succeed in distributing some of their net earnings through inflated salaries, various perquisites granted to employees and other forms of excess payments (Hansmann 1980, page 844). III Abstract In my master thesis in economics, I draw attention to nonprofits with core focus on the ones that are operating in the business sector. I aim to investigate how nonprofits functions, and how they differ from other organizations. The main question I ask is: ‘What are the pros and cons of nonprofits, and in what ways do they differ from other organizations?’ Furthermore, I raise three probed further: ‘What are the roles of the nonprofit sector, and why does it play these roles?’ ‘What do nonprofits do when they are not maximizing profit, and which other aims are relevant?’ ‘How does the interior incentive structure function when the organization has other aims than profits, and there are no owners to discipline the management?’ After pointing out my questions, I sketch the organizational map for forprofit, public and nonprofit organizations, before I give a brief introduction to the nonprofit landscape. Thereafter, I investigate the three most common demand approaches to nonprofits; namely the public good approach, the trust approach and the stakeholder approach. In relation to the public good approach, I show how green worker theory could be integrated to the formal model framework. I also suggest an integration of green consumer theory in the trust approach. Further on, I examine three supply approaches; the entrepreneurship approach, the voluntarily failure approach and the organizational behavioral approach. After reviewing the prevailing theories, I continue by discussing the potential problems of moral hazard and rent-seeking, before I display how these can be overcome both with and without behavioral factors, inter alia by my own game of internal control. Towards the end of the thesis, I turn to the financial side of the nonprofits, comprising sources of financing and potential financial rigidity. I discuss the lack of financial flexibility and how the problem can be countered, which is one of the most neglected realms in the prevailing nonprofit literature. I conclude that nonprofits could be the best response to governing and market failures, both on the demand side and the supply side. Moreover, nonprofits seem to achieve comparative advantages contra the forprofits and the public enterprises under certain circumstances, by their combination of inability to distribute profits, political autonomy and social aims; and for some nonprofit organizational designs; their leeway for stakeholder control. These features may inter alia enable nonprofits to attract green workers, provide public goods that cut across political priorities and achieve more trustworthiness in the provision of unverifiable goods. IV Preface In 2008, I got a summer internship at the financial department in the Norwegian administration of the Norwegian business foundation, Det Norske Veritas (DNV). DNV is engaged in various business fields within various energy and maritime sectors. After starting in my new job, I soon got fascinated by what I perceived as a very idealistic and well- functioning organization, albeit the lack of owners to discipline the management. Admittedly, I observed certain perquisites like an extra week holiday for the employees and support to the employees’ environmental initiatives. Yet, I chiefly perceived my colleagues as hard-working with an idealistic affiliation towards the organizational objectives. Allegedly, DNV was not even a wage leader. I even heard stories about employees returning from Aker Solution and Statoil for lower wages, because they felt a stronger belonging to DNV. I continued my engagement at DNV as a financial accountant, mainly during holidays, up the spring of 2010. Gradually, I became more aware of other nonprofits in the society and started to wonder which role they played in the economy. During my studies, I was puzzled by the limitedness of literature on various organizational forms and the absence of behavioral factors within the theory of the firm. It was this absence of literature and the complex characteristics of nonprofits that made me choose nonprofits as the topic of my master thesis. As an ambitious person, both in positive and the negative meaning of the word, I tried to embrace most aspects of the literature, although focusing mainly on nonprofits in the business sector. In context of my thesis, I would like to direct an especially great thank to my supervisor, professor Kjell Arne Brekke, for useful guidance, productive feedback, fruitful discussions – and moreover – a good collaboration during the writing of my thesis. What is more, I would like to thank my good friends Craig Peter Taunton, Endre Kildal Iversen, Marianne Fiedler Rørvik and Tord Kopland Eid for solid proof-reading and encouraging support, all contributing both on academic and linguistic matters. In addition, I would like to thank my second cousin Ragnhild Holmen Waldahl for valuable inputs. Waldahl is a researcher at Nordland Research Institute and is specialized within the interaction of the civil society and the public sector. All inaccuracies and errors in this thesis are mine and mine alone. Rasmus Bøgh Holmen February 2012 V Contents 1 Introduction ........................................................................................................................ 1 2 Categorization of Organizations in the Business Sector .................................................... 5 2.1 Categorization of Forprofit Organizations .................................................................. 6 2.1.1 Basics about the Forprofit .................................................................................... 6 2.1.2 Types of Forprofit Organizations ......................................................................... 6 2.2 Categorization of Public Organizations ....................................................................... 9 2.2.1 Basics about the Public Organizations in the Business Sector ............................. 9 2.2.2 Types of Public Organizations in the Business Sector ....................................... 11 2.3 Categorization of Nonprofit Organizations ............................................................... 14 2.3.1 Weisbrod’s Categorization of Nonprofits .......................................................... 14 2.3.2 Hansmann’s Categorization of Nonprofits ......................................................... 16 2.3.3 Ware’s Categorization of Nonprofits ................................................................. 17 2.3.4 Legal Based Categorization of Third Sector Organizations ............................... 17 3 The Nonprofit Landscape ................................................................................................. 20 3.1 A Glimpse of the Nonprofit Sector’s History ............................................................ 20 3.2 The Modern Nonprofit Landscape ............................................................................ 20 3.3 Norwegian Nonprofits ............................................................................................... 25 3.4 The Future Trends of the Nonprofit Sector ............................................................... 27 4 Theory of Demand for Nonprofits ................................................................................... 28 4.1 The Public Good Approach ....................................................................................... 28 4.1.1 Weisbrod’s Public Good Approach .................................................................... 28 4.1.2 Extensions of Weisbrod’s Public Good Approach ............................................. 30 4.1.3 Schiff and Weisbrod’s Public Good Model Extended ....................................... 31 4.1.4 Critique on Weisbrod’s Public Good Approach ................................................ 40 VI 4.2 The Trust Approach ................................................................................................... 42 4.2.1 Hansmann’s Trust Approach .............................................................................. 42 4.2.2 Extensions of Hansmann’s Trust Approach ....................................................... 43 4.2.3 Holtmann and Ullmann’s Trust Model .............................................................. 45 4.2.4 Green Consumer Theory .................................................................................... 46 4.2.5 Critique on Hansmann’s Trust Approach ........................................................... 47 4.3 The Stakeholder Approach ........................................................................................ 49 4.3.1 Introduction