Managerial decision making in nonprofit organizations

1. Unbounded rationality

Economic analysis of nonprofit organizations primarily assumes unbounded rationality. That is, the models employ optimization tech- niques that propose a specific objective (such as maximizing revenue, budget, or quality of service) and develop implications for nonprofit outcome (typically output, inputs, cost and/or quality levels). These models generally show that nonprofit organizations are inefficient rela- tive to comparable for-profit firms. Alternative outcomes indicate one or more of the following: larger than optimal output and/or budget levels; above minimum cost of production, and in particular, a nonop- timal input mix; and overinvestment in quality of service.

Newhouse (1970) developed a managerial model of a nonprofit deci- sion maker in a hospital. He assumed a utility maximizing manager, where utility depended on income and prestige, both related to quan- tity and quality of output or service provided by the hospital. There is, of course, no minimum profit constraint. The organization must cover its costs, however. Therefore, the nonprofit is constrained to produce where revenue equals cost. His model shows an overinvestment in quality relative to quantity of service provided as compared to what a comparably structured for-profit competitive hospital would produce.

Tullock’s (1971) model of nonprofit decisions is neoclassical in that there is no distinction between the decision maker and the organization. He assumes revenue maximization as the objective of the nonprofit organization and shows that the nonprofit produces greater than opti- mal promotional activities and less than optimal output. His results are based on the additional assumption that the service provided by the nonprofit has no value to donors, and that their only source of satisfac- tion is information on the services that the nonprofit could provide, even if no services are actually provided. That is, misinformation pro- vides satisfaction to donors who will respond with additional donations.

The Tullock revenue maximizing nonprofit therefore puts all of its resources into promotion and none into service provision.

Niskanen (1971) models a nonprofit organization similarly to his approach to modeling a government bureau. Like that model, his model of a nonprofit organization is neoclassical in spirit, for he does not dis- tinguish between the manager and the organization in describing either preferences or behavior. His nonprofit organization (or manager) seeks to maximize revenue (analogous to the bureau’s budget) from the organi- zations’ funding sponsor (analogous to the legislator, who he also refers to as funding sponsor). Not surprisingly, Niskanen’s model of a non- profit organization yields the same results as does his model of a bureau: larger than optimal output compared to what would be produced by a comparable for-profit competitive firm.

Galaskiewicz and Bielefeld (1998) propose that in general nonprofits maximize income. Pauly and Redisch (1973) model a nonprofit hospi- tal as a cooperative of income maximizing physicians. Because of their critical role in the operation of the hospital, the physicians are in the position of choosing their preferred input mix. Thus, physicians in their model of the nonprofit hospital are in the interesting position of hav- ing residual rights (in the form of income) and control rights (choice of inputs), and thus having effective economic property rights. One of the outcomes of their model is that they restrict entry of other physicians, selecting the number that maximizes the physician average product which results in their achieving maximum income. Thus their model predicts an inefficient input mix in the provision of nonprofit hospital services.

Clarkson (1981) examines the nature and effects of institutional con- straints faced by managers of art museums. The constraints he consid- ers are the sources and forms of museum revenue, museum tax status, and the organizational structure of museums. His analysis assumes indi- vidual utility maximization on the part of all actors, including the museum manager and members of the board of directors, for example. He compares the behavior of these decision makers with that which would occur in a comparable for-profit organization which faces differ- ent institutional constraints than those outlined for the museum with nonprofit status. He states that the prediction of inefficient production, that is, higher per unit cost, in the nonprofit museum as compared to a comparable for-profit museum may be ambiguous (p. 42). His general prediction, however, is that the incentives established by the property rights in the nonprofit organizational form promote inefficient decision behavior in nonprofit museums (p. 53). The outcome of his model of nonprofit institutional constraints imposed on utility maximizing board members or trustees and managers is that the resulting decisions in the nonprofit museum, such as for resources allocated to maintain- ing collections, will be inefficient and will not maximize social wealth. James and Rose-Ackerman (1986) also consider alternative revenue sources and tax status in a generalized model of a representative non- profit that is not industry specific. Like Niskanen (1971), their model is neoclassical in spirit, not differentiating between the manager as deci- sion maker and the nonprofit organization as a whole. They assume output maximization on the part of the nonprofit organization or man- ager, subject to a breakeven constraint. Their model demonstrates that the nonprofit under alternative configurations will most likely produce larger than optimal output and higher per unit cost than would occur under comparable conditions with a for-profit firm. One configuration of their model shows the same efficient output as that of a for-profit firm. However, the difference in cost due to tax status changes the resulting organizational mix in the industry, the lower cost (nontaxed) nonprofits replacing the higher cost (taxed) for-profit firms. To obtain this result, their model assumes homogeneous outputs across the for- profit and nonprofit sectors. Their model does not explicitly consider variations in quality between the nonprofit and for-profit organizations or any other form of intersectoral product differentiation.

Borjas, Frech, and Ginsburg (1983) find that nonprofit nursing homes pay higher wages than do either public or for-profit nursing homes. They attribute the differences in wages to differences in property rights structures. They suggest, however, that this might reflect higher quality of inputs in the nonprofit nursing homes, which is consistent with Newhouse (1970) and Weisbrod (1988).

Thus, in economic  models  of  nonprofit  organizations,  the  source of such inefficiencies is derived from the property rights system of no ownership and therefore no monitoring that decision makers face. Clearly, the property rights system applied to nonprofit organizations in these models is directly derived from the nondistribution constraint that specifies that there is no legal residual claimant. Thus, in these models the property rights system in which nonprofit decision makers operate is characterized as one with no owner, that is, no individual or group with residual rights and therefore no individual or group with any interest in monitoring the decision maker. In the context of the usual principal–agent framework, there is no principal (legal residual claimant) to which the agent (nonprofit manager or decision maker) is accountable. The nonprofit decision maker is therefore effectively assigned full economic property rights: control rights plus effective residual rights.

The lack of an effective legal constraint imposed by the absence of a residual claimant permits the nonprofit manager with control rights to employ resources in a way that is subject to only two sources of dis- cipline. One is the presence of competition, via either the output mar- ket for the service being provided, or the input market for managerial services. If no one is assigned residual rights and no one has any inter- est in managerial or organizational performance, it is not clear how these devices serve to discipline the manager, particularly where fees are either not charged or do not cover full cost of service due to subsidies provided, which is frequently the case for nonprofits. Hansmann (1996, p.239), however, suggests that a competitive environment is sufficient to promote efficient managerial behavior. The second source of disci- pline is the legal limit on the ability to appropriate surplus for personal use. This requires monitoring by the government, usually an agency such as the US Internal Revenue Service or a state regulatory agency. The (assumed) minimal discipline of these two sources results in the ineffi- ciencies of the sort found in economic analysis of nonprofit organiza- tions noted above.

The implication of the assumption of complete separation of owner- ship and control and utility maximization on the part of the nonprofit manager is that the lack of accountability permits managers to appro- priate residual returns in forms that increase their own satisfaction. These analyses assume that nonprofit managers engage in unrestrained opportunistic behavior. Appropriation by the manager occurs primarily through attaining prestige and higher community standing, although compensation (income or benefits) may also increase commensurate with these. Any resulting expansion in output and/or quality, or larger staff or capital requirements as in hospitals, for example, serves to increase operating costs to the level of revenue. This is the observable breakeven point of production.

These results are clearly consistent with the legal nondistribution constraint that requires that any residual generated must be reinvested into the organization. Observable increases in the number of services provided or clients served, the quality of those services, or inputs required to provide them also meet this requirement. In these models, the lack of incentive to create a residual that no one can receive thus creates an incentive to permit the pursuit of managerial preferences and the associated inefficiencies that result. The outcome is that the marginal cost of output (or quality or inputs) exceeds the relevant mar- ginal value.5

2. Bounded rationality

Economic analysis of nonprofit organizations has been limited to opti- mization models, that is, models of unbounded rationality. As in firms and bureaus, conditions of bounded rationality exist in nonprofit organizations and affect efficiency of nonprofit outcomes.

Both sponsors who fund nonprofit organizations and nonprofit man- agers are subject to bounded rationality. Donors and grantors know their own preferences but are not in a position to observe and fully understand the production  process  of  the  nonprofit  organization. The nonprofit manager has limited ability to process information on the preferences of multiple types of individuals: funding sponsors, paid employees, volunteers, and clients.

Donors and grantors have goals that they expect will be achieved by the funded nonprofit organization. Their goals are not precise objectives, as stated in models based on unbounded rationality. Their goals may be articulated in a mission statement of a foundation, or in a program description of a bureau that makes grants available. These statements are typically given in a general form, however, sometimes because the goal itself is not well understood, sometimes because the goal may not be one that can be easily summarized or quantified, or because it may be difficult to translate into clear actions (Wolf, 1999). The nonprofit man- ager will be required to interpret this information as well as to interpret the preferences of multiple individual donors.

The nonprofit manager’s problem of bounded rationality with respect to organizational operations and procedures would most likely result in attenuated property rights relative to those funding sponsors. To counter this effect, specific behavioral rules may be developed in the organiza- tion to proscribe the behavior of employees and volunteers so that their behavior (in the way that they use organizational resources) is aligned with managerial preferences. This structural solution is more likely to develop in a large complex nonprofit organization than in smaller non- profits where flexibility and fluidity may promote responsiveness. In the smaller nonprofit organizations employee and volunteer screening by the manager may be an alternative to rules as a means of aligning their interests to those of the manager (Wolf, 1999).

Where nonprofit manager–employee–volunteer preferences are aligned, managerial property rights may be at least as great as the rights of the funding sponsors. Ex ante, with bounded rationality of all parties, managers of nonprofit organizations are likely to have full economic property rights. Ex post, this may not be the case, for if preferences of donors and grantors are not met, even if they are only generally stated, then future funds will be withheld from the nonprofit organizations. Donor-investors may reclaim economic property rights even under con- ditions of bounded  rationality  once  they  have  access  to  information that they can process sufficiently to relate to their aspirations from their donations. As noted in Chapter 5, at the point of managerial decision making, ex ante conditions prevail. Thus, the ability of donor-investors to reclaim economic property rights even when taking action is limited, because any action taken occurs ex post. The interest of nonprofit managers in maintaining reputation as a way to increase or continue funding is important here as well.

The efficiency implications differ ex ante and ex post as well. In the effi- cient market model, the preferences of buyers are articulated through exchanges that reflect their value for the good or service. In the analysis of social welfare, the sum of these values is assumed to be social value. Shubik (1971) has noted the problems associated with the determination of social value through the aggregation of individual values, even in the absence of any market failures, including bounded rationality. With market failures, even assuming that individual buyer preferences are consistent with social preferences, social preferences are not met. The relationship of nonprofit outcomes to social value then depends on the extent to which donor and manager preferences reflect social preferences. If donor preferences are a measure or a reflection of society’s preferences, then the ex post situation is more efficient, although how much more efficient depends on the effectiveness of corrective action taken. For example, where markets fail to provide the socially desired outcome, either in the quantity or quality of services, donor corrective action would increase efficiency if donor preferences are aligned with society’s prefer- ences. If the donor’s preferences are highly individual and conflict with society’s preferences, then the ex ante managerial decision behavior may be more efficient. Even though the donor has the means to advance an agenda, this agenda may not be consistent with social preferences.

Under conditions  of  bounded  rationality,  interpretation  of  social value becomes even more of a problem, for bounded rationality is a form of market failure in the efficient market model. However, the view that bounded rational decision making is a way of economizing on lim- ited resources in the decision process alters this perspective. This issue is examined further in Chapter 12.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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