Contract Failure Theory and Non-Profits [...]

Contract failure theory was first proposed by Henry Hansmann in 1980. It examines what happens in markets where buyers are unable to judge the quality of what they are buying. In such markets, the sellers will be motivated to reduce quality of product to increase profit. According to some theorists, the sort of market failures contract failure theory predicts explain why non-profits are necessary in some industries. [link l=]

As an example, consider a for-profit company — let’s say one owned by stockholders — which serves the needs of the poor in Bangladesh. You donate $1,000 to this for-profit, with the assumption that they will do their best to help the people of Bangladesh.

But there’s a conflict here. The more money that flows to helping the people of Bangladesh, the less money flows to the stockholders. Now if you had a way of evaluating the quality of what the company provided, then the company could become more efficient at helping the poor, and use that efficiency to increase profit through saving money.

The problem is that you don’t have a way to evaluate the quality of the service, so the company is tempted to take the easy way out — increasing profits by reducing quality.

Note that this problem does not exist (at least to this extent) in a normally functioning market. If Samsung wants to increase profits by reducing the quality and features of their phones, you will notice as a buyer and take your business somewhere else.

Contract Failure Theory stipulates that by taking the profit motive of the table, non-profits reduce internal incentives to increase profits by dropping quality

Fundamental to this theory is the idea of the [w l=”Non-Distribution Constraint”] placed on NPOs.

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