Why do some nonprofit organizations get so expensive?
Papers that changed how I see things: a series
(Conceptual design (about which I have questions) for Vancouver’s new art gallery, which is getting very expensive indeed).
Joseph Newhouse’s “Toward a Theory of Nonprofit Institutions” was published in the American Economic Review in 1970, back in the day when a decent senior undergraduate in economics could still read papers in the AER. He uses hospitals as his case study, but it applies very well to colleges, and I always included it in my arts administration org theory class, since it nicely explains a lot that goes on in the high arts. It explains how budgets get so large, and why those budgets are devoted to the “production values” of what goes on rather than to expanding access. I was writing about opera yesterday, and Newhouse helps explain in part why it is so expensive (it is not all about “cost disease”).
To begin: what is a nonprofit? The key to this organizational form is not that it cannot earn a profit - many rich nonprofits turn a surplus every year - but rather that it cannot distribute the profit to owners in the form of dividends or shares. There are no owners, and so any surpluses must be retained in the organization, either as current or future spending. In his influential “The Role of Nonprofit Enterprise”, Henry Hansmann says this “nondistribution constraint” is the defining feature of nonprofits, and it enables the firm to gain the trust of clients and customers, and, importantly donors: we are willing to give to an organization when we know that what we give is not going to further the income of the proprietor, but that it must be used somehow within the firm. Yes, we get an income tax break for our donations, but nonprofits in the US, including in the arts, predate the introduction of the income tax; the tax system encourages donations, but donations would still exist (if to a lesser degree) without the tax breaks.
Some organizations can only exist as nonprofits because they need those donations. A commercial opera company can price discriminate on its seats, to try to get more money out of people with a lot of money who really like opera, while still rounding out the house with cheap seats, but this will only take you so far. If some millionaires [I can still use this word to describe a rich person?] think having an opera in town is worth a few thousand dollars a year to them, you can’t just offer a row of seats worth eight hundred dollars each when the row behind is seventy-five dollars - no-one will buy the expensive seats. But philanthropy can work; price discriminate on seats and extras as you will, but also encourage giving. For some nonprofits, this is the only possible way to cover even basic costs. If you were an entrepreneur wanting to start a theatre company in a mid-sized city, you would almost certainly chose the nonprofit organizational form - going commercial will leave you struggling for revenue.
All right, back to Newhouse. He is thinking about hospitals, but I will include colleges and arts organizations as well. What all these types of nonprofits have in common (that they don’t have with, say, a nonprofit food bank), is that they all rely on high-priced, highly-trained, specialized talent to make the place work: doctors, professors, curators and musicians. What we know about this type of professional are (1) they like to have a say in how the organization makes its programming choices, and (2) they care a lot about the quality and prestige of the organization within their field. They want to work alongside the best, they want to be known to be at a top-ranked place.
Two things about quality and prestige: first, it doesn’t come cheaply - you need to invest in attracting the best new hires, and you need all the capital equipment and bells and whistles to go along with it. Second, the world, to a point, will be willing to pay more for high quality; this applies to direct users (students (i.e. their parents); opera-goers) as well as to private and foundation philanthropists. It also costs money to serve more people, and so there is a trade-off. But the professional staff cares about quality a lot (wealthy colleges don’t have many faculty meetings where people ask “right, what can we do to accommodate greater student numbers?”).
Profit, remember, is not a motive for anybody. So the outcome in the end becomes: what is the highest quality level we can possibly be that is still economically feasible?
So, in 2014 the Metropolitan Opera spent $169,000 so it could have a cool-looking poppy field for a production of Prince Igor. I’m sure it looked great. But if some stick-in-the-mud economist were to ask “is this a good idea?” the response would be “well, why not? What else are we going to use our money for?”
The upshot: art museums will invest in any capital project that might have the outcome of increasing the prestige of the place, so long as it is possible (even if risky) given the increased donations and future membership fees that will fund it. If students and donors will pay more to a “higher-ranked” college, then invest all you can in boosting that ranking. Mid-sized regional colleges that could do a grand job of providing affordable higher ed to the locals seek to build their research capabilities, even when the social payoff to such an emphasis is far from clear. We invest huge amounts of funds in a Cadillac1 health care system - this Canadian was taken aback at the opulence of American doctors offices and facilities when he first moved here - with the trade-off of still leaving many Americans with inadequate access.
Newhouse, with a fairly simple model, gives a warning: nonprofits that rely heavily on specialized talent will be biased towards increasing the quality and prestige of the firm over increasing access and numbers served, and extra resources that come available will go disproportionately to quality and prestige, where by “disproportionately” I mean “not what a disinterested observer might advise in terms of overall social benefit”.
He meant “Lexus” but he ain’t know it