In a recent post at Longterm Liberalism, I discussed how the calculation problem applies to the nonprofit sector. While nonprofit organizations purchase factor inputs in markets, they do not sell the goods and services they produce. And as their name suggests, they do not receive profit-and-loss feedback. This lack of feedback means that decision-makers at nonprofits do not know whether they have created value for those they hope to benefit, especially if they hope to benefit people other than their donors and employees.

I’m certainly not the first Austrian school economist to discuss this issue. Peter J. Boettke and David L. Prychitko discussed it in much more detail in an article in Conversations on Philanthropy. As they explain:

“Voluntary nonprofit organizations and associations may, and surely do, purchase or lease inputs on the market, and are therefore guided by prices at that stage, but they don’t price their “product” or service (however they define it). They engage in unilateral transfers, providing a scarce service to others without the exchange of money (or any other commodity, for that matter) in return (Boulding 1981, ch. 1). They do have access to market processes (and, of course, political processes). Being “in” the commons does not imply they are divorced from other social institutions and processes. Yet, although nonprofits can undertake measurements, and, if encouraged, a rational assessment of their outcomes (using both quantitative and qualitative means), they have no way of calculating the realized results against the expected results. Nonprofit organizations and associations cannot, in other words, calculate the residual or monetary value-added of their endeavor, ex ante or ex post. In this sense, nonprofit is a better term for those that don’t price their service or product. There is no calculated monetary profit.”

However, they argue that this inability to calculate need not mean that nonprofit organizations fail in some serious sense. They elaborate extensively on this:

“Nonprofits are not isolated islands of human activity within the voluntary sector—the commons. Like another institution, the family, participants in nonprofits are themselves embedded in the institutional matrix of the market economy. Nonprofits have prices to guide them, particularly when purchasing or leasing inputs. In this way they can coordinate their resource demands with the supplies of resource providers, and they can and do participate in the knowledge-disseminating features of the market process. Although they cannot calculate the value added of their efforts, they can determine whether their specific goals and efforts are worthwhile. Nonprofits have to persuade prospective donors that their effort is worthwhile, of course. Rather than persuade them with the lure or calculated signal of monetary profit, however, they must turn to noncalculative but measurable or assessable means. The lack of economic calculation does not in itself create any impediment to coordination. Likewise, there can be no theoretically sustainable notion of “voluntary failure” such as that proposed by Salamon. The objection might be made, however, that application of a subjective theory of value as proposed here cannot help produce overall efficient allocation of philanthropic resources (or of tax-generated resources for welfare). Here, more broad accomplishment of plan fulfillment must suffice in the necessary absence of some more comprehensive yet undefinable and unattainable standard of social optimality. Even against the Pareto standard, there is little justification for criticizing nonprofit firms as failing in terms of efficiency.

We suggest that the managers of nonprofits, “social entrepreneurs,” and their donors are able to make rational decisions about the effectiveness of their activities even though they cannot calculate the value added in a monetary sense—calculation being, again, a dollar measure of the total costs of their efforts and the total benefits of their efforts, the difference being monetary profit (or loss). We would add that they would have a greater incentive than government officials to assess effectiveness, because unlike Mises’s councilmen they cannot rely upon the power to tax. Instead, they must depend upon the voluntary contributions of their donors. This, of course, is problematic in our society, where many nonprofits often bypass the responsibility of persuasion and voluntary exchange and instead seek support from the state (not unlike many private business enterprises). In this regard, to accept Salamon’s advocacy of third-party government, which in effect seeks to legitimate nonprofit firms as arms of state action, would further weaken the effectiveness of nonprofit organizations by encouraging them to engage more in political rent-seeking than in marketplace persuasion.”

Requiring nonprofits to persuade donors guards against the tendency towards rent-seeking and ensures that nonprofits will at least benefit their donors more than they cost them, nonprofits often claim to be pursuing more high-minded goals. They often purport to improve the lives of individuals who will never donate to the nonprofit organization, nor supply any factor input to it. To learn whether they are succeeding in such high-minded goals, they need some other way of assessing their actions. As Boettke and Prychitko acknowledge:

“In an independent nonprofit sector, actors must rely on the signal of voluntary contributions and construct measures of output to show that desired results are, in fact, being achieved. This is an admittedly difficult project, not only for the real-world participants within this sector but also for theorists striving to explain the coordinating properties of the sector.”

Boettke and Prychitko offer good reasons to reject Lester Salamon’s proposals for government intervention meant to prevent purported “failure” in the nonprofit sector. But the question of how nonprofit decision-makers can best learn and guide their efforts to improve the world is still an open and important one.

The community of “effective altruists” engage in a variety of forms of analysis, contestation, empirical and theoretical work, and discussion to try to discover how to improve the world through philanthropy, research, and other voluntary action. But they’re certainly not the only people engaged in these kinds of projects.

Some nonprofit organizations attempt to construct market-like mechanisms within their organizations to learn more about how to serve others. For example, in the Journal of Economic Perspectives, Canice Prendergast explains how the nonprofit Feeding America “switched from a centralized queuing system, where food banks would wait their turn, to a market-based mechanism where they bid daily on truckloads of food using a ‘fake’ currency called shares.”

Another example of the use of market logic to serve aid recipients more effectively can be seen in the work of GiveDirectly, which offers direct cash transfers to desperately poor recipients. This enables the recipients to buy whatever they value most with the cash, rather than simply receiving whatever decision-makers at a nonprofit think they might need.

Of course, not all decisions made within nonprofits can use quasi-market mechanisms. And we should not pretend that we can design anything that will act as a proxy or replacement for economic calculation. But philanthropists and social entrepreneurs can engage in various forms of social learning as they seek to better help others.

Nathan P. Goodman is a Postdoctoral Fellow in the Department of Economics at New York University. His research interests include defense and peace economics, self-governance, public choice, institutional analysis, and Austrian economics.