Sector Failure

Written by Manal Issa

Definition

Sector failure refers to the “three-failure” theories: market failure, government failure and voluntary failure. It addresses the existence and roles of nonprofit organizations in a mixed economy of a three sector society - government, for-profit and nonprofit. The three-failure theories focus on the economic efficiency of nonprofit organizations, when the market and government sectors are expected to fail in providing public goods and responding to the diverse demands of the communities (Ott & Dicke 2016). This creates the opportunity for nonprofit organizations to take on additional roles. In cases of voluntary failure, the market and government sectors take roles in providing services and responding to public needs (Powell & Steinberg 2006).

Historic Roots

The nonprofit sector in the United States started to grow and enhance its role in the 1970's. Prior to that, it consisted of traditional charities, depending substantially on philanthropic contributions. Although these charities were active in different industries, their roles were not clear (Hansmann 1987). Economists saw them in isolation; they did not consider their roles in market economies (Powell & Steinberg 2006). In the late 1960's, nonprofit organizations started to be noticed as a sector when the health industry was growing, and nonprofits could make profit off of  patients’ bills, which brought focus to the economic model of nonprofits (Hansmann 1987). In 1975, Burton Weisbrod examined the roles of nonprofit organizations, by classifying the work of for-profits and the government, and then identifying roles for nonprofits. He found nonprofit roles exist when the other two sectors “fail”. He articulated “market failure” and “government failure” theories (Hansmann 1987). In 1987, Lester Salamon analyzed nonprofit virtues and set roles for market and government sectors when nonprofits are expected to fail (Salamon 2016). He articulated the “voluntary failure” theory. The three theories emphasized the interaction among the three sectors from an economic perspective, focusing on efficiency and identifying the role of nonprofits as part of market economies.

Importance

Understanding the roles of the nonprofit sector from an economic perspective enabled scholars and researchers to study further ways to improve these roles and enhance contributions to respond to citizens’ demands and solve social problems. It is through the combination of theory, policy, and action that a strong nonprofit sector came into reality. The nonprofit sector in the United States became very active and grew over the last century. It employed over 11 million people in 2012 (U.S. Bureau 2014) and according to Giving USA in 2016, giving to the sector grew to 390 billion dollars (Giving USA 2017).  

The nonprofit and government sectors complement each other. The government supports nonprofits by providing funding and regulations to the sector. It also relies on nonprofits to achieve the government’s purpose, particularly in enhancing democratic values and practices. The sector failure theories do not assume preference or priority of one sector over the others. It organizes the three sectors in a circuit, where each sector reacts to the failures of the other sectors. However, Salamon put nonprofits as the first sector, considering nonprofit organizations as the first actor responding to natural disasters (Powell & Steinberg 2006).

Ties to the Philanthropic Sector

The “market failure” theory provides an understanding of nonprofit roles from a sector failure perspective. It analyzes the role of the market, as it functions well in providing private goods for individuals’ consumption, such as food and clothes. However, it is inefficient in responding to demands for collective or public goods, where public goods are referred to as the type of goods people consume collectively, such as clean air and safe neighborhoods. Once public goods are produced, they are consumed by everybody without paying. For-profit organizations do not produce pure public goods without consumers paying for them. Government is also limited in providing public goods, especially in diverse ethnic and religious communities with diverse priorities. In such situations, nonprofit organizations respond to demands of groups and individuals, and the government provides the space for voluntary participation in order to produce the needed goods by the majority of each group (Salamon 2016).

When the government fails to provide some products and services efficiently, nonprofit organizations fill the gap and offer public goods in demand. This role of nonprofits is articulated in the “government failure” theory. The theory highlights how the government responds only to the demands of homogeneous groups and the median voter, leaving other demands of different groups unmet (Anheier 2014). Median voters are the electorate of the government. The government cannot satisfy all citizens’ demands, specifically those of diverse religious, ethnic, and social groups. Thus, the unsatisfied groups move into community solutions, acting through nonprofit organizations to meet these demands (Powell & Steinberg 2006).

Even though nonprofit organizations appear to be filling the gaps and responding to demands when the market and government fail, nonprofits also fail and are limited in taking on roles. In 1987, Lester Salamon analyzed the nonprofit virtues and set roles for market and government sectors when nonprofits are expected to fail (Salamon 2016). He articulated the “voluntary failure” theory, which identified four reasons as sources of voluntary failure. First, philanthropic insufficiency is when resources available for nonprofits are insufficient to meet citizens’ demands. Second, philanthropic particularism is when nonprofit organizations focus on specific demands for ethnic, religious, geographic, and ideological groups, duplicating efforts in some cases and neglecting other demands. Third, philanthropic paternalism is when nonprofits rely on philanthropic contributions and volunteers. They are governed by the interests of the contributors among donors and volunteers who decide on their own priorities, rather than having the beneficiaries setting these priorities. Fourth, philanthropic amateurism is embodied in nonprofits’ reliance on volunteers who lack professional credentials and specialized knowledge in certain areas of action (Powell & Steinberg 2006).

Key Related Ideas

• Contract Failure Theory: a variation to the three-failure theories developed in 1980 by Henry Hansmann. He studied a specific aspect of the general “market failure” and focused on conditions when for-profit organizations fail to provide specific goods due to competition and to consumers’ fear of being cheated (Young 2016). This is true especially when consumers cannot decide on the quality and quantity of the goods and services they are receiving, such as daycare of young children and nursing homes. Consumers trust that nonprofits will provide these services more efficiently, specifically because there is no profit produced in return of their services (Hansmann 1987).
• Criticisms of the Three Failure Theories: criticism focuses on the economic approach of these theories towards nonprofit organizations with an emphasis on efficiency, while nonprofits have other values to bring to society. Nonprofits enhance different values among the communities they serve, which was ignored by the “three-failure theories”. These values include: trust, charity, and compassion (Ott & Dicke 2016).

Important People Related to the Topic

• Henry Hansmann (born in 1945) articulated the “contract failure” theory in 1980.
• Lester M. Salamon (born in 1943) articulated the “voluntary failure” theory in 1987.
• Burton Weisbrod (born in 1931) set the grounds for “government failure” theory and “market failure” theory in 1975.

Reflection Question

What is the most pressing need for youth in your community, and how can the three sectors (nonprofit, for-profit, and government) collaborate to solve it?

Bibliography

• Anheier, H.K. (2014). Nonprofit Organizations theory, management, policy. New York: Routledge.
• Giving USA. Giving USA 2017. https://givingusa.org/tag/giving-usa-2017/
• Hansmann, Henry  (1987). Economic theories of nonprofit organization. The nonprofit sector: A research handbook. Edited by Walter W. Powell and Richard Steinberg, 27-42. New Haven, CT: Yale University Press.
• Ott, J. S. & Dicke, L.A. (2016). The Nature of the Nonprofit Sector, 3rd Ed.  Boulder: Westview Press.
• Powell, W. W. & Steinberg, R. (2006). The Nonprofit Sector: A Research Handbook. New Haven: Yale University Press.
• Salamon, L. M.  (2016). Market Failure. The Nature of the Nonprofit Sector, 3rd Ed.  Edited by Ott, J. Steven, and Lisa A. Dicke, 119-120. Boulder: Westview Press.
• Young, R.D. (2016) Contract Failure Theory. The Nature of the Nonprofit Sector, 3rd Ed.  Edited by Ott, J. Steven, and Lisa A. Dicke, 121-125. Boulder: Westview Press.
• US Bureau of Labor Statistics. Nonprofits account for 11.4 million jobs, 10.3 percent of all private sector employment. https://www.bls.gov/opub/ted/2014/ted_20141021.htm