Should we pay nonprofit workers as much as for-profit workers?

 

Charity payThis blog post will tackle the perhaps controversial topic of whether those who work in the nonprofit sector should receive the same remuneration as their counterparts in for-profit roles. My short answer is no – that to some extent those who work in nonprofit roles should in fact be paid less than those in for-profit roles. However, what I hope to do is systematically lay out why the existing gap is far too large – in fact, so large that it not only penalises those who work in these roles and those disadvantaged members of our society who rely on the work of the nonprofit sector, but also that it traps the sector in a self-reinforcing cycle of underfunding and lower social impact.

Firstly, let’s tackle the question of whether or not the earnings of those in the nonprofit sector should be less than those in the for-profit sector. In economics there’s a concept known as ‘motivated agents’. In contrast to early classical economics, this theory argues that financial compensation is not the only force that drives people to work, and that there are situations in which people are in fact rewarded by the very nature of the work they do. Entrepreneurs, artists, and those who work in nonprofits are all classic examples of this. Suppose, for argument’s sake, that in the for-profit sector my work is worth $50 an hour (assume that I am willing to work for this rate, and that I get zero additional satisfaction from the job itself). Now suppose that I have an alternative job available to me in the non-profit sector that offers me $25 an hour. Should I take this job? Well it depends. Say I’m a ‘motivated agent’, and that working in a job that contributes directly to positive social outcomes is equivalent to $30 an hour to me in financial gain. Then yes, I should, because the non-profit job is effectively offering me the equivalent of $55 an hour in remuneration. So long as such people exist, the non-profit sector is able to compete in the labour market for the same pool of talent while offering lower financial remuneration. And it absolutely should make use of this fact – in the same way that for-profit firms want to keep labour costs down in order to maximise profits, the nonprofit sector should want to keep labour costs down in order to maximise the social impact it is able to generate with each dollar of donations.

Now let’s suppose our model nonprofit sector needs two employees (to keep it very simple, imagine it’s just one firm), and suppose it continues to offer $25 an hour. For argument’s sake suppose that there are three potential employees in the labour market. I can earn $50 an hour in the for-profit sector and value work in the nonprofit sector at $30 an hour, while Person X can also earn $50 per hour in the for-profit sector and values work in the nonprofit sector at $24 an hour. Person Y, however, is half as productive as myself and Person X, and so can only earn $25 in the for-profit sector; suppose that they receive no value from working the non-profit sector. In this situation, myself and Person Y take jobs in the non-profit sector, and Person X does not.

Can you see what the problem with this situation is? Let’s assume that an employee’s productivity in the for-profit sector is the same as their productivity in the nonprofit sector. Suppose myself and Person X produce 100 units of social impact per hour of work in the nonprofit sector, which implies Person Y produces 50 units of social impact. When the nonprofit sector offers a rate of $25 an hour (with a total labour cost of $50 per hour), it therefore is able to produce 150 units of social impact (this translates to 3 units of social impact for every dollar spent). If, however, the nonprofit sector had offered a rate of $26 per hour, it would have employed myself and Person X and been able to produce 200 units of social impact for a total labour cost of $52 (corresponding to roughly 4 units of social impact per dollar spent). Because this model nonprofit sector has underspent on labour, half of its workforce is competent motivated agents, while the other half are simply incompetent workers who could never have earned a higher rate in the for-profit sector anyway. By offering a greater wage the nonprofit sector would have been able to effectively compete for talented workers and ultimately achieve a greater social impact per dollar spent.

I’ve used this example, while obviously extremely simplified, to demonstrate the following logic: while the nonprofit sector should be able to pay below the market rate due to the presence of motivated agents, if it pays too little the result is a mixture of motivated agents and less competent staff, which in turn depresses the per dollar social impact of the sector

So why wouldn’t the nonprofit sector just increase wages, assuming they are rational? Unfortunately, I don’t think it’s all that easy. People give to the nonprofit sector because they value positive social outcomes (if you want more of an exploration of this issue, have a read of the other posts on my blog on this topic). In effect, then, people are ‘buying’ social impact from the nonprofit sector. If a product is lower quality, you pay less. If the nonprofit sector is not able to generate as much social impact, it receives less donations. It is therefore able to offer less financial remuneration to its staff, which in turn maintains a lower social impact from the sector. This trap is reinforced by two facts: firstly, it can be difficult for the average donor to tell when a charity has increased its social impact; secondly, donors have historically expected remuneration to be quite low in the nonprofit sector (probably because of the role that the church, which produces many highly motivated agents, played in the initial formation of the sector).

Even the most cursory glance at the numbers suggests that the nonprofit sector on the whole simply does not compete for the same talent pool as the for-profit sector. In his TED talk (which I highly recommend), social entrepreneur Dan Pallotta observes that 10 years after business school the median remuneration for a Stanford MBA graduate is $400,000. At the same time, the median remuneration for the CEO of a hunger charity in the US is roughly $80,000. Such charities would only be able to compete for those minds if there was a sufficiently large number of MBA grads that valued social impact against financial remuneration at a ratio greater than 4:1, which seems extremely unlikely. Instead, our best management minds go on to the for-profit sector.

Somehow, we as a society are okay with people making a lot of money for themselves and doing nothing to help the disadvantaged (or advancing causes such as environmental protection or cures for cancer), while those who earn a competitive salary doing good are seen as social parasites – to me, this seems very backwards. It is worth keeping this in mind next time you hear yourself or someone else complaining about the ‘administrative expenses’ of charities, rather than working out where your money can do the most good.

Competing charities – what does that mean, and when is it a problem?

I wrote a post on this blog a couple of months back now that tackled some of the myths and misunderstandings about the charity sector that I frequently came across while researching for my honours thesis. As a kind of sequel to that post I decided it would be a good idea to delve a bit deeper into the notion of competition between charities. If you haven’t already, I would strongly recommend reading this post in conjunction with my previous post on the charity sector.

I’m a big believer in always having a ‘first principles’ understanding of an issue –  that is, starting at a kind of logical ground zero. The human brain is very good at taking short cuts – or, more technically, using ‘heuristics’ – to try to reach an understanding of something. The best way to get around this is to start at square one.

So, what is square one here? I think the first question that needs to be asked when we’re trying to understand the nature and desirability of competition between charities is to understand why we would want more than one charity for any given cause (something that I touched on briefly in my earlier post). For instance, what’s the benefit of having Oxfam if we already have World Vision? There are, of course, many different reasons why we may have more than one charity. If we stick with the previous example then, for starters, Oxfam and World Vision were founded in separate countries in a period where communication and the flow of resources was notably less globalised than it is today. Indeed, it’s not hard to think of lots of reasons why multiple charities may form. We have religious charities and we have secular charities. We have ‘branded’ charities (for instance, celebrity charities) and we have charities established to focus on a certain niche area that particularly concerns their founders. And so on.

But why we would have many charities is not the same question as why we would want many charities. (The first question is definitely interesting from a regulation perspective, but not so important here). The first proposition I’d like to make is that having multiple charities increases the efficiency of the ‘production’ of charity (if you’ll let me use that terminology). There’s a phrase in economics called ‘X-inefficiency’. The phrase was basically developed to explain the fact that companies just don’t operate as efficiently as economists’ models expect them to. Businesses are complex entities made up of complex people whose incentives are rarely exactly the same as the companies they work for. This is as true for the charity sector as it is for the private sector. But here’s the important point: in the private sector, competition for dollars forces firms to stamp out X-inefficiency, or else risk losing customers to competitors who can deliver the same things more cheaply or at a higher standard. This logic carries across to the charity sector. Oxfam cannot afford to consistently operate less efficiently than World Vision, or whatever other development NGO prospective donors weigh them against, because donors would sooner or later realise that every dollar they give Oxfam delivers less results in the cause they care about than if they were to allocate that dollar to another charity. (Quick aside – obviously none of this should be taken as an assessment of the relative merit of these charities/causes). Of course, the diffusion of this information may take a bit longer in the charity sector as ‘social impact’ is a more opaque concept than price. But the logical foundation is the same.

Wait a second. Charities don’t actually compete that way, right? Don’t they compete using fundraising? This was a comment I got from many people in response to my previous blog post on charities, and I can definitely understand where they are coming from. But I think there’s a deeper conceptual layer here that needs to be properly understood. I don’t buy a particular brand of clothes because of their marketing campaign. Instead, I buy that brand because the marketing campaign has convinced me that the product looks better/feels better/is better/is cheaper/whatever. Again, the logic is the same for charities. Oxfam’s advertising campaign is intended to convince me that giving to Oxfam is the best use of my discretionary dollar. The fundraising effort is ultimately just a mode of communication – the actual competition is occurring at a deeper level.

The potential social benefit of fundraising is that it fosters competition between charities – ultimately, it is difficult for a charity to consistently persuade people that it does the best work if that’s clearly not the case. By definition, then, fundraising is socially beneficial if the increased value it produces through improved efficiency exceeds the cost of fundraising. At an aggregate level, I think this is a very low bar which is easily met, and probably well exceeded, by what we actually observe from the fundraising activities of charities.

In fact, I think I’m of the view that the charity sector should probably spend substantially more than it presently does on fundraising (though there’s been no empirical study of this to date, so it’s just a hunch). This is only in part because of the benefits I just mentioned in terms of increased competition. The other really important point to make is that a charity is not just competing for some fixed pie of total charitable donations. Certainly, some people have a fixed giving budget each year, but this is neither indicative at an aggregate level nor is it constant over the longer-term. Rather, when you think about it, the charity sector as a whole is actually competing for a slice of total discretionary spending in the economy. When I decide how much of my money to allocate towards charitable giving I am weighing up how much ‘utility’ (economics jargon for something like happiness or satisfaction) I expect I will get from giving to my preferred causes against how much utility I will get from spending my money on other stuff. My expectation of the relative utility I will get from these different destinations for my money is strongly connected to the messaging I have been exposed to, which includes marketing from the charity sector. In other words, World Vision is not just competing with Oxfam, but it’s actually also competing with Myer, Apple, JB Hi-Fi, and the numerous other companies who want to trade you your money for some purported increase in your happiness.

In my own experience, giving $100 away to a cause I care about brings me far more joy and lasting satisfaction than buying a new pair of jeans. Perhaps money can buy some measure of happiness – you just have to find the right cause.

Charities – the good, the bad, and the frequently misunderstood

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There was a popular TED talk doing the Facebook rounds last year by Dan Pallotta entitled ‘The way we think about charity is dead wrong’. Essentially, Pallotta, a veteran social entrepreneur, was presenting an argument that the modern nonprofit sector is severely constrained by the way society expects charitable organisations to operate. These preconceptions we hold, Pallotta argued, are often not based on careful thought, which leads to problematic outcomes for those trying to make a meaningful difference in the world.

The nature of the ‘charity market’ (if you’ll excuse that terminology) is a topic that has interested me for a number of years now. In fact, this was the topic of my recently completed economics thesis. For the last couple of months, I think I would have imploded if I had so much as thought about charities – I’m sure anyone who has written a thesis can relate to the feeling. Nevertheless, after a bit of a vacation from the topic, I thought it would be worthwhile to pen the observations and conclusions that arose from my research. Of course, as an economics thesis, what I wrote was about 90% mathematics (the other 10% being jargon). For those that are interested in the original thesis, I am happy to pass it on. Here, however, I offer a translation (to the best of my ability). To make it easily digestible, I have broken it down into a series of seven remarks.

Remark 1: Charities are far more important to our economy than you realise.

In the United States, the nonprofit sector represents a larger portion of GDP (an economy’s annual output) than agriculture. Here in Australia, the nonprofit sector is larger than agriculture, communications, and defence. I found this to be a particularly startling fact. Far from being a minor anomaly in the modern economy, the charity sector is actually a major employer and a major service provider for the most economically marginalized members of our local and global communities. I was quite taken aback by how little previous research there had been into the operation of the charity sector within the economics discipline. My suspicion is that many economists have not fully grasped the importance of nonprofit organisations (from a purely economic perspective, that is). With this in mind, it is perhaps less surprising that so little attention has been given to the question of what is desirable (or ‘efficient’) and what is undesirable (‘inefficient’) in terms of the activities of our charities.

Remark 2: When someone says to you “Charity X will spend Y% of your donation on fundraising”, they’re not quite on the money.

We have probably all heard someone say something like this in the past, and, if you’re guilty yourself, don’t be embarrassed – it seems to be a pretty common argument that’s based on a genuine concern. However, it also involves a formal logical error. In the economics jargon, it involves mistakenly conflating ‘marginal cost’ and ‘average cost’. In English, when I give a charity $100, it doesn’t matter how much was spent by that charity to get that $100 – that money has been spent, it’s gone! What matters is how the charity then goes and spends that $100 you have given it. You might find it helpful to think about it like a production line. In order for a charity to ‘produce’ $100 in donations, it needs to spend some money on fundraising (charities don’t just spend money on advertising for kicks – they do it because they need to generate money to fund their charitable activities).

(A more difficult question is whether the charity sector as a whole spends too much on fundraising as a result of competition for donations. For various reasons, this one is actually surprisingly complex, so I won’t tackle it in this blog post, though you’re welcome to send me an email if you’re really interested.)

Remark 3: When someone says to you “Charity X will spend Y% of your donation on administrative expenses”, your response should be “So what?”.

This is probably the most common misunderstanding when it comes to what is desirable and what is undesirable in our charity sector. Again, people raise this concern with the best of intentions, but again the thought process is not logically correct. Or, more accurately, it would be logically sound if every charity was producing a unit of ‘social impact’ in their respective area for exactly the same cost. What the hell does that mean? Consider this: a charity is not like a distribution company. They don’t take your dollar, carry it across the world, and give it someone who needs it. Rather, what they do is they take your dollar and use some kind of program to try and get the most social impact from it. A poverty alleviation charity takes your dollar and invests in clean water, education, or microfinance programs. A cancer research charity takes your dollar and hunts down the most promising line of research that seems to be presently underfunded. However, different charities have different strategies that cost different amounts. The real question, then, is not how much of the charitable dollar is going to ‘administration’ (which is a very poorly defined term anyway). Some programs are very complex to implement, and therefore have a large staff requirement, but their potential social impact can be very large too. Instead, the question should be, colloquially, how much bang do I get for my buck. That is, where will my dollar have the most impact.

Interestingly, the administrative expenses criticism is one that is often leveled at larger charities. However, perhaps surprisingly, all the empirical evidence to date indicates that larger charities actually have a lower administrative expenses ratio. That is, there are cost benefits to being a large charity (in the economics jargon, ‘increasing returns to scale’). Nonetheless, as I have noted above, this doesn’t mean that the actual per dollar impact of these charities is necessarily higher or lower.

Remark 4: Having multiple charities is a good thing.

One of the main issues I was interested in for my thesis was whether or not we actually need many charities. After all, if larger charities are more efficient, why not just have one super monopoly charity fighting poverty alleviation, one fighting homelessness, and so on. Of course, this is not what we observe in reality. In basically any charitable field you can think of there will be multiple charities operating. The answer is actually fairly simple: in the same way that having many firms in the for-profit sector encourages efficiency, having multiple charities competing for donations forces each charity to try and be the best. When I can choose between two nearly identical poverty alleviation charities, I will choose the one that is having the greatest impact. This forces both charities to compete by vying for the greatest social impact, lest they fail to maintain their donor base.

Remark 5: But we probably have too many charities already.

Great, so I should go and start my own charity to make the charity sector even more efficient, right? Probably not. I say ‘probably’ because there’s no available empirical data on this issue, and because there are theoretical exceptions anyway. Still, if you make a couple of basic assumptions (which I won’t go into here) the theory suggests that more than two charities competing over the same donor would be superfluous, and indeed cost-inefficient. And it’s not hard to think of two charities for pretty much every charitable cause. Moreover, there are charities that are formed for the wrong reasons (for instance, vanity, or, in the economics jargon, ‘ego rents’), which means it’s quite probable that we already have more charities than we need, unfortunately.

The exception, of course, is when you have a particularly unique method that you’re wanting to employ, or if you believe you will be particularly good at getting donations from people (e.g. you’re a celebrity). Otherwise, you’re almost certainly going to have more of an impact by donating to an existing charity and keeping your day job.

Remark 6: Donors are not like shareholders. They’re more like customers.

Often donors feel as though their contribution should buy them the right to tell a charity how to operate. This is kind of like me feeling like I have the right to tell Apple how to make their products because I choose to buy them. Charities do not have shareholders. Instead, charities have missions. To eradicate Malaria, AIDS, or Polio. To end absolute poverty. To fight for Americans’ right to own guns (yep, the NRA is a charity…). As a donor, you choose to give money to a charity because you actually benefit from the work they do in a roundabout sort of way. I want to live in a world in which children do not have their physical development stunted by malnutrition; I want to live in a world in which nobody suffers from diseases that are curable. These are my preferences, analogous to my preference for Verdelho over Semillon. Of course, these preferences are more fundamental to who I am as a person. But the point remains: I choose to give to a particular charity because I believe that doing so will help bring about the world I want to live in, and I believe that the particular charity I’m giving to is able to deliver the biggest social impact with my contribution. In the same way that a discerning customer must choose between multiple different products, a discerning donor must find the best charity to give their money to. The only difference is that the stakes are much, much higher.

Remark 7: Charities don’t already receive enough money.

As most of us see it, the work of making our world a better, kinder, and more sustainable one is already being done, and will continue to be done whether or not we give. The problem, however, is precisely that this is how most of us see it. We free ride off the donations of others, and tell ourselves that only the very rich need give a nontrivial portion of their income away. The irony, of course, is that we are the very rich, and if we don’t give abundantly, there’s no reason to expect that others will. The question that we have to ask ourselves, then, is what kind of world would we like to live in, and what are we willing to pay to make that world a reality. If you just try to take this ‘free riding’ element out of the equation for a moment, you may notice that living in a world that is free of abject hardship is far more important to you than many of the things that you allocate your money towards.

Somebody once told me that the answer to the question ‘How much should I give?’ is always the same: ‘More’.