Good-Bye Henry Hansmann: HWang and Lund on “Purposeful Enterprise”

It is probably academic blasphemy to assert that Hansmann’s contract failure theory is outdated junk science. But that’s my position and now I’m pretty sure I have academic support for it.  It’s been that at least since the late 1980’s, I was just way too insecure to say so. Hansmann’s theory is based on a donor’s inability to verify whether he got what he “paid” for.  I think its vulgar, or at least cynical, because it assumes away true altruism and replaces it instead with the “rational economic actor” who insists on getting what he pays for, and spends money only when he is assured of verification.  The theory labels donors “consumers” instead.  But donors don’t “pay” and they are not “consumers.”  I think it was bullshit then, its bullshit now. Void ab initio, if  you like.

There, I said it and I feel better.  For me, it’s like discovering that the Wizard of Oz — the contract failure theory, I mean, not Hank necessarily — was never what he was cracked up to be.  Just some authoritative sounding bullshit coming from a loudspeaker behind an Ivy silk screen.  Sorry Hank.

I know the economic actor rationale is ridiculous every time I give spare change to someone claiming they need a meal.  There is a better chance the panhandler needs a drink instead, and yet I still give if I am feeling charitable. I bet a lot of rational people do the same thing.  I really don’t care to verify that the panhandler is spending the money for a meal. Hansmann’s theory is that the nondistribution constraint satisfies my desire for verification and that I would not give without it.  Nonsense.  

Some historians place the start of the information age in the 1970’s so Hansmann’s theory might have been counter-factual  from the outset to the extent it was based on information asymmetry.  My basic objection to the contract failure theory is that it’s way too easy for a donor to verify that her donation went to its intended public purpose.  Even if the public purpose is some good or service dispensed on the other side of the globe.  A donor can monitor, on a macro level at least, whether her donation for disaster relief far far away was actually used for that purpose. Nonprofit spending has been verifiable since the proliferation of personal computers and then cell phones. And that proliferation began when Hansmann was first issuing proclamations from behind his academic silk screen. 

So I agree with two scholars who implicitly, if not explicitly question the continued viability of Hansmann’s explanation for the existence of nonprofit enterprise.  I don’t think they say so, but I would agree if they asserted that his theory was bankrupt from the start.  It sounded good, just like everything the Wizard of Oz said to Dorothy and her fellow travelers.

Here is an extract from an interesting paper by Cathy Hwang and Dorothy S. Lund: 

Why does nonprofit enterprise exist? Fifty years ago, Henry Hansmann proposed the leading economic theory: contract failure. In certain industries—hospitals, nursing homes, and education, for example—consumers cannot easily evaluate or bargain with service producers. For example, consumers often find themselves seeking hospital services during an emergency, making it hard for them to shop around for the best deal. This contract failure is ameliorated when the producer organizes as a nonprofit: the nonprofit form assures the consumer that they are purchasing services from a business that cares about healthcare, for example, rather than one that is primarily motivated by generating profits for shareholders. 

Hansmann’s elegant theory anchors an important literature on nonprofit enterprise. And yet, in the years that followed Hansmann’s article, it has become clear that contract failure is not the whole story. Today, nonprofit enterprise proliferates across a broad spectrum of industries, beyond those with severe consumer information asymmetries. Indeed, nonprofits successfully run clothing manufacturers, insurance companies, beer breweries, candy manufacturers, furniture makers, and more—that is, industries where consumers can easily evaluate goods and services.

Moreover, changes in the information environment undermine the existence of contract failure in Hansmann’s paradigmatic examples. Consider higher education. Hansmann theorized that parents sending their children to college might not be able to evaluate such a “complex and subtle service,” preferring to rely on nonprofits as an indication of quality. Of course, modern college rankings and college advisory services offer detailed descriptions of colleges, and therefore, it is difficult to attribute the success of nonprofit colleges to contract failure alone. This Article therefore offers a new “purposeful enterprise” theory to explain the existence and persistence of nonprofit enterprise. This theory posits that corporate purpose can play an important role in both the selection of the nonprofit form at the outset and the success of the entity over time.

Our theory also explains how nonprofit enterprise can flourish despite departing substantially from “good governance” practices thought to be responsive to the central problem in corporate law and governance—that of managerial agency costs. Agency costs are inherent in many business entities—when the owners of an entity are not the managers of the business, managers have an incentive to behave self-interestedly and to the detriment of the business. A complex corporate governance machine has risen to combat agency costs in for-profit business, with shareholder monitoring and control at its core.

Through the power to elect directors, make shareholder proposals, and review books and records (among others rights),  shareholder monitoring and control is thought to ameliorate managerial agency costs. An enduring puzzle of the nonprofit form is that nonprofits are, by definition, entities without shareholders. As such, they should suffer from pronounced agency costs. Without shareholder monitoring, who will monitor management and ensure that they pursue the organization’s mission and not extract undue private benefits? And yet, nonprofit enterprises not only exist, but thrive. Certain industries—such as hospitals and higher education—are dominated by nonprofit businesses, which outcompete their for-profit rivals.27 Other industries, including technology,28 retail trade, 29 and pharmaceuticals, are seeing more and more productive activity conducted by nonprofits. What explains this expansion and success? 

Our theory provides an answer. We argue that nonprofit enterprises can harness corporate purpose as a substitute for shareholder monitoring and intervention rights, mitigating agency costs in the process. In particular, we draw on insights from behavioral economics and organizational science to describe how an authentically communicated purpose can provide direction for management, serve as a powerful source of motivation across the organization, and empower stakeholders as enforcers. Indeed, because authenticity of purpose depends on the sacrifice of profits, nonprofits have a head start relative to for-profit enterprise because of their non-distribution constraint. We further explain how purposeful enterprise can generate organizational efficiencies by increasing the resilience and stability of the organization over time, by eliminating an expensive stakeholder with powerful control rights that may undermine the organization’s mission. 

darryll k. jones