1.3 Economic explanations

At a glance

About 30 minutes, including a 10-minute reading. By the end of this lesson you will be able to

• explain what theories of the nonprofit sector are for

• describe five economic explanations of why nonprofits exist

• match a theory to a real case and judge its limits

Lesson 1.2 helped us decide which organizations to include; we can now ask why they exist. Imagine five situations: a village has no clinic, a family cannot judge the quality of a care home, a charity cannot meet growing need, a founder chooses mission over profit, and a government pays an NGO to deliver a public service. Each situation directs attention to a different mechanism.

What theories do

Theories of the nonprofit sector do three jobs. Some explain why nonprofits come into being. Some describe the roles nonprofits play, however they started. Others justify the sector, arguing for what it should be and why a society benefits from it. As you meet each theory, ask which of these jobs it is doing.

Five economic explanations

The five explanations are easiest to distinguish by following the problem each one tries to solve.

Market and government failure

Markets work well where there is profit to be made, and many things people need, such as food security, housing or mental health support, may not pay. Governments provide basic services, yet these tend to suit the average voter. A rural village, an ethnic minority or a religious community may have needs that mainstream programs miss. Burton Weisbrod (1977) argued that nonprofits emerge in these gaps because they are well placed to offer mission-driven services for particular communities.

Contract failure

Why might you choose a nonprofit care home, or donate to a charity instead of a for-profit relief provider? Henry Hansmann (1980) pointed to trust. When you cannot easily check quality, as with elder care, a child's education or how a donation is spent, a for-profit provider may be tempted to cut corners. Nonprofits cannot distribute profits to owners, which gives people more confidence that they will not exploit that information gap.

Voluntary failure

Lester Salamon turned the question around and asked why governments get involved at all. In his account, voluntary groups often respond first, and governments step in when their limits show. He named four limits. Insufficiency means too few resources for growing needs. Particularism means serving only some groups. Paternalism means donors' priorities outweigh community needs. Amateurism means lacking trained staff and systems. In many countries, religious and charitable groups built the first schools and hospitals, and governments later took on a larger role to ensure fairness and quality.

Supply-side theory

Even where demand exists, someone has to build the organization. Dennis Young (1983) showed that some entrepreneurs choose the nonprofit form because it fits their values, their mission or their wish to work outside bureaucracy. Estelle James and Helmut Anheier found that religious and ideological movements often stand behind large nonprofit sectors, as with faith-based schools and health services in many parts of the world.

Interdependence

Salamon (1987) also argued that failure theories overlook how often governments and nonprofits work together. Governments fund nonprofits to deliver services, a pattern he called "third-party government", because nonprofits can be more flexible, cheaper and closer to particular communities. Much of Europe's welfare provision works this way, and in many lower-income countries NGOs deliver donor-funded public programs.

Read

• Brandsen, T., Mendonça, P., & Smith, S. (2025). Theory of the third sector. In A. Bassi, M. Aquino Alves, & C. Cordery (Eds.), The future of third sector research (pp. 11-25). Springer. https://doi.org/10.1007/978-3-031-67896-7_2

The chapter is free to read. Read pages 11 to 13, on the early economic theories. You will read the next section, on social origins, in Lesson 1.4.

Go further, with library access. Child, C. (2024). An overview of nonprofit sector theories, and LePere-Schloop, M., & Nesbit, R. (2024). The prevalence of traditional nonprofit sector theories in research. Both in C. Child & E. Witesman (Eds.), Reimagining nonprofits. Sector theory in the twenty-first century. Cambridge University Press.

Try it

Use each theory as a focused question rather than a complete account. Match every case to the theory that explains it best, give one reason and identify something that explanation leaves out. Then open the answers.

1. Small nonprofits run health clinics in rural India, where neither government nor private providers operate.

2. After a major earthquake, Médecins Sans Frontières provides emergency care in a country with weak oversight of for-profit aid providers.

3. Faith-based orphanages in parts of sub-Saharan Africa are often underfunded, religiously exclusive and staffed by untrained volunteers, and governments come under pressure to step in.

4. Young founders in Brazil's favelas start nonprofit ventures offering skills training and arts programs.

5. NGOs in Germany deliver language training and job placement for refugees with government funding.

Key takeaway

No single economic theory explains the entire sector. Together, the five show nonprofits emerging from unmet demand, problems of trust, limits of voluntary action, mission-driven supply and partnership with government; the strongest explanation depends on the problem we are trying to understand.