Rethinking the contract‐failure theory

Abstract The contract‐failure theory posits that the nonprofit form can be an indicator of high product quality because the nondistribution constraint reduces the nonprofit manager's financial benefits from cheating. This would give nonprofits an advantage over for‐profit firms when consumers cannot determine product quality and thus explains nonprofits' existence. This article finds that nonprofits are not generally more trustworthy. It is methodologically wrong to compare the nonprofit and for‐profit managers' personal benefits from cheating to one another. Instead, both nonprofit and for‐profit managers will act to maximize their respective utility, seeking either higher income and/or more leisure. Since providing low‐quality products leads to both less effort and a lower cost, both nonprofits and for‐profit firms will cheat. Further, providers cannot overcharge because there are no informational asymmetries about product price. The market price in contract failure situations will drop, forcing both nonprofits and for‐profit firms to offer only the lowest quality product. Shifting to nonprofit purposes requires nonprofits to allocate part of their resources through giving, which makes some of their transactions trustworthy. However, consumers usually cannot identify trustworthy transactions. Adopting the nonprofit form will not make an untrustworthy provider trustworthy; and trustworthy providers are also not necessarily more likely than untrustworthy ones to take that form because it costs untrustworthy‐inefficient providers even less to do so. The nonprofit form thus cannot be an effective signal of high quality. Even if nonprofits were more trustworthy, this cannot explain why nonprofits exist. It is the supply side, which only partly overlaps the contract failure situations, that drives the nonprofit sector. The existence of other informational‐asymmetries‐relieving mechanisms also reduces consumers' demand for the nonprofit form. In debunking the contract‐failure theory, this article will be useful for scholars examining nonprofits' behavior and the justification for the nonprofit sector.