Contract failure
{{Short description|Economic theory}}
Contract failure describes a situation in which the consumer of a good or service is unable to evaluate its quality, thus incentivizing the producer to produce a lower quality good or service.{{cite book|author1=Walter Powell (W.)|author2=Richard Steinberg|title=The nonprofit sector: a research handbook|url=https://books.google.com/books?id=ligvL-cLFIEC&pg=PA121|accessdate=29 April 2013|year=2006|publisher=Yale University Press|isbn=978-0-300-10903-0|page=121}} Such behavior creates suboptimal economic conditions.{{cite book|author=Peter Benson|title=The Theory of Contract Law: New Essays|url=https://books.google.com/books?id=3GSf6QGASEoC&pg=PA54|accessdate=29 April 2013|date=5 February 2001|publisher=Cambridge University Press|isbn=978-0-521-64038-1|page=54}} Contract failure is one explanation for the existence of non-profit organizations,{{cite book|author=Helmut K. Anheier|title=A Dictionary of Civil Society, Philanthropy and the Third Sector|url=https://books.google.com/books?id=fmaB0OmPNjEC&pg=PA65|accessdate=29 April 2013|date=17 June 2004|publisher=Taylor & Francis|isbn=978-0-203-40337-2|page=65}}{{cite book|author=Robert D. Herman & Associates|title=The Jossey-Bass Handbook of Nonprofit Leadership and Management|url=https://books.google.com/books?id=pGlboTeI4XkC&pg=PA211|accessdate=29 April 2013|date=31 January 2011|publisher=John Wiley & Sons|isbn=978-1-118-04658-6|page=211}}{{cite book|author=Jyh-An Lee|title=Non-Profit Organizations and the Intellectual Commons|url=https://books.google.com/books?id=IGmgp8pMTI8C&pg=PA106|accessdate=29 April 2013|year=2012|publisher=Edward Elgar Publishing|isbn=978-1-78100-158-5|page=106}} although even non-profits can fall victim to contract failure in the right situations. Contract failure is connected to, but distinct from, market failure.{{cite book|author=Stephen P. Osborne|title=Public Management: Critical Perspectives|url=https://books.google.com/books?id=Hq5_Co-9S5EC&pg=PA172|accessdate=29 April 2013|year=2002|publisher=Taylor & Francis|isbn=978-0-415-23382-8|page=172}} Generally, non-profit organizations are more trusted because their corporate structures do not provide incentives to cheat.{{cite book|author1=Debra King|author2=Gabrielle Meagher|title=Paid Care in Australia: Politics, Profits, Practices|url=https://books.google.com/books?id=PYIDWsbJqKEC&pg=PA64|accessdate=29 April 2013|year=2009|publisher=Sydney University Press|isbn=978-1-920899-29-5|pages=64–67}}{{cite book|author1=Helmut K. Anheier|author2=Wolfgang Seibel|title=The Third Sector: Comparative Studies of Nonprofit Organizations|url=https://books.google.com/books?id=M3Jw9XqsOxYC&pg=PA65|accessdate=29 April 2013|year=1990|publisher=Walter de Gruyter|isbn=978-0-89925-486-9|page=65}}
Information Asymmetry
The known cause of contract failure is called information asymmetry; when one party (the producer) has more information than the other party (the consumer) about a product or service.{{cite book|last1=Young|first1=D|title=Contract Failure. In The Nature of the Nonprofit Sector|date=1998|publisher=West View|location=Philadelphia|pages=154–157|edition=2nd}} There is information inequality between the two parties.{{cite journal|last1=Arrow|first1=J.K.|title=Uncertainty and the welfare economics of medical care.|journal=The American Economic Review|date=1963|pages=941–973}} According to Young, there are three causes in which situations dealing with asymmetric information arise from, to include the following, 1) the quality of a product or service is too complex to be judged such as medical care or higher education; 2) the end consumer of the product or service cannot evaluate it him or herself such as a child in daycare or an elderly individual in a nursing home; and 3) the product or service is not consumed by the individual who purchased it, therefore the purchaser would never know if the producer delivered what was promised.
Nonprofit Existence
When contract failure occurs, there is a suboptimal provision of public goods, which results in market failure.{{cite journal|last1=Weisbrod|first1=B.A.|title=Economics of Institutional Choice|journal=Working Paper|date=1979}} Arrow argues that nonprofits will step in and provide the necessary good or service in response to market failure. When markets potentially take advantage of the information asymmetry situation, nonprofits must protect the consumer.{{cite journal|last1=Ihlan|first1=H.|title=Nonprofit Organizations as Providers of Public Goods.|journal=Journal of Management & Economics|date=2013|volume=20|issue=1|pages=95–104}}
Non-Distribution Constraint
According to Hansmann, the “non-distribution constraint - prohibits the distribution of residual earnings to individuals who exercise control over the firm”.{{cite journal|last1=Hansmann|first1=H.B.|title=The Role of Nonprofit Enterprise.|journal=The Yale Law Journal|date=1980|volume=5|page=835|doi=10.2307/796089 |jstor=796089 |url=https://digitalcommons.law.yale.edu/ylj/vol89/iss5/1 |url-access=subscription}} It prohibits those who have a vested interest in the organization from receiving the organization’s profit for personal gain. This constraint is a common characteristic of nonprofits, which creates less of a need for the company to take advantage of the consumer’s lack of knowing about such incidents. The nonprofit has no reason to cheat the consumer out of quality or service delivery because the organization's individuals cannot benefit in a direct manner. Therefore, the consumer is more likely to trust a nonprofit organization providing services than to trust a for-profit organization because of the nonprofit’s non-distribution constraint. According to Easley and O'Hara, state law stipulates that the organizations day-to-day costs should be reasonable.{{cite journal|last1=Easley|first1=D.|last2=O'Hara|first2=M.|title=The Economic Role of the Nonprofit Firm|journal=The Bell Journal of Economics|date=1983|pages=531–538|doi=10.2307/3003654 |jstor=3003654 }}