This perspective came alive to me in a dramatic way as the class began their term projects with five different nonprofit organizations in Cleveland. These organizations, selected simply for their variety of missions and interest in possible earned income projects, feature widely varying revenue portfolios. A floating museum is primarily dependent on grants and donations and secondarily dependent on fees, as is a fledgling organization that seeks to improve nonprofit governance through leadership training. A balanced mix of membership fees, grants and fees for service finances a religiously based community center. An agency for the sight-impaired is financed primarily by returns on an endowment, while a community social service agency depends primarily on government funding. What are the reasons for these widely varying revenue mixes, and what should each of these agencies be aiming for in terms of more efficient portfolios of revenues and concomitant service offerings? I asked the class to put these overall financial portfolios into perspective as they considered earned income projects for their various agency clients.

It seems to me that a theory of nonprofit finance would have two basic parts. First, the theory would have to explain the circumstances under which each type of income is appropriate, or as economist would say - efficient. That is, when does it make sense to charge fees, seek donations, seek government contracts, build endowments, borrow from banks, and so on? Surely, nonprofit managers would like to be systematic and sensible in these decisions, rather than simply respond in ad hoc fashion to opportunities as they arise. More to the point, nonprofits managers need to be able to make a good case for their financial decisions, so as to convince donors, gain acceptance of fee schedules, secure government funding, or build endowments. That case should be based on solid theory-based reasoning.

Second, nonprofit finance theory must provide guidance on revenue and service portfolios. It is the relatively rare nonprofit that depends on just a single source of revenue or provides a single service. As work by economists Estelle James, Burton Weisbrod, Jerrold Schiff and others have indicated, nonprofits are “multi-product firms” that must decide upon the combinations of services they offer, and the degrees to which each service is expected to contribute to mission or net profit or both. However, there is more to determining appropriate combinations of services and revenue streams than that. As Kevin Kearns, Sharon Oster and others have demonstrated, issues of strategic positioning, risk, and “economies of scope” all affect the determination of efficient service and revenue portfolios for nonprofits. Overall, what makes nonprofit finance special is not just the presence of certain sources of revenue and support, such as gifts and grants, but rather the wide mixes of revenue portfolios. Businesses depend overwhelmingly on sales revenues, and government bureaus depend primarily on taxes and fees. No such generalization can be made for nonprofits Nonprofits must be guided by principles that allow them choose appropriate mixes based on their circumstances, missions and potential service offerings.

An editorial is no place to embark on a major initiative to construct a theory of nonprofit finance! But nonprofit finance is a good theme for a series of columns that can suggest how the development of such a theory can proceed - by building on existing economic theory of nonprofits and identifying areas where further work needs to be done. Hopefully, my colleagues associated with the NCNE will help take up the challenge and move forward with this initiative in coming months so that eventually we can approach a comprehensive theory. Let me begin in this column with part of the first challenge - what underlying rationale do we have for pursuing particular sources of revenue? - starting with individual donations.

Economic theory offers at least two powerful interrelated ideas about where donations are an appropriate means of support for a nonprofit’s services. The first idea is the concept of “externalities” associated with goods and services that nonprofit organizations can sell in the marketplace. (Another part of the theory needs to deal with when it is appropriate for nonprofits to sell such marketable goods.) An externality is a side-benefit that is produced as a result of the production or consumption of a good or service. If production of a service associated with positive externalities is left solely to the marketplace and financing by fees, then the service will be under-produced. That is, not enough fee revenue can be generated to maximize the net social benefits that are possible. Hence, there is an argument for donors to supplement fee revenue with gifts, so that the nonprofit can produce a maximum level of social benefit.

A simple example is the case of inoculations to prevent a disease. Left to the market, some people may decide not to become inoculated because the price outweighs their anticipated personal benefit. While such an individual may be an accurate judge of his or her personal benefit, that individual will not take into account the social benefits (from reduced contagion) that are produced by having as many people inoculated as possible. Hence a case can be made to a donor that subsidizing the price of inoculation through charitable giving is a worthwhile social investment. Similarly, a nonprofit pre-school can make the case to the community and to its more prosperous clientele that subsidizing the price of tuition for children from lower income families through donations, is a good social investment in future community welfare and in the enriched education of all children enrolled in the school that comes through diversity of the student body.

A second strand of economic theory based on the concept of “public goods” also makes a case for financing a nonprofit through charitable contributions. Here the argument centers on goods and services that are not marketable because they have certain characteristics, including “non-excludability” - which means that is impossible or very expensive to refrain people from benefiting from the service once it is produced. Examples include public safety (police and fire protection) and public television and radio. The result of this attribute is that the services cannot be sold in markets because, as a practical matter, suppliers cannot charge for them. Clearly government can and does provide such goods (and a comprehensive theory of nonprofit finance needs to address when it is appropriate for nonprofits to seek government funding). However, even with government provision, economic theory points out that in heterogeneous communities people will have different preferences for public goods and as a result many will be left unsatisfied with what government decides to provide. Nonprofits can then offer their own versions of public goods to supplement government supply, such as neighborhood watch programs, environmental protection initiatives, or public service programming.

This then, is another rationale that nonprofits can offer to donors for providing charitable gifts. However, nonprofits must also be aware of the situations where such solicitation is likely to be effective. Here too, economic theory can be helpful. Voluntary support for public goods is subject to “free rider effects.” That is, not everyone that benefits from public goods will support them through gifts and grants. However, the theory of collective action, pioneered by Mancur Olson, points to various ways and circumstances in which free rider tendencies can be (partially) overcome. These include focusing on small groups where social pressure can be exerted (e.g. church congregations), on “privileged donors” who perceive substantial personal benefits from certain public goods (e.g., rich individuals who value preserving a piece of public land), on services that make donors feel good about giving per se (e.g., relief of suffering children) and on circumstances where “selective” private incentives or benefits can be conferred on donors (e.g., invitations to opening receptions of museum shows).

Clearly, many nonprofits have learned these strategies through experience, but there are also many instances where such strategies are not productively engaged or where nonprofits try to raise donations in unpromising circumstances. A theory of nonprofit finance that attended to the rationale for donations would help systematize the guidelines that nonprofits could use to determine their reliance on charitable contributions.

Hopefully, this editorial provides a taste of things to come. I welcome the comments of my academic and research associates on how to move forward with a full theory of nonprofit finance, and especially I welcome the views of practitioners as to the utility of this line of reasoning and suggestions for its development.