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Are nonprofits getting more by paying less?
By Femida Handy & Eliabkim Katz
Canadian FundRaiser: May 13, 1999
Nonprofit managers are paid lower wages, in general, than managers with comparable qualifications in the for-profit sector. In fact, this may reflect a successful policy of generating public trust by causing positive self selection in managerial employees of nonprofits, which in turn is based on three important aspects of nonprofit institutions:

First, nonprofits often emerge in markets characterized by asymmetric information between producer and the consumer and in which therefore, consumer trust emerges as an issue.

Second, nonprofit managers tend to have very different characteristics from their counterparts in the for-profit sector.

And third, nonprofits tend to pay their employees, and especially managers, a lower wage than for-profits.

Competitive advantage?
Nonprofits may have a comparative advantage over for-profits in generating consumer and donor trust, but the mere absence of a profit motive is a weak basis for trust. The exploitation of the consumer or donor in the name of profit maximization can easily be replaced by reduction in managerial effort and the increase of perquisites. To fulfill their role effectively, nonprofits will have to convince the public that such abuses are unlikely to occur, and will therefore actively pursue policies aimed at enhancing public trust.
Boards of trustees help secure public trust for the nonprofit by offering their reputation as collateral. The public infers correctly that its own risk has been reduced from the fact that the board of trustees has exposed itself, on the public's behalf, to the same risk, and presumably, will wish to minimize its own, and therefore the public's risk.

"Internal" as well as "external" trust an issue in nonprofits
Since trustees are not involved in the day-to-day running of nonprofits, they must rely on the management of the nonprofit to ensure quality and efficiency. To safeguard their reputation, trustees must be able to trust the managers of the nonprofit to do their job honestly and conscientiously, so internal trust also emerges as an issue in nonprofits. Of course the board of directors of a for-profit institution must also be able to trust its management to perform adequately, but there are relatively straightforward measures of managerial performance in a for-profit organization, e.g. profit, that are not, in general, available to a nonprofit. Hence, problems of external trust (between the nonprofit and the public) are likely to be connected to problems of internal trust.
One way in which nonprofits may reduce the internal trust problem is to attract committed individuals, those whose preferences are such that, given the same parameters (prices, wages, rates, etc) he/she will provide the nonprofit with greater output than an uncommitted individual with the same abilities. There is a general consensus that nonprofit managers are, in fact, significantly different in this regard from their counterparts in the for-profit sector. Nonprofits seem to attract individuals with a strong commitment to the philosophy of the nonprofit, and a subordinate interest in monetary gains.

Nonprofit packages promote self-selection
It appears that nonprofits attract committed individuals by offering them compensation packages that promote self-selection among potential employees. Committed individuals like working for nonprofits, and are therefore prepared to work for less while also doing a better job than uncommitted managers.
Our interpretation of the fact of lower managerial incomes in nonprofits compared with for-profits may seem to be counter-intuitive. To the extent that the monitoring of nonprofit managers is more difficult in this regard than the monitoring of for-profit managers, wages in the nonprofit sector might have been expected to be higher than in other sectors. Managerial wages in the nonprofit sector are persistently lower than in other sectors, we believe, because adverse selection issues - the attempt to screen out uncommitted managers - may dominate such other issues as the need to ensure that such employees do not shirk. In fact, self selection in nonprofits reduces the need for monitoring and the payment of an "efficiency wage". The efficiency-wage hypothesis argues that difficulties in the monitoring of managers may be partially resolved by an excessive wage, which implies that a greater penalty is imposed on shirkers who are caught and fired.

Nonprofits do not attract less than capable managers
Studies of the wages of managers and professionals working for nonprofits and for-profits show that these differences persist independently of gender, and that there are no significant educational differences between individuals employed in the for-profit and nonprofit sectors. They also show that nonprofits do not attract less than capable managers; the wage differentials between nonprofits and for-profits do not reflect differences in productivity. Yet other studies suggest that nonprofit managers are strongly committed to the philosophy of the nonprofit and view the nonprofit primarily as fulfilling a social rather than business need. These studies, therefore, support the notion that nonprofits have been successful in attracting individuals with characteristics desirable by the nonprofits without incurring the cost of attracting the rejects of the for-profit sector.
Our conclusion, in fact, is that a nonprofit firm that wishes to hire a manager will do better by offering a lower monetary wage and attracting a more committed individual while using the usual signals of education and experience to screen for quality. If correct, this theory explains why nonprofit institutions tend to pay their managers a lower wage than that paid to similarly qualified managers in for-profits. Lower wages attract managers that are more committed to the cause of the nonprofit, and the process is made easier for such managers by the fact that a low managerial income earned in a nonprofit is less detrimental to social status than a low managerial income earned in for-profit.

Attracting qualified managers by paying less
The need for such self-selection is particularly important in nonprofits because they are not subject to the usual checks and balances imposed by shareholders on for-profits. Nonprofits appear to be able to attract committed and qualified managers with an output that is not lower than that of managers in the for-profit sector, and who, in fact, contribute to reducing problems of public trust. They do so by paying less.
Based on an article in the Journal of Comparative Economics, June, 1998, 26(2), pp. 246-261. Femida Handy is a professor in the Faculty of Environmental Studies, and Eliabkim Katz a professor in the Department of Economics, Faculty of Arts, York University. For more information, call 416-736-2100 x22633.