Nowadays, crowdfunding has come up as a feasibleand prominent way for entrepreneurs to fund their initiatives by drawing onrelatively small contributions from a large number of individuals (the “crowd”).The concept of crowdfunding derives from the broader concept of crowdsourcing,which includes using the “crowd” to acquire ideas, comments, and solutions todevelop corporate activities. In the case of crowdfunding to which this essayrefers, the primary aim is to raise money through online social networks forinvestment. Instead of collecting money from certain small sophisticated groups,entrepreneurs raise money from large congregation, the crowd. Crowdfundinglargely takes place on crowdfunding platforms, i.
e., Internet-based platformswhich link fundraisers to funders with the purpose of funding a particularcampaign by typically many funders. Through social networking services, crowdfundingrelies on such platforms to reduce the degree of information asymmetry so as toimprove resource matching efficiency. At the same time, someone argues thatcrowdfunding is a dangerous fad with economic analysis taken intoconsideration. From my standpoint, generally the advantages of crowdfunding areover its backwards. It is not deniable there are limitations of crowdfunding concerninginformation asymmetry and moral hazard. Therefore, even the benefits andcompetence of crowdfunding are surprising, participants should be aware of theexistence of moral hazard and they must be very careful when taking actions.
First, economic theory can help to betterunderstand the recent popularity of crowdfunding, the benefits fromparticipating, and possible market failures. Crowdfunding is one of the resultsdue to rapid commercialization of Internet. Internet has lowered thetransaction costs and financial risks of crowdfunding, making it aneconomically feasible way of financing small ventures. For example, searchcosts are lowered by Internet, facilitating cheap and efficient matchingbetween funders and entrepreneurs (Agrawal et al., 2014).
Communication costsare also reduced in this mode, which allows funders to gather information,monitor their investment, and engage with the entrepreneurs easily, in spite oftheir geographic isolation. Besides, the large number of funders accessible makesit possible for a potential project’s risk to be spread over many contributorsand allows funders to contribute small denominations (Agrawal et al., 2014).Some questions about the economic viabilityof this new entrepreneurial financing model and, in particular, about replacingthe traditional financial intermediary are raised. Economic theory has providedefficiency arguments in favor of a specialized financial intermediary.
For instance,by coordinating investment through a single financial intermediary, complicatedproblems, such as monitoring the borrower’s behavior, can be prevented. However,in some cases, market players may prefer crowdfunding over traditional fundingsources (Agrawal et al., 2014). From the perspective of entrepreneurs,crowdfunding lowers the cost of accessing capital by three ways: 1) finding funderswith the highest willingness to pay for entrepreneurs; 2) bundling multipleproject goals together; and 3) attracting social media attention. Entrepreneursmay also regard crowdfunding as a way of engaging their customer base andaccessing valuable market information from funders such as customer preferences(Agrawal et al.
, 2014; Gerber and Hui, 2013). Funders may engage in becausethey can access affordable investment opportunities without being accreditedinvestors, acquire products before mainstream uptake, participate in thecrowdfunding community, support a project that is important to them, and formalizetheir contribution through a reputable platform (Agrawal et al., 2014). However, the crowdfunding market is vulnerabledue to market inefficiencies which may deter economically valuable transactionsor even cause market failure. The main problem appears to be moral hazard.
Moralhazard would describe a situation where an entrepreneur acts in self-interestand fails to deliver on project goals. In reality, entrepreneurs, as theproject initiators, naturally know much more about the project than the funders.This disparity in information accessibility is intensified in the crowdfundingsetting. Entrepreneurs are often geographically isolated from their funderswhom are often inexperienced in the nominal field (Agrawal et al., 2014;Agrawal et al., 2015). The borrower (project initiator) is essentially paid tocarry out the project’s stated goals on behalf of the funders. From thisperspective, monitoring to limit a borrower’s moral hazard seems especiallyimportant for entrepreneurial financing.
Entrepreneurs are typically newplayers in the market, who, contrary to well-developed firms, have not yet hadthe ability to build up a reputation to demonstrate their trustworthiness.With moral hazard existing, consumers worryabout whether the entrepreneur will deliver a good in the end that meets the originalspecifications, or whether they will receive some good at all. All thesedifferent forms of moral hazard can be regarded as a weaker version of the problemthat the entrepreneur simply takes total pledges and does not invest at all.Clearly, if the entrepreneur could, he would do so, because obviously he isbetter of running off with these pledges instead of incurring any additionalcosts for realizing the project. In the face of such moral hazard problems,rational consumers will not participate and the crowdfunding scheme ends up infailure. The reason for failure is obvious: the entrepreneur receives thepledged funds before he actually invests and he gets nothing after realizingthe projects.
Therefore, one way to alleviate this problem is to change thecrowdfunding pattern so that the entrepreneur obtains the consumer’s pledgesonly after having produced the good. But such a delay in payments is possibleonly up to some degree because the penniless entrepreneur needs at least theamount I to develop the product. Toillustrate the situation, we can assume a crowdfunding scheme (p, T). The price p stands for the pledge-level of an individual consumer, and T stands for the target level. The sumof pledges, P, has to be met beforethe investment is triggered.
The entrepreneur first obtains only the requiredamount I in order to develop the productand he obtains the remaining part P ? Ionly after delivering the good to consumers. The entrepreneur can produce the good at somemarginal cost c ? 0, 1. After the entrepreneur has obtained the money fromthe crowdfunding platform, he can “make a run for it” and thereby keep a share ? ? 0, 1. In order to characterize crowdfunding schemes with deferredpayments that prevent moral hazard, note that the entrepreneur now obtains onlythe payoff ?I from a run and thepayoff P ? I ? cP/p from realizingthe project.
With a pledge lever p=1,he has no incentive to run if ? I ? P?I?cP ? P ?(1+ ?) I/(1-c) Inparticular, the deferred crowdfunding scheme (p, T) = 1, (1+ ?) I/(1-c) leads to an equilibrium outcome wherethe entrepreneur never runs. By this scheme, the project is triggered when atleast T = (1+?) I/(1-c)consumers pledge so that it induces the entrepreneur to diligently complete theproject. Even though crowdfunding schemes with a deferred payment prevent therisk of moral hazard, they only do so with an inefficiently high target level T. That is because by taking the moneyand running, the entrepreneur can ensure a rent of at least ?I. To induce the entrepreneur not torun, the project must therefore yield him a surplus of at least ?I. Yet, by definition, when completingthe project diligently, the project yields a surplus of exactly zero. Raisingthe target level might ensure the entrepreneur to obtain a rent if the targetlevel is triggered. However, an inefficiently high target level implies thatthe scheme exhibits underinvestment.
That is to say, although the scheme doesprevent the moral hazard problem, it does not attain the efficient outcomebecause its trigger level is too high.Nevertheless,if the entrepreneur only knows that Pexceeds T, but not the exact P itself, he then rationally anticipatesan expected payoff EP|P > T?I?cEP|P > T/p from not running with the money. Since the conditionalexpectation EP|P > T exceeds T, a crowdfunding scheme that revealsonly whether P exceeds T can deal with the moral hazard problemmore efficiently.
Thus, in the presence of information asymmetry as well asmoral hazard, one neither wants too much nor too little information revelation toget optimal outcome.Toconclude, crowdfunding severs the traditional separation of finance andmarketing and thereby fundamentally reshapes the model of entrepreneurship. Meanwhile,it should be noticed that due to the free-riding problem that individuals havereduced incentives to monitor as compared to the crowd as a whole, the threatof entrepreneurial moral hazard may potentially counter its effect. Discussionsabove shows that the susceptibility of crowdfunding to entrepreneurial moralhazard can impede the performance of fully efficient outcomes.
In particular,crowdfunding promotes fully efficient outcomes only if they are well-off, wherethe project’s ex-ante expected return exceeds the agency costs associated withmoral hazard and private information. Constrained efficient mechanisms exhibitunderinvestment, leading to crowdfunding schemes with inefficiently high targetlevels.