November 18, 2019

Nowadays, the advantages of crowdfunding are over its backwards.

 

Nowadays, crowdfunding has come up as a feasible
and prominent way for entrepreneurs to fund their initiatives by drawing on
relatively 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 to
develop corporate activities. In the case of crowdfunding to which this essay
refers, the primary aim is to raise money through online social networks for
investment. Instead of collecting money from certain small sophisticated groups,
entrepreneurs raise money from large congregation, the crowd. Crowdfunding
largely takes place on crowdfunding platforms, i.e., Internet-based platforms
which link fundraisers to funders with the purpose of funding a particular
campaign by typically many funders. Through social networking services, crowdfunding
relies on such platforms to reduce the degree of information asymmetry so as to
improve resource matching efficiency. At the same time, someone argues that
crowdfunding is a dangerous fad with economic analysis taken into
consideration. From my standpoint, generally the advantages of crowdfunding are
over its backwards. It is not deniable there are limitations of crowdfunding concerning
information asymmetry and moral hazard. Therefore, even the benefits and
competence of crowdfunding are surprising, participants should be aware of the
existence of moral hazard and they must be very careful when taking actions.

First, economic theory can help to better
understand the recent popularity of crowdfunding, the benefits from
participating, and possible market failures. Crowdfunding is one of the results
due to rapid commercialization of Internet. Internet has lowered the
transaction costs and financial risks of crowdfunding, making it an
economically feasible way of financing small ventures. For example, search
costs are lowered by Internet, facilitating cheap and efficient matching
between funders and entrepreneurs (Agrawal et al., 2014). Communication costs
are also reduced in this mode, which allows funders to gather information,
monitor their investment, and engage with the entrepreneurs easily, in spite of
their geographic isolation. Besides, the large number of funders accessible makes
it possible for a potential project’s risk to be spread over many contributors
and allows funders to contribute small denominations (Agrawal et al., 2014).

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Some questions about the economic viability
of this new entrepreneurial financing model and, in particular, about replacing
the traditional financial intermediary are raised. Economic theory has provided
efficiency arguments in favor of a specialized financial intermediary. For instance,
by coordinating investment through a single financial intermediary, complicated
problems, such as monitoring the borrower’s behavior, can be prevented. However,
in some cases, market players may prefer crowdfunding over traditional funding
sources (Agrawal et al., 2014). From the perspective of entrepreneurs,
crowdfunding lowers the cost of accessing capital by three ways: 1) finding funders
with the highest willingness to pay for entrepreneurs; 2) bundling multiple
project goals together; and 3) attracting social media attention. Entrepreneurs
may also regard crowdfunding as a way of engaging their customer base and
accessing valuable market information from funders such as customer preferences
(Agrawal et al., 2014; Gerber and Hui, 2013). Funders may engage in because
they can access affordable investment opportunities without being accredited
investors, acquire products before mainstream uptake, participate in the
crowdfunding community, support a project that is important to them, and formalize
their contribution through a reputable platform (Agrawal et al., 2014).

However, the crowdfunding market is vulnerable
due to market inefficiencies which may deter economically valuable transactions
or even cause market failure. The main problem appears to be moral hazard. Moral
hazard would describe a situation where an entrepreneur acts in self-interest
and fails to deliver on project goals. In reality, entrepreneurs, as the
project initiators, naturally know much more about the project than the funders.
This disparity in information accessibility is intensified in the crowdfunding
setting. Entrepreneurs are often geographically isolated from their funders
whom are often inexperienced in the nominal field (Agrawal et al., 2014;
Agrawal et al., 2015). The borrower (project initiator) is essentially paid to
carry out the project’s stated goals on behalf of the funders. From this
perspective, monitoring to limit a borrower’s moral hazard seems especially
important for entrepreneurial financing. Entrepreneurs are typically new
players in the market, who, contrary to well-developed firms, have not yet had
the ability to build up a reputation to demonstrate their trustworthiness.

With moral hazard existing, consumers worry
about whether the entrepreneur will deliver a good in the end that meets the original
specifications, or whether they will receive some good at all. All these
different forms of moral hazard can be regarded as a weaker version of the problem
that the entrepreneur simply takes total pledges and does not invest at all.
Clearly, if the entrepreneur could, he would do so, because obviously he is
better of running off with these pledges instead of incurring any additional
costs for realizing the project. In the face of such moral hazard problems,
rational consumers will not participate and the crowdfunding scheme ends up in
failure. The reason for failure is obvious: the entrepreneur receives the
pledged funds before he actually invests and he gets nothing after realizing
the projects. Therefore, one way to alleviate this problem is to change the
crowdfunding pattern so that the entrepreneur obtains the consumer’s pledges
only after having produced the good. But such a delay in payments is possible
only up to some degree because the penniless entrepreneur needs at least the
amount I to develop the product.

To
illustrate 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 sum
of pledges, P, has to be met before
the investment is triggered. The entrepreneur first obtains only the required
amount I in order to develop the product
and he obtains the remaining part P ? I
only after delivering the good to consumers. The entrepreneur can produce the good at some
marginal cost c ? 0, 1. After the entrepreneur has obtained the money from
the crowdfunding platform, he can “make a run for it” and thereby keep a share ? ? 0, 1. In order to characterize crowdfunding schemes with deferred
payments that prevent moral hazard, note that the entrepreneur now obtains only
the payoff ?I from a run and the
payoff P ? I ? cP/p from realizing
the project. With a pledge lever p=1,
he has no incentive to run if

                 ? I ? P?I?cP    ?   P ?
(1+ ?) I/(1-c)

In
particular, the deferred crowdfunding scheme (p, T) = 1, (1+ ?) I/(1-c) leads to an equilibrium outcome where
the entrepreneur never runs. By this scheme, the project is triggered when at
least T = (1+
?) I/(1-c)
consumers pledge so that it induces the entrepreneur to diligently complete the
project. Even though crowdfunding schemes with a deferred payment prevent the
risk of moral hazard, they only do so with an inefficiently high target level T. That is because by taking the money
and running, the entrepreneur can ensure a rent of at least ?I. To induce the entrepreneur not to
run, the project must therefore yield him a surplus of at least ?I. Yet, by definition, when completing
the project diligently, the project yields a surplus of exactly zero. Raising
the target level might ensure the entrepreneur to obtain a rent if the target
level is triggered. However, an inefficiently high target level implies that
the scheme exhibits underinvestment. That is to say, although the scheme does
prevent the moral hazard problem, it does not attain the efficient outcome
because its trigger level is too high.

Nevertheless,
if the entrepreneur only knows that P
exceeds T, but not the exact P itself, he then rationally anticipates
an expected payoff EP|P > T?I
?cEP|P > T/p from not running with the money. Since the conditional
expectation EP|P > T exceeds T, a crowdfunding scheme that reveals
only whether P exceeds T can deal with the moral hazard problem
more efficiently. Thus, in the presence of information asymmetry as well as
moral hazard, one neither wants too much nor too little information revelation to
get optimal outcome.

To
conclude, crowdfunding severs the traditional separation of finance and
marketing and thereby fundamentally reshapes the model of entrepreneurship. Meanwhile,
it should be noticed that due to the free-riding problem that individuals have
reduced incentives to monitor as compared to the crowd as a whole, the threat
of entrepreneurial moral hazard may potentially counter its effect. Discussions
above shows that the susceptibility of crowdfunding to entrepreneurial moral
hazard can impede the performance of fully efficient outcomes. In particular,
crowdfunding promotes fully efficient outcomes only if they are well-off, where
the project’s ex-ante expected return exceeds the agency costs associated with
moral hazard and private information. Constrained efficient mechanisms exhibit
underinvestment, leading to crowdfunding schemes with inefficiently high target
levels.

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