[[{“value”:”My latest paper, Signaling Quality: How Refund Bonuses Can Overcome Information Asymmetries in Crowdfunding (with the excellent Tim Cason and Robertas Zubrickas) is just published in Management Science. Many promising crowdfunding projects fail due to a fundamental issue: trust. Potential backers often hesitate because they lack confidence in the credibility or viability of the projects.
The post Signaling Quality in Crowdfunding Projects with Refund Bonuses appeared first on Marginal REVOLUTION.”}]]
My latest paper, Signaling Quality: How Refund Bonuses Can Overcome Information Asymmetries in Crowdfunding (with the excellent Tim Cason and Robertas Zubrickas) is just published in Management Science.
Many promising crowdfunding projects fail due to a fundamental issue: trust. Potential backers often hesitate because they lack confidence in the credibility or viability of the projects. This gap is natural, as traditional bank financing involves a bank acting as an intermediary, vetting the project, assessing its risk, and effectively endorsing it with their reputation. In contrast, crowdfunding operates without such intermediaries. Backers rely on limited, often one-sided information provided by project creators, making it challenging to assess risks or validate claims. Unlike banks, which can access financial records, credit histories, and industry expertise, individual backers typically lack the time, resources, or skills to conduct rigorous due diligence. Moreover, assessing risk is expensive. So how can we convey information about the true value of a crowdfunding project to investors?
Here my co-authors and I turn to refund bonuses. We have previously shown in lab experiments that refund bonuses can dramatically increase the rate of success of crowdfunding contracts and, more generally, make it possible to produce public goods privately. The idea of a refund bonus is simple. In an ordinary Kickstarter-like contract, if a project fails to raise enough funds to reach its threshold, the funds are returned to the investors. In a refund bonus contract, if a project fails to reach its threshold the investors get their money back plus a refund bonus. The effect of the refund bonus is to make investing in socially valuable projects a no-lose proposition. Either the project succeeds which is great because the project is worth more than its cost or it fails and you get a refund bonus. The investor is better off either way.
Now consider the refund bonus from the point of view of the entrepreneurs. An entrepreneur who offers a refund bonus has a special reason to want their project to succeed, namely, if the project succeeds they don’t have to pay the refund bonus. Entrepreneurs know more about the quality of their project than investors. The entrepreneurs, for example, know the truth about their advertising campaign. Does the cool demo really work or was it puffery or worse? Entrepreneurs who offer refund bonuses are thus implicitly offering a kind of testament or bond–I am so confident that this project will succeed that I am willing to offer a refund bonus if it doesn’t succeed. As with a warrantee, the point of the warrantee is not that consumers will use it but that they won’t. The warrantee is a signal of quality. Similarly, we show that offering refund bonuses can signal quality.
Working out the equilibrium requires some game theory because if refund bonuses 100% guaranteed high-quality (i.e. if only entrepreneurs with high quality projects offered refund bonuses) then every project that offered refund bonuses would succeed but then entrepreneurs with lower quality projects wouldn’t fear offering refund bonuses. Thus, the equilibrium is mixed, all entrepreneurs with high quality projects offer refund bonuses but some entrepreneurs with low quality projects also offer refund bonuses. Nevertheless, the equilibrium is such that on average refund bonuses signal quality. We test the theory in a lab experiment and it works. Investors were significantly more likely to put their money into projects where the entrepreneurs chose to offer refund bonuses (n.b. this is in comparison to experiments where refund bonuses were imposed, i.e. we specifically test the signaling role of refund bonuses.)
Thus, refund bonus for crowdfunding provide a decentralized method of reducing asymmetric information. The refund bonus credibly allows information about quality to be transmitted from the entrepreneur to the investors. The bottom line is that refund bonuses increase the power of crowdfunding finance making it more competitive with intermediated finance.
Addendum: Here is an excellent podcast on refund bonuses and crowdfunding. “Refund bonuses could revolutionize crowd funding!”
The post Signaling Quality in Crowdfunding Projects with Refund Bonuses appeared first on Marginal REVOLUTION.
Economics
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