Intermediation in reward-based crowdfunding: a cash deposit mechanism to reduce moral hazard

Abstract

A major impediment to crowdfunding is the unobservable actions initiated by an entrepreneur, which generally results in moral hazard. This study aims to demonstrate how an online intermediary, functioning as a crowdfunding platform, can reduce the moral hazard problem by designing a cash deposit mechanism. A model that illustrates the relationship among a crowdfunding platform, an entrepreneur and various consumers is built. With crowdfunding, an entrepreneur can ask a large audience to back up his/her project with money and then reward each funder with a product. The quality of the product depends on the combined effort of the entrepreneur and pure luck. Our results show that for projects with a high marginal cost of effort and low difference in quality, the crowdfunding platform tends to set a high compensation ratio and implement strict control of the starting capital. The crowdfunding platform prefers projects with a low marginal cost of effort and high difference in quality due to the higher amount of financing. The major findings indicate that crowdfunding platforms can reduce moral hazard by setting up a cash deposit mechanism. However, this mechanism exhibits limitations in projects with high fixed costs, that is, the effort cannot reach the constrained first-best level. For projects with a high marginal cost of effort or low difference in quality, this mechanism will reduce social welfare.