Crowdfunding mechanism comparison when product quality is uncertain

• Date: 01 September 2020
• Author: Yangguang Zhu,Xinxiu Wang,Shaofu Du,Tengfei Nie
• DOI: http://doi.org/10.1111/itor.12612
• Published date: 01 September 2020

Intl. Trans. in Op. Res. 27 (2020) 2616–2657

DOI: 10.1111/itor.12612

INTERNATIONAL

TRANSACTIONS

IN OPERATIONAL

RESEARCH

Crowdfunding mechanism comparison when product

quality is uncertain

Tengfei Niea, Xinxiu Wanga, Yangguang Zhuband Shaofu Dua,∗

aSchool of Management, University of Science and Technology of China, Hefei230026, P.R. China

bSchool of Economics, Hefei Universityof Technology, Hefei 230009, P.R. China

E-mail: ntf1986@ustc.edu.cn [Nie]; wxx1996@mail.ustc.edu.cn [Wang]; yanggzhu@mail.ustc.edu.cn [Zhu];

sdu@ustc.edu.cn [Du]

Received 11 May2018; received in revised form 30 October 2018; accepted 31 October 2018

Abstract

Many entrepreneurs have recently employedcrowdfunding to raise money. Although thereare several crowd-

funding mechanisms, there is no clear dominant strategy for the type of mechanisms that should be adopted

by the entrepreneur. This paper compares two commonly used mechanisms of crowdfunding by building a

two-person and two-period model wherethe entrepreneur first makes the decision then two consumers follow.

The all-or-nothing (AON) mechanism allows entrepreneurs to set a funding target and keep nothing unless

the goal is achieved. In contrast, entrepreneurs under the keep-it-all (KIA) mechanism must also set a target

and keep any funds regardless of whethert he goal has been achieved. To compare these two mechanisms, we

assume that customers are not sure about the quality of the product, which is very common in reward-based

crowdfunding. Using a unified model, our results show that large or poorly scalable projects are more likely

to choose the AON mechanism.

Keywords:crowdfunding; pricing strategy; mechanism comparison; symmetric Bayesian equilibrium

1. Introduction

Crowdfunding, a new mode of scientific and technological financing innovation, not only enables

Internet finance to have the financing function of traditional investment banks, but also brings

a breakthrough business model for the financial industry. As a new commercial financing model

and marketing method, crowdfunding not only provides a new channel for the collection of cor-

porate funds, but also provides a new marketing method for companies to promote products and

disseminate corporate image. In recent years, crowdfunding has been a very common way for en-

trepreneurial companies to seek external financing. The concept of crowdfunding originated from

∗Corresponding author

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T. Nie et al. / Intl. Trans. in Op. Res. 27 (2020) 2616–2657 2617

crowdsourcing, which refers to using the crowd to obtain ideas, feedback, and solutions to develop

corporate activities (Howe, 2008; Bayus, 2013). Kleemann et al. (2008) state that crowdsourcing

refers to the fact that a for-profit company publishes specific tasks necessary for making or selling

products to the public in the form of public Internet calls, the purpose of the individual is to make a

contribution to the company’s production free of chargeor lower than the company’s surplus. Based

on the definition of crowdsourcing, Belleflamme et al. (2014) define that crowdfunding involves an

open call, mostly through the Internet, and refers to individuals providing financial resources or

donations in exchange for future products or other forms of reward to support certain specific

measures. In crowdfunding projects, the goal of the entrepreneur is to raise enough funds, usually

through online social networking. Entrepreneurs go through crowdfunding in order to raise funds

from a large number of people, each individual need only pay a small amount of money, not from

a small group of professional investors. Crowdfunding campaigns generally take place in several

common forms, equity purchase, loan, donation, or preordering of the product (Agrawal et al.,

2011, 2014; Mollick, 2014; Kuppuswamy and Bayus, 2018).

Compared with traditional financing channels, crowdfunding is more open, and the availabilityof

funds is no longer the sole criterion for the commercial value of the project.As long as it is a project

that users like, all of them can get the start-up funds for project initiation through crowdfunding,

providing infinite possibilities for many small businesses or creative entrepreneurs. It is difficult

for entrepreneurs to conduct external financing through traditional financing channels in the early

stages of development, including bank loans and equity financing (Cassar, 2004; Cosh et al., 2009).

To overcome these challenges, creative founders have started to directly seek financial help from

the general public (the “crowd”),instead of approaching financial investors such as business angels,

banks or venture capital funds,generally using online social networks (Lambert and Schwienbacher,

2010).

This paper considers reward-based crowdfunding in which the reward is given to backers in the

form of products in most cases. In fact, reward-based crowdfunding on mainstream platforms now

exists mainly in two forms. Under the AON mechanism, the entrepreneurial firm sets a capital-

raising goal below which the entrepreneurial firm does not keep any of the pledged funds, and the

crowd does not get any reward. Under the KIA mechanism, in contrast, the entrepreneurial firm

can keep the entire pledged amount, albeit at higher fees, as explained further herein, regardless of

whether the stated capital-raising goal is reached(Cumming et al., 2015). Kickstarter and Indiegogo

are reward-based crowdfunding platforms whereby entrepreneurs state capital-raising goals, and,

in exchange, individuals are offered a reward for participating (Agrawal et al., 2015). Compared

with Kickstarter, Indiegogo has a wider scope and lesser restrictions on projects. One of the main

differences between Indiegogo and most other platforms is that the entrepreneur can choose the

KIA or AON mechanism (Belenzon and Schankerman, 2015).

In this paper, we mainly investigate crowdfunding mechanism selection, in which condition the

entrepreneur chooses the AON or KIA mechanism. To address this issue, we develop a unified

two-person model to compare two main forms of crowdfunding. In both forms, the entrepreneur

invites consumers to preorder the product, like most projects on Kickstarter and Indiegogo. The

entrepreneur must choose one form of crowdfunding before the campaign begins. Next, the en-

trepreneur needs to set up a fundraising target and product price for her project, regardless of the

chosen mechanism. Of course, the entrepreneur may choose different pricing strategies under dif-

ferent mechanisms. Then consumers arrive and make the purchase decision simultaneously. While

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consumers do not know each other’s decision, they all know that the other’s decisions can affect

their utility. In order to further solve this problem, the Bayesian equilibrium needs to be obtained.

For entrepreneurs, selecting the AON mechanism usually means a higher success rate, at the same

time, it also increases the probability of keeping nothing. In contrast, although the success rate of

KIA crowdfunding may be lower, entrepreneurs can always raise funds even if the capital target is

not achieved. Our result indicates thatthe entrepreneur is more likely to choose the KIA mechanism

when the capital goal is not too high or when the production is scalable. If it is necessary to raise

more funds, the AON mechanism can be used to attract more consumers or higher prices can be

charged. In a generalized model, we can get similar conclusions by a numerical analysis.

In a model extension, we consider several directions. First, to explore the influence of risk attitude

on the choice of mechanism, we assume that the entrepreneur is risk-averse in the extended model,

instead of the risk-neutral assumption in the basic model. The results are similar to the basic model.

Moreover, it shows thata risk-averse entrepreneur is more likelyto use the KIA mechanism. Besides,

we extend the basic model to a menu pricing strategy;the entrepreneur can provide a price menu for

consumers to choose. The result shows that the price gap is higher under the AON mechanism, the

“all-or-nothing” characteristic makes high-risk consumers willing to pay higher prices to make the

project successful, and this overpaid behavior can also improve their own surplus. In addition, we

also consider the repeat funders in crowdfunding who have pledged for similar projects before. We

want to explore the difference between such repeat funders with the first-time funders in strategic

choices and the impact of crowdfunding mechanisms. The result shows that repeat funders may be

more willing to pledge for similar projects. Finally, we consider the optimal structure of the platform

in terms of their fees and obtain the conclusion that the crowdfunding platform should charge the

same fixed percentage fees for all crowdfunding projects.

Our research makes the following contributions to the literature. First, previous theoretical

research on reward-based crowdfunding mostly focused on AON crowdfunding. To the best of our

knowledge, the present paperis the first theoretical paper to investigate the mechanism comparison

between AON and KIA crowdfunding mechanisms by modeling analysis. Although there have been

empirical studies on the comparison of these two crowdfunding mechanisms, the purpose of our

paper is to deductively analyze similar important empirical implications in some generality, and

theoretical analysis helps deepen our understanding of the causes of differences between the two

mechanisms. To describe the essential differences between the two mechanisms, we propose that

the quality of the final product under the two mechanisms may be different and consumers can

well expect such quality differences. We point out that such a difference in product quality leads to

the difference between the two crowdfunding mechanisms. Under the KIA mechanism, consumers

may have a higher degree of concern about the final product quality and such concerns can be

guaranteed under the AON mechanism. Our conclusion shows that both mechanisms are likely

to be optimal, depending on some other characteristics of the current market. Second, we also

make our analysis closer to reality through model extensions, and these more realistic assumptions

verify the robustness of the conclusions. Third, our conclusions provide some suitable advice for

entrepreneurial companies thatneed external financing. Risk-averse entrepreneurs with a low capital

goal or a scalable production should use KIAcrowdfunding mechanism for external financing.

The rest of the paper is organized as follows. We review relevant literature studies in Section 2.

In Section 3, we establish a basic two-person model and analyze it. We generalize the basic model

and analyze it numerically in Section 4. We propose some extensions based on the basic model in

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