An Experimental Study of Quality Signaling through Seed Money and Matching Gifts

The nonprofit sector is known for significant presence of highly inefficient organizations. Apart from the well-publicized fraudulent nonprofits, such as the Cancer Fund of America, there are many organizations that may not blatantly scam donors, but are nevertheless doing a poor job of providing public benefits. Donors' lack of information is likely a contributing factor. While the presence of rating agencies can help donors, the staggering number of charitable organizations makes the available information imperfect and costly to obtain. Consequently, a big challenge for well-run nonprofits is finding ways to credibly inform donors of their quality and distinguish themselves from their poorly performing counterparts.

We aim to investigate experimentally the role that leadership giving plays in conveying information to donors. Leadership gifts can be in the form of an unconditional lump sum called “seed money” or a promise of matching small donations by a fixed ratio called “matching gift”. Our goal is to understand how the type and size of the leadership gift impact donors' beliefs about the quality of the public good and their willingness to donate.

This is based on our novel theoretical model of fundraising, which reveals that the fundraiser's choice of leadership scheme depends crucially on the lead donor's information. If the lead donor is fully informed about the quality, either exogenously or endogenously via costly information acquisition, the charity relies on the lead donor to reveal the quality to subsequent donors through the size of her donation. This eliminates the signaling concern of the high quality charity when choosing her optimal fundraising scheme. Consequently, consistent with the existing theoretical literature, we find that in absence of signaling considerations, the fundraisers should optimally choose the matching scheme, as it alleviates the free rider problem present in public goods provision. However, if the leader is not fully informed about the quality, the lead donor's gift becomes a less reliable source of information and the fundraiser may have to employ the fundraising scheme itself to inform donors. In this case, the model gives rise to a strong prediction regarding the use of the two schemes to signal quality information to donors. While, as any signaling game, multiplicity of equilibria may arise, we find that in any equilibrium with partial information acquisition by the lead donor, the use of seed money in equilibrium is associated with higher expected quality compared to matching gift. Intuitively, since seed money is less effective in alleviating the free-rider problem compared to matching, it becomes a costly signaling tool for the high quality fundraiser that aims to differentiate itself from the low quality fundraiser. As a result, in equilibrium the high quality fundraiser solicits for seed money more often and for matching gift less often than the low quality fundraiser. This, in turn, gives rise to an equilibrium belief among donors that seed money is indicative of higher quality.

We investigate the theoretical predictions regarding the use of seed money as a signal of high quality in controlled lab experiments. The lab is an ideal environment for this as it allows us to control the amount of information available to donors, which is hard to achieve in the field. Moreover, we are the first to endogenize the choice of leadership scheme in the lab to understand the information that each scheme carries, how donors form beliefs, and how they respond to different schemes. In particular, our experimental design consists of a piece-wise linear public good game, in which the marginal per-capita return (MPCR) varies with the total amount raised and the quality of the public good. This ensures sufficient variation in the equilibrium contribution amounts to make both channels of signaling, namely the scheme choice and the lead donor's gift, possible. Since the ability of matching to alleviate the free-rider problem, and thus raise more contributions relative to seed money, is a key driving factor for seed money to emerge as a costly signal of quality in the incomplete information setting, our investigation consists of four treatments: a control setting, focusing on a complete information, and three main treatments with incomplete information. The control treatment compares the two schemes and studies the endogenous choice of scheme when the quality is known to all players. The three main treatments extend the framework to incomplete information and vary the probability of verification by the lead donor in order to establish how the choice of scheme and the lead donor's contribution choice interact to convey information to the downstream donor. This will allow us to measure the signaling value of each scheme.