Strategic Responses to Third-Party Ratings : Theory and Evidence from Charities

In markets with asymmetric information about quality, third-parties often introduce ratings. With ratings increasingly available, two important research questions arise: Do the ratings influence the behavior of those rated? And if so, do the reactions change other outcomes indirectly? Specifically, I consider how third-party ratings affect the decisions of rated charities, and consequently, overall giving. From a charity's perspective, fundraising expenses increases contributions, but doing so hurts ratings that are based on financial metrics. I develop a theoretical model of this trade-off showing that a rated charity will reduce fundraising regardless of its rating, relative to being unrated. Panel data of 5,500 charities over fifteen years confirms that fundraising expenses decline, by 45% for the lowest-rated charities. The large reductions in fundraising expenses cause losses in contributions and account for most of the ratings effects on giving, rather than the other effect of donor responses to ratings. Furthermore, substituting the estimated parameters into the theoretical model implies the fundraising decreases are disproportionately large and charities could earn more in contributions without damaging ratings. These results have implications for interpreting the effectiveness of third-party ratings, for designing ratings, and for improving the supply of public goods and services