Assurance contracts
Encyclopedia
An assurance contract, also known as a provision point mechanism, is a game theoretic mechanism
and a financial technology that facilitates the voluntary creation of public good
s and club good
s in the face of the free rider problem
.
The free rider problem is that there may be actions that would benefit a large group of people, but once the action is taken, there is no way to exclude those who did not pay for the action from the benefits. This leads to a game theoretic
problem: all members of a group might be better off if an action were taken, and the members of the group contributed to the cost of the action, but many members of the group may make the perfectly rational decision to let others pay for it, then reap the benefits for free, possibly with the result that no action is taken. The result of this rational game play is lower utility
for everyone.
Assurance contracts operate as follows:
In a binding way, members of a group pledge to contribute to action A if a total contribution level is reached (often a monetary threshold, or a quorum of N members making the same pledge). If the threshold level is met (perhaps by a certain expiration date), the action is taken, and the public good is provided; otherwise, the parties are not bound to carry through the action and any monetary contributions are refunded. The treatment of excess contributions varies: they may be lost, rebated proportionally to the contributors, or used to provide more of the public good.
The binding mechanism may be a contract enforced by a government, a contract enforced by a private organization (e.g. a mediator, a protection agency in an anarcho-capitalist
society, etc.), an escrow organization (in such cases, the "binding contract" is "signed" by depositing funds in advance, which are later either disbursed according to the contract, or refunded), etc.
In the economics literature, assurance contracts were first described by Bagnoli and Lipman (1989).
as they solve a problem that has usually required governments, and do so in a way that does not involve coercion.
Assurance contracts are also relevant to international public good provision problems, where there is no world government that can use coercion to provide the public good.
, involve an extra component - an entrepreneur who profits when the quorum is reached and pays the signors extra if it is not. If the quorum is not formed, the signors do not pay their share, and indeed, actively profit from having participated since they keep the monies the entrepreneur paid them. Conversely, if the quorum succeeds, the entrepreneur is compensated for taking the risk of the quorum failing. So, a player will benefit whether or not the quorum succeeds; if it fails he reaps a monetary return, and if it succeeds he pays only a small amount more than under an assurance contract, and the public good will be provided. Tabarrok asserts that this creates a dominant strategy
of participation for all players. Because all players will calculate that it is in their best interests to participate, the contract will succeed, and the entrepreneur will be rewarded. In a meta-game, this reward is an incentive for other entrepreneurs to enter the Dominant Assurance Contract market, driving down the cost disadvantage of Dominant Assurance Contracts versus Assurance Contracts.
Mechanism design
Mechanism design is a field in game theory studying solution concepts for a class of private information games...
and a financial technology that facilitates the voluntary creation of public good
Public good
In economics, a public good is a good that is non-rival and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability means that no one can be effectively excluded from using the good...
s and club good
Club good
Club goods are a type of good in economics, sometimes classified as a subtype of public goods that are excludable but non-rivalrous, at least until reaching a point where congestion occurs...
s in the face of the free rider problem
Free rider problem
In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...
.
The free rider problem is that there may be actions that would benefit a large group of people, but once the action is taken, there is no way to exclude those who did not pay for the action from the benefits. This leads to a game theoretic
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...
problem: all members of a group might be better off if an action were taken, and the members of the group contributed to the cost of the action, but many members of the group may make the perfectly rational decision to let others pay for it, then reap the benefits for free, possibly with the result that no action is taken. The result of this rational game play is lower utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
for everyone.
Assurance contracts operate as follows:
In a binding way, members of a group pledge to contribute to action A if a total contribution level is reached (often a monetary threshold, or a quorum of N members making the same pledge). If the threshold level is met (perhaps by a certain expiration date), the action is taken, and the public good is provided; otherwise, the parties are not bound to carry through the action and any monetary contributions are refunded. The treatment of excess contributions varies: they may be lost, rebated proportionally to the contributors, or used to provide more of the public good.
The binding mechanism may be a contract enforced by a government, a contract enforced by a private organization (e.g. a mediator, a protection agency in an anarcho-capitalist
Anarcho-capitalism
Anarcho-capitalism is a libertarian and individualist anarchist political philosophy that advocates the elimination of the state in favour of individual sovereignty in a free market...
society, etc.), an escrow organization (in such cases, the "binding contract" is "signed" by depositing funds in advance, which are later either disbursed according to the contract, or refunded), etc.
In the economics literature, assurance contracts were first described by Bagnoli and Lipman (1989).
Political overtones
Assurance contracts are popular with libertarians and anarcho-capitalistsAnarcho-capitalism
Anarcho-capitalism is a libertarian and individualist anarchist political philosophy that advocates the elimination of the state in favour of individual sovereignty in a free market...
as they solve a problem that has usually required governments, and do so in a way that does not involve coercion.
Assurance contracts are also relevant to international public good provision problems, where there is no world government that can use coercion to provide the public good.
Variants
Dominant Assurance Contracts, created by Alex TabarrokAlex Tabarrok
Alexander Taghi Tabarrok is a Canadian-American economist and co-author, with Tyler Cowen, of the economics blog Marginal Revolution....
, involve an extra component - an entrepreneur who profits when the quorum is reached and pays the signors extra if it is not. If the quorum is not formed, the signors do not pay their share, and indeed, actively profit from having participated since they keep the monies the entrepreneur paid them. Conversely, if the quorum succeeds, the entrepreneur is compensated for taking the risk of the quorum failing. So, a player will benefit whether or not the quorum succeeds; if it fails he reaps a monetary return, and if it succeeds he pays only a small amount more than under an assurance contract, and the public good will be provided. Tabarrok asserts that this creates a dominant strategy
Dominance (game theory)
In game theory, strategic dominance occurs when one strategy is better than another strategy for one player, no matter how that player's opponents may play...
of participation for all players. Because all players will calculate that it is in their best interests to participate, the contract will succeed, and the entrepreneur will be rewarded. In a meta-game, this reward is an incentive for other entrepreneurs to enter the Dominant Assurance Contract market, driving down the cost disadvantage of Dominant Assurance Contracts versus Assurance Contracts.
See also
- Threshold pledge systemThreshold pledge systemThe threshold pledge or fund and release system is a way of making a fundraising pledge as a group of individuals, often involving charitable goals or financing the provision of a public good. An amount of money is set as the goal or threshold to reach for the specified purpose and interested...
- Micropatronage
- Contingency marketContingency marketContingency markets are markets where contracts are made to exchange funds contingent upon an event or combination of events or contingencies thereof.-Difference from prediction markets:...
- Preorder EconomyPreorder EconomyA preorder economy is a type of proposed future economy where the exact demand for goods is known ahead of time, before any material production takes place...
- KickstarterKickstarterKickstarter is an online threshold pledge system for funding creative projects. Kickstarter has funded a diverse array of endeavors, ranging from indie film and music to journalism, solar energy technology and food-related projects.-Model:...
External links
- A popular introduction to the theory of assurance contracts (as measured by GoogleGoogleGoogle Inc. is an American multinational public corporation invested in Internet search, cloud computing, and advertising technologies. Google hosts and develops a number of Internet-based services and products, and generates profit primarily from advertising through its AdWords program...
page- blogosphereBlogosphereThe blogosphere is made up of all blogs and their interconnections. The term implies that blogs exist together as a connected community or as a social network in which everyday authors can publish their opinions...
-ranking), was this post in the Marginal Revolution blog. - Tabarrok's paper on Dominant Assurance Contracts (PDF).
- Participation in the Free State Project is based on an assurance contract. Participants agree to relocate to New Hampshire upon getting pledges from 20,000 other people (by a certain date) to do the same. If not enough people pledge, pledgers are absolved from the requirement to relocate.