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 goods and club goods 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).
Assurance contracts are popular with libertarians and anarcho-capitalists to solve a problem that has usually required governments, and to 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.
Dominant Assurance Contracts
Dominant assurance contracts, created by Alex Tabarrok, 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 DAC market, driving down the cost disadvantage of DACs versus regular assurance contracts.
- Contingency market
- Crowd funding
- Preorder Economy
- Threshold pledge system
- Bagnoli, Mark and Lipman, Bart. 1989. Provision of public goods: Fully implementing the core through private contributions. Review of Economic Studies. 56, 583-601.
- A popular introduction to the theory of assurance contracts (as measured by Google page- blogosphere-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.