If you, as a private citizen, want to build a bridge across the river to shorten your commute, you run into a few problems. The incredible cost of the proposed bridge puts it beyond your limited resources, so you try and convince thousands of your neighbors to chip in donations. But you don’t want to contribute money unless you reach the total amount necessary to build the bridge; a half-built bridge is worse than no bridge at all.
One answer to this problem is to use the State to coerce contributions (taxes) from the community, but that comes with ethical problems and inefficiencies from bureaucracy and regulatory capture. Recently, new internet-based alternatives like Kickstarter have fueled the rise of private sector crowdfunding (properly known as assurance contracts), solving the fundraising problem by guaranteeing that contributors will only be debited if total contributions reach the required amount.
However, there is still a free rider problem given that people who want the bridge will be unwilling to contribute since there’s a chance that the bridge will be built regardless of whether they, personally, contribute. They can have a bridge without paying, thus the temptation to free ride. To mitigate that problem, Alex coined the idea of the dominant assurance contract, which gives potential free riders an additional incentive to contribute. And dominant assurance contracts could be combined with smart contracts on the blockchain to remove the need for as much trust in the good intentions of strangers.
What is a dominant assurance contract? What is a public good? How much of each public good do we want? How are assurance contracts just like crowdfunding? What is Kickstarter?
Making Markets Work Better: Dominant Assurance Contracts and Some Other Helpful Ideas, written by Alex Tabarrok
Kickstarter and the NEA, written by Tyler Cowen
The private provision of public goods via dominant assurance contracts, written by Alex Tabarrok
What Theory Won’t Tell You About Public Goods, written by Jon Murphy
Prices Are Too Damn High, Building Tomorrow Podcast
Modern Liberalism and the Paternalism of Things, written by Jason Kuznicki
00:05 Paul Matzko: Welcome to Building Tomorrow, a show about the ways tech and innovation are making the world a better place. I’m here once again with Alex Tabarrok, the professor of economics at George Mason University. This is part 2 of our series, covering everything from why are the prices so damn high to now a fascinating concept called dominant assurance contracts, which was invented by or coined by Alex himself. Okay, that’s really jargony though. I say dominant assurance contracts and maybe you’re tempted just to fall asleep as you listen to this unfamiliar title.
00:38 Paul Matzko: We’ll parse it a bit more here in a second but a dominant assurance contract in a sense is like a legal technology or device in a sense. It’s no different in that regard than fee simple property, a concept invented in the 13th century, or limited liability corporations in the 19th century. Now dominant assurance contracts in the 1990s. These are legal innovations or technologies in the sense of being recipes of knowledge which have to be invented, have to be thought of just as much as tangible tech, like combustion engines and phones, and it’s hard to imagine the hockey stick shaped boom in modern and capitalist prosperity without these recipes of knowledge. So let’s start with basics. Before we get to dominant assurance contracts, Alex, the communists talk a lot about public goods versus, I guess, private goods. What are public goods?
01:31 Alex Tabarrok: A public good is defined as a good which is a non-rival and non-excludable. So what does that mean? My favorite example of a public good is asteroid deflection. Just a few weeks ago, an asteroid barely missed the world. It could have destroyed an entire city. Asteroid deflection or destruction would be a public good because if someone were to go and were to deflect the asteroid from hitting the Earth, everyone would benefit.
02:04 Paul Matzko: Yeah. [chuckle]
02:05 Alex Tabarrok: So it’s non-rival because if I have an apple and I give it to you, I lose the apple. But if I deflect the asteroid, we both get the benefits of deflecting the asteroid. So that means it’s non-rival; anyone in the world can benefit. And the second, it’s non-excludable. This means that I can’t make you pay. I could make by forcing you, but I can’t exclude you from benefiting from the asteroid deflection if you don’t pay. So I could say, “Listen, we need to get together. Nobody wants to die from this asteroid. We don’t wanna be the dinosaurs, so let’s get together and put some money in a pool and then we will be able to save our planet.” Unfortunately, many people are gonna think, “You know, I’ll let the other guys put their money in the pool. I’ll buy some jeans instead because the jeans are a private good; I get the benefit of that. If I contribute to the asteroid then probably enough other people are gonna contribute anyway that the deflection is gonna happen anyway. And if not enough other people contribute then my money is wasted.” So there’s an incentive to free ride. So public goods are one of the classic so-called market failures that even though deflecting the asteroid might be very valuable, it’s gonna be tough to produce that in a market.
03:50 Paul Matzko: And therefore you need state coercion. We’re going to make everyone contribute via taxation, police power, etcetera. That’s the idea the state helps mitigate the free rider problem in the public goods model.
04:05 Alex Tabarrok: Exactly. One of the reasons why I like the asteroid example, which Tyler and I use in our textbook, Modern Principles of Economics, one of the reasons I like it is, of course, the state fails here as well.
04:18 Paul Matzko: Yeah, they can’t get taxes from everyone. They try, yeah, yeah.
04:20 Alex Tabarrok: Well, and in actual point of fact, we don’t spend a lot of money. [chuckle] This is a good, which is a public good and I would like to see it actually funded, but the government does not actually spend a lot of money on deflecting asteroids. So it’s a public good where we have market failure and government failure.
04:39 Paul Matzko: Yeah, interesting.
04:41 Alex Tabarrok: Not too surprising.
04:42 Paul Matzko: Yeah, that’s interesting. So there’s a free rider problem that’s inherent to public goods. There’s also… You have an article out. I read the original, at least the bits of it that weren’t too technical, that you wrote I think in the 1990s, about dominant assurance contracts where you say, “Look, we can break down the problem with public goods into a preference revelation and contribution problems.” What are those? How do those relate to the free rider issue?
05:12 Alex Tabarrok: Right. So there are some public goods where it’s obvious how much we want. “We just want to deflect the asteroid,” that’s it; it’s not a question of deflecting it 1%, 2%.
05:25 Paul Matzko: In gradations, right, yeah, yeah.
05:26 Alex Tabarrok: Yes.
05:28 Paul Matzko: I only want to deflect half of it.
05:30 Alex Tabarrok: Exactly. And if we wanna build a bridge, it’ll be pretty obvious how big the bridge has to be. We can measure the amount of traffic and so forth. Or we wanna have a lighthouse, we know pretty much how tall it has to be and how powerful the light. So we don’t have to worry. In this case, in the case of the asteroid and the lighthouse and the bridge, it’s really a question of getting people to pay. It’s not a question of figuring out what we actually want or how much of the good we actually want. But there are other public goods such as charity for example, welfare payments, where if I give a poor person some money and we both care about the person, you benefit as well, and therefore you have an incentive to free ride. But here it’s not entirely obvious how much of the public good we want. Or suppose we think education is a public good, how much of it do we actually want? It’s not quite so obvious. So there’s a more… Also a preference revelation problem. We have to figure out exactly what quantity to produce, and that depends upon people’s preferences.
06:50 Paul Matzko: So I might be willing to pay a $1000 per pupil for a public school education, but my neighbor might be willing to pay $2000 maybe because they actually have a kid, whereas I don’t and just want to feel like I’m contributing to the common wheel therefore, but we have different preferences on how… What’s the optimal level of spending.
07:13 Alex Tabarrok: Exactly. Exactly right. And so the dominant assurance contract, which I guess we’ll get to in a minute, this solves the contribution problem. It does not solve the preference revelation problem. So this is a particular mechanism which is very good for producing lighthouses or bridges or other collective action goods of that type, but it doesn’t solve everything.
07:41 Paul Matzko: So before we get to the dominant part of this, how about we start with the assurance contract part, which I think it’s a little older in the ’80s, I think I saw that assurance contracts were kind of proposed by other economists. And my understanding after reading that is that assurance contracts are basically kickstarter or crowd funding. So what is that in more technical economic terms, and did this surprise everyone? I also get the impression that no one in the ’80s could have imagined Kickstarter. They imagined the concept, but how that would actually be expressed. So take us through what is an assurance contract?
08:21 Alex Tabarrok: Exactly right. So Kickstarter makes this pretty familiar to everyone, and that is that on Kickstarter, if you’re contributing to a good, it could be a public good, you only pay if enough other people contribute so that the good can be produced. So the assurance contract or the Kickstarter contract assures you that your money won’t be wasted. It will only be spent if enough other people contribute such that everybody together is enough to actually produce the good.
09:02 Paul Matzko: So I’m concerned. I wanna build a bridge across the river, but I don’t have enough to fund that just by myself. It’s a very expensive thing to build a bridge. But the problem is, is you don’t wanna start building the bridge if you’re not gonna end up having enough money to pay for all of it. A half-built bridge isn’t any good.
09:22 Alex Tabarrok: Exactly.
09:23 Paul Matzko: So let’s not start this until we’re guaranteed to have enough funding to build the bridge. So how do we do that? You could start the bridge and hope that you raise enough funding once people see that it will work, but there’s a real risk of failure. If you want to mitigate that risk, an assurance contract is a way of, “We’re not gonna start it until everyone’s agreed to raise enough.”
09:47 Alex Tabarrok: Exactly. And if you think about you as a contributor, not as the producer but as a contributor, and you say, “Well, they’ve gotten a quarter over the way, do I really wanna give them some money?” You might say, “Well, if they’re only gonna get halfway, then my money is just gonna be wasted.” Right? So you wouldn’t wanna contribute unless you had some guarantee that enough other people would contribute in order to make the bridge successful.
10:16 Paul Matzko: This makes sense. It helps mitigate the contribution problem, I suppose, where it’s also a promise. “I promise to give the money but I haven’t actually given the money yet. So I’m not gonna lose… I’m fine if you will “losing the money” if it produces this good. But the problem is if I hand over the money and the good isn’t produced, it’s a total loss. I haven’t gotten the good and I’ve lost money.” So with an assurance contract system, you have an organization like Kickstarter that says, “Hey look, we will hold the money in a sense, in escrow, and we’ll only give that money to the producer, if they get to this certain level. And if they don’t get there, we’ll give it back to you.” So it makes people more willing to contribute. There are projects… There are bridges that are going to be built. Maybe not on Kickstarter, but there are things that are going to be produced that wouldn’t be produced otherwise because you’ve lessened people’s anxiety about contributing to an uncertain project.
11:16 Alex Tabarrok: Exactly. And it turns out, Kickstarter has been remarkably successful and more successful, I think as you pointed out, than people would have expected when they were just talking about these ideas in theory. People have given billions of dollars to various kind of Kickstarter projects and of course there are many other similar sites other than Kickstarter. So it’s been very successful. But it’s still the case that most projects on Kickstarter fail. Most do not reach the critical level at which the money is disbursed. So on most projects, you agree to give the money and your money is returned to you because not enough other people agree.
12:06 Paul Matzko: So why is that? What’s the…
12:08 Alex Tabarrok: Well, I think there could be a variety of reasons. First, there still is a reason not to give. That is you hope that if you might wanna see the Veronica Mars movie, but you say, “Well, if I don’t contribute and other people do, it’s still gonna be produced and I’ll still be able to see it without having to pay my contribution.” So there’s still an incentive to free ride. The Kickstarter contract reduces the fear of wasting your money, but it does not eliminate the incentive to free ride on others. And that’s where my contribution comes in.
12:51 Paul Matzko: So let’s talk about the dominant part of dominant assurance contracts. How does this mitigate even more the free rider problem?
13:00 Alex Tabarrok: When I proposed… This was well before Kickstarter. When I…
13:04 Paul Matzko: Yeah. It was like 90… Mid ’90s? Something like that?
13:06 Alex Tabarrok: Yeah, I think I was ‘89…
13:07 Paul Matzko: ‘89? Oh, even early.
13:09 Alex Tabarrok: I can’t even remember. I might be wrong. I don’t remember.
13:13 Paul Matzko: You were a young whippersnapper at that… Yeah, alright.
13:17 Alex Tabarrok: Yes, yes. So what I proposed was a very simple modification of what we would now call the Kickstarter contract.
13:25 Paul Matzko: Okay.
13:25 Alex Tabarrok: And the simple modification is this: If the contract fails to reach critical mass, if not enough people, in fact, contribute towards producing the Veronica Mars movie or whatever it may be, the entrepreneur-in-charge will give to each of the people who promised that they would give, they give them a refund plus a bonus. So it’s like a refund bonus. So now think about this contract from the point of view of you as a potential contributor. If you give money and the contract is successful, a lot of other people contribute, well, that’s good for you because the good is actually produced, and we can assume that the value to you of the good is greater than your contribution so you are on net better off. On the other hand, you say to yourself, “Well, if I contribute and others fail to contribute, I’m also better off.”
14:32 Paul Matzko: It’s a win-win.
14:34 Alex Tabarrok: It’s a win-win. Exactly right. That’s why it’s called the dominant assurance contract because the dominant strategy is to contribute no matter what other people do. So whatever, you don’t care now what other people do. You just say, “Well, it’s a win-win. I can’t lose, therefore I contribute.” So this makes it possible to produce public goods. It eliminates the free rider. It eliminates most of the free rider problem and it means that people now wanna contribute, and it greatly enhances the ability of Kickstarter-like contracts to produce public goods.
15:18 Paul Matzko: Do we have any real-world examples, real-world examples of dominant assurance contracts?
15:23 Alex Tabarrok: Interestingly, some colleagues and I have recently been running lab experiments. So this is economic experiments. And what we do in these experiments is we put people into a Kickstarter-like situation where they have the ability to contribute to a variety of public projects and some… In some cases, we give them the dominant assurance contract. We tell them there’s gonna be refund bonuses if you contribute to this project and in other cases not. And so, what we compare and what we find in our experiments is that in a variety of circumstances, the refund bonuses double the probability that the contracts are successful.
16:18 Alex Tabarrok: And in fact we… It’s enough of a gain so that these contracts can be self-funding. So an entrepreneur, it’s true that it’s not 100%, right? So an entrepreneur does take some risk because there will be some circumstances where even with the refund bonus, the contract fails and then the entrepreneur has to pay out the refund bonuses. However, the number of contracts that succeed is so much larger using the refund bonus system that, overall, entrepreneurs have enough profits so that they’re more than willing to pay refund bonuses in the minority of cases where they have to.
17:04 Paul Matzko: So how about we talk about what the blockchain adds to the dominant assurance contract. So in a sense, we’re layering on an additional innovation here. How does the blockchain strengthen the potential willingness of people to contribute to a dominant assurance contract?
17:23 Alex Tabarrok: Right. So what makes this particularly amenable to the blockchain or to smart contracts is that all of this can be done in code. So as you pointed out, Kickstarter is really acting as an escrow agent. They are collecting the funds and only releasing them to the entrepreneur if a certain total has been reached. Well, you can easily code that and put that in a smart contract. And similarly, for the payment, the refund bonuses if enough has not been… If the critical mass has not been reached. So all of this can be put in code, put in the blockchain, put on Ethereum. Once you do that, you don’t even have to worry that the entrepreneur is gonna rip you off because all of the code is open source, it’s viewable, and so this provides a super strong credible argument that the code actually will be executed in exactly the way which the code describes. So you can automate these things and that would be great.
18:37 Paul Matzko: So another question here. So a lot of this framing, it’s easy to see the value from a libertarian perspective of converting public goods, of providing public goods via private means, reducing the role of the state in building infrastructure. Like, there’s kind of a prima facie appeal to libertarian audiences there. What’s the best non-libertarian argument you can think of for wanting to reduce the number of public goods provided by the state through dominant assurance contracts?
19:06 Alex Tabarrok: Yeah, so I think the best argument there is the one I alluded to is that there could be very many public goods which the state simply fails to provide. Asteroid deflection being one example of that that I gave earlier. But the state just isn’t very good at doing a lot of things, and if you look at what the state does do, most of it is not providing public goods. Most of what the state does is not addressing market failure. And so the state although it is conceptually capable of producing public goods and addressing market failures, in actual point of fact, the incentive structure doesn’t really promote those activities in an especially powerful way.
20:02 Alex Tabarrok: So if we could instead have public goods provided by entrepreneurs, and if you could get capitalism to produce public goods, which in a traditional context doesn’t make any sense at all because you think public goods mean market failure, but with a dominant assurance contract, public goods are not necessarily market failures. Public goods could be provided by markets certainly more than they are today. So if we could have public goods provided by entrepreneurs in a capitalist highly incentivized system, we might actually have a lot more of them provided, particularly local public goods. As you pointed out in your introduction, this is kind of a social technology which helps us cooperate. So this is simply a way of making it easier, lowering the transactions cost, increasing the incentives to act in a cooperative manner. And don’t we all want more cooperation? So this is a tool, a technology, to increase cooperation.
21:07 Paul Matzko: Maybe we were thinking during the conversation about dominant assurance contracts. How is this technology? And that’s where it’s important that we realize that technologies are just recipes of knowledge, just as devising a better widget that can make cheaper and that works just as effectively makes us all better off, coming up with ideas. The person who imagined that there could be a better widget, that itself is the recipe of knowledge that produces certain outcomes, that produces a tangible outcome. But the idea comes first, processes come before manufacturing, ideas come before new physical technologies. And often through a confluence of factors these recipes of knowledge unlock immense knock on gains with broad positive social and economic consequences.
21:54 Paul Matzko: And I think it’s important that we talk about these ideas, that we don’t just focus on startups producing tangible products in the next couple of years, that’s an important part of tech. But what’s also important is this conceptualization process. These abstract ideas, it trains us to stretch our imagination to think about what might be possible. It’s kind of a forecasting exercise. It’s a muscle, it’s a thing that we work at, that we improve, that we strengthen. It’s an intellectual muscle that if we strengthen it, we can have a real advantage when it comes to being part of an innovative future ourself. It helps us conceptualize which new ideas could succeed and which ones won’t, and what has the real potential to transform our human future for the better.
22:40 Paul Matzko: Thanks for listening. Building Tomorrow is produced by Tess Terrible. If you enjoy Building Tomorrow, please subscribe to us on iTunes or wherever you get your podcasts. If you’d like to learn more about libertarianism, find us on the web at www.libertarianism.org.