Making Markets Work Better: Dominant Assurance Contracts and Some Other Helpful Ideas

I agree with Jason Kuznicki that “libertarian social engineering” is underdeveloped and promising. The better markets work, the less the demand for the state. By improving markets and other voluntary organizations, libertarians can make their political vision more attractive while at the same time making people better off.

Modern libertarianism began after many of the market institutions that we take for granted had already been developed. Fee simple property, for example, dates to 1290. Could we have a libertarian society without fee simple property? In theory, yes. In practice, the free society is attractive because it generates wealth. Without fee simple property it is, at the very least, more difficult to create a rich, industrialized society. The limited liability company dates much later than fee simple property, to the 19th century. Without the limited liability company, it would probably have been much more difficult to raise large amounts of capital. As a result, without limited liability, markets would be at a great disadvantage compared to the state in conducting economic activity on a large scale. Thus fee simple property and the limited liability company are among the technological/legal institutions that have made a free society possible, not because they are constitutive of a free society, but because they make a free society work better and compete better against statist alternatives.

Public goods are one of the big challenges to markets.[1] Indeed, it was long thought that the free rider problem prevented public goods from being provided voluntarily. David Hume (1739), for example, wrote that such provision was impossible, which is why we need the state:

Two neighbours may agree to drain a meadow, which they possess in common: because it is easy for them to know each other’s mind; and each must perceive, that the immediate consequence of his failing in his part, is the abandoning of the whole project. But it is very difficult, and indeed impossible, that a thousand persons should agree in any such action; it being difficult for them to concert so complicated a design, and still more difficult for them to execute it; while each seeks a pretext to free himself of the trouble and expense, and would lay the whole burden on others. Political society easily remedies both these inconveniences…Thus, bridges are built, harbours opened, ramparts raised, canals formed, fleets equipped, and armies disciplined, everywhere, by the care of government…

In Tabarrok (1998) I showed that such reasoning was wrong; a large class of public goods can be produced voluntarily using what I called a dominant assurance contract. My paper was written long before sites like Kickstarter made crowdfunding a common idea, but the dominant assurance contract is a modified crowdfunding contract. In a standard crowdfunding contract, entrepreneurs seek voluntary donations, but they commit to use those donations if and only if the total meets or exceeds a critical threshold. If total donations are less than the threshold, the donor’s funds are returned. Billions of dollars have been raised using crowdfunding contracts, but much more may be possible. The crowdfunding contract solves the assurance problem, because donors need not fear their contributions will be wasted, but it doesn’t fully solve the free riding problem.

The dominant assurance contract adds a simple twist to the crowdfunding contract. An entrepreneur commits to produce a valuable public good if and only if enough people donate, but if not enough donate, the entrepreneur commits not just to return the donor’s funds but to give each donor a refund bonus. To see how this solves the public good problem consider the simplest case. Suppose that there is a public good worth $100 to each of 10 people. The cost of the public good is $800. If each person paid $80, they all would be better off. Each person, however, may choose not to donate, perhaps because they think others will not donate, or perhaps because they think that they can free ride.

Now consider a dominant assurance contract. An entrepreneur agrees to produce the public good if and only if each of 10 people pay $80. If fewer than 10 people donate, the contract is said to fail and the entrepreneur agrees to give a refund bonus of $5 to each of the donors. Now imagine that potential donor A thinks that potential donor B will not donate. In that case, it makes sense for A to donate, because by doing so he will earn $5 at no cost. Thus any donor who thinks that the contract will fail has an incentive to donate. Doing so earns free money. As a result, it cannot be an equilibrium for more than one person to fail to donate. We have only one more point to consider. What if donor A thinks that every other donor will donate? In this case, A knows that if he donates he won’t get the refund bonus, since the contract will succeed. But he also knows that if he doesn’t donate he won’t get anything, but if does donate he will pay $80 and get a public good which is worth $100 to him, for a net gain of $20. Thus, A always has an incentive to donate. If others do not donate, he earns free money. If others do donate, he gets the value of the public good. Thus donating is a win-win, and the public good problem is solved.[2]

Thus, contrary to Hume and many others, it may be possible to produce bridges, harbors, ramparts, and canals privately (“fleets equipped and armies disciplined” may require different institutions). In fact, Cason and Zubrickas (2017) recently tested dominant assurance contracts in an experiment and found that they do increase the provision of public goods. Moreover, there are advantages to the private method of provision over “political society.” Political society avoids the problem of free riders at the expense of creating forced riders, people who are forced to pay for a public good that they value at less than their cost. More generally, how do we know that a bridge is truly worth more than its cost? Hume takes the value of the bridge as given, but we need a discovery process for public goods just as for other goods.

Dominant assurance contracts open the provision of public goods to entrepreneurship, innovation, and the market discovery process. We may find that more and different public goods exist than have previously been imagined. An option to allow refund bonuses on crowdfunding websites such as Kickstarter could improve the efficiency of those sites and provide a wealth of useful test data.

Public goods are not the only challenge to markets. Markets are also challenged by externalities, asymmetric information, and the demand for redistribution. Redistribution is probably the greatest challenge. Markets don’t handle redistribution well, but they can handle the closely related issue of insurance, and insurance contracts can be improved. It’s long been thought, for example, that unemployment insurance can’t be provided privately because of the risk of adverse selection and moral hazard. But although it may be difficult to create an unemployment insurance contract that pays out when you are unemployed, what about one that pays out only when you are unemployed and there is unusually high national unemployment, or unusually high unemployment in your industry or city? Conditioning payouts at least partially on things that the worker does not control could alleviate problems of asymmetric information and still allow the market provision of unemployment insurance.

Health insurance markets are likewise ripe for improvement. Cochrane’s Time Consistent Insurance (1995, 2009) improves the market provision of health insurance (see also Tabarrok 1994, 2002b for “Gene Insurance”, an early precursor). Similarly, Robert Schiller’s (2003) macro markets in housing and GDP reduce the risk from housing bubbles and business cycles.[3] The better the market can insure against risk, the less will be the demand for coercive solutions.

New technologies such as smart contracts and the rise of ubiquitous and massive computing power, including all manner of sensors and location technologies, may make these ideas implementable at lower cost and in better ways than ever before (Tabarrok and Cowen 2015).

In conclusion, it is time to reexamine market challenges in light of new ideas and new technologies and begin a research program in libertarian social engineering.

References

Beito, David, Peter Gordon and Alexander Tabarrok (eds). 2002. The Voluntary City: Choice, Community, and Civil Society. University of Michigan Press.

Cason, T. N. and Zubrickas, R., 2017. Enhancing fundraising with refund bonuses. Games and Economic Behavior, 101, pp. 218-233.

John H. Cochrane. 1995. Time-Consistent Health Insurance. Journal of Political Economy 103, no. 3:445-473. https://doi.org/10.1086/261991

Cochrane, John H. 2009. Health-Status Insurance: How Markets Can Provide Health Security. Cato Policty Analysis No. 633: https://www.cato.org/publications/policy-analysis/healthstatus-insuranc…

Hume, David. 1739. A Treatise on Human Nature. Available online at https://ebooks.adelaide.edu.au/h/hume/david/h92t/B3.2.7.html

Schiller, Robert. 2003. The New Financial Order. Princeton University Press.

Tabarrok, A. 1994. Genetic Testing: An Economic and Contractarian Analysis. Journal of Health Economics 13:75-91. http://www.sciencedirect.com/science/article/pii/0167629694900051

Tabarrok, A. 1998. The Private Provision of Public Goods Via Dominant Assurance Contracts. Public Choice 96:345-362.

Tabarrok, Alexander (ed.). 2002a. Entrepreneurial Economics: Bright Ideas from the Dismal Science. Oxford University Press.

Tabarrok, Alexander. 2002b. Gene Insurance. In Entrepreneurial Economics: Bright Ideas from the Dismal Science. Oxford University Press.

Tabarrok, A., & Cowen, T. 2015. The End of Asymmetric Information. CATO Unbound. Retrieved from https://www.cato-unbound.org/2015/04/06/alex-tabarrok-tyler-cowen/end-asymmetric-information