Pareto Assurance Contracts

Alex Tabarrok blogs about assurance contracts, an idea he originally wrote about in the 90's. An assurance contract helps get around the public goods problem.

In an assurance contract people pledge to fund a public good if and only if enough others pledge to fund the public good. 


What a dominant assurance contract adds is that the entrepreneur agreeing to produce the public good if k or more pledge also agrees that if fewer than k pledge he will pay a prize to those who did pledge.

Many companies have used the power of the internet combined with assurance contracts to create new businesses. Groupon assures businesses that if they engage in a promotion they will have a minimum number of customers, while Kickstarter and Indiegogo fund products or ideas that can be closer in nature to public goods because without the funding many of the projects they support wouldn't exist. The existence of a product in the market place that large groups of people would wish to purchase isn't the most common example of a public good, but it seems to qualify even if the good itself is a private good.

It is important to note that Kickstarter figured out a better way than dominant assurance contracts to fund their projects. Rather than forcing entrepreneurs to risk large payouts to potential funders (or arbitragers who can seek out projects certain to fail), the Kickstarter business model is to provide extra benefits to funders. They allow project creators to offer different levels of rewards, depending on the choice of the funder. The rewards can be capped, so only the first X amount of people to fund at a given level are given significant rewards while late coming crowdfunders will get slightly inferior rewards that are still better than what the general marketplace will get.

This is a solution where all sides benefit (assuming the people kickstarting the project didn't miscalculate their rewards), so perhaps the type of contracts used by Kickstarter and other crowd funding platforms should be called Pareto assurance contracts.
2 responses
I remember reading about assurance contracts about 10 years ago and thinking, "That's cool... I wonder why they don't actually exist in practice." Then, when Kickstarter/etc. came along, I didn't make the connection =/. Thanks for pointing it out. Also, I haven't followed Groupon in years, but when they first started out, it was an interesting dynamic. Groupon wasn't using the customer-acquisition target because the economics of the service dictated it. Businesses were selling e.g. massages, where each marginal massage costs the same amount and there's no economy of scale -- in contrast with most Kickstarter campaigns, where it really is an all-or-nothing proposition, depending on whether they raise enough money to develop the product. So Groupon was using the customer-acquisition target to incentivize people to spread the word. They were essentially holding the deal hostage unless the buyers convinced enough of their friends to buy in as well. So (as I saw it), they were using the same mechanic as assurance contracts, but for a different reason.
Kevin, good point about the Groupon mechanism "holding the deal hostage" though I think the customer limit is there for a wide variety of reasons. The logistics of honoring small deals might not be worth it to Groupon or the businesses. And in a small deal it is much more likely that the deal is being done by existing customers, cannibalizing the small business's customer base without providing any benefit. I think one of the reasons Groupon's growth has stalled is because there came to be many dedicated Groupon customers - customers who are used to buying Groupons and not heading back to stores afterwards. When small businesses realized that Groupon's deals were bad for their profit margins and also didn't acquire permanent customers they stopped being repeat customers of Groupon. The main places where this business model works is apparently spas, gyms and restaurants (as you can probably easily confirm by checking a random groupon email in your spam folder).