Assurance contract

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 problems often assigned to governments and to do so in a way that does not involve coercion.

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