Friday, November 26, 2010

Assurance contracts and dominant assurance contracts

Frances at WCI notes an innovative use of assurance contracts by Public Enemy.
Political rap band Public Enemy is financing their latest album through www.sellaband.com. This is how it works. The band, in this case Public Enemy, announces a fundraising goal - $75,000 to record an album. Fans make on-line donations through sellaband - but if a fan changes his mind, he can switch his funding to another band at any time, up until the point when Public Enemy's fundraising goal is met. Fans can expect some future payback - downloads, a share of any profits, whatever the band promises.

At first glance, Public Enemy's approach doesn't look so different from Radiohead's or Wikipedia's. Yet individuals' incentives to contribute are fundamentally different. Wikipedia is there whether I donate or not, so the best strategy (warm glow of giving aside) is not to donate.

But imagine that 7,499 other people have aready donated $10 to Public Enemy. My $10 donation brings the total up to $75,000, enough to generate a new Public Enemy album. I have no incentive to withdraw my donation, because if I do, the project won't be funded. My donation is a "pivotal contribution."

Indeed, if any one of the 7,499 people pull out, the project won't be funded. Each one of those 7,499 donations are pivotal, so no one has an incentive to pull out.

In the language of game theory, the situation where Public Enemy's album is financed by 7,500 people each donating $10 is Nash equilibrium - each person is making the choice that is best for themselves, taking the behaviour of other people as given.
Public Enemy's fundraising was successful. But there still was a problem in strategy.

If I think that somebody else would be the pivotal contributor were I to hold back, then I've incentive to refrain from donation until the last minute. Frances is definitely right if we consider only the population of folks who have contributed. Given everyone else's contribution, my dominant strategy is to stay in if I'm pivotal. But there's a whole other domain of folks who might contribute but who haven't as yet. Any of them could be the pivotal donor and I could save my money. If too many folks do that, we can get coordination failure where everyone waits to see if their contribution would be truly pivotal, then fails to sign up because the target looks too far from reach.

Public Enemy ran an assurance contract but not a dominant assurance contract. How to make it dominant strategy, or at least much closer to it, to pledge early and stay in? Provide some item of value to the contributor for pledging early. Suppose everyone who pledges some minimal amount to the assurance contract, and doesn't withdraw his pledge before the deadline, gets a token to download one MP3 track available only to pledgers. If the project goes ahead, the song is included as a special bonus track for contributors. The band then takes the place of Tabarrok's assurance entrepreneur: bearing downside risk of paying out to pledged contributors should the project fail to go ahead but earning returns if it succeeds.

All the incentives for pledgers in the model Public Enemy ran - numbered CDs and potentially a share in album revenues - eventuate only if the project is successful. You want an incentive for folks to go in early and to stay in, helping to ensure that the project does finally go ahead. Paying them for doing so is one way of solving the problem. Public Enemy was successful in raising the $75,000 needed to record another album; they lowered their target from the $250,000 that included marketing and other costs. Perhaps dominant assurance contracts could have helped.

Public Enemy is playing Christchurch next year. So is Weird Al. I wonder how many folks will be in the intersection. Conditional on babysitting availability and spousal indulgence....

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