The June 2017 issue of Cato Unbound looks at how the private sector could provide public goods. It considers the idea of what Alex Tabarrok calls a Dominant Assurance Contract.
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.
I think of a public good as a special case of a more general problem, which is that it is often the case that average cost exceeds marginal cost. In fact, one of my main complaints about courses in basic microeconomics is that they focus on the opposite situation where marginal cost exceeds average cost, which is is not so often observed in reality.
For example, if you are building a cell phone network, the fixed cost of the infrastructure will be high. However, once you have the infrastructure, the marginal cost of transmitting a gigabyte of data will be low. If you charge this low marginal cost, you will never recover your fixed cost. Instead, you need customers to “donate” to pay for the infrastructure. The “donation” comes in the form of a monthly subscription fee.
In a typical cell phone pricing model, the charge for using data is zero until you reach your limit, and then it is ridiculously high. This model helps facilitate price discrimination. You pay a higher subscription fee to be in a higher data tier, meaning that you face the zero price at higher levels of data usage. Price discrimination of this sort helps the cell phone company recover fixed cost while making sure that most customers are charged low marginal costs most of the time.
The cell phone company has the ability to exclude non-subscribers from getting its service. With a public good, such as national defense, you no longer can exclude particular individuals. Either everybody gets it, or nobody gets it. Call this the non-excludability property.
Note: The textbook definition of a public good is one that is non-excludable and non-rivalrous. What I am suggesting here is any good that has very low marginal cost is “pretty close to” non-rivalrous. These “pretty close to” non-rivalrous situations are very common. {And with the Internet, they become more common. As maps turned into Google Maps, the marginal cost of producing a tryptich plummeted. As travel agents became TripAdvisor, the marginal cost of vacation planning services plummeted. etc.] Those that are also non-excludable, and therefore meet the textbook definition of public goods, are less common.
Governments, like private firms, can and do use price discrimination and bundling to cover fixed costs. People pay different tax amounts. People receive bundles of services–you pay for trash collection and government schools, even if you desire one but not the other.
Non-excludability is a different issue. Governments typically solve the problem of non-excludability by using coercion–you are forced to “donate.” Coercion produces the “everybody gets it” outcome instead of the “nobody gets it” outcome.
Alex’s contract is an alternative to coercion. The idea is that a typical consumer will receive a small benefit in the “nobody gets it” outcome, but only if that consumer is willing to donate. With the “everybody gets it” outcome, the consumer gets a benefit above that consumer’s willingness to pay. That is the sense in which either outcome is a win for a consumer who is willing to donate, so that it is in the consumer’s interest to be willing to donate.
My problem is that I cannot see a way to combine Alex’s contract with price discrimination and bundling. And I think that price discrimination and bundling are very important for funding government in practice.