I’ve been absolutely fascinated by the idea of dominant assurance contracts ever since I first heard about them in one of Cowen’s papers. Still, to my knowledge the whole concept of dominant assurance contracts is not well-known, even in academia. (Sorry, no links – I’m lazy.)

For those of you unfamiliar with, or unwilling to read Cowen’s paper, a DAC works like this:

A person, or a group of people decide they want to have the benefit of a park, a road, etc. But they can’t afford this all on their own. So they incorporate, and pitch their plan to others. By contract, they stipulate that either the project will be completed, or any “investments” will be returned plus an agreed upon interest payment.

It creates an incentive for people to “invest” in a project even if – especially if – they think the project will not raise enough funds. DACs provide, among other things, for a refund plus interest payment if the funds collected are insufficient to complete the project. If new taxes are levied to increase teacher salary, and as a result, there is a mass exodus from the municipality which reduces the budgetary strain (because fewer students require fewer teachers), those citizens who remained are not returned their tax payment. No, what happens is the money is diverted into a general fund, and it is spent on some other project which may very well not have been approved by ballot, but which is now realizable in light of the circumstantial “surplus”.

DACs also subject publicly funded projects to a powerful cost/profit incentive.

Imagine your typical “public good.” A road. A city park. A bridge to nowhere in Alaska. These are all largely financed by people who were probably A)unwilling or B) only partially willing. A DAC removes the unwillingness from funding such projects. It does several things that traditional public finance does not do. It sets a specific dollar amount for the project, which is to be paid for entirely with earmarked, task-specific funds. The public offer money to the Contractor who promises to them to either A) build the project as specified, or B) return their initial “investment” plus a pre-determined interest payment. Note that this implies a level of funding, F, such that:

F > total cost of construction

But what if not enough money is raised? All of the funding is returned, plus interest. Note that there is a level of funding, F2, such that F2 < Total Cost of Construction < F2(1+r); under these circumstances, construction will proceed, albeit a loss is incurred on behalf of the corporation who undertook it. So it’s possible that public goods could be brought about even if funding isn’t quite enough.

But a few things to consider: I still abhor the idea of DACs as a matter of public policy and I would not support any measure which would permit governments to contribute to these funds with their tax receipts. What I mean here is that governments could effectively ensure that no such projects (politically expedient, of course) would go unproduced. This necessarily distorts the market in favor of contractors at the expense of investors. Spending someone else’s (read: taxpayers’) money necessarily perverts the incentive system, and the presence of a DAC, instead of our typical will-of-the-legislators does little to mitigate this effect.

Would it be necessary to have a one-shot auction, almost like a vote, where the interested “investors” would inject funds, or could it be an ongoing process over a short to medium-run period of time?

Would the intermediate results of the fundraising need to be kept secret until all money was tallied, or would it be appropriate to leak the information? For instance, leaking the information that “We’ve almost reached our goal of one billion dollars” sends a powerful signal to institutional investors: stay out. But it sends an equally powerful signal to altruists: Your measly $10 donation <i>means</i> something at this point. I would also imagine that the vested parties would cry foul at such information leaks – after all, “almost” to the goal may in truth be far short of the goal, and it may be an attempt by the Contractor to cover his losses. In any event, it may reduce the likelihood that speculators will earn a return; and switching the rules and expectations halfway through the game is something to be punished.

I don’t have an answer to any of these questions, but I believe that DACs might be one of the most popular ways of raising funds for public goods, so-called, in a completely free market; that is, a marketplace free of violent coercion, theft, graft, and government monopoly.