Institution Formation in Public Goods Games

Sanctioning institutions are of utmost importance for overcoming free-riding ten-dencies and enforcing outcomes that maximize group welfare in social dilemma sit-uations. We investigate, theoretically and experimentally, the endogenous formation of institutions in public goods provision. Our theoretical analysis shows that players may form sanctioning institutions in equilibrium, including those governing only a subset of players. The experiment confirms that institutions are formed and that it positively affects cooperation and group welfare. However, the data also shows that success is not guaranteed. Players are unwilling to implement equilibrium institu-tions in which some players have the opportunity to free ride. Our results emphasize the role of fairness in the institution formation process. (JEL C72, C92, D72) “Persons agree to constraints on their own liberties in exchange for comparable constraints being imposed on the liberties of others.” — James M. Buchanan and Roger D. Congleton (1998, p. 4) When markets fail, the design of appropriate institutions is a key issue for eco-nomic analysis and policy. Social dilemma situations (e.g., public goods, com