Free rider problem

The free rider problem exists when people enjoy the benefits of government provided goods independent of whether they pay for them.

In the analyses of economics and political science, free riders are actors who take more than their fair share of the benefits or do not shoulder their fair share of the costs of their use of a resource. The free rider problem is the question of how to prevent free riding from taking place, or at least limit its effects.

Because the notion of “fairness” is highly subjective, free riding is usually only considered to be an economic “problem” when it leads to the non-production or under-production of a public good, and thus to Pareto inefficiency, or when it leads to the excessive use of a common property resource.

The classic example is national defense; I am protected whether or not I pay, so there’s no reason for me to pay unless forced to do so. In such cases, the government must provide the good itself and force individuals to pay for it with taxes.

Also see: benefit approach principle, equal sacrifice theory, tax incidence, tragedy of the commons

Source: R A Musgrave and P B Musgrave, Public Finance in Theory and Practice (New York, 1975)

Free-Rider Incentive

The underlying incentive which generates the free-rider problem can be explained via the application of the Prisoner’s dilemma, within the context of contributing to a public good. Suppose two people were to split a contribution to a public service (such as for a police station) with society benefiting from their contribution. According to the Prisoner’s dilemma, certain conclusions can be drawn from the results of this scenario. If both parties donate, they are out of pocket and society benefits. If one party doesn’t pay (in the hopes that someone else will) they become a free-rider, and the other will have to cover the cost. If the other party also decides to become a free-rider and neither pay, then society receives no benefit. This demonstrates that the free-rider problem is generated by individuals willingness to let other pay, when they themselves can receive the benefit at zero cost.^[8] This is reinforced by the economic theory of rational choice, stating that humans make choices which provide them with the greatest benefit. Therefore, if a service or resource is offered for free, then a consumer will not pay for it.^[9]

Economic issues

Free riding is a problem of economic inefficiency when it leads to the underproduction or overconsumption of a good. For example, when people are asked how much they value a particular public good, with that value measured in terms of how much money they would be willing to pay, their tendency is to under-report their valuations.^[10] Goods that are subject to free riding are usually characterized by : the inability to exclude non-payers, its consumption by an individual does not impact the availability for others and that the resource in question must be produced and/or maintained. Indeed, if non-payers can be excluded by some mechanism, the good may be transformed into a club good (e.g. if an overused, congested public road is converted to a toll road, or if a free public museum turns into a private, admission fee-charging museum). This problem is sometimes compounded by the fact that common-property goods are characterized by rival consumption. Not only can consumers of common-property goods benefit without payment, but consumption by one imposes an opportunity cost on others. The theory of ‘Tragedy of the commons’ highlights this, in which each consumer acts to maximize their own utility, and thereby relies on others to cut back their own consumption.This will lead to overconsumption and even possibly exhaustion or destruction of the common-property good. If too many people start to free ride, a system or service will eventually not have enough resources to operate. Free-riding is experienced when the production of goods does not consider the external costs, particularly the use of ecosystem services.

An example of this is global climate change initiatives. As climate change is a global issue, the benefits of reduced emissions in one country will extend beyond their own countries’ borders and impact countries from around the world. However, this has resulted in some countries acting in their own self-interest, limiting their own efforts and free-riding on the work of others. In some countries, citizens and governments don’t wish to contribute to the associated effort and costs of mitigation, as they are able to free-ride on the efforts of others. This free rider problem also raises questions in regards to the fairness and ethicalness of these practices, as countries most likely to suffer the consequences of climate change, are also those who typically emit the least greenhouse gases and have fewer economic resources to contribute to the efforts, such as the small Island country of Tuvalu.^[11]

Economists widely believe that Pareto-optimal allocation of resources in relation to public goods is not compatible with the fundamental incentives belonging to individuals.^[12] Therefore, the free-rider problem, according to most scholars, is expected to be an ongoing public issue. For example, Albert O. Hirschman believed that the free-rider problem is a cyclical one for capitalist economies. Hirschman considers the free-rider problem to be related to the shifting interests of people. When stress levels rise on individuals in the workplace and many fear losing their employment, they devote less of their human capital to the public sphere. When public needs then increase, disenchanted consumers become more interested in collective action projects. This leads individuals to organize themselves in various groups and the results are attempts to solve public problems. In effect this reverses the momentum of free riding. Activities often seen as costs in models focused on self-interest are instead seen as benefits for the individuals who were previously dissatisfied consumers seeking their private interests.

This cycle will reset itself because as individuals’ work for public benefit becomes less praiseworthy, supporters’ level of commitment to collective action projects will decrease. With the decrease in support, many will return to private interests, which with time resets the cycle. Supporters of Hirschman’s model insist that the important factor in motivating people is that they are compelled by a leader’s call to altruism. In John F. Kennedy’s inaugural address he implored the American people to “ask not what your country can do for you; ask what you can do for your country.” Some economists (for example, Milton Friedman) find these calls to altruism to be nonsensical. Scholars like Friedman do not think the free-rider problem is part of an unchangeable virtuous or vicious circle, but instead seek possible solutions or attempts at improvement elsewhere.^[13]

Economic and political solutions

Assurance contracts

An assurance contract is a contract in which participants make a binding pledge to contribute to building a public good, contingent on a quorum of a predetermined size being reached. Otherwise the good is not provided and any monetary contributions are refunded.

A dominant assurance contract is a variation in which an entrepreneur creates the contract and refunds the initial pledge plus an additional sum of money if the quorum is not reached. The entrepreneur profits by collecting a fee if the quorum is reached and the good is provided. In game-theoretic terms this makes pledging to build the public good a dominant strategy: the best move is to pledge to the contract regardless of the actions of others.^[14]

Coasian solution

A Coasian solution, named for the economist Ronald Coase, proposes that potential beneficiaries of a public good can negotiate to pool their resources and create it, based on each party’s self-interested willingness to pay. His treatise, The Problem of Social Cost (1960), argued that if the transaction costs between potential beneficiaries of a public good are low—that it is easy for potential beneficiaries to find each other and organize pooling their resources based upon the good’s value to each of them—that public goods could be produced without government action.^[15]

Much later, Coase himself wrote that while what had become known as the Coase Theorem had explored the implications of zero transaction costs, he had actually intended to use this construct as a stepping-stone to understand the real world of positive transaction costs, corporations, legal systems and government actions:^[16][17]

I examined what would happen in a world in which transaction costs were assumed to be zero. My aim in doing so was not to describe what life would be like in such a world but to provide a simple setting in which to develop the analysis and, what was even more important, to make clear the fundamental role which transaction costs do, and should, play in the fashioning of the institutions which make up the economic system.

Coase also wrote:

The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave. What I did in “The Problem of Social Cost” was simply to shed light on some of its properties. I argued in such a world the allocation of resources would be independent of the legal position, a result which Stigler dubbed the “Coase theorem”.^[18]

Thus, while Coase himself appears to have considered the “Coase theorem” and Coasian solutions as simplified constructs to ultimately consider the real 20th-century world of governments and laws and corporations, these concepts have become attached to a world where transaction costs were much lower, and government intervention would unquestionably be less necessary.

A minor alternative, especially for information goods, is for the producer to refuse to release a good to the public until payment to cover costs is met. Author Stephen King, for instance, authored chapters of a new novel downloadable for free on his website while stating that he would not release subsequent chapters unless a certain amount of money was raised. Sometimes dubbed holding for ransom, this method of public goods production is a modern application of the street performer protocol for public goods production. Unlike assurance contracts, its success relies largely on social norms to ensure (to some extent) that the threshold is reached and partial contributions are not wasted.

One of the purest Coasian solutions today is the new phenomenon of Internet crowdfunding. Here rules are enforced by computer algorithms and legal contracts as well as social pressure. For example, on the Kickstarter site, each funder authorizes a credit card purchase to buy a new product or receive other promised benefits, but no money changes hands until the funding goal is met.^[19] Because automation and the Internet so reduce the transaction costs for pooling resources, project goals of only a few hundred dollars are frequently crowdfunded, far below the costs of soliciting traditional investors.