Incentives of agency theory – Hume, Wicksell, Groves: The Free-Rider Problem

Hume (1740) may be credited with writing the first explicit statement of the free- rider problem:

Two neighbours may agree to drain a meadow, which they possess in common; because it is easy for them to know each others mind; and each must perceive, that the immediate consequence of his failing in his part, is the abandoning the whole project. But it is very difficult, and indeed impossible, that a thousand persons shou’d agree in any such action; it being difficult for them to concert so complicated a design, and still more difficult for them to execute it; while each seeks a pretext to free himself of the trouble and expence, and wou’d lay the whole burden on others.

—Hume (1740, p. 538)

At the end of the nineteenth century, a lively debate over public finance took place among European economists about the “benefit” approach and the “ability to pay” approach to taxation. In particular, Mazzola, Pantaleoni, and de Viti de Marco in Italy, and Sax in Austria, used the “modern” concepts of marginal utility and subjective value, extending the benefit approach implicit in the writings of many authors of the eighteenth century, such as Bentham, Locke, and Rousseau. Wicksell (1896), in his discussion of Mazzola’s contribution, pointed out what became known later as the free-rider problem, which had been ignored in the benefit approach to taxation:

If the individual is to spend his money for private and public uses so that his satisfaction is maximized he will obviously pay nothing whatsovever for public purposes. . . . Whether he pays much or little will affect the scope of public service so slightly, that for all practical purposes, he himself will not notice it at all. Of course, if everyone were to do the same, the State will soon cease to function.

—Wicksell (1896, p. 81)

Wicksell suggested a solution: the principle of (approximative) unanimity and voluntary consent. Each item in the public budget must be voted simultaneously with the determination of its financing and must be accepted only if unanimity (or quasi-unanimity) is obtained.8 If we could ignore strategic behavior, this process would lead to Pareto optimality. However, which one of the Pareto optima will be reached depends upon the sequential realization of the decision-making process. Indeed, this is the main reason justifying strategic behavior by the participants as they try to manipulate the path of the procedure.

With the exception of Bowen’s (1943) voting procedure discussed in the next section, nothing was proposed until the seventies to solve the free-rider prob- lem, which appeared formidable. Nevertheless, in 1971, Drèze and Vallée Poussin extended the literature on the iterative planning procedures of the sixties to public goods. At each step of the procedure, agents announce their marginal rates of sub- stitution between public goods and the private good. They noted that revelation of the true marginal rates of substitution was a maximin strategy, which is a weak incentive property.

Finally, Clarke (1971), Groves (1973) and Groves and Loeb (1975), making strong restrictions on preferences to evade the Gibbard-Satterthwaite Impossibility Theorem,9 provided mechanisms with monetary transfers inducing truthful reve- lation of preferences and making the Pareto optimal public good decision. The literature that followed substantially developed incentive theory and mechanism design methodology.

Source: Laffont Jean-Jacques, Martimort David (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

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