What is the Free Rider Problem?

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Definition:

A free rider problem is a reference to the ability of a person to receive a benefit without incurring the cost associated with it.

🤔 Understanding the free rider problem

A free rider problem occurs when an individual can reap a reward without paying for a service. Free rider problems are market failures resulting from the difficulty of coordinating who pays for what amenities and resources. In most cases, they are solved through central management and taxation. A government, homeowners association, business, or not-for-profit organization can solve a free rider problem by charging a fee or tax on all users to provide the desired service. However, the provider of a function must enforce collection from all beneficiaries or exclude people that do not pay. Otherwise, the free rider problem can lead to inefficient outcomes, including the loss of a service for which people are willing to pay.

Example

Imagine living on a cul-de-sac in a town that gets a lot of snow. In the wintertime, everyone on the street might chip in $20 for someone to plow the road after a heavy snowfall. However, Dan might decide not to contribute to the plowing pool. But if everyone else gives an extra buck, the road can still get cleared. Dan knows that he can get the benefit of a plowed street without paying for it. Dan is a free rider, and everyone shares an extra burden to carry him.

Takeaway

A free rider problem is like a person hitching a ride without chipping in any gas money…

A hitchhiker wants to get from Point A to Point B, but needs someone else to provide transportation. If the hitchhiker pitches in some gas money, that may be a fair exchange for the driver picking them up. If, however, the hitchhiker doesn’t pitch in, they’re getting a literal free ride. Similarly, free riders in other domains get access to amenities or services without contributing financially or otherwise.

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What is the free rider problem?

In economic theory, the free rider problem is an example of a market failure, which arises from positive externalities (things that benefit people that didn’t pay for it) in the marketplace. Free riders can be trivial, like a person watching their neighbor’s firework show. Or they can be more significant, like a person benefiting from a neighborhood trash cleanup without contributing or participating.

Just picture a person entering through the back door on a public bus and not paying. That free rider gets a service without contributing to the cost of providing it.

When does the free rider problem arise?

Free riders become a problem when they interfere with the ability of the service in question to exist. It often arises in the context of public goods, but can also appear in private settings. In general, free-riding becomes problematic when it results in an inefficient economic outcome. For instance, the existence of a few free riders might lead others to follow suit, either out of perceived fairness or because of the observation that there is no punishment for nonpayment.

If you have the choice of paying $20 for a ticket to the fair, or getting in for free, a rational person might choose not to pay. Unless there’s something unethical or immoral going on, rational choice theory (the idea that people approach choices with a rational process) would point out that you get the same value at a lower cost. However, if enough people stop paying the entrance fee, there won’t be enough money to pay the people that make it happen. Consequently, the fair might go away altogether. Even though enough people would receive more value than the cost to make it work, the free rider problem doesn’t allow them to reap that benefit of their labor.

The free rider problem usually comes up if there are high upfront expenses and low incremental costs. For instance, if you’re already driving to the airport, the additional cost of letting someone tag along is pretty small. If you spend $200 on fireworks for your family to enjoy, the neighbors watching from across the street don’t add to that cost. The problem is that there is an incentive to sit around and hope someone else pays the bill. But what if nobody does? Then, the good might not be provided at all.

Are free riders bad for the economy?

Free riders can lead to suboptimal outcomes in a free market economy. It can happen in two ways. First, it could lead to the loss of services for which people are willing to pay. Second, it can lead to overutilization of public goods, which could destroy them.

To illustrate how this works, imagine that you and your neighbor both would like a fence between your yards. You call a contractor, and they quote you $10,000 to do the work. That’s more than you are willing to pay. Let’s say you would get $7,000 worth of value by having that fence. Now, imagine that your neighbor is in the same position. They also called a contractor, got the same quote, and came to the same conclusion.

This scenario is a coordination problem. There is a total of $14,000 worth of value and a total cost of $10,000. But because there is not enough individual value to cover the full expense, it doesn’t happen. That’s a suboptimal outcome. The obvious solution is to split the cost. But what if your neighbor thinks you will build that fence whether they chip in or not? They could be tempted to let you pay the entire bill while they get the same benefit. Consequently, nothing happens, and the economic activity is lost.

The other scenario, which is also bad for the economy, is called the tragedy of the commons (when free use of commonly held goods leads to overconsumption). In this case, imagine there is a community garden that is open for anyone to take whatever they want. You happen to really like snap peas. So when the snap peas get close to fully developed, you take a few. Then you start to think about how other people also want them. This might be the only chance you get to collect some before everyone else empties the vines. So, you pick a little more than you need.

Everyone faces the same dilemma. Anything they save for later won’t be there when they come back. So people harvest more than they need. They pick the fruits and vegetables sooner than they should. And people take more than they contribute to the upkeep.

In reality, a community garden might avoid falling victim to the tragedy of the commons, since there are social norms and a closeness to the other members of the group that prevent it. But that’s not always the case.

Open-source services, like Wikipedia, also face a free rider problem. Anyone can look up information on Wikipedia, without being a contributor — either financially or in terms of contributing knowledge or labor. To date, Wikipedia has managed to survive on donations and volunteer labor — at least temporarily solving the site’s free rider problem.

How does the free rider problem present in politics?

The free rider problem often arises in the political arena, both at the voting booth and in government actions.

Political science would suggest, for instance, that non-voters free ride on the efforts of those who take the time to stop at the polling place.

Public policy routinely deals with free rider problems. For instance, once a public road is built, it exists for all drivers to use. It doesn’t matter who paid for it. That fact provides an incentive to drive more often, without contributing anything to the upkeep of the road. A gas tax, indirectly charging people for how much they drive, is one way of solving this free rider problem. (Also, of course, some roads are directly tolled, eliminating the free rider problem in that case.)

This free rider situation shows up with anything that has a substantial upfront cost, but very little to no additional expense for additional users. Major infrastructure projects — even a system of national defense — also fall into this category. Many citizens, of course, pay federal taxes that fund national defense. But not everyone pays federal taxes; those people still benefit from national defense.

What are the solutions to the free rider problem?

Free rider problems are mostly coordination problems. Often they are solvable with a system that coordinates the costs and benefits. Any meaningful solution must align the costs and benefits of the users. Therefore, an effective solution must charge those who benefit and exclude those who don’t pay.

Here are a few examples of overcoming the free rider problem.

Taxation

A government can coordinate a project or service using its taxing authority. Because taxes are required by law, it can be more difficult for people to avoid them. While taxation can't guarantee that tax avoidance or evasion doesn’t happen, it does provide a way to ensure that the necessary costs to provide a service get collected.

Of course, not everyone pays taxes. That fact allows some people who benefit from a service to do so without paying anything for it. In that way, taxation doesn’t prevent free riding, but it does solve the free rider problem. The service is still provided.

Privatization

Another approach to preventing free riding is to limit access to the service. Denying the service to people who aren’t paying for it better aligns the costs and benefits. Of course, this doesn't work if there is non-excludability. But, in other cases, turning a public service into private good does the trick. Whether it’s charging a toll on a bridge, or turning the management of a park over to a for-profit enterprise, privatization can reduce free riding.

However, there are complications with this approach from a public policy perspective. Sometimes, the purpose of a program is to level the playing field for lower-income individuals. If free riding is the desired outcome, things can be more complicated.

Social Norms

One of the reasons that free riding occurs is because there is little accountability for cheating. If 10,000 people say they are going to clean up a park, it will probably get just as clean with 9,999 people. That one person can take a nap in the woods without anyone noticing the difference. But if the group is only 10 people, the absence of one person is much more noticeable. Therefore, anyone not pulling their weight might get called out. Social pressure can solve the free rider problem without government intervention.

Contracts

Signing a binding agreement to do something can also help keep people to their word. And it does so with the force of law. Since free riding becomes a problem when things are not well-coordinated, a contract can help. Imagine a group of homes that want to split the cost of plowing the road for the winter. One person might opt not to pay their share after the work is done. If so, everyone else would need to pay more to cover it. A contract can assure everyone that what they expected to pay is the actual cost they will bear. One example of this approach could include a homeowners association, which collects a monthly fee and pays for such services on behalf of the group.

Conditional Commitments

A clever way to get everyone on board, each paying their share, is called a dominant assurance agreement. This agreement collects donations for a project, but only delivers if the coordinator raises enough money to pay for it. If they don’t raise enough money, the donations get refunded. This effort protects donors, but doesn’t quite provide the incentive to discourage people from waiting for everyone else to donate. That’s where the dominant assurance kicks in. The coordinator promises an additional refund if they don’t raise enough money. That changes the math a little bit. Now a donor wins whether the project happens or not, which makes it more likely that it will.

Advertising

For a public good like radio or television, it might be impossible to prevent free riding. The non-excludable content is out there for anyone who wants it. But there is a tricky way to get everyone to pay their share, in a sense. Advertising. Anyone who benefits from the content for free pays by listening to commercials — and the advertisers pay the stations. That makes free riding more difficult, although the users’ payment for the service is not strictly monetary.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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