G302
Week 4:
Free Riding
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Assignments
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Read: “A Manager’s Guide to
Government in the Marketplace”, free
rider newspaper articles.
This week in the breakout sessions we
will be reviewing market failure and
surplus analysis.
Online Quiz 1: You can take it starting
this Friday.
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Quiz 1
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Quiz 1: Friday, Feb. 1, 3:30 p.m. to
Friday, Feb. 8, 3:30 p.m.
Before you take, it, download the Figure
from Oncourse--under Schedule
You will have 30 minutes to finish the
quiz. It is open book, but not “open
friend”-- do it by yourself.
The quiz covers everything up to Feb. 1
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except the free rider readings.
Key Idea
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If individual efforts contribute to group
output, then people will tend to shirk
on their effort.
Often, everybody is worse off as a
result.
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Three Approaches to
Understanding Free Riding
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Marginal costs and benefits
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Positive externalities
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As a prisoner’s dilemma game
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1. Marginalism and the free
rider problem
Suppose the efforts of N different people
contribute to a good result for all of them. If
one person reduces his effort, he saves the
entire cost of his effort, but most of the lost
benefit would have gone to the other N-1
people.
He will reduce his effort to where the marginal
social cost (to himself) is less than the
marginal social benefit (to everyone).
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2. Positive externalities and
the free rider problem
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When there is a free rider problem, a
person’s effort has positive externalities. He
may receive some benefit himself, but there is
additional benefit to other people.
As always when there are positive
externalities, too little of the good (effort) will
be provided.
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3. Free riding as a “Prisoner’s
Dilemma” game
Jones
High
Low
effort
effort
Smith and Jones will
each choose Low effort!
Smith
High
effort
3,3
-1,4
Low
effort
4,-1
0,0
Suppose low effort costs $0 and adds $0 to output;
high effort costs $5 and yields $8; Smith and Jones split output
equally. The net payoffs are shown above.
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Explanation of the game
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If Jones chooses low effort, Smith does best by
choosing low effort (receiving $0 instead of $-1).
If Jones chooses high effort, Smith does best by
choosing low effort (receiving $4 instead of $3).
•
Thus, Smith will choose low effort.
•
Parallel reasoning shows that Jones will choose low
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Public Goods
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Public goods have two key features.
They are:
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Non-excludable (Can’t exclude people who
don’t pay)
Non-rivalrous (Your use doesn’t harm
mine) (positive externalities)
Public goods suffer from free-riding
(people use them but don’t pay)
Thus, markets won’t supply enough
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Examples of Public Goods
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National defense
Legal system
Public television
Lighthouses
Basic science
Monitoring politicians to check that they
serve the public interest
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A Variety of Applications of
Free Riding
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Canadian aid to the United States
Corporate governance
Stock market fragmentation
Pharmaceuticals in Europe
Ebay and Bidder’s Edge
Microsoft and the state lawsuits
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1. Free Riding by Countries
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Poll: Should Canada support the US war on
terrorism?
73 percent of Canadians polled said YES.
Should Canada support the US war on
terrorism even if Canadian civilians might be
targeted by terrorists?
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26 percent of people changed their minds,
and said NO, leaving support for the US at 57
percent.
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2. Free Riding by Shareholders
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Problem: Each shareholder has only a
small incentive to monitor management,
since the benefits go to all shareholders.
Solution: If the managers do poorly,
someone will try to take over the firm,
buying it at a low price, firing the
managers, and then selling at a higher
price.
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3. Stock Market Fragmentation
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Suppose the current price of stock is 20.25,
too high for you, but you offer to pay
20.125 per share for 500 shares.
Your bid will appear on everyone’s
computer screen.
But they don’t have to sell to you-- they
might just trade with each other at 20.125.
Thus, your effort and risk in posting a price
is unrewarded.
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The Central Book Order
System
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All orders would be posted on the
computer network and filled in order of
arrival.
This would not allow Schwab to match its
own customers’ buy and sell orders
without posting them.
Schwab’s costs would go up, but more
information would reach the market.
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4. Pharmaceuticals in Europe
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In the U.S., sellers choose the prices at
which they sell drugs.
In Europe, the governments are the big
buyers, and negotiate lower prices.
When prices fall, the drug companies
have less incentive to develop new
drugs.
Thus, the European countries are free
riding on the high prices paid in the
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5. Information on the Web
http://www.biddersedge.com/
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Bidder’s Edge, an “aggregator”,
combines the auction prices at Ebay
and other sites, hurting Ebay’s business.
It is free riding on Ebay’s effort.
But there is a gain to consumers and to
Bidder’s Edge.
Is government failure likely?
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6. Settling Lawsuits
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19 states sued Microsoft for antitrust
violations.
New Mexico settled out of court first,
for $100,000 and a share of whatever
the other states collect.
So New Mexico will get a share of
what’s collected, but not pay any more
legal fees! It will free ride.
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Free Riding and G302
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A justification for government provision
of public goods
An explanation for government failure
An explanation for why cartels tend to
break down
A problem for businesses wishing to
affect government
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