- Explain the free rider problem
Private companies find it difficult to earn profits from producing public goods. If a good or service is nonexcludable, like national defense, so that it is impossible or very costly to exclude people from using this good or service, then how can a firm charge people for it? Once it’s provided no one will voluntarily pay for it.
When individuals make decisions about buying a public good, a free rider problem can arise, in which people have an incentive to let others pay for the public good and then to “free ride” on the purchases of others. The free rider problem can be expressed in terms of the prisoner’s dilemma game, which we learned about in the module on monopolistic competition and oligopoly. Say that two people are thinking about contributing to a public good: Rachel and Samuel. When either of them contributes to a public good, such as a local fire department, their personal cost of doing so is $4 and the social benefit of that person’s contribution is $6. Because society’s benefit of $6 is greater than the cost of $4, the investment is a good idea for society as a whole. The problem is that, while Rachel and Samuel pay for the entire cost of their contribution to the public good, they receive only half of the benefit, because the benefit of the public good is divided equally among the members of society. This sets up the prisoner’s dilemma illustrated in Table 1.
|Samuel (S) Contribute||Samuel (S) Do Not Contribute|
|Rachel (R) Contribute||R pays $4, receives $6, net gain +$2
S pays $4, receives $6, net gain +$2
|R pays $4, receives $3, net gain –$1
S pays $0, receives $3, net gain +$3
|Rachel (R) Do Not Contribute||R pays $0, receives $3, net gain +$3
S pays $4, receives $3, net gain –$1
|R pays $0, receives $0
S pays $0, receives $0
If neither Rachel nor Samuel contributes to the public good, then there are no costs and no benefits of the public good. Suppose, however, that only Rachel contributes, while Samuel does not. Rachel incurs a cost of $4, but receives only $3 of benefit (half of the total $6 of benefit to society), while Samuel incurs no cost, and yet he also receives $3 of benefit. In this outcome, Rachel actually loses $1 while Samuel gains $3. A similar outcome, albeit with roles reversed, would occur if Samuel had contributed, but Rachel had not. Finally, if both parties contribute, then each incurs a cost of $4 and each receives $6 of benefit (half of the total $12 benefit to society). There is a dilemma with the Prisoner’s Dilemma, though, as you can see in the following example.
The Role of Government in Paying for Public Goods
The key insight in paying for public goods is to find a way of assuring that everyone will make a contribution and to prevent free riders. For example, if people come together through the political process and agree to pay taxes and make group decisions about the quantity of public goods, they can defeat the free rider problem by requiring, through the law, that everyone contributes.
However, government spending and taxes are not the only way to provide public goods. In some cases, markets can produce public goods. For example, think about radio. It is nonexcludable, since once the radio signal is being broadcast, it would be very difficult to stop someone from receiving it. It is nonrivalrous, since one person listening to the signal does not prevent others from listening as well. Because of these features, it is practically impossible to charge listeners directly for listening to conventional radio broadcasts.
Radio has found a way to collect revenue by selling advertising, which is an indirect way of “charging” listeners by taking up some of their time. Ultimately, consumers who purchase the goods advertised are also paying for the radio service, since the cost of advertising is built into the product cost. In a more recent development, satellite radio companies, such as SiriusXM, charge a regular subscription fee for streaming music without commercials. In this case, however, the product is excludable—only those who pay for the subscription will receive the broadcast.
Some public goods will also have a mixture of public provision at no charge along with fees for some purposes, like a public city park that is free to use, but the government charges a fee for parking your car, for reserving certain picnic grounds, and for food sold at a refreshment stand.
In other cases, social pressures and personal appeals can be used, rather than the force of law, to reduce the number of free riders and to collect resources for the public good. For example, neighbors sometimes form an association to carry out beautification projects or to patrol their area after dark to discourage crime. In low-income countries, where social pressure strongly encourages all farmers to participate, farmers in a region may come together to work on a large irrigation project that will benefit all. Many fundraising efforts, including raising money for local charities and for the endowments of colleges and universities, also can be viewed as an attempt to use social pressure to discourage free riding and to generate the outcome that will produce a public benefit.
This video reviews and gives examples of the four categories of goods: rival, nonrival, excludable, and nonexcludable. It also explains the problem of free riders, and then compares free riders to a related concern: forced riders, or people who are forced to pay for goods when they don’t benefit from them.
These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.
- free rider:
- those who want others to pay for the public good and then plan to use the good themselves; if many people act as free riders, the public good may never be provided
- free ride:
- a song written by Dan Hartman and performed by The Edgar Winter Group. The single, engineered by Jim Reeves, was a top 20 U.S. hit in 1973, hitting number 14 on the Billboard Hot 100 Chart.