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January 20, 2018 

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ADVERSE SELECTION: When a negotiation between two people with different amounts of information, that is, asymmetric information, restricts the quality of the good traded. This typically happens because the person with more information is able to negotiate a favorable exchange. This is frequently referred to as the "market for lemons."

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FREE-RIDER PROBLEM:

A problem underlying the provision of public goods that occurs when a person consumes or benefits from a good without making payment. The free-rider problem is the primary reason that public goods are produced by governments. Because public goods are characterized by the inability to exclude nonpayers, once a public good is produced anyone, everyone, can consume without making payment, that is, get a "free ride." Voluntary payments like those occurring in markets will not provide enough revenue to pay production costs. The only way to finance public goods is to force free-riders, and everyone else, to pay through government taxes. The free-rider problem also applies to common-property goods.
The free-rider problem arises due to the fundamental nonpayer nonexcludability characteristic of public goods. Because nonpayers can continue to consume and benefit from public goods without paying they are unlikely to make voluntary payments. Given the choice of paying only for a public good or purchasing a private good and also receiving a public good for "free," most people will opt for the private good purchase and then free ride the public good.

Nonpayer nonexcludability and the resulting free-rider problem mean that public goods can not be efficiently exchanged through markets. Public goods can not produced by private business producers then offered for sale over a market like private goods. Once produced, buyers are able to consume public goods and thus have no reason to pay. With private goods, private business producers can refuse to transfer ownership without payment. Not so for public goods. Once produced everyone consumers public goods.

A Public Good Review

Let's review the key characteristics of public goods. Public goods are nonrival in consumption, meaning consumption by one does not prevent the consumption by others. Everyone can consume public goods simultaneously.

More to the point of the free-rider problem, public goods are also characterized by the inability to exclude nonpayers, meaning anyone can enjoy the benefits of public goods whether or not they pay.

For example, the protection from foreign invasion extended to Edgar Millbottom by virtue of a strong national defense extends to Alicia Hyfield, as well. As citizens and residents of the country, Winston Smythe Kennsington III, Jonathan McJohnson, and Pollyanna Pumpernickel are also protected.

More over, as citizens and residents of the country, Edgar, Alicia, Winston, Jonathan, and Pollyanna are all protected regardless of whether they pay or how much they pay for national defense. The only way to exclude residents from enjoying the benefits of national defense is to eliminate their resident status, that is, boot them from the country. For all practical purposes, nonpayers can not be excluded from receiving the benefits.

Riding for Free

The nonexclusion principle of public goods gives rise to the free-rider problem. The free-rider problem occurs when a person consumes or benefits from a public good without making payment to help cover the cost of production. The free-rider problem arises when someone, figuratively speaking, receives a "free ride" on a public good. They "ride" the benefits of the public good for "free," without making payment.

By their very nature, public goods provide members of society with a "free ride." And for an efficient allocation of resources, public goods should provide people with a "free ride." Because the opportunity cost of consumption is zero, efficiency dictates that the price of consumption should also be zero.

A Market for Public Goods?

The free-rider problem is what prevents public goods from being exchanged through markets. To illustrate, let's once again return to the provision of national defense. Suppose that a "market" for national defense is established and that the "price" charged each buyer is $100. That is, the total national defense budget of $30 billion is divided equally among the 300 million citizens of the country. To "purchase" national defense through this "market," each citizen needs to pay a "price" of $100.

Quotation marks are used for several terms in the preceding paragraph, because the free-rider problem prevents this "market" from working like a market should work. The key is that regular markets are voluntary. Buyers decide to buy or not to buy. They voluntarily choose whether or not to make payment and to purchase the good.

Suppose, for example, that Edgar Millbottom is faced with this voluntary decision. He can choose to pay $100 to purchase national defense or not. If he pays $100, then he receives the benefits of national defense protection. However, if he decides NOT to pay $100, then he still receives the benefits of national defense protection.

As a human being who prefers more to less, it makes sense that Edgar chooses NOT to pay the $100. If he pays, he receives national defense. If he does NOT pay, he can receive national defense PLUS other good purchased with the $100, such as an MP3 player.

Suppose then that half of the 300 million residents of the country make the same choice, which they are free to do in this voluntary market. As such, the $30 billion national defense budget must now be divided among 150 million citizens making voluntary payment, a "price" of $200 each. In accordance with the law of demand, a higher price is bound to reduce the quantity demanded, that is, fewer citizens will voluntarily opt to pay this higher $200 "price."

For sake of argument, let's say that half of the remaining 150 million choose not to pay. The $30 billion budget is now divided among 75 million voluntary "buyers," generating a "price" of $400 each. This higher price prompts more to voluntarily choose not to pay, which places the payment burden on fewer and fewer voluntary "buyers." Eventually, when the "price" reaches $30 billion for the last voluntary "buyer," that person is also likely to opt out, making every resident a free rider.

An Involuntary Alternative

If everyone is a free rider and no one voluntarily pays to finance the provision of national defense, then no national defense is provided. What's a country to do? The only alternative facing a country seeking to provide the benefits of a public good such as national defense is to force "buyers" to make payment, that is, to impose taxes on the citizens. How those taxes are structured is another question altogether.

The key implication though is that the free-rider problem prevents public goods from being produced and exchanged in the same way as private goods -- through markets. Public goods are fundamentally different from private goods and can not be exchanged through voluntary markets. The provision of public goods requires governments to impose mandatory taxes. The benefits obtained from public goods, combined with the free-rider problem helps to explain the creation and (at the very least) the continued existence of governments.

A Note on Common-Property Goods

Common-property goods, like public goods, are characterized by the inability to exclude nonpayers. As such, they too are subject to the free-rider problem. However, this problem is compounded by the fact that common-property goods are also 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. This combination is a recipe for overconsumption and in all likelihood the eventual exhaustion or destruction of the common-property goods.

Other Market Failures

The free-rider problem of public goods is one of four key reasons that markets might fail to efficiently allocate resources. The other three are market control, externality, and imperfect information.
  • Market Control: Market control arises when buyers or sellers are able to exert influence over the price of a good and/or the quantity exchanged. An extreme example of market control exists with monopoly, a market with a single seller. Market control prevents a market from equating demand price and supply price.

  • Externality: An externality exists if a benefit is not included in the demand price or a cost is not included in the supply price. This means that the demand price does not reflect all benefits of a good or the supply price does not reflect all opportunity cost of production. As such, market equilibrium does not achieve an efficient allocation.

  • Imperfection Information: The lack of information among buyers or sellers often means that the demand price does not reflect all benefits of a good or the supply price does not reflect all opportunity costs of production. That is, buyers might be willing to pay more or less for a good because they don't know the true benefits generated. Or sellers might be willing to accept more or less for a good than the true opportunity cost of production.

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Recommended Citation:

FREE-RIDER PROBLEM, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: January 20, 2018].


Check Out These Related Terms...

     | public finance | consumption rivalry | nonpayer excludability | public good | market failures | private goods | common-property goods | near-public goods | public goods: demand | public goods: efficiency |


Or For A Little Background...

     | good | price | production | efficiency | consumption | market demand | market | market efficiency | government sector | public sector | property rights | private sector | voluntary exchange |


And For Further Study...

     | taxation principles | tax proportionality | tax effects | tax equity | involuntary exchange | benefit principle | ability-to-pay principle | deadweight loss |


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