1 G302 Week 4: Free Riding

2 Assignments Read: A Managers 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.

3 Quiz 1 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 except the free rider readings.

4 Key Idea If individual efforts contribute to group output, then people will tend to shirk on their effort. Often, everybody is worse off as a result.

5 Three Approaches to Understanding Free Riding Marginal costs and benefits Positive externalities As a prisoners dilemma game

6 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).

7 2. Positive externalities and the free rider problem When there is a free rider problem, a persons 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.

8 3. Free riding as a Prisoners Dilemma game 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. Jones Smith 3,3 High effort Low effort High effort Low effort 4,-1 -1,4 0,0 Smith and Jones will each choose Low effort!

9 Explanation of the game 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 effort too.

10 Public Goods Public goods have two key features. They are: Non-excludable (Cant exclude people who dont pay) Non-rivalrous (Your use doesnt harm mine) (positive externalities) Public goods suffer from free-riding (people use them but dont pay) Thus, markets wont supply enough

11 Examples of Public Goods National defense Legal system Public television Lighthouses Basic science Monitoring politicians to check that they serve the public interest

12 A Variety of Applications of Free Riding Canadian aid to the United States Corporate governance Stock market fragmentation Pharmaceuticals in Europe Ebay and Bidders Edge Microsoft and the state lawsuits

13 1. Free Riding by Countries 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? 26 percent of people changed their minds, and said NO, leaving support for the US at 57 percent.

14 2. Free Riding by Shareholders 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.

15 3. Stock Market Fragmentation Suppose the current price of stock is 20.25, too high for you, but you offer to pay per share for 500 shares. Your bid will appear on everyones computer screen. But they dont have to sell to you-- they might just trade with each other at Thus, your effort and risk in posting a price is unrewarded.

16 The Central Book Order System 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. Schwabs costs would go up, but more information would reach the market.

17 4. Pharmaceuticals in Europe 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 U.S.

18 5. Information on the Web Bidders Edge, an aggregator, combines the auction prices at Ebay and other sites, hurting Ebays business. It is free riding on Ebays effort. But there is a gain to consumers and to Bidders Edge. Is government failure likely?

19 6. Settling Lawsuits 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 whats collected, but not pay any more legal fees! It will free ride.

20 Free Riding and G302 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