G302 Week 4: Free Riding

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G302Week 4Free Riding
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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.

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Quiz 1

• Quiz 1 Friday, Feb. 1, 330 p.m. to Friday, Feb.
  8, 330 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.

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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.

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Three Approaches to Understanding Free Riding

• Marginal costs and benefits
• Positive externalities
• As a prisoners 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

• 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.
  

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

• 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.

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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

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Examples of Public Goods

• 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

• Canadian aid to the United States
• Corporate governance
• Stock market fragmentation
• Pharmaceuticals in Europe
• Ebay and Bidders Edge
• Microsoft and the state lawsuits

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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.

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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.

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3. Stock Market Fragmentation

• 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 everyones computer
  screen.
• But they dont 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

• 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.

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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.

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5. Information on the Webhttp//www.biddersedge.c
om/

• 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?

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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.

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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