The Free Rider Problem

The citizens of small town in USA like seeing fire works on the Fourth of July. Each of town’s 500 residents place a $10 value on the experience. The cost of putting on a fireworks display is $1,000. Because the $5,000 of benefits exceed the $1,000 of costs it is efficient for small town residents to have a firework display on the fourth of July.

Would the private market produce the efficient outcome? Probably not. Imagine that Ellen, Small town entrepreneur decided to put on a fireworks display. Ellen would surely have trouble selling tickets to the event because her potential customers would quickly figure out that they could see the fireworks even without a ticket. Because fireworks are not excluded, people have an incentive to be free riders. A free rider is a person who receives the benefits of a good but does not pay for it. Because people would have an incentive to be free riders rather than ticket buyers, the market would fail to provide the efficient outcome.

One way to view this market failure is that it arises because of an externality if Ellen puts on the fireworks display, she confers an external benefit on those who see the display without paying for it. When deciding whether to put on the display however, Ellen does not take the external benefits into account,. Even though the fireworks display is socially desirable it is not profitable. As a result Ellen makes the privately rational but socially inefficient decision not to put on the display.

Although the private market fails to supply the fireworks display demanded by small town residents, the solution to small town’s problems is obvious. The local government can sponsor a Fourth of July celebration. The town council can raise everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks. Everyone in the small town is better off by $8 – the $10 in value from the fireworks minus the $2 tax bill. Ellen can help small town reach the efficient outcome as a public employee even though she could not do so as a private entrepreneur.

The story of small town is simplified but it is also realistic. In fact, many local governments in the United States do pay for fireworks on the Fourth of July. Moreover, the story shows a general lesson about public goods: Because public goods are not excluded the free rider problems prevents the private market for supplying them. The government however can potentially read the problems. If the government decides that the total benefits of a public good exceeds its costs, it can provide the public good pay with tax revenue and make everyone better off.

Some important Public goods:

There are many examples of public goods. Here we consider three of the most important examples:

National Defense: The defense of a country from foreign aggressors is a classic example of a public good. Once the country is defended, it is impossible to prevent any single person from enjoying the benefits of this defense. Moreover when one persons enjoy the benefits of national defense he does not reduce the benefit to anyone else. The, national defense is neither excluded nor rival in consumption.

National defense is also one of the most expensive public goods. In 2004, the US federal government spent a total of $546 billion on national defense more than $1,500 per person. People disagree about whether this amount is to small or too large but almost no one doubts that some government spending for national defense is necessary. Even economists who advocate small government agree that the national defense is a pubic good the government should provide.
Excerpts from Principles of Economics