Tuesday, September 16, 2014

How the Free Rider Idea Evolved

In social science parlance, a "free rider" is someone who benefits from a collectively provided good but does not make an appropriate contribution to the provision of that good. A homely example might be the family that shows up each year empty-handed at the big reunion, planning just to eat what all the other families provides. In an introductory economics class, the idea of a free rider often arises the discussion of public goods, referring to the idea that self-interest can lead people to a wish to benefit from collective--often government--goods and services, without contributing an appropriate share. Of course, if many people behave in this way, collective action can become difficult to sustain.

The meaning of "free rider" has evolved over time, until terminologysort of popped up in the economics literature. Philippe Fontaine explores earlier and current uses of  "Free Riding" in  the September 2014 issue of the  Journal of the History of Economic Thought (v. 36, pp 359-376). The journal isn't freely available on-line, but many readers will have access through library subscriptions.

Fontaine discusses two main uses of "free rider" in economics leading up to the 1960s: one in the context of securities practices and the other in the context of labor unions.

The use of "free rider" in the context of securities practices seemed to involve situations where there was an expectation that established institutional participants in financial markets had a responsibility to act in certain ways, and that holding back in an attempt to increase profits was acting like a "free rider. Fontaine offers examples going back to the 1930s, but here's one example from the 1960s which involves about a case where in an initial public offering, certain securities dealers who had been allocated shares would hold back shares from the public, and then plan to sell them later at a higher price. Here's Fontaine (citations omitted):
The NASD [National Association of Securities Dealers] likewise prohibited the practice of free riding “hot issues.” Here, professionals who had withheld shares from the public at the initial public offering were castigated for selling them with a significant profit in the trading market afterwards. From the mid-1960s, free riding was used to describe “the practice of purchasing during distribution and selling after a subsequent rise in price in the aftermarket.” Though not illegal, this practice was forbidden by the NASD because the broker-dealer was not supposed to enjoy “an unfair advantage from his position as a distributor of securities.” ... For its proponents, regulation of the securities market was justified by the need to defend the interests of the public against unfair practices and free riding in particular, while, for its adversaries, this regulation appeared as an obstacle to access a supposedly open market.
Discussions of labor unions in the 1940s and 1950s often referred to the "free riders" who wanted to receive union wages and benefits without paying union dues. Fontaine again:
"Discussing the Taft–Hartley Act, the former president of the American Economic Association and authority on labor issues, Sumner H. Slichter (1949, p. 2), wrote that the “‘free-rider’ is a well-known problem of the American union.” That problem referred to the “reluctance of workers to pay union dues after their immediate demands have been met.” Among the characteristics of the American trade unions, the institutionalist economist saw “reliance upon the closed shop or the union shop,” which he defined as “devices partly to deal with the problem of the ‘free-rider’” (p. 5).  In an issue of the Annals of the American Academy of Political and Social Science devoted to discussing labor in the American economy, even Senator Robert A. Taft (1951, p. 196), Republican of Ohio, who wrote the Taft–Hartley Act of 1947 as a result of his conviction that the Wagner Act was too favorable to the labor unions, conceded that a “limited type of compulsory membership contract is a complete answer to the ‘freerider’ argument so often advanced to support the need for a closed shop.”
When did the free rider terminology jump from being specific to a financial or a labor union context, and become a general term widely used by economists? The answer here turns out to be trickier than one might expect.

In a conceptual sense, the free rider arguments entered mainstream economics as a result of the work of Mancur Olson's classic 1965 book The Logic of Collective Action. However, the terminology of "free rider" is only found once in that book, referring to the labor market context. But there is an intriguing use of the "free rider" terminology in a speech given by James Buchanan, "What Should Economists Do?,” originally given as the Presidential Address to the Southern Economic Association in November 1963, and published in the January 1964 issue of the Southern Economic Journal (30:3, 213-222). Buchanan said:

Suppose that the local swamp requires draining to eliminate or reduce mosquito breeding. Let us postulate that no single citizen in the community has sufficient incentive to finance the costs of this essentially indivisible operation. Defined in the narrow, orthodox way, the "market" fails: bilateral behavior of buyers and sellers does not remove the nuisance. ... This is, however, surely an overly restricted concept of market behavior. If the market institutions, defined so narrowly, will not work, they will not meet individual objectives. Individual citizens will be led, because of the same propensity, to search voluntarily for more inclusive trading or exchange arrangements. A more complex institution may emerge to drain the swamp. The task of an economist includes the study of all such cooperative trading arrangements which become merely extensions of markets as more restrictively defined. 
I have not got out of all the difficulties yet, however. You may ask: "Will it really be to the interest of any single citizen to contribute to the voluntary program of mosquito control? How is the "free rider" problem to be handled? This spectre of the "free rider," found in many shapes and forms in the literature of modern public finance theory, must be carefully examined. ... There may be cases where the expected benefits of the draining are not sufficiently high to warrant the emergence of some voluntary cooperative arrangement. And, in addition, the known or predicted presence of free riders may inhibit the cooperation of individuals who would otherwise contribute. ... Hence, the "market," even in its most extended sense, may be said to "fail." What recourse is left for the individual in this case? It is surely that of transferring, again voluntarily, at least at some ultimate constitutional level, activities of the swamp-clearing sort to the community as a collective unit, with decisions delegated to specifically designated rules for making choices, and these decisions coercively enforced once they are made. Therefore, in the most general sense (perhaps too general for most of you to accept), the approach to economics that I am advancing extends to cover the emergence of a political constitution. 
As Fontaine notes, "Buchanan maintained that the “‘free rider’ problem” could be “found in many shapes and forms in the literature of modern public finance theory. That was true, indeed, but the phrase free rider problem was no part of public finance language. No mention was made of the free-rider problem or free riding in [Buchanan's book] The Calculus of Consent of 1962." However, Buchanan had read pre-publication drafts of Olson's Logic of Collective Action, which explores the dynamics of what came to be called free riders in detail, and Buchanan apparently brought the term over from its earlier applications to labor unions and securities regulation.

As in Buchanan's explanation, it is straightforward to use the idea of a "free rider" as a justification for why people form governments and give them legal power to collect taxes. But the notion of the free rider developed a little further in the 1960s, in a way with less clear justifications for government. Olson explained near the start of the Logic for Collective Action, "[A]ny group or organization, large or small, works for some collective benefit that by its very nature will benefit all of the members of the group in question. Though all of the members of the group therefore have a common interest in obtaining this collective benefit, they have no common interest in paying the cost of providing that collective good. Each would prefer that the others pay the entire cost, and ordinarily would get any benefit provided whether he had borne part of the cost or not."

But Olson, Buchanan, and others argues that the free rider dynamic was quite different in large and small organizations. Fontaine explains the dynamic in this way:
[T]he free-rider problem was above all a theoretical construct, the logical basis of which rested on group size. The main difference between small- and large-number settings was that, in the former, individuals might see their action as exerting some influence on others and their lack of contribution as making a difference, which might cause them to contribute. In the large-number settings, by contrast, the individual believed that others would compensate for his or her lack of contribution—hence, free riding. In other words, the problems posed by free riding had little to do with the weakening of moral norms and they could not, therefore, be solved by simply urging people to improve; rather, they betrayed the increasing permeation of society by self-interest—taken as a rule for behavior—as a result of social change and, in particular, the increase in group size. If free riding was a rational response to certain circumstances, then it was for policy makers to help change the environment in such as way as to make it less conducive to such behavior and for social scientists to convince them that they knew what ought to be done.

Thus, free riding offers a broad explanation for why government needs power of compulsory taxation and regulation. But when smaller political groups that we call "special interests" organize themselves, free riding also explains why those groups would like to receive benefits of collective action, through the actions of government compulsion without paying appropriate costs. Conversely, when a group becomes large--like the size of a country or government--there will be irreconcilable divisions of opinion within the large group: for example, producers of goods and services like high prices and predictability, while and consumers of goods and services like low prices and ever-changing variety. In contemplating the problems of collective action and free-riding, Olson later wrote: "[T]here is no fully satisfactory intellectual framework or theory for the analysis of society-wide social problems.”