Wednesday, February 12, 2014

When Free Riding is Good

Frowned on Free Riding

Free riding often reduces economic welfare by discouraging the production of public or collective goods.  A classic example is national defense.  If one individual invests resources in defending the nation from invasion, others will reap the benefits without contributing anything to such defense, thus free riding upon the first individual's investments.  If all individuals reason this way, none will invest in national defense, as each individual hangs back and waits for others to do so instead.  As a result, and because of this free riding, a private market will not produce an optimal level of national defense, that is, will not induce some investments in such defense that are cost-justified.  In these circumstances, only coercion by the State or other central authority can raise and expend the resources necessary to produce an optimal level of such defense.

Advertising and promotion by retailers provides a more mundane example.  Assume that a manufacturer sells its product to numerous independent dealers that serve the same base of customers.  Like individual expenditures on national defense, advertising expenditures by individual dealers will benefit several dealers, each of whom might benefit some from enhanced consumer interest in the product.   Like national defense, then, promotion and advertising of the good in question will be beset by free riding, as each dealer hangs back, hoping that other dealers will educate consumers, consumers that the shirking dealer who incurs no advertising expenses can attract with cut rate prices.   Various contractual arrangements known as intrabrand restraints can overcome this market failure and encourage more optimal levels and types of promotion and advertising, increasing the nation's output.  
However, a case currently before the U.S. Supreme Court illustrates how free riding can actually be good and how regulation designed to reduce such free riding can thus reduce society's economic welfare.  The case in question is Harris v. Quinn, No. 11-681.  (Go here for a collection of the briefs.) In Harris several individuals who provide in-home care for disabled persons, usually family members, are challenging an Illinois law that treats such individuals as employees of the State and coerces them to provide financial support to a union of public employees they do not wish to join.  Between 1985 and 2003, Illinois law sensibly provided that such individuals were not state employees at all, but instead independent contractors who provided services to patients whose care was reimbursed by the State.  However, in 2003 then-Governor and now convicted felon Rod Blagojevich, whose mugshot appears above, issued an executive order declaring such individuals to be employees of the State of Illinois.  (It should be noted that Mr. Blagojevich has appealed his conviction.)   The order paved the way for the unionization of thousands of such workers by a union that had contributed hundreds of thousands of dollars to Mr. Blagojevich's campaign.    The petitioners have declined to join this union, which has sought to compel them to contribute their "fair share" to the union's coffers.  The petitioners object to subsidizing an organization that will, under the aegis of collective bargaining, advocate higher government spending contrary to their political beliefs.
Illinois concedes that the First Amendment precludes it from forcing individuals, including union members, to support a union's political speech.   See Knox v. SEIU Local 1000, 132 S. Ct. 2277 (2012); Abood v. Detroit Board of Education, 431 U.S. 209 (1977).  However, it claims, with some support in Supreme Court precedent, that it may nonetheless compel non-union employees to provide financial support to subsidize a union's collective bargaining activities over wages, working conditions and the like.  While recognizing that such compulsion interferes with the liberty of non-union employees, the State nonetheless claims that such compulsion serves a "vital interest."  That is, Illinois contends that such coercion will prevent  "free riding" by employees who purportedly derive benefits from collective bargaining in the form of higher pay and enhanced benefits whether or not they pay fees to subsidize such bargaining.  (See pp. 45-48 of the State's brief, here.)

Illinois may well be correct that allowing employees to opt out of support for collective bargaining will result in free riding and thus smaller investments in collective bargaining and reduced wages and benefits.  Indeed, allowing such opt-outs could undermine collective bargaining altogether, as more and more employees realize they can decline to contribute to the union.   However, such a demonstration would not itself establish the wisdom of the coercion the State seeks to defend.  After all, some free riding increases the nation's welfare and thus should be encouraged.  Imagine, for instance, that the  Congress is considering new legislation that will prevent inefficient pollution.  Imagine further that the affected industries are fragmented and unable to organize effective opposition to the proposed legislation, because of free riding by the industry's firms on each other's lobbying efforts.  Such free riding will increase the nation's welfare by dampening opposition to beneficial legislation.
Shaky cartels provide another example of beneficial free riding.  Assume that an  industry's firms have entered a collusive agreement or engaged in tacit coordination that requires each firm to reduce its output 15 percent below what each would produce in a competitive market.  Judge Elbert Henry Gary, pictured above, famously orchestrated just such an arrangement between U.S. Steel and the rest of the steel industry early in the 20th century via so-called "Gary Dinners."  It is, of course, in the industry's collective interest for each firm to maintain that output reduction, thereby increasing prices above the competitive level and enhancing each firm's profits.  At the same time, each firm will have an individual incentive to cheat on the arrangement, secretly discounting its product slightly below the cartel price and increasing output, thereby taking advantage of the cartel price.

Such cheating is a form of free riding, as it depends upon an assumption that other firms are adhering to the agreement and thus maintaining output below and prices above the competitive level.  While such free riding will reduce the welfare of the industry by undermining collective output reduction, society should applaud this behavior, which will increase output, enhance the allocation of resources and increase society's economic welfare.

The example of the steel cartel sheds important light upon the social consequences of the sort of free riding Illinois is trying to stamp out.  According to Nobel Laureate George Stigler, and as previously noted on this blog, labor unions are simply cartels of employees.  George J. Stigler, The Theory of Price, 279 (4th Ed. 1987) ("The labor union is for the labor market the equivalent of the cartel for the product market.").    Moreover, unlike the steel cartel discussed above, labor cartels known as unions are perfectly lawful and thus more stable than cartels in the product market.  Indeed, the National Labor Relations Act, which the Supreme Court upheld in 1937, compels private employers to bargain with such cartels against their will.  As previously explained on this blog, such cartels deepened and lengthened the Great Depression and distort the allocation of human capital in the labor market by inducing firms to substitute capital for labor.  Given these anti-social consequences of unionization, wise public policy would encourage, and not discourage, free riding, for the same reasons that society would applaud free riding by members of a steel cartel and without regard to whether the prevention of "free riding" is a "vital interest" within the meaning of the Court's free speech jurisprudence.  A ruling that the Illinois scheme violates the First Amendment would thus have the incidental effect of encouraging such free riding and increasing the nation's welfare.