A free rider problem is a situation in which individuals or businesses are receiving benefits without actually contributing anything, thus creating an unfair balance in the distribution of revenues or other resources. A problem of this type can exist in a number of scenarios, since free riding can create a financial hardship over time that renders the process unprofitable for everyone concerned. To this end, many businesses will take steps to weed out free riders and thus minimize the problem.
In order to understand the nature of the free rider problem, it is necessary to first understand what is meant by a free rider. The term has its origins in transportation. In days gone by, anyone who was found to be riding a stagecoach, or later a public street car or subway system without paying for a ticket was referred to as a free rider. Over time, the term has come to mean anyone who benefits from a business or investing situation, but does not actually pay for the benefits the receive.
With investing, a free rider problem may come about when an investor purchases shares on margin, but ultimately is unable to gather the resources to pay for those shares. This creates a situation where the brokerages involved in the transaction are left with unpaid fees for services rendered to the investor. At the same time, the inability to pay for the shares also has a negative impact on sellers, sometimes to the point of affecting their ability to pay for investments they have purchased on margin. In order to minimize the frequency of this problem, many brokerage houses have strict rules that govern the ability of investors to buy on margin.
Businesses may sometimes encounter a free rider problem. This often occurs when shopkeepers seek to collectively make their shopping district attractive and enticing to shoppers. If one of those shops does not actively participate in that effort, there is a good chance that shop will still benefit from the foot traffic generated by the efforts of the other stores in the area. In this scenario, others are committing resources to enhance the profitability of the area, while the lone business that does nothing still reaps benefits in terms of sales because of the expenses and efforts of others in the same area.
The free rider problem, if not kept in check, can ultimately cause losses to all concerned. For example, if enough people manage to use public transportation without paying, there is a good chance the service will be under-funded and have to either eliminate some routes or shut down altogether. In like manner, the presence of one shop that is not maintained with the care of other shops in the area may lead to a perception that the district is in decline, discouraging some customers from shopping there. Ultimately, this means fewer sales for all the shops in the district, and possibly the failure of one or more of the retailers in the area.