Capitalism 2.0: The Free Rider Problem

If you have studied economics, you are familiar with the free rider problem. To refresh everyone’s memory, here is Wikipedia’s definition of the concept:

In economics, collective bargaining, psychology, and political science, a free rider (or freeloader) is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding (or its negative effects). Free riding is usually considered to be an economic problem only when it leads to the non-production or under-production of a public good (and thus to Pareto inefficiency), or when it leads to the excessive use of a common property resource.

The term free rider comes from the example of someone using public transportation without paying the fare. If too many people do this, the system will not have enough money to operate. Another example of a free rider is someone who does not pay his or her share of taxes, which help pay for public goods that all citizens benefit from, such as roads, water treatment plants, and fire services.

As we think through the restructuring of capitalism as a system, we need to look carefully at the free rider problem.

Unfortunately, the system we operate under today is a colossal free rider problem in action. From the West’s massive budget, debt and deficit crisis to support welfare economics, to the Internet’s rampant appetite for free resources – products, services, and content – the situation is unsustainable.

To give you an example, only 2% of the customers who play their games pay any money to Zynga. The rest play for free. But it takes resources to offer those games free, creating a question of fairness and sustainability.

Those of you who enjoy this blog free of charge and express your displeasure that 1M/1M premium is a paid program and that we do not offer our self-assessment content free disregard that the cost of running this operation – this effort at global entrepreneurship development – is not zero.

The New York Times is gradually tightening the belt on free content. The Wall Street Journal was never free. There is a cost to developing, researching, writing, and publishing articles and columns, and free is not a business model.

All over the startupsphere, we see freemium  being offered as a business model. But only 2-4% of free traffic typically converts into paid customers. Free users consume infrastructure and talent, both of which are becoming cheaper.

If you follow the value chain, creating the infrastructure costs money. The people who work on the projects need to pay their bills and have a decent standard of living.

There are a few ways of supporting free services without destroying the downstream value chain. One of them is venture capital. A second is charity funding.

But remember, the capitalism 2.0 I envision assumes that the primary transaction is between the producer of value and the consumer of value, with the financier being optional. If you apply that model, neither option, venture capital or charity funding, is acceptable. The consumer needs to pay a fair price for the value he or she consumes. That is the most desirable result.

As has happened with so many previous fads, VC enchantment with the freemium model will end badly. A great deal of money will be lost, and there will come a point when freemium business plans no longer find the capital they need to get off the ground. They will simply go out of fashion.

The charity option will remain. And, to be fair, projects like Salman Khan’s Khan Academy are welcome nonprofits supported by the generosity of philanthropists. Nonetheless, the sustainability of these efforts is dependent entirely on charity funding, which I find concerning.

Finally, there is also a tremendous skill mismatch in the workforce today in that the skills in demand are not the skills that are available, creating a pressing need for retraining. That companies are not willing to foot the bill for retraining is again an economic issue. The margin pressure is tremendous, causing training budgets to erode and wages to drop. This creates further dimensions of unsustainability.

Although globalization and technology create competition that drives down wages, we must not miss the fact that the downward pressure on pricing and margins is causing similar devastation.

We could describe what is happening today as creative destruction. It is hard for those suffering to digest, but it is not an inaccurate assessment of the situation.

The system that will emerge from this rubble needs to deal with the free rider problem with greater care. Otherwise, humanity’s progress over the past century, progress that has been largely on the wings of capitalism, could end ignominiously in a new period of regression.

This segment is a part in the series : Capitalism 2.0