How Free Riding Affects Stockholder Equity

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Once a consumer has a company’s product in his/her hands there is not much a company can do to limit what the consumer does with it. This includes copying it and learning from its design, functions, or features. The result can be free-riding. Free-riding is the gaining of benefits from someone else’s expenditure. Reverse-engineering is a kind of free-riding because it reveals what the company did to maximize its revenue from a product. There are some limits to free-riding but not enough to thwart its presence as a risk factor to corporations.

Free Riding

Companies spend millions on product development with the intention of using anything learned as a weapon in the market against rival companies and substitutes. These expenditures are real costs and represent an investment with an uncertain outcome. If nothing is gained from the expenditure, it becomes a sunk cost. Consequently, research and development is a risky investment, one that requires a large return to compensate investors for the risk.

Some free-riding is prevented through law. Copyrights, patents, and registered trademarks all attempt to protect a firm’s investment in money and other resources. Companies also attempt to protect themselves against free-riding by limiting what a consumer may do with a product. For example, some purchases require that a customer agree not to disassemble a product or else void the warranty. Some agreements include the inability of a consumer to reverse-engineer a product. Computer software, which is highly susceptible to copy, pirating, and redistribution, usually comes with a licensing agreement allowing the company to take action should the customer try to benefit from the firm’s expenditures. Of course, these steps are limited in preventing free-riding because the company has no control over what goes on once the consumer has the product in his/her hands.

One of the biggest problems facing companies today is the international nature of the corporation. No longer can large corporations compete without a global focus. Unfortunately, there are no international standards for copying and free-riding. For example, copyright laws in some countries do not preclude someone from taking someone else’s work and selling it. This is, again, especially true of computer software. The Microsoft Corporation has a particularly difficult time preventing people in foreign countries from benefiting from its expenditures and investments because some countries don’t have the commitment to an owner’s right to proprietary works the way some countries, especially the United States, do. The result is a conflict between consumers and companies which erodes stockholder equity due to the risk associated with free-riding. Higher risk means higher returns are necessary to compensate for the potential of free-riding.


It is not usually obvious that the relationship between consumers and corporations is one of agency. Most people see the relationship between these two parties as one of explicit transactions. However, with the potential of free-riding, companies must be prepared to protect themselves against higher risk and, consequently, higher required returns to compensate. Higher required returns make alternative investments more attractive, reducing the ability to innovate and bring new products to market to compete with rival companies’ products. The free-riding potential of consumers only ends up hurting consumers in the end.