Monday, May 24, 2010

Don't you hate traffic?

In his book, The Armchair Economist, Steven Landsburg introduced the concept of taxes and fees that generate no revenue. The concept is so ubiquitous that I thought it'd be useful to show an underappreciated example of it.

I work in Midtown Manhattan. If you look out the window on a weekday at 5 pm, you'll see serious traffic congestion. I used to work near Times Square; if you looked out the window there at almost any time, you saw absolutely horrifying traffic. Consider a few facts:

1. People in Manhattan (at least those that can afford to keep a car there or take a cab) tend to have at least a moderate income; many of them are very wealthy and work long hours. Either way, their time is very valuable.

2. Getting to where they're going must also be incredibly valuable. After all, they're willing to sit in ghastly traffic delays to get there. (The traffic is generally not a surprise, so they knew in advance the trade they were making. And if you are surprised by traffic in Times Square, you should be shipped back to New Jersey.)

3. They're charged a very high toll to get where they're going, but the toll is in the form of lost time, frustration, and unpredictability. (Unpredictability translates into lost time if people have to pad their trip time to get to that important meeting.)

4. The roads and traffic lights are paid for from tax receipts. I doubt the gasoline tax and DMV-related fees cover it, so many other taxes are probably used, e.g. income taxes and sales taxes. These taxes generate large deadweight losses.

Right away, I can see that this arrangement has suboptimality oozing out of its orifices. We use inefficient taxes to build very popular roads. The roads are so popular that there are huge “tolls” (time wasted), and the worst part of all is that nobody benefits from those “tolls”. It's a tax that collects no revenue.

Normally, if I pay a $6 tunnel toll, then I lose $6 and the local government gains $6. That can be used to maintain the tunnel, hire more school teachers, get rid of some of the more destructive taxes, or the money can even be refunded equally to all the residents. Even if the government manages to incinerate half the revenue through bureaucrats' pay and mismanagement, we're still $3 better off than we would be if I paid an equivalent toll that consisted of sitting in traffic. (Even if the bureaucracy is wasteful, it would've been wasteful for income tax revenue and toll revenue alike.)

So let's do a quick thought experiment. Imagine that there are a very large number of people in your city and they're all roughly the same in their behavior and preferences. Yes, that's ridiculous, but we can relax that assumption later. This simplified case can give some serious insight into the problem.

Now let's also imagine that there are roads, which are incredibly valuable, but there are not enough roads to accommodate all the people. In other words, they are a scarce resource. This applies to Manhattan and most cities during rush hour, and it probably does not apply to the smaller suburbs of Kalamazoo.

Ok, now under these assumptions, how many people will use the roads at once? We assumed that the use of these roads is very valuable and so at least some people are going to use the roads. Maybe getting to that meeting a mile away is worth $300 and it really only takes $10 of time, fuel, and wear & tear on your car when the roads are empty.

What if the roads aren't empty, but there are a tiny number of cars on the road? In this case, the roads are slightly less valuable. Sure, now there are a few guys you could have an accident with, and you might have to actually yield to another car once in a while. But being able to use the road is still very valuable. So now if you have a $300 meeting to go to and it costs $12 in time and money to drive, you're going to do it.

How many cars are going to be on the road in equilibrium? What will constrain the growth of traffic? The answer is that if everyone has a meeting that's worth $300 to get to, the traffic will keep building until it costs everybody (remember, we're all alike) just about $300 in time, frustration, fuel, wear & tear, and accident risk. Let's say that magic number is 5000 drivers.

So each driver is “paying” $300 to use the roads and nobody else benefits from that $300 “toll”. Each person gets to his $300 meeting and loses $300 in time, frustration, fuel, wear & tear, and accident risk. I have no idea in advance how much fuel costs, how much their time is worth, etc., but I can still say, assuming the roads can't accommodate everybody, that traffic will increase until the total cost of driving is $300 per mile. At that point, nobody else will decide to jump in his car.

So the road does just about zero good. Each driver spends $300 and gets $300 of benefits. No one on “the other end” of the transaction collects the $300.
Actually, it's even worse than that. I only counted costs to the drivers on the road. But there are costs to the people who didn't drive. They (like the drivers) have to deal with air pollution (again, not a big deal in the suburbs of Kalamazoo, but it can be a big problem in city centers) and noise (try sleeping in Manhattan when you can hear a driver who just discovered how his horn works). While we're at it, the pedestrians are now a little less safe.

Finally, taxes probably had to be raised to build and maintain the road. A few businesses on the margin may have gone under as a result, a few other entrepreneurs decided not to launch their new business in this city, and a few businesses still in operation made one fewer batch of widgets since the price of production went up.
What a great deal! We raise taxes, create some economic distortions in the process, build some roads, the drivers get zero benefit from it, and the non-drivers are made slightly worse off!

Now, I'm not anti-roads or anti-driving. On the contrary, I love both those things. When they're implemented properly they can be extremely welfare-enhancing, they can make you feel like a real man, and they make you think that you really have freedom. I just think that there are much more (economically) efficient implementations.

Let's take a first crack at this idealized case, suppose we got rid of whatever inefficient tax was used for getting road money and instead put a $100/mile toll on the use of the roads. (I'm not being very precise about how the tolls are collected, but that's a detail we can work out later.)

I don't know how many people will choose to drive, but I can guarantee that it will be a lot less than before. This time, if there's only one driver on the road, he faces costs of $110 (the toll plus the $10 from before). Getting to your destination is worth $300 so it's a good deal. So more people will join him. But the number of people can't grow to 5000 anymore since then the cost of driving would be a whopping $400 ($100 toll plus $300 of time/fuel/etc.)

So maybe only 4000 people drive. Each person is getting $300 of benefit, paying a $100 toll, and paying an additional $200 in traffic delays/aggravation/fuel. So the drivers still gain no benefit from the road, but the city raised $400,000 in the process. Now we can ditch those inefficient taxes we implemented to maintain the roads. Imagine that: Rationing a scarce resource using the price system actually improved things!

Now I have no idea what the correct toll is and it would almost certainly vary by time of day. ($100/mile in Manhattan rush hour is high but not really as crazy as it sounds.) And if you are worried about poor people not being able to afford to drive, don't be. If you want to help poor people, give them money or cut their taxes. (Incidentally, this toll plan allows you to eliminate job-killing taxes.) Don't try to help poor people by subsidizing their car use. Does anyone actually think that it'd be a bad thing to eliminate NYC's insane income or sales taxes and replace it with a drive-during-rush-hour tax? (I should also mention that any plan that reduces traffic makes it much, much more practical to travel by bus. Currently in Midtown, a Cub Scout troup can run a three-legged race faster than a city bus can drive.)

But this gets to the heart of why people reflexively distrust politicians who propose ideas such as congestion taxes. (Mayor Bloomberg got to find this out first hand.) Few of us are naïve enough to think that a new tax will replace an old tax. If a politician proposes replacing tax A with tax B, it's a good bet he's pushing to create tax B, leave tax A in place, and then spend a whole lot more money. And that's why this plan will reliably be shot down over and over again.

So I really don’t blame voters for opposing congestion pricing on these grounds. But I do hope that the next time you see a traffic jam, you become enraged at the economic waste before your eyes.

Future post: I’ll toss out that assumption that everyone is the same. And how do you deal with privacy issues?

Sunday, May 2, 2010

Price-Gouging as a Remedy for Shortages

Yesterday, the Boston area suffered a catastrophic failure of its water supply system. A 10-foot diameter pipe carrying water from the Carroll Water Treatment Plant to Boston and neighboring communities ruptured and is not currently usable. Although fresh water is widely available from local reservoirs, treated water is not. It will be a few days in the most optimistic scenario before potable water is available at taps for over 2.5MM people. Reading between the lines of press reports, it was (and maybe still is) a distinct possibility that potable water could be unavailable for weeks, as the pipe is custom-designed, and replacement parts would have to be machined from scratch.

Of course, all of the supermarkets were stripped bare of bottled water and other beverages within hours of the news. There were even reports of fights and near riots over a product which costs approximately $0.25 per bottle.

Local governments announced plans to distribute bottled water (such as they have in storage) free of charge to needy residents.

This situation is instructive from the perspective of economics, and a simple analysis leads us to a solution which is both optimal and politically impossible at the same time.

If owners of bottled water (e.g. supermarkets, convenience stores, normal citizens, and free lancers) were able to sell at any price without fear of being accused of price-gouging, then there would be two beneficial effects:

1) water would be allocated in a more rational way, rather than by luck or by who gets to the supermarket first; and

2) supplies would increase as enterprising people truck bottled water in from other areas.

To offset the problem that poor people will be priced out of the market, the state government could hand out checks to every affected household -- perhaps $10 per person per day (a $30MM per day hit to the annual state budget of almost $30B). It is up to each person to decide how much of that distribution should be spent on bottled water.

It's important to remember that there are other options to drinking bottled water or using it to wash your hands or brush your teeth. It's possible to create your own potable water by boiling tap water for at least 1 minute and then cooling it back down. A pain in the neck to be sure, but boiled water is a cheap substitute.

This is pure speculation, but if implicit price controls were removed, I suspect that the price of bottled water would triple or quadruple initially. And then you would see a mad rush of supply as people from as far away as New York rent trucks to ship bottled water to Boston. The opportunity for a quick profit is very attractive. You could probably fit 2,000 half-liter bottles in the bed of a one-ton pickup truck alone. Attach a trailer, and you could probably pull another 5,000 bottles easily. If there was a gross profit of $0.50 per bottle to be had driving 7,000 bottles up from NY in a pickup truck, I think a lot of New Yorkers would jump at the opportunity. And that's for a random guy with a pickup truck.

The bottom line is that if price-gouging were allowed, the market would clear at an acceptable level, and there would be enough bottled water to satisfy everybody. Those who are willing to make do with a little less, can save the cash distributed by the state. Those who need more water will have to make do with a little less cash.

We see these local shortages from time to time (e.g. gasoline shortages in Florida after hurricanes), and always there is a crackdown on price-gouging. Too bad more people don't recognize that the solution to local shortages is to allow price-gouging. Indeed we should encourage it.