DRI-299 for week of 4-28-13: Can You Trust Taxi Drivers? Why or Why Not?

An Access Advertising EconBrief:

Can You Trust Taxi Drivers? Why or Why Not?

Last week’s news brought a report that the state of Nevada audited taxicab trips taken to and from McCarron Airport in Las Vegas. The results revealed alleged overcharges of approximately $14.8 million. The drivers were accused of a practice often ascribed to taxicab drivers the world over: “long-hauling,” or deliberately taking passengers by a longer-than-necessary route in order to rack up a larger-than-necessary fare. According to the AP account of the audit, some 22.5% of trip sheets recorded these overcharges.

Throughout the history of the industry, accusations of this practice have provoked endless discussions. They tend to recur between two poles. On one side, the cab driver is portrayed as a low-life, immoral and unscrupulous, anxious to cheat his customers at the drop of a hat. At the other pole is a poor, downtrodden driver who battles long hours, short earnings, poor working conditions and physical danger. Sometimes these handicaps are offered as the drivers’ bona fides, the proof of their innocence of the charge of cheating; alternatively, they are the justification for bending the rules to get out from behind the societal eight-ball.

But we never hear the one discussion that would really tell us what we need and want to know: Is long-hauling practiced systematically and, if so, why? We never hear it because the economist is the last one consulted about the economics of driving a taxicab. It is time to remedy that omission.

The Economic Incentives Facing the Taxicab Driver

The workings of the taxicab business are similar throughout the United States and, indeed, much of the world. Taxicab companies provide highly visible, marked motor vehicles offering for-hire passenger-transportation services in local markets. They also provide dispatch services to drivers from call centers that field telephone requests for service. These requests are related to drivers either through the time-honored method of two-way radio communications or the newer digital mode of computer transmission. Dispatched calls are one of the two principals sources of taxicab business for drivers, the other being informal street hails and pickups attained via taxi queues at major hotels and restaurants. Prearranged delivery business and personal arrangements with customers can also produce significant business in many markets. Very recently, the advent of cellphones and Smartphones has created direct links between taxi drivers and customers that has reduced the need for a company middleman.

In the overwhelming bulk of U.S. markets, both entry and price are tightly regulated in the taxicab business. This is a notorious stylized fact of economics, so much so that microeconomics textbooks often feature taxicab markets as an example of harmful government regulation of business. Taxi fares are almost always generated by meters, formerly mechanical but now push-button digital devices. The meter records a unit mileage charge as the principal fare determinant, supplemented by a waiting charge when the cab is stationary or caught in heavy traffic. The other component of the taxi fare is the fixed charge, or “meter pull,” that accrues immediately when the meter is activated. The meter pull is crucial to comprehension of the incentives facing the taxicab driver, not so much because of its size but because of its existence.

It seems self-evident to almost everybody that a taxicab driver has a clear incentive to run up the fare by driving his passengers around in circles as long as possible before disgorging them. Unless forestalled by statute, government regulation or his conscience – so conventional thinking goes – the driver will pick his passengers’ pockets clean using the taxi meter as his accomplice.

Like many things in life that seem self-evidently true, this is false.

Why? The short answer is that – as a first approximation – short trips are more profitable for taxicab drivers than long trips. Since a cab driver who “long-hauls” is deliberately lengthening the trip, he is acting against his own interest. Of course, a driver might do this inadvertently, just as any businessman might mistakenly reduce his profit. But businessmen who repeatedly cut their own throats are unlikely to survive long in competitive markets. Unregulated taxicab markets are some of the most competitive known to humankind, as drivers themselves will readily testify. Thus, the cure for long-hauling – again, as a first approximation – is simply to deregulate the market and allow competition to do its work. And this is also the best course to follow if long-hauling were never a threat, since the competitive fares produced by free entry into the market are preferable to the regulated fares dictated by government.

Understanding the superiority of short trips will cement our faith in the operation of the market. It will also help us understand why the process can sometimes go wrong.

A Numerical Example

To illustrate basic principles, a simple numerical example may be useful. Assume taxicabs that get 10 miles per gallon of gas, with each gallon costing $3. The taxi fare is $2.40 per mile and the fixed charge or “meter pull” is $2.50. Compare two drivers, 1 and 2. Driver 1 runs 4 10-mile trips and 3 20-mile trips, traveling 100 total miles and paying $30 for gas. His total revenue is $267.50 and his net revenue is $237.50. His revenue-per-mile is $2.37. Driver 2 runs 4 5-mile trips, 3 10-miles trips and 25 1-mile trips, traveling 75 miles and paying $22.50 for gas. His total revenue is $260 and his net revenue is $237.50. His revenue-per-mile is $3.17.

Our numerical example might seem unbalanced, but it accurately reflects a disproportion between the work habits of two types of taxicab driver. One type deliberately specializes in airport trips because these usually involve long trips between outlying airport locations and the city. The second type typically operates within the metro boundaries, running shorter trips with only occasional excursions outside city boundaries. At day’s end, the Type 1 (airport specialist) driver will almost always rack up a larger mileage – even though he runs significantly fewer trips – because his average trip is much longer and because he will often incur “dead” (non-paid) mileage by returning to town to seek his next airport trip. (Return trips from the airport are less numerous and more concentrated in time than trips to the airport.) The Type 2 (in-town) driver has a much shorter average trip, but cannot equal Type 1’s total mileage because Type 2 must spend time locating addresses, loading and unloading passengers and belongings and coping with traffic delays. Type 2 works much harder for his money, which makes Type 1 more willing to accept less total income.

We must specify the precise cause of Type 2’s lower revenue-per-mile. It is the meter pull. Type 2 earns a much larger proportion of his revenue (the numerator in the revenue-per-mile ratio) by traveling zero miles – merely by punching the button activating the taxi meter – than does Type 1. The easiest way to appreciate this principle at work is through a reduction ad absurdum: Assume that a driver spends his entire 12-hour shift doing nothing but loading up a passenger, punching the meter on, then deactivating it, unloading the passenger and repeating the process for the whole 12 hours. Total mileage would be zero. By the rules of mathematics, as the denominator approaches zero the ratio approaches infinity. Obviously this would never happen, but it illustrates the power of the meter pull. Ceteris paribus (all other things equal), a taxicab shift top-heavy with short trips must glean more revenue from the meter pull, thereby making it odds-on to earn greater revenue-per-mile.

Our simplified example left various real-world factors out of account. Most of these only reinforce the conclusion reached above. One example is physical depreciation of the taxicab. For the last 30-40 years, most U.S. taxicab drivers have owned or leased their cabs. Thus, they experience depreciation as an implicit cost of ownership or a hidden cost buried in the rental fee. As a first approximation, this cost will be less for low-mileage Type 2 drivers, thus reinforcing their revenue-per-mile advantage. Another excluded factor is tip income, which is an important component of a driver’s income. Since there is no indisputable basis on which to say whether the Type 1 or Type 2 driver’s tips should be higher (Type 1’s customers may have higher incomes, but Type 2 works harder), we assume that tips are equal.

However, there is one real-world complication left to be considered. This one can derail the careful chain of reasoning we have constructed thus far.

The Continuous Flow of Taxicab Trips – or Not

The implication of the economic model we have developed to this point is that a taxicab driver would be a chump to take his passengers for a (roundabout) ride. Instead of trying to increase his income illegally by running up the bill with wasted mileage charges, he should instead take the shortest route to his destination and score up another meter pull as soon as possible.

But what if, upon reaching that destination, he should discover that no new trip awaits him? In effect, we have assumed heretofore that the cab driver’s trips came in an uninterrupted, continuous flow. Let’s change that. Assume, in our numerical example, that the Type 2 driver can only scrounge an equal number of trips as his Type 1 counterpart – 7 trips consisting of 4 one-mile trips, 2 5-mile trips and 1 10-mile trip. Total mileage is only 24 miles and total revenue is only $75.10. Net revenue is $67.90. Revenue-per-mile is $2.83, still greater than for the Type 1 driver. But in order for Type 2’s overall superiority to hold, Type 1 demand would have to fall by roughly the same percentage magnitude – down to 1 or 2 trips –  which is unlikely for many reasons.

In order for Type 2’s revenue-per-mile superiority to win out, the two drivers must drive somewhere close to the same paid mileage, which will allow Type 2’s superior cab-driving skills to assert themselves and his flock of trips and meter pulls to add up to a larger total of net revenue.

Las Vegas is the perfect venue in which to compare the two scenarios. For decades, Las Vegas was a Mecca for taxicab drivers because gambling tourism attracted hordes of cab riders to the city. These tourists rode cabs 24/7 because the city’s wide-open gambling policies allowed continuous casinos to dispense with door locks and remain open continuously. It was not at all unusual for a taxicab driver to arrive loaded at a casino, only to disgorge his passengers and find his next trip waiting on the spot. The City That Never Sleeps was the locus classicus for the continuous trip-flow model of taxicab operations.

But the Great Recession and accompanying financial crisis flattened the red-hot real-estate markets of fast-growing regions like Las Vegas. New-home construction and tourism were especially hard-hit – and Las Vegas was a national leader in these markets. Taxicab drivers were gobsmacked by a recession that seemed fiendishly designed to eviscerate them.

Suddenly the continuous flow of taxicab trips dried up like a drought-stricken riverbed. A Type 1 driver on his way to the Vegas strip from the airport faced the live possibility of not acquiring a succeeding trip for an hour after kicking his current occupants loose. Now that new meter pull became a speculative proposition.

Facing the live possibility that the passengers now in his cab may be the last he sees during his current shift, the taxicab driver wants to maximize his return from this “bird in the hand.” In the limit, revenue gained by shearing those passengers would be pure gain – indeed, the only way to improve his revenue take.  No amount of hard work will do him any good if the business simply isn’t there to be serviced. Airport trips are the logical venue for these shenanigans, since passengers inbound from the airport are the least likely to recognize an inefficient travel route.

Not only do bad economic times present the best opportunity for long-hauling, they also threaten the relative superiority enjoyed by the Type 2 modus operandi. Long trips become more attractive because they are a sure thing, a “bird in the hand” – insurance that for the relatively long duration of the trip, the cab will be occupied and the meter running. Maximizing revenue-per-mile takes a back seat to the cruder strategy of getting something down on the trip sheet. When the taxicab trip itself is a highly uncertain variable, a high-dollar trip suddenly takes precedence over a less-costly but less-remunerative one.

The advent of taxicab-industry recession does two things to our economic model, both of them bad. It creates an incentive for Type 2 drivers to become Type 1 drivers. And it creates an incentive for those Type 1 drivers to cheat.

Of course, the fact that cheating becomes more attractive doesn’t turn all drivers into cheaters. But taxicab driving is heavily populated by people whose incomes, skills and values are marginal. Both economic logic and history tell us that incentives form a firmer basis for good behavior than morality in any market, particularly this one.

Regulation – Help or Hindrance?

The reflex response to news like the taxi long-hauling reports is to call for regulation – or to call for more regulation, or better regulation, or a reform of regulation. In fact, the Nevada taxi audit was produced by the state’s Taxicab Authority. A brief review of its activities is instructive.

One might suppose, given the widespread publicity and outrage that greeted release of the report, that the Authority was a veritable Pinkerton Agency of taxicab regulation, surveilling the industry with unblinking vigilance. Yet its previous audit was 3 ½ years ago. (Apparently no scandal comparable to the latest one was uncovered, which supports the economic model outlined above.) In 2003, the Nevada legislature appropriated funds for future audits, but these were diverted to “staffing for other tasks,” according to the AP article.

What “other tasks” could be more important than policing the industry that the agency was created to regulate? The question might perplex a layman, but not an economist. Taxicab regulation is perhaps the most notorious of all regulatory case studies featured in economics textbooks in post-World War II decades. Although politicians and their appointees give lip service to high-minded notions of protecting the public, taxicab regulation began in the early 20th century to protect streetcars against competition by taxicabs. It soon was captured by taxi industry interests such as Yellow Cab and became a vehicle for cartelizing the market in cities throughout America.

The proof of cartelization is provided by the high prices commanded by taxi licenses in places like New York City, where the legal supply of taxi permits has been frozen since World War II. A taxi medallion in the Big Apple is often worth a six-figure price, which reflects the monopoly profits the holder can earn. Moreover, these profits are capitalized into the purchase price, so that the buyer is actually only earning a competitive rate of return. (It is the auctioning of medallions in the secondary market, rather than market competition in the taxicab market itself, that lowers the rate of return to the competitive point.)

Obviously, regulation does not have the “public interest” in mind, since any definition of that term would have to include taxi-service consumers who are harmed by monopoly prices and the restriction of entry and output. Regulatory agencies exist first and foremost in order to perpetuate themselves and the welfare of bureaucrats and employees, which is why “other tasks” were able to divert funds allocated for audits of the taxi industry.

Might there be worthwhile tasks other than audits on which those appropriated funds might have been spent in Las Vegas? Certainly. Educating airport travelers about fares and competitive alternatives would be one such purpose. Under deregulation, conspicuous posting of company names, fares and contact information would go a long way toward preventing price gouging. In the more common regulated environment, explanation of the regulated fare – alone with same fares to common destinations – and posting of competitive alternatives would accomplish the same thing. Yet taxicab regulators are very loathe to do this, further impugning their protestations of devotion to public service.

The involvement of airports with long-hauling is not coincidental. Moreover, the lower detection capability of non-natives is only part of the reason why airport trips are the occasion for long-hauling. Even in cities where the taxicab industry is otherwise deregulated, it is common for taxi service to be regulated at the airport. Drivers must obtain special airport licenses and special fares – either flat-rate or discounted from the meter rate – are enforced. Again, the ostensible purpose is public protection while the real rationale lies elsewhere.

Separation of the airport from regular taxi service allows regulators to practice a form of price discrimination. They can charge a particular market segment – in this case, the traveling public – fares calculated to maximize revenue based on that segment’s responsiveness to price and consumption alternatives. Then they can use their government authority to appropriate part of the additional revenue, thereby splitting the profits of the monopoly they have created.

The airport rates are typically lower than cartelized rates paid by in-town taxi consumers, since airport travelers have alternatives like buses, shuttles and rides from friends and family. But they are higher than prices that would prevail under competition. This is demonstrated by the market itself, in which drivers will individually negotiate lower fares with airport passengers in order to win the business. (This is sometimes legal, sometimes not.)

We have seen above that the best prophylactic against long-hauling is a continuous flow of taxi trips for drivers, which provides a clear incentive to operate efficiently rather than dishonestly. Regulation cartelizes taxi markets, substituting monopoly for competition. Monopoly increases price and reduces output, relative to the competitive outcome; that is, it drives the market away from the desired outcome rather than toward it. In addition, it artificially attracts drivers to the business, which tends to bid up prices of permits. This forms a permanent barrier to reform, since lifting restrictions on entry and pricing would eliminate the value of the permits and inflict a capital loss of permit holders.

Though presumed to be and touted as the solution to long-hauling, regulation is actually the proximate cause of the problem. True, it does not cause recessions, but it prevents the taxicab market from competitively adjusting to whatever conditions prevail, in good times or bad.

Put Your Trust in Competition

If life were governed primarily by morality, religion would suffice as a guide to understanding and shaping human behavior. The scarcity of means relative to ends causes us to respond to incentives. Too many everyday decisions cannot be reduced to a choice between good and evil; people cannot simply be ordered to “do good.” The long-hauling taxicab case illustrates economics at its best, both in diagnosing our ills and treating them.

Can we trust taxicab drivers? Our analysis suggests that we can trust them as much as we trust anybody else in life – when there is competition. When there is regulation, we should trust only our own vigilance and precautions, because regulators are from the government and they are not here to help us.

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