DRI-335 for week of 9-30-12: The Economic Concept of the ‘Free Lunch’

An Access Advertising EconBrief:

The Economic Concept of the ‘Free Lunch’

“Give me liberty or give me death!” “54-40 or fight!” “What do you want – good grammar or good taste?” “Where’s the beef?” “There’s a sucker born every minute.”

Aphorisms, slogans and catch-phrases decorate the American idiom like Christmas-tree ornaments. They punctuate our points, intensify our insults, amplify our arguments and rationalize our rituals. They often start life as political or advertising jingles, only to outlive their original inspiration to become part of the language.

Economics has left its mark on our idiomatic heritage. Its most famous contribution has been: “There’s no such thing as a free lunch.” Although both the phrase and the concept date back to the 19th century, the line didn’t hit its stride until the 1940s, when a few economists revived it. Just as these origins would lead you to expect, the slogan contains a hard core of imperishable truth.

The Literal Free Lunch That There’s No Such Thing As

Today, children at K-12 public schools (and many private schools) commonly eat at least two meals at school. These meals are planned and paid for, wholly or partly, by government using taxpayer funds. Current programs evolved from the original federal program of “free” school lunches provided to poor elementary schoolchildren, begun in 1946. Today, some 31 million children receive subsidies, which go to those in families with incomes up to 185% of the poverty-level income. (Some children in wealthier families also receive subsidies, particularly for after-school snacks.)

Debate over the wisdom of the program attracted the attention of economist Milton Friedman, who reoriented the focus of the debate with his famous declaration: “There’s no such thing as a ‘free lunch.'” Before wasting time arguing about whether it was morally or constitutionally justifiable for government to provide free school lunches, Friedman maintained, we should first acknowledge that the lunches weren’t “free” in the true economic sense.

In the first place, somebody was paying for them. Sure, neither the children nor their impecunious parents were effectively plunking down cash in payment, but the foodstuffs were nevertheless being purchased by somebody. But even this wasn’t the ultimate point. Suppose, for example, that government had simply ordered private-sector firms to supply food to school cafeterias as an act of charity. That still wouldn’t make the lunches truly free.

The food was grown or raised. It was prepared and packaged. It was transported to the schools. All this required the use of resources – human labor, natural resources like land and water and chemicals, capital goods of various types. These resources had alternative uses, which meant that alternative output was sacrificed in order to produce the food and make it available. The sacrifice of that alternative output was the true economic cost of the food. Even if the school lunches carried no nominal price to their consumers, they still carried a real economic cost in the form of a foregone output. This is the only meaningful concept of the word “cost” – the highest-valued alternative foregone in production or consumption.

Friedman objected to free school lunches – not because he lacked compassion for poor schoolchildren but because he had compassion for children, their parents and everybody else. He wanted to see resources used as efficiently as possible, thereby making everybody as happy as possible.

The General Fallacy of the Free Lunch

To maximize happiness, we should use resources where people value them the most. To do that, we need to place a market value on the output produced using the resources, then let people compare that to the personal value they get from consuming those things. People will increase consumption for so long as their personal value exceeds the market value, finally arriving at their stable, ongoing consumption point when the two values coincide.

But school-lunch programs misled consumers by presenting them with a false picture of the market value. By presenting children and parents with a false market value of zero, the school-lunch programs encouraged poor children to consume far more food than they would have otherwise. (Some qualifying children pay a flat fee of $.40 for a lunch, but this does not alter the logic of the case.) Indirectly, parents were deceived as well, since they would otherwise have reacted to market-value prices of food by economizing on the lunch-money budgets they allocated to their kids.

Over time, free lunches for poor children have gradually metamorphosed into free or subsidized lunches for many schoolchildren in both public and private schools. Is it any wonder, then, that we have gradually developed a nationwide problem of childhood obesity pari passu with the escalating phenomenon of “free” and subsidized school lunches (and breakfasts) provided by government?

The inefficiency of free school lunches extends far beyond the current epidemic of child obesity. The fact that children consume too much subsidized food is complemented by the fact that producers produce too much. Indeed, agricultural subsidy programs for certain crops are the mirror image of the consumer school-lunch subsidies. One original rationale for the school lunch program was to complement agricultural price-support programs by liquidating or reducing crop surpluses.

Consumer subsidies artificially present a price that is too low; agricultural price supports artificially hold the price too high, creating a surplus. Production and consumption are driven beyond the point where the true personal value placed on the goods produced and consumed equals the opportunity cost of producing them. Instead, the opportunity costs exceed the value; the subsidies make us poorer.

The “us” in the last sentence includes nearly everybody, even the schoolchildren. By subsidizing the children with cash instead of lower lunch prices, they could consume alternative output that would make them better off overall than do the lunch subsidies. (Obviously, the cash subsidies would enable children to meet their varying individual nutritional needs.) There are only two possible net losers from abolition of food subsidy programs. Farmers might not gain enough from consumption of the additional output produced to compensate for capital losses on the value of their agricultural land. The other loser-candidates are the people in government whose incomes are directly dependent on the programs.

Milton Friedman’s position is now clear. Now we know why there is no such thing as a free lunch. But why did government insist on giving us something that made us worse off? And why do we insist on receiving it?

The Lure of the Free Lunch

Government’s behavior is conditioned by our responses, so the two questions above are not independent. The disconnect between tax collections via withholding on wage and salary income and provision of free school lunches means that taxpayers have traditionally failed to add up all the various government expenditures and gauge their personal value against their cost. Instead, they have said to themselves: “This individual subsidy is such an insignificant pro rata fraction of my total tax bill that it is not worth the time it would take me to mount an effective protest against it – which would only end up making me look selfish and insensitive, anyway.” Food consumers – parents of schoolchildren – say to themselves: “All I can be sure of is what I see in front of me – a free lunch for my kids. Refusing it won’t get me a cash subsidy. Maybe I’ll consider voting for somebody who makes that proposal – if anybody does.” But nobody does – and the subsidies are enacted, and grow ever larger and more inclusive.

The incentives offered government by these programs are utterly perverse. The beneficiaries of the subsidy – more specifically, the parents of the schoolchildren – represent a huge pool of potential votes. So politicians have an obvious incentive to propose and approve the program. Administering the program requires a large staff of bureaucrats and a much larger army of low-level employees. The larger the program, the more money bureaucrats make. This is an obvious incentive for bureaucrats to lobby for the program’s approval and enlargement. The low-level employees are getting secure government jobs; they are another obvious source of potential votes for politicians.

The longer this process goes on, the more entrenched and secure the program becomes. The more tenacious and vehement are its defenders – farmers, bureaucrats, politicians, government employees, even many ill-informed parents and schoolchildren. The more established the program becomes in the government budgetary process, where programs are routinely extended from year to year with an allowance for increases in prices and population. Any decrease in this routine increase is referred to as a “budget cut,” belying the fact that the actual spending on the program has risen.

The Free Lunch Pretext

The reader will have noticed at least two outstanding ironies in the foregoing explanation. First, the “solution” to the original problem of poor schoolchildren suffering inadequate nutrition ended up making practically everybody worse off – including the schoolchildren. Second, an actual solution that would have solved the initial problem for a fraction of the actual cost – a cash subsidy – exists but is spurned by the ostensible problem-solvers.

This seeming irony is explained by the fact that the problem-solvers are not really trying to solve the problem posed. The provision of the supposed free lunch is only a pretext. It is only an excuse for doing what politicians, bureaucrats, lobbyists and other enthusiasts for big government want to do; namely, expand the power and reach of government. The schoolchildren themselves are only pawns, convenient fronts and poster-children, a sympathetic public face for a most unappetizing enterprise.

Any doubts on this score have been expunged by the recent shift in emphasis by the federal school-lunch program. The Obama administration, supported by allies in academia, regulatory agencies, leftist think tanks and municipal authorities like Mayor Bloomberg of New York City, has proposed mandatory menu standards for school lunches in the Healthy Foods Act. The Act drastically modifies calorie, fat, carbohydrate and salt content of K-12 school lunches. Calories have been set between 650 and 850, depending on the age of the students.

The purpose of these modifications has been to preserve the free-lunch pretext of using government subsidies and mandates to help schoolchildren while really serving the interests of big government. Whereas the free-lunch pretext was to alleviate the effects of poverty by making lunches “free,” the pretext here is curing obesity by making healthy eating mandatory.

And as before, the real purposes are left unstated. The regulatory standards will require more and bigger government to formulate and enforce. They will absolve government from blame for the childhood obesity epidemic in the familiar way – by making government look as active as possible. This entails spending as much money as possible, which in turn serves the interests of bureaucrats, lobbyists and government employees.

Washington, D.C. is an official irony-free zone, but inhabitants outside the beltway may appreciate the irony that the same federal government now purporting to cure childhood obesity was a key contributor to it. The artificial underpricing of school lunches were one substantial contributor to child overnutrition. The new learning on obesity reveals another government link to obesity and to other worrisome trends – early- and late-onset diabetes.

In the last decade, research into Type II diabetes has confirmed a relationship hinted at by doctors such as Robert Atkins, whose low-carbohydrate diet gained tremendous popularity in the 1970s and 80s. Obesity is not always, or even primarily, the simple outcome of excess calorie intake relative to energy expended. Nor is it necessarily conducive to treatment via low-fat and low-calorie diets.

Many people suffer a double whammy of blood-sugar fluctuation and weight gain. Blood-sugar spikes occur when carbohydrates – particularly simple carbohydrates such as sugars – are ingested and enter the bloodstream quickly. This process drives blood sugar levels above the safety zone, causing neurological damage that eventually leads to peripheral neuropathy and other symptoms of Type II diabetes. Meanwhile, the spikes trigger a bodily alarm that releases insulin into the blood stream. The insulin restores the blood sugar level to normal, but causes the carbohydrates to be stored as fat molecules. These later produce arteriosclerotic plaque in the veins and arteries, causing heart disease – the common ultimate cause of death among diabetics. (The primary difference between Types I and II diabetes is that Type I sufferers cannot produce insulin, which must be supplied externally to prevent diabetic shock and coma.) And the fat storage produces weight gain – another commonly observed symptom of diabetes.

The new nutritional approach is to minimize carbohydrate intake and/or combine carbohydrates with substances like fiber, protein, fat and acid – all of which retard the quick release of carbohydrates as metabolized sugar in the bloodstream. Far from being the villain in obesity, fat plays a beneficial role by providing taste in food, preventing food cravings and satisfying hunger by filling you up. This fat doesn’t make you fat because it doesn’t accumulate in the cells; protein and fat are the primary source of energy and are burned by the body. Thus, meat is a dietary staple, along with fish. Fruits and vegetables are encouraged as long as they are high in fiber – whole fruits like apples with the skin on for fiber and nutrients, and vegetables like broccoli and beans.

How did the federal government figure in this nutritional revolution? Just prior to the emergence of the Atkins diet, the federal government’s nutritional recommendations followed the conventional thinking that carbohydrates should be the primary source of energy. White bread and potatoes were healthy and wholesome; fruit juice was wholeheartedly recommended; meat was highly suspect and eggs were virtually verboten due to their high cholesterol content. As noted cardiologist Dr. Arthur Agatston has ruefully pointed out, today we know that the reverse is nearer the truth.

Nobel laureate Milton Friedman once compared the behavior of politicians and bureaucrats to leaders of a flock of ducks flying in V-formation. Periodically, the leader looks back to discover in confusion that the formation has deserted him and is flying away. Immediately, he scrambles to catch up and get back in front of the V, where he can pretend to be the leader once again.

Today, the public has flown away from government leadership with the help of doctors like Atkins and Agatston. The flock of commercials on television advertising treatments for the symptoms of peripheral neuropathy testifies to the prevalence of Type II diabetes. The ubiquitous sight of restaurants and grocery stores nationwide offering foods catering to low-carbohydrate diets – sweet-potato fries, unsweetened iced teas and the like – shows that the free market moves faster to meet the needs of consumers than do federal regulatory agencies. Federal agencies are scrambling to get back in front of the nutritional V by imposing standards to make up for the obesity crisis that they played an important role in causing. It remains to be seen whether government standards will ever again regain the prestige they once enjoyed, or whether they will increasingly come to be recognized as pleas for special interests.

Economists vs. the World

The foregoing makes it clear why special interests embrace the free lunch pretext. It explains why the general interest – in this case, taxpayers and schoolchildren – cannot or will not mobilize sufficiently to overturn the current status quo. But why do so many people actively oppose reform? That is, why does the general public so often oppose efforts to end, let alone mend, subsidy programs like school lunches, food stamps and agricultural price supports?

Recall the arguments mobilized above against the free lunch. The one question never debated by economists is virtually the only question the general public considers worthy of argument. That is: Should the federal government give lunches to poor schoolchildren?

Economists don’t ask the question because they generally stipulate an answer. Given the assumption that “we” (e.g., the government in its capacity as executor of the collective will) have already decided to help schoolchildren who are too poor to afford adequate lunches, what is the most efficient way to do that job? Economists stipulate this answer because most of them are leftist in sympathy and owe their living to government employment. But that is misleading. The answer to the economic question (“what is the most efficient way to do the job?”) is purely a function of analysis, not of ideology.

There are at least three sensible answers to the general public’s question (“Should we or shouldn’t we subsidize poor schoolchildren via the government?”). 1. Government should subsidize poor schoolchildren in the most efficient way possible. 2. Government has no legal or moral authority to subsidize schoolchildren while private citizens have the legal authority but no special moral duty to do so. 3. Government has no legal or moral authority to subsidize schoolchildren but private citizens have both legal authority and a moral duty to do so. And no matter which one of these sensible answers you select, the current “free lunch” system is horribly wrong.

That is the unique contribution made by economists to the debate – the realization that the free lunch is a sham and a delusion that makes a bad situation much worse, rather than better. And unless you accept the likelihood that government can be persuaded to reform itself, economic analysis also tells you that you’re probably wasting your time selecting alternative 1. So, the choice is between alternatives 2 and 3 above.

Alas, the only issue that receives much public airing is “compassion for kids.” Ostensibly, free-lunch supporters are compassionate while opponents are hard-hearted and insensitive. In reality, the issue of compassion is a non-sequitur. Everybody, whether compassionate or hard-hearted, should unite in opposition to free lunches.

Yet the major issue is not a moral one. If you believe that bad parents or freeloaders are a burden on society, then you support alternative 2 above. If you believe that the only important question is how to improve the lot of poor children, then you favor alternative 3. But nobody should support what we have now and nobody should defend free school lunches or any of the other subsidy programs. Not only do they make most people worse off, they don’t even help the poor schoolchildren they were supposedly designed to benefit.

The widespread support that these programs do command is the strongest kind of proof that economists have failed in their primary mission – to teach basic economic logic to the general public. We cannot even persuade people to defend their own economic interests.

There Is No Such Thing as a Free Lunch

There is no such thing as a true, legitimate free lunch in the economic sense. There is only the pretext of a free lunch, which buys time for authorities to pretend that one exists. And the special-interest beneficiaries of the free-lunch pretext are very different than the supposed beneficiaries of the ostensible free lunch.

Having outlined the concept, we will devote the next EconBrief to an exploration of more expensive free lunches.

DRI-416: ‘Recession Ride Taxi’ is the Epitome of Capitalism

“We are all of us teachers,” was Nobel laureate-economist Milton Friedman’s thumbnail sketch of his profession. Teachers are continually on the lookout for real-life illustrations of their subject. Last week, National Public Radio (NPR) provided a dandy.

Apparently NPR saw no need to interpret its facts with the use of economic logic. Fortunately, we can remedy that monumental oversight.

Eric Hagen’s “Recession Ride Taxi”

In a June 26, 2012 story, NPR introduced its audience to Eric Hagen, a taxicab owner-operator in Burlington, VT. Like many a taxi driver, Hagen traveled a roundabout route to his profession. Laid off his job as a Wall Street banker during the Great Recession, Hagen next worked for the American Red Cross – a job that would presumably earn the approval of Barack Obama and the NPR audience. Unfortunately, it didn’t earn enough money to pay Hagen’s mortgage.

So, like millions of Americans before him, Eric Hagen found himself pushing a hack to pay his bills. But unlike his predecessors, Hagen had both the institutional freedom and the native instincts to sell himself and his service to the public.

For upwards of a century, taxis have priced their services using taxi meters that recorded both mileage and time. Eric Hagen’s method for determining his taxi fares is: “Whatever the passenger can afford.” He names his business “Recession Ride Taxi.” Not surprisingly, his stated business rationale is that many people can’t afford to pay traditional taxi rates because they are experiencing hard times. Listeners are cordially invited to the conclusion that he is being kindly and altruistic by letting each passenger set the fare.

But don’t passengers double-cross him by low-balling their rates – or even stiffing him completely? “People know there’s value in a service,” Hagen replies, “and they’re generally not going to try to get over on you.”

Never has NPR accepted a businessman’s rationale so unblinkingly. “At a time when former colleagues on Wall Street continue to feel public scorn,” the station intoned piously, “Hagen says Recession Ride Taxi is running on trust.”

And Now for the Rest of the Story…

At this point, the late Paul Harvey might have intervened with: “…and now it’s time for the rest of the story.” It begins with the recognition that Hagen is not practicing altruism, but rather the most calculated kind of economic logic. His technique dates back at least to 19th-century railroads and country doctors. Airlines have used it for decades. It underlies the success of Priceline, among other online companies.

It is called price discrimination. A seller charges different prices to different buyers (or groups of buyers) for the same good or service at the same point in time. The different prices are not functionally related to different costs of serving the different buyers or buyer groups.

Why would a seller choose this strategy in preference to the simper one of charging a uniform price to all? To earn larger total revenue and profit. It won’t always be either feasible or desirable to discriminate on the basis of price, but the potential advantage in doing so lies in the possibility that different buyers differ in their sensitivity to price. The term economists use to denote sensitivity to price is price-elasticity of demand.

Two prime sources of demand for taxis in large urban markets are out-of-town visitors (tourists and business travelers) and low-income natives. The visitors have fewer and less satisfactory substitutes for taxi travel and tend to have higher incomes. Thus, they are less sensitive to price and more willing to pay higher prices than are natives, who can acquire their own cars or beg a ride, take a bus or subway or simply walk. In the vernacular, we say that visitors’ demand is more price-inelastic (less price-sensitive). Thus, it is in a taxi owner’s interest to charge differential prices, the higher one being assigned to visitors.

Even within groups of buyers whose price sensitivity is broadly similar, there will still be individual variations in price elasticity. The dream of a taxi owner would be to somehow charge each rider the highest price he or she would be willing to pay for the trip – what the economist calls the reservation price. That would constitute the practice of perfect price discrimination and would result in the maximum collection of revenue. Of course, this is only the stuff of dreams; no seller has enough individualized information about customers to realize their dream.

Now the method in Eric Hagen’s seeming madness starts to take form.

Crazy Like a Fox

The knee-jerk response of most people would be that a seller who allowed his customers to set the price is crazy. But Eric Hagen is really allowing individual customers to tell him what price they will accept – information he can’t get any other way. His modus operandi has the general appearance of a system of perfect price discrimination, except for one thing – he can’t be sure that the price they pick will be their reservation price. In fact, he can be pretty sure it isn’t.

Still, he has gained a great deal compared to the standard, taxi-meter-determined, single-price model. Consider the comments of one regular customer, sous chef Alan Flanders. “I’d be walking to work this morning if it weren’t for Eric.” That sounds pretty extreme, but NPR pointed out that “in most cabs, this ride would cost more than $20.” But because “Hagen takes whatever amount Flanders can afford, today it’s $12.” From the consumer’s standpoint, a 40% discount on a daily commute is a stunning saving.

We have a reflexive tendency to compare the $12 Hagen collects with the $20+ he “could” have collected from a regular taxi-metered ride. Wrong, wrong, wrong. Mr. Flanders makes it clear that at a price of $20, he was walking to work, not taking a taxi. Hagen’s alternative take was $0, not $20+. The genius of Recession Ride Taxi is that it brings customers into the market who otherwise wouldn’t ride taxis at all. A taxicab driver’s competition consists not merely of his fellow cab drivers, if there are any. It also includes subways, buses, shuttles, walkers, self-drivers, people who oblige hitchhikers – every alternative means of transportation. (In Burlington, VT, the second-most-popular commuting method is walking.) His most expensive input isn’t gas or repairs – it is time. His worst enemy is an empty cab.

No wonder that the motto of veteran cab drivers has always been “keep the meter running.” In this case, Eric Hagen has taken that excellent axiom to its logical extreme. He has realized that the best way to keep the meter running is to throw the meter away.

The Implications of Profit Maximization

Not long ago, President Barack Obama made headlines by stating that profit maximization by business owners served their interests at the expense of the general societal interest. This has long been an article of faith and a general principle on the left wing. Adam Smith founded the modern study of economics in 1776 by observing that trade proceeded on the principle of mutually beneficial voluntary exchange. The left has treated this concept with a mixture of incredulity and disdain, but mostly as if it were a deus ex machina invented to excuse the excesses of capitalism.

Members of the right wing and economists have responded by citing the role played by profit in allocating resources. It is fluctuations in profit, the argument runs, which allow consumers to direct the activities of producers – increasing profits cause producers to redirect resources toward goods and services in high demand, falling profits draw resources away from things for which demand is waning. This thinking is correct and conclusive, as far as it goes. But, as the example of Recession Ride Taxi suggests, it doesn’t go nearly far enough.

Eric Hagen is admittedly and avowedly utilizing a particular pricing technique. An economist recognizes this technique as price discrimination, which is practiced by sellers expressly to increase their total revenue and profit. In the great American tradition of motivational deception, he disavows a desire for personal gain while seeking exactly that. But the overarching significance is that his customers gain from his pursuit of profit maximization and his gains in total revenue and profit.

A layman will be persuaded of this result by hearing the testimonials of Hagen’s customers. The economist is used to hearing people lie about or rationalize their actions, but expects people to act in their own interests; the proliferation of Recession Ride Taxi’s customers means that buyers are better off riding it than not. Hagen claims that he averages 20 trips per day, the average fare running somewhere between $10 and $15. That works out to an annual income in the $50-75,000 range. Not Park Avenue territory, but not bad for low-skilled labor.

The presumption that the interests of buyer and seller are inexorably at odds is utterly false. Adam Smith’s dictum has found its practical expression – unwittingly unearthed by NPR, the unlikeliest of sources.

The Implications for Regulation

The agency of NPR isn’t the only improbable feature of this case. Economists would have quoted heavy odds against the taxi business being the locus of innovative entrepreneurship. For nearly a century, in most cities and towns of the U.S., taxicabs have been stifled under a choking blanket of regulation.

Early in the 20th century, the taxicab began to threaten the streetcar as a means of commercial passenger transport. Because of relative easy of entry into the business and low labor-skill requirements, taxis were plentiful, cheap and competitively attractive to riders. Streetcar companies combined with the largest taxi companies – usually Yellow Cab – to cartelize the taxi market by tightly regulating taxi fares and entry into the business. Fare schedules – soon replaced by taxi meters – and strict limitations on the number of taxi licenses issued combined to prevent effective competition among taxi firms. This raised profits for incumbent firms but harmed consumers. In New York City, where the number of taxi licenses has not increased since World War II, the monopoly profits capitalized into the price of a (transferable) taxi license (called a medallion) have raised its value to over six figures.

Strict regulation has been another hallmark of the Obama administration. The tacit premise has been that markets are not self-regulating, beneficial mechanisms, but rather treacherous, double-edged swords that cut safely only when their every move is guided and supervised by appointed regulators. (Where these regulators acquire the moral wisdom and practical knowledge required to manipulate markets is never specified.) One might have supposed, then, that a story on NPR about mutually beneficial success in the taxi industry would have featured regulators as the prime movers and market principals as passive reactors.

The truth is just the opposite. Eric Hagen is a lone entrepreneur who succeeded by discarding the most sacred tool of taxi regulation – the taxi meter. Indeed, in most American cities, what he did would be illegal. Even if it were technically permissible, owners of airport buses, municipal buses, shuttles, and competing taxi firms would throw a fit about it – which leads us to still another field of significance.

Implications for Antitrust

Traditionally, the practice of price discrimination is viewed with ambivalence by economists. On the one hand, when different consumers within a particular geographic market face different prices for the same good, this is inefficient. Each consumer will maximize his or her utility by arranging consumption so as to equate personal willingness to sacrifice alternative consumption with the objective rate of tradeoff offered by the marketplace, where the latter is embodied in the price paid. Suppose, for example, that one consumer faces a $5 price for good X and another consumer faces a $3 price. The first consumer’s personal marginal valuation of X is $5; the second consumer’s personal marginal valuation of X is $3. Give each the opportunity to trade in X at a price of $4 and both will do so – the first would gain by buying more X and the second by “selling” (consuming less) X. That tells us that the initial position was inefficient.

Carrying this logic to its ultimate end requires that all consumers in a given market face equal prices of a good or service, in order for consumption to be efficient – that is, for all consumers to get the most satisfaction.

The theory of equilibrium price formation studied by students in their college price theory courses brings about just this outcome. The problem is that the underlying assumptions behind this theory are seldom spelled out fully enough for the students to appreciate its highly abstract character. In fact, it often seems that economists (and lawyers) are often unaware of it. Goods are assumed to be homogeneous; each seller is assumed to supply an infinitesimal fraction of the total market amount; all buyers and sellers are assumed to possess all relevant information about available goods, costs and future contingencies.

Undoubtedly, this accounts for the prima facie structure against price discrimination in the Clayton Act, one of the earliest antitrust enactments. Price discrimination is inefficient, according to the textbooks. Those same textbooks also describe a perfectly competitive industry as one in which no seller possesses any power over price – but price discrimination couldn’t exist in this environment.

A price-discriminating seller must have some discretion over price. He must also be able to segment or divide his market into identifiable groups or individual buyers and prevent them from re-selling the good or service – otherwise, the low(er)-price buyers could themselves re-sell the good to the high(er)-price buyers at a slightly lower price, thereby spoiling the would-be discriminator’s party.

Real-world markets are a good deal messier than textbook ones. The information assumed by textbooks can only arise from a market process, and the equilibrium outcome proudly touted is an ever-receding goal. Recession Ride Taxi displays the opportunistic tenor of true capitalism – regulation strands sous chefs without a ride to work and the free market comes riding to the rescue with an improvised solution – imperfect, but a major improvement on the status quo.

This has always been true. Consider our early historical examples. A railroad often provided the only timely means of getting farmers’ crops to market, and the railroad magnate would sometimes charge farmers more for a short haul on which he faced no competition than for a long haul served by one or more competing roads. Outrageous! The first federal regulatory agency, the Interstate Commerce Commission (ICC), was created to remedy just such excesses. And so it did – by raising the long-haul rates into equality with the short-haul rates! This ended the price discrimination but it worsened the exercise of monopoly pricing power.

Country doctors often served sparse, strung-out populations that were unattractive markets. In order to increase their total revenue, country doctors charged much higher rates to wealthy patients, whose price-elasticity of demand was much lower than their poorer neighbors’. Communities encouraged this as a means of attracting physicians. Doctors rationalized it as favoring the poor; this inaugurated the practice of treating physicians as noble, self-sacrificing healers rather than ordinary businesspeople.

Clearly, price discrimination could be a good thing when it promoted competition and enabled consumers to enjoy a good or service that otherwise would not be provided. And regulations against it were no panacea for improved consumer welfare. Economists took this lesson to heart by qualifying their disapproval of price discrimination to cover only those cases where it harmed competition and promoted monopoly. It is perfectly obvious that Eric Hagen has enhanced both competition and consumer welfare with his Recession Ride Taxi.

Can We Generalize the Example of Recession Ride Taxi?

It may occur to the reader to wonder: If Eric Hagen’s Recession Ride Taxi is a boon to consumers and a specimen of marketing genius, where has it been all our lives? Why hasn’t it swept all before it over the course of one century of taxicab-industry history?

The short answer is two-fold. First, it’s been there all along, right under our noses. Second, it is right for some market circumstances and wrong for others. Most American cities represent intermediate cases, in which a mix of Hagen’s technique and conventional techniques are currently optimal. But the best approach would be to junk all forms of taxicab regulation and give the “Hagen System” full scope to operate.

Veteran taxicab drivers in virtually all American cities have utilized a species of the Hagen System by engaging in informal negotiation for taxi fares. Although variation of fares by time of day is typically illegal, it is common practice among business travelers and longtime drivers to vary airport fares by time of day. This helps travelers by securing passage and gaining discounts. It helps drivers by increasing capacity utilization during slack periods of demand.

A more comprehensive allegiance to Hagen’s methods is practiced by drivers who develop a personal clientele, which they service to the exclusion of radio calls and street hails. This tends to evolve naturally into a system of tailored fares, negotiated informally between driver and customer. (Depending on circumstances and the letter of the law, the taxi meter may or may not be engaged during the trip, but its reading is irrelevant.)

The central principle of Hagen’s Recession Ride Taxi – customer-chosen fares – practically requires this kind of repeat-customer format. Hagen may give lip service to “trust” in his customers, but he wants and needs the freedom to drop the occasional customer who stiffs him or intends to repeatedly shortchange him. He undoubtedly does this not by explicitly refusing to carry, which is illegal in most cities, but by “inadvertently” lengthening his response time to the deadbeats until they drop him. (This highlights a subtle but important aspect of the business – that the taxi fare is determined not just by the monetary fare but also by the time taken for the cab to show up.)

Why hasn’t this approach – developing a personal clientele – utterly overshadowed the visible taxi market of radio calls and street hails? Much taxi business is opportunistic, arising from unique and unforeseeable circumstances that cannot be handled in a personal, repeat-customer framework. Even more telling is the fact that the repeat-customer system requires the driver to incur substantial dead mileage and time wastage in servicing what often amounts to a predetermined route. In densely packed cities with large, continuous taxi demand like New York City, Las Vegas and Washington, D.C., drivers can operate much more efficiently “on the radio” and the street by taking their next call at the closest location.

But small towns like Burlington, VT face a taxi problem not unlike the old country doctor scenario. With around 40,000 people and no other close metropolitan areas, Burlington needs to generate a critical mass of driver income in order to get any taxi service at all. Price discrimination is the tried-and-true means of accomplishing this. Economic theory predicts that the Hagen System will predominate in this setting.

Most American cities fall in between these two clear-cut cases. They are oppressed by taxicab regulation and high meter rates that have suppressed or virtually killed off demand among low-income and minority populations. (Sometimes this demand is services by informal car or bus service provided by jitneys – vehicles owned by private individuals not affiliated with a business.) The climate is favorable for the Hagen System, but it is employed only at the cost of violating the law. Big government has created so many laws, almost all of which are counterproductive and contain innate incentives for violation, that governments cannot begin to enforce most of them. Thus, enforcement is lax to non-existent.

Nonetheless, the case of Recession Ride Taxi sharpens the case against taxicab regulation. Taxi meters are not valuable ipso facto; neither are newer computer systems for automatic dispatch that have largely replaced human taxicab dispatch. Technology should be judged according to the economic value it creates for consumers. The only way to do that is to allow the market to value technology and govern its use. The illusion that sellers set price is just that – an illusion, a mirage. Pricing is a negotiation between buyer and seller and either should be free to initiate the process. When regulation interferes with that freedom, it harms those it is ostensibly set up to protect.

Thanks, NPR

We have discovered that the simple case of a single taxicab driver in Burlington, VT is, in reality, a microcosm for capitalism at work. How much of the panorama we unfolded above was dealt with by NPR in their report on Eric Hagen’s Recession Ride Taxi?

None of it. NPR ignored every relevant economic issue, presenting the case as if it were nothing more than what the late Richard Nadler satirically called “caring and sharing.” Still, we should be grateful to NPR for at least reporting the news. There is no precedent for expecting this station to produce an incisive interpretation.