DRI-311 for week of 3-30-14: The Dead Hand of Regulation

An Access Advertising EconBrief:

The Dead Hand of Regulation

One of the venerable legal principles, dating from common law and drummed into every lawyer, is the rule against perpetuities. Its purpose is to stay the “dead hand” of the past from controlling life into the indefinite future.

Economists have adopted the study of economic regulation as a specialized field. They have gradually come to realize that regulation acts as a “dead hand” that retards the advance of progress wherever it prevails.

This characterization departs radically from the conventional view of regulation as an all-purpose cure-all for whatever ails an economic system. The knee-jerk responses of mainstream news media and academia to a problem are variously to blame an absence of regulation, excoriate lax regulation, perceive insufficient regulation or lament poorly funded regulation. Indeed, these constitute virtually the full menu of choice.

The obvious inference to draw from this is that regulation is the cine qua non of problem solution. Sure, sometimes the shortsighted legislators neglect to regulate some stray industry or human activity; sometimes the regulators get lazy and just sit on their hands or posteriors; sometimes those silly laws tie the hands of regulators; and sometimes we stingy so-and-sos don’t give the heroic regulators the money they need to do their jobs. But set up a good old government bureau, populate it with noble, altruistic, tough-minded, tender-hearted civil servants and unlock the public treasury – then just watch those regulators go. The industry will hum like a Welsh chorus – so we are supposed to assume.

Unfortunately, economists have been hard put to find even one exemplary example of regulation. It isn’t just that regulatory agencies share the deficiencies common to all government agencies. No, they invent new ones. And this is just about the only kind of innovation they do promote. In all other respects, regulation is analogous to the “dead hand” that the institution of law has been trying to thwart for over a millennium.

Some of the most famous case studies of regulation provide persuasive testimony for the economic case against it.

Taxicab Regulation

Almost every major city in the U.S. regulates taxicabs. Taxi regulation began not long after the automobile’s popularity began to zoom upward; it accompanied the regulation of trucking in the 1920s and 1930s. It is a variety of occupational regulation, requiring licensure and registration with the police department. Taxi fares are regulated by city bureaus rather than marketplace competition, and this regulation serves as a cartel that prevents competitive price declines by taxi firms (or individual drivers). Licenses have been severely restricted – for example, New York City has issued virtually no new taxi licenses after World War II. The licenses, or “medallions,” could be sold. The restriction on their number and cartelization of fares combine to create monopoly profits that are capitalized into the market price of the medallions; that is why medallion prices have sometimes reached six figures.

Economics textbooks teach that consumption is the end-in-view behind all economic activity. We are all consumers. They demonstrate that competitive markets produce larger output and lower prices than do the same market dominated by a single monopoly producer, thus validating the economist’s customary preference for pure competition over pure monopoly as a form of market organization. Since the local taxi cartels created by taxicab regulation essentially duplicate the outcome of pure monopoly – but with producer benefits spread over multiple firms rather than a single one – it is not surprising that economic textbooks have long featured taxicab regulation as a real-world application of regulation-gone-wrong.

Anybody who has ridden a taxicab regularly over the last half-century didn’t need to pick up an economics textbook to know that something was wrong with taxi service. It was proverbially difficult to get a taxi during morning and evening rush hours, and also during the “bar rush” late at night. When the city was visited by bad weather or a big convention, taxis were even scarcer. Wait times could stretch into hours even during the off-peak times for predominantly black residential areas plagued by high rates of crime. The level of professionalism among drivers varied from sky high to dirt poor.

We can gauge the degree of influence exerted on political reality by academic economists and taxi consumers by the fact that only a tiny handful of communities have deregulated taxi service in response to the complaints of either group. Washington, D.C. long featured the nation’s least regulated taxi market – and lowest taxi fares – among major cities. In the mid-1980s, Kansas City, MO deregulated both taxi fares and entry into the market, ushering in a few years of fierce taxi competition and dramatic benefits to local consumers and tourists. But the forces of regulation eventually regained the upper hand in the 1990s and the market was once more cartelized. A few other cities experience their competitive moment. Until recently, the Dark Side ruled mostly unopposed.

In 2010, somebody came up with a new kind of challenge to taxicab regulation. Bucking the regulatory establishment with lawsuits and publicity campaigns was too costly and difficult. Rather than confront taxicab regulation head on, it was better to make an end run around it.

The Uber Innovation: Outflanking Taxi Regulation

Technology made it inevitable. The intersection of the Internet, online credit-card payment methods, smart phones and GPS mapping suddenly made traditional taxicab service virtually obsolete. Now customers could book a taxi the same way they make a dinner reservation, by calling up a provider, reserving a car and paying in advance. Then they could track their vehicle’s progress to their location. No more “mission impossible” trips during peak hours! No more dealing with unresponsive monopoly providers! No more surly, badly dressed drivers or uncomfortable vehicles! No more monopoly taxi fares!

But wait – what about the dearth of drivers? What happened to the regulatory bottleneck that prevented entry of firms? This is where the end run came in. The new taxicab entrant, a firm called Uber, got around taxi regulation by not being a taxicab company. First, it entered the market for transportation services by providing town cars for its trips. These Lincolns, Cadillacs, BMWs and Mercedes were functioning as livery vehicles because they were available by appointment only; thus, they were technically outside the realm of taxi regulation. (As we’ll see, that hasn’t stopped taxi regulators from trying to regulate the company or its imitators.) Then it doubled as a middleman that recruited ordinary drivers and matched them up with people who needed trips where the drivers were going – or were willing to go. Thus, Uber reduced overhead costs to the bone by utilizing pre-existing capital goods that had competing alternative uses. Either way, though, the central idea is to provide the services of a taxicab company without being shackled by taxicab regulation.

The company took about a fifth of the cost of a trip, leaving the rest as gross revenue to the driver. The trip cost itself is calculated much as a taxi fare would be – distance based unless the car is moving less than 11 miles-per-hour, then time-based. Uber’s driver compensation incorporates a tip and the passenger advisory declares tipping unnecessary. This muddies direct comparison with taxi fares, particularly for Uber’s high-end livery-like town-car trips. Most of the customary problems faced by both driver and passenger are eliminated or greatly reduced. For example, there is very little incentive to rob an Uber driver since they do not collect the revenue (even tips) for their trips. Not surprisingly, Uber has attracted imitative competitors like the ride-sharing services Lyft and Sidecar.

It would seem, then, that this innovative new form of competition to traditional taxicab service is a boon to consumers. Since the whole purpose of economic activity is to benefit consumers, that change is a good thing. Since the purpose – the ostensible purpose – of regulation is to make things better, regulators should welcome this change with open arms. How do the noble, heroic, altruistic, tough-minded municipal civil servants feel about Uber and its ilk?

Why, they hate it, of course.

The Empire Strikes Back Against Uber, et al

“I’m hoping that people will…pay attention to what this actually is, which is an attempt to deregulate the taxi industry.” That is the view of Matthew Daus, former chairman of New York City’s Taxi and Limousine Commission, as quoted in a profile of Uber in Bloomberg Businessweek (2/24-3/02, “Invasion of the Taxi Snatchers,” by Brad Stone). His opinions were apparently shared by officials in Miami and Austin, TX, where Uber was prevented from operating by regulators. Perhaps because New York City has long been profiled in so many unfavorable examinations of taxicab regulation, the Bloomberg piece focused particularly on Uber‘s operations in San Francisco.

Despite an increasing population (up by 300,000 in the last decade), San Francisco “has long capped the number of taxi medallions.” Members of the taxi cartel “didn’t seem to care about prompt customer service since they make money primarily by leasing their cars to drivers” and extracting the monopoly rents embedded in the medallions through the fees charged for lease, dispatch and phone-order services provided to drivers. (The only way drivers could afford weekly lease fees of $400 or more was by reaping the benefits of monopoly taxi fares.) The article quotes the acerbic view of David Autor, MIT economics professor, that the industry is “characterized by high prices, low service, and no accountability. It was ripe for entry because everybody hates it.”

Well, that certainly doesn’t sound like an idyllic regulated industry, does it? It sounds more like taxi operations in New York City; indeed, like the typical regulated industry anywhere. Why, then, are regulators so averse to change? Why are they dead set against interlopers like Uber?

Innovation implies change. Change means doing things differently. That means that either the people doing them now must change – or new people must do them using the new methods. And that makes the incumbent doers unhappy, since they lose their jobs or suffer a loss of income or both. In this case, the disaffected include taxi-company owners and employees and taxicab drivers.

The Bloomberg piece is replete with complaints. Some complainants are cab drivers, who “complain that they can no longer pick up riders in the city’s tonier neighborhoods.” They stare down and block Uber and block ride-sharing drivers in traffic and confront them at airport terminals. “I’ve made it my personal mission to make it as difficult as possible for these guys to operate,” vows a director of the San Francisco Cab Drivers Association.

Taxi companies play a harder game of ball. “In Boston and Chicago, taxi operators have sued their cities for allowing unregulated companies to devalue million-dollar operating permits.” Uber has faced lawsuits and regulatory objections in San Francisco, New York City and virtually everywhere else it has been. Taxi companies “accuse Uber of risking passengers’ lives by putting untested drivers on the road, offering questionable insurance, and lowering prices as part of a long-term conspiracy to kill the competition, among other transgressions.”

Of course Uber is lowering prices – that is what competition is all about, reducing monopoly prices and benefitting consumers. Uber lacks the ability to “kill competition,” as the entrance of various competing ride-sharing services proves. As for killing its own customers – well, Uber‘s interest hardly lies in attracting big-dollar liability lawsuits. Nothing could be more slipshod than traditional taxi regulation. Its taxi-inspections and employee background-checks were laughably lax; for example, it is a truism that convicted felons usually can only get a job driving a cab. Monopoly taxi firms have much less incentive to keep passenger interests in mind than Uber does today.

Regulators themselves feed off the complaints of incumbents because they need a constituency to protect. By protecting the interests of incumbents, they are really protecting their own interests. If the regulated go out of business, then regulators will have nobody to regulate and no justification for retaining their jobs and incomes. Notice the tacit premise in the quoted passage objecting to Uber‘s hidden agenda of deregulation; namely, that deregulation is unthinkable.

But what about consumer complaints? They were legion under regulation. Have they vanished with the advent of competition?

How Innovation Solves Problems that Regulation Doesn’t

The principal complaint is lodged against Uber‘s “surge pricing,” which “jacks up” (Bloomberg’s wording) prices in peak times like rush hours. While prices are announced to customers in advance, that doesn’t forestall grumbling or accusations of “exploiting customers.”

For decades, academic economists pushed this very type of “peak-load pricing” for regulated electric utilities, which experience the same peak loading problems that taxi firms do. The idea was to persuade customers to use less electricity during peak times and spread their use more evenly throughout the day.

The same logic applies to taxi demand; ironically, consumer complaints show that demand is indeed sensitive to price on-peak. But Uber‘s real innovation is that surge pricing has solved one of the age-old supply problems of taxicab operation: how to “produce” more drivers in bad weather, evening rush-hour and late night peaks. Bloomberg interviewed a dozen drivers and found agreement that the higher prices attracted drivers magnetically to the street just at the time they were most needed. The peaking problem is that the quantity of taxi services demanded greatly exceeds the quantity supplied. Surge pricing significantly reduces the former and greatly increases the latter. Voila! Problem solved in less than four years. This is something taxicab regulation never succeeded in doing – hardly even attempting – over a century of existence.

This is just the start of competition’s problem-solving career in taxi-type services. Uber CEO Travis Kalanick envisions “a dense network of Uber cars in every city,” which could be used “to deliver such things as packages from online stores and takeout food. (The company delivered flowers on Valentine’s Day.) Uber could one day even allow other companies – say, a laundry pickup startup – to use its fleet.” Eventually, the widespread coordination of private cars for multiple purposes could vastly cut down on the number of autos and fuel use and improve the efficient use of existing transportation capacity. Again, this can only be accomplished via a competitive pricing mechanism; it is something that government regulation has never come close to achieving or even contemplating.

The (Non-) Case for Taxicab Regulation

Regulators take it for granted that taxicabs must be regulated by government. For decades, New York City has been warning its residents against using the vast supply of illegal, unregulated “gypsy” cabs that prowl the streets. Customers are risking their money and their very lives, warn the regulators darkly. But the history of taxi regulation does not support the necessity of regulation.

Government regulation of business began at the state level in the second half of the 19th century with regulation of grain elevators. In 1887, the Interstate Commerce Commission was created to regulate railroads. Letters exchanged by the wealthy railroad owners at the time indicate that they intended to use the ICC to cartelize the industry, and that is indeed what happened. In the early 20th century, trucks were regulated because their competition threatened the freight-carriage business of railroads. Taxicabs were regulated because they threatened the business of streetcars, which lingered into the mid-20th century despite their technological obsolescence.

The pattern is clear. Regulation occurs not to cure the evils of competition but to protect incumbents from the effects of competition. In the vernacular of economics, regulation and competition are substitutes, not complements. This gives the lie to the pretense that regulation is supposed to polish and buff away the excesses, evils, flaws, mistakes and unsightly features of competitive capitalism. The purpose of regulation is to replace free-market capitalism with government control of markets.

To illustrate the flimsiness of the regulatory case, consider the “argument” advanced for taxicab regulation in the Bloomberg piece by – of all people – a professor of economics at Northwestern. “Traditionally, we had to have price regulation in cabs because when you are hailing a cab or standing in a taxi stand, you had to take the first car and you didn’t know the price in advance. You could be exploited.” Of course, all that price regulation does is to require all cabs to charge the same price – it doesn’t, in and of itself, inform the customer what that price is. That is accomplished by painting the fare on the outside of the cab. But that could be done under competitive pricing, too – and was in deregulated markets like Kansas City in the 1980s! In essence, the Northwestern economist was saying that a high monopoly price wasn’t “exploitation,” but the chance that a consumer might not know all possible prices charged by all companies was – even though most consumers undoubtedly don’t possess perfect knowledge of all prices. For this we need tenured professors of economics?

The Past and the Future

The history of taxicab regulation suggests that regulation produces bad current outcomes. But the inherent logic of regulation suggests that its effect on the future is just as bad through its discouraging impact on innovation. According to Bloomberg, “there’s a battle for the future of transportation being waged outside our offices and homes” involving “Uber and a collection of startups.” If regulators succeed in killing Uber and its imitators, their vast potential for economic growth will die in infancy.

The next EconBrief will review various new products and industries whose innovative benefits are similarly threatened by government regulation.