Taxi Pricing4 min read

The following article is published in this week’s econoception newsletter. To subscribe, go here.

One of the ways in which I hope the Econoception newsletter will bring value to its readers is through its analysis of articles such as this one. I often think of The Economist as a gold mine that requires quite a bit of digging before one can reach the treasure. Unfortunately, this is not something H2 Economics students are well prepared enough to do. Frequently, the gold nuggets are hidden in plain sight – this article on the taxi market serves as a classic example.

“Taxi markets often end up suspiciously clubby, with cabs in short supply and fat profits for the vehicle owners.”

The second paragraph of the article describes the nature of the taxi market. The industry is typically dominated by a few firms because of licensing restrictions and other barriers to entry. This is not a good outcome for consumers because firms can abuse their market power to charge prices above marginal costs. However, I would disagree with the assertion that “In theory, entry should be easy – all that is needed is a car and a driving license…” In fact economic theory would suggest the complete opposite. Without proper licensing and regulation by a central agency, the market is likely to suffer from adverse selection and moral hazard problems. Adverse selection: drivers may have poor knowledge of the streets but passengers will have no way of finding out about that information beforehand. Moral hazard: drivers have no incentives to choose shorter routes. Therefore, the entire market may function inefficiently or even cease to exist without proper regulation.

Uber, the new entrant into the market, provides a matching service, playing the role of the middle man between drivers and passengers. By filtering out poorly informed and untrustworthy drivers by imposing some minimum level of checks for them, the firm ensures the market functions properly. It charges a 20% commission for this service. One way you can think of this situation is to imagine a perfectly competitive market, with price and quantity being determined by pure market forces. Now imagine the government imposing an ad-valorem tax of 20% on producers and think about how that will affect the equilibrium price and quantity. Then, replace the government with Uber and you will end up with Uber’s business model. The revenue it earns is equal to the ‘tax revenue’ that would have been generated.

“By charging drivers a flat monthly fee Uber would generate revenue without creating a price wedge that gets in the way of matches.”

But as you learn in H2 economics, indirect taxes have an distortionary effects on markets, and generate a deadweight loss to society. The same problem exists here. Suppose instead of charging an ad-valorem tax, Uber charges a lump sum tax on producers and allows the market to equilibrate without the tax. In theory, there will no longer be any distortionary effects and the recovered deadweight loss can be redistributed to producers, consumers and Uber, thus benefiting everyone involved. However, this situation seems overly idealistic. In reality, few drivers will willingly commit to paying for a license upfront. It may well be the case that much of the supply comes from a large pool of drivers who each only picks up a few passengers per month. By imposing a fixed fee, most of these drivers may no longer wish to participate in the market. This is just one of the many issues that Uber has to deal with if it decides to switch to a lump-sum fee system.

Implicit in a system that is based on a model of perfect competition is that prices can vary significantly depending on demand and supply conditions. These can change rapidly and even multiple times throughout a single day. For instance, supply is likely to become price inelastic in the wee hours of the morning because most drivers will be asleep and will require a higher compensation for their service. The same can be said for holidays like New Year’s Eve when most people would prefer to spend time with their loved ones than to fetch passengers in a car. Assuming Uber uses a reliable algorithm to generate prices based on demand and supply in real time, prices in these situations are likely to be higher than usual due to higher demand and lower supply. The article calls this price discrimination, but I think that is inaccurate because cost conditions are NOT the same. I prefer to think of it as simple market dynamics at work to ensure that markets clear and efficiency is achieved. Personally, I find this innovation in the taxi market pretty neat and would love to see it being implemented in Singapore.

Till next time, dream economics.

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