Perspective Unlimited

Monday, January 21, 2008

Deadweight Loss of High Taxi Fare?

The issue of taxi pricing has been a subject of some debate recently. Before the recent changes to the fee structure, the perennial complaint was too few taxis (particularly during peak hours in the city). After the increase in the structured fare, there are many empty taxis around waiting for customers.

Nevertheless, many taxi drivers have reported that though the number of trips they make are down, it is made up for by higher fares, and that overall takings per day have remained roughly the same as before. The question here is whether this situation optimal?

Simple Demand and Supply

We can use a very simple demand and supply structure to answer this question. The caveat here is that some important and complicated factors - such as waiting times, differential demands at different times of the day, effects on congestion, market power - are ignored. The simple demand and supply diagram is presented below.

The market for taxis is subjected to two important forces - the fixed supply of taxis and the controlled price structure. As every economic student can tell, one can either set prices or quantities. It is never possible (in general) to set both prices and quantities and expect demand to be equal to supply (or market clearing).

The demand for taxi is the downward sloping line in the diagram. Suppose the supply of taxis is fixed at Qf. The price before recent changes is at Pl. Total revenue is given by the area O-Pl-F-Ql (simply price Pl times the constrained quantity Qf). At this price however, there is excess demand. Taxi prices are way too low and there aren't enough taxis to go around. This of course explains why you previously could never get a taxi when you needed one.

Recent prices changes have pushed the price to Ph. At this price, the total revenue for taxis becomes the area O-Ph-H-Qh. This area is drawn with the same size as before, which shows that taxi takings have remained unchanged after the price hike. Taxi drivers are not worse or better off than before since they now pick up fewer customers but get more per customer.

Deadweight Loss

But what is wrong with this equilibrium? Excess supply. At this high price, there are way too many empty taxis on the roads. This is a loss to society (jargon: deadweight loss). Empty taxis are plying the roads when they should be picking up customers. It is an inefficient outcome since precious resources (taxis) are using up precious road space but providing no value to potential customers who might want to use their services if only prices are more reasonable.

I stress however, that this is the benefit of hindsight. Given that fares had been fixed for a long period of time before recent changes, there was previously no telling how consumers would react. In other words, there was too little information on consumer demand. With the benefit of the new knowledge about consumer demand, we now know that current prices are set too high to clear the market, resulting in the inefficient use of resources.

Bring Prices Down

Obviously, we cannot return to the old price level of Pl since it will create the same excess demand as before. However, there are obvious benefits from lowering prices from Ph. Firstly, consumer surplus would increase since there will be more passengers filling the empty taxis. Secondly, if you look at diagram above, setting a price between Ph and Pl may actually increase the revenue of taxi drivers since the area characterised by price times quantity increases*.

Therefore if the situation of excess supply persists, taxi companies should consider bringing the price down.

* Except in the case where the demand curve is unit-elastic. Taxi takings will remain constant if that is the case but still, consumer surplus will increase.