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On The Tradeoff Between Efficiency And Equity, Airline Style…

April 18th, 2009 · 21 Comments
Discrimination · Policy

It’s not very often that I come across an issue where I find it hard to take a stand in one direction or the other, but I am sitting here a bit perplexed on a very nice Friday afternoon. Let me start with a quick primer on the idea of efficiency versus equity:

“Efficiency” refers to maximizing the total size of the economic pie.
“Equity” refers to, well, equity, or fairness.
(I am both a Libra– you know, the scales and all- and an economist, so this tradeoff kind of makes me want to pull my hair out.)

Usually these two concepts, or goals, are at odds with each other. This can be illustrated with a simple example. Let’s think about taxes, in honor of tax day earlier this week:

The main downside of taxes from an efficiency perspective is that taxes decrease the incentive for people to work and create what economists call deadweight loss. As an example, suppose that an hour of your labor is worth $20 to an employer. From your perspective, working kind of sucks and you would rather sit on the couch and watch TV. You need to be paid $18 (that you get to keep, since that’s really what you care about) in order for it to be worth it to you to get off of the couch. In a tax-free world this works out fine, since you and your employer can come up with some wage between $18 and $20 that will be amenable to both of you and you get a combined $2 of value out of the transaction. (If you got paid $20 for something you would have been willing to do for $18, you get $2 of value. If an employer pays you $18 to do something that is worth $20 to them, they get $2 of value. If you agree on a wage between $18 and $20, you share the $2 in some fashion.) But now say that there is a $3 per hour tax on labor. With this tax, there is no way to make everyone happy, and that hour of work doesn’t get done. Deadweight loss refers to the fact that, with this tax, the employer and the worker lose their $2 of value, since the work doesn’t get done, and the government doesn’t even win because it can’t collect tax revenue on work that isn’t done.

In general, income taxes are partly a transfer of value from employers and workers to the government and partly deadweight loss, or value that goes into an economic black hole, never to be seen again. This deadweight loss comes about whenever incentives to work are affected. Therefore, it should not be surprising that the most efficient tax is the one that doesn’t affect the incentives to work. I introduce to you the king of efficient taxes, the lump-sum tax. Let’s say we put a lump-sum tax of $500 in place. This would mean that every person in the U.S. would pay $500, regardless of how much money he makes or even if he doesn’t make any money at all. This tax certainly doesn’t distort the incentives to work, since it’s constant and there regardless of how much or little one chooses to work.

So the lump-sum tax is efficient in that it maximizes the size of the economic pie that results for society (since there is no economic black hole of deadweight loss), but it certainly doesn’t pass the equity sniff test. Think about it- would you like to pay the same amount in taxes as Bill Gates? Didn’t think so. So what we do as a society is we sacrifice a little in terms of efficiency (how much we sacrifice is up for debate) to gain in equity. In fact, you can think of the political right versus the political left at least partly in terms of where they fall on this efficienc versus equity tradeoff. There are two possibilities (that are not mutually exclusive):

  1. The left places a higher priority on equity versus efficiency than does the right.
  2. The left believes that there is a lower cost (in terms of efficiency) to increasing equity.

The point is that there isn’t a “right” answer in the efficiency versus equity game. To make matters worse, it isn’t always even clear what is fair versus not fair.

Which brings me back, at long last, to airlines. Consider this article from The Consumerist, titled “United: If You Can’t Fit In One Seat You Need To Buy Two.” (The thesis of the article is nicely summed up by the article, in case you don’t feel like reading.) I am perplexed in that I don’t know how to feel about this, though on a related note I do get frustrated that I cannot purchase two seats for myself on the Chinatown bus to New York, which would give me a very comfy ride for a grand total of $30 each way. (I’ve tried to reason with the ticket people on multiple occasions to no avail.) Anyway…it is economically efficient to have people pay for the costs that they are imposing on others, whether by “others” we mean the airline or other passengers. The costs in this case are things such as:

  • Inconvenience to other passengers whose personal space is infringed upon
  • Increased fuel cost (I was told once that when sports teams and such travel, there are adjustments made because the plane is carrying larger than average people.)

That said, there are plenty of businesses where low-cost customers subsidize high-cost customers (all-you-can-eat buffets, car insurance to some degree, etc.). But, as I have pointed out in a previous post, consumers have strong notions about what is fair and unfair, and if these notions come into play in purchasing decisions then they are worth thinking about when developing a pricing policy.

Here is a rough summary of the situation:

So, there are two relevant questions:

  • What should United do from a business standpoint? How much should it care about equity versus efficiency?
  • What, if anything, should regulators do regarding the new pricing policy?

I’m going to let you think about this for a bit, and then I will follow up with my thoughts.

Tags: Discrimination · Policy

21 responses so far ↓

  • 1 Dr. Ari Cole // Apr 18, 2009 at 5:30 pm

    Dear Colleagues,

    ShALOHA from Honolulu, Hawaii…

    United should work on efficiency first…They have high Bills and should pay them…Debts and Red Ink Kills airlines…FULL STOP…Everyone should pay their minimum costs per se for the flight with the caveat that First Class Travelors should probably pay 3-10X a normal Pax…

    I do believe a salad approach should be used by United et al, as is applies to Models…If there is ample business then the best Model should apply to the flight based on Efficiency, but if Business is slow then Equity Models should apply perhaps…

    Jodi is a Pro at figuring these out and has a PhD or has nearly finished it…Use a floating set of models to maximaize profits via the web, etc..

    Pax luxury, and overall Corporate needs based on the Business Climate is Key…The computer and web Global floating price structure allows the Airlines to change course(s) at will…And should be looked at that way…

    I will end with a phrase that may be helpful beloved airlines’ and Academic Colleagues, ‘Flexibilty is a Sign of Intelligence’…

    Mazal Tov & ShALOHA m Honolulu,

    Dr. Ari Cole, BS, MD, MPH, MPA/MC

    Harvard ’08 & Yale ’95

    Intensive & Critical Care Physician & Young Government Leader- Running for Office in ’16

  • 2 The PULSE Review // Apr 18, 2009 at 5:31 pm

    In terms of taxation, instead of the lump sum tax, why not a flat rate? It still scales, and it doesn’t deincentivise success. I’ve heard the idea kicked around a bit in my more libertarian circles, and have yet to hear a good argument against it, though I’m sure one exists.

  • 3 Nathan // Apr 18, 2009 at 5:43 pm

    I’m personally a fan of the fat @ss tax…

  • 4 Philip // Apr 18, 2009 at 6:03 pm

    I think Southwest did this a while back and frankly it’s the most equitable solution I can think of. The mandatory second seat charge is only applied when the plane is full. If there is an empty seat, then the person who cannot fit into a single seat (e.g., get the armrest down and buckle up with an extender), is moved into the seat adjacent to the empty so they don’t infringe on the space of another passenger. In other words, the only time the “fat tax” gets applied is when the obese passenger is taking up space that somebody else paid for.

  • 5 Chase // Apr 18, 2009 at 7:11 pm

    I find myself in the same sort of position as you do with different rationales. As far as fuel costs and the actual cost to carry the larger passenger is concerned should be such a minimal cost difference that it shouldn’t make much of a huge difference in respect to the entire airplane that carries hundreds of passengers. The real problem arises from eliminating future business from the passengers that are inconvenienced by the larger passengers because they move their business to another airline.

    The question then becomes at what point do we enforce the “buy an extra seat rule?” Would it be subjective to the person giving the boarding passes? The stewardesses? Would there be a certain circumference rule? There would be no truly equitable way of enforcing such a rule.

    Another possibility would be to charge the same way that luggage is charged. Up to a certain weight is allowed and then for every incremental difference there is an added charge, but then the airline still loses the future business of the inconvenienced as well as possibly the business of the overly large because they find an airline that doesn’t charge after they have flown with the original charging airline.

    Personally, I am almost always in favor of the most efficient solution but even in this case the “efficient” solution may not be so because of hidden costs associated with lawsuits arising from bad subjective use of whatever rule is made as well as bad publicity which would then lose the business of those that feel a more equitable solution should have been sought out.

    Sucks to be an airline carrier.

  • 6 Tim Cullen // Apr 18, 2009 at 11:39 pm

    Many of the left’s goals can be supported without appealing to equity. A moderately progressive tax code and basic social safety net can be supported under a fee for service/public good model. The rich have more income to protect and are more likely to be targeted, thus they pay more for domestic and national security. Further, we can consider a social safety net a public good as it can be an effective way to prevent crimes of desperation and can keep potentially productive individuals, mainly children of the poor, from falling through the cracks due to poor luck. I don’t support income redistribution because the poor deserve it or to legislate altruism, but because everyone benefits from some of it. My problem with the left today is that they don’t restrict income redistribution to just the poor nor tie that redistribution to the poor also helping themselves, thus eliminating much of the public good that can be done through such programs.

    I don’t think there is an equity concern here provided that the obese are charged the amount of additional costs they impose on the airline. Even if the obese person had no control over their weight like a person has no control over their race or ethnicity, it would still be ok to discriminate; because there is a real reason that person is imposing a cost on others not just some made up racist garbage or subjective charge of offense. The fact that obesity is more often a result of lifestyle than circumstance makes the action even more appropriate, few see it as a violation of smokers rights that one can’t smoke on the plane. Further, since the additional cost is only assessed if someone sits next to them it limits the higher price to only the time when the obese person imposes that portion of the higher cost.

    This is likely a good policy for united, what they should do is explain it to customers; most of who I hope can understand it. The previous idea similar to luggage pricing is good, but some people who are heavier may not be wider and thus wouldn’t necessarily cause a problem for those sitting next to them, and if one could get people onto scales in airports it would at least seem less arbitrary. However the armrest rule is pretty clear and better accomplishes the problem of assuring comfort to all passengers. The most regulators could do here would be to make sure that the airlines didn’t try and trick obese people into paying for a second seat when the plane isn’t full, as they would likely be forced to pay more than the additional fuel to fly them would cost; and of course the regulators ought make sure that if someone is forced to buy two seats, they also get their two in flight meals or bags of pretzels.

  • 7 Braden // Apr 19, 2009 at 9:09 pm

    I think it is actually defensible to refuse to allow people to purchase extra seats on public transit; an empty seat means the government is subsidizing a good without positive externalities, unless people just like seeing trains. Of course, it would be better to make you pay a price adjusted for subsidies, but nonetheless.

    I’m surprised that this blog has such high-quality posts and commentary–I’d figured nothing good could come of Facebook ads.

  • 8 Tom // Apr 19, 2009 at 10:53 pm

    i’ve always taken a rather unpopular view on the tax issue. I feel that the majority of taxes should be paid by the poor, not the rich.

    one reason for this is that the poor use the vast majority of the services that our taxes are used for, ex. welfare, unemployment, food stamps, public housing, and the subsidized public transportation Braden mentioned.

    another reason is that it would (theoretically) drive people to work out of poverty. the common example used is taxing the rich. if you tax everyone who makes above $100,000 (or whatever salary you choose to use) you’ve raised the cost of being rich and as such productivity will dramatically fall. but the same logic works in the opposite direction on the poor. by taxing the poorest most heavily it will lead more to more of them working and producing.

    its a win-win, or to put it in terms of our two words of the day, its efficient and equitable. the poor win because they make more money and get to keep more of that which they earn. they’re now more efficient. and society wins because those who use the services are paying for them and those who don’t aren’t. and you get to keep more the more productive you are to society. these are equitable. since the more you make the more you keep, and since the way you make money is by being productive, there’s always incentive to increase productivity.

    such a system will never be adopted though since suggesting it is political suicide. for that reason i usually support the flat rate or flat amount positions.

  • 9 Matt D. // Apr 21, 2009 at 4:11 pm

    While such a system (taxing the poor disproportionately) may follow traditional economic incentive logic, it seems it undermine one of the few purposes for government to exist in a social structure.

    Not all poor are that way because of lack of work or work ethic, as all of us know, and these same people would become even poorer due to such taxation. At some point, going in this direction would cause it to be better for no tax to exist because the amount of money spent by poor, after a certain point on such a curve, will be more than what they receive in services from the government. After that point a rational poor person wouldn’t pay taxes and many of the government programs they arguably should be supporting for themselves will crumble to pieces right? Or at least cease to be useful. Similar to a Laffer curve? And then suppose the government knows that point and sets the tax rate for the poor at the level just prior to that, maximizing the amount that the taxes of the poor people support the programs of the poor people, we would essentially be creating the poorest possible group of people, right? Hmm, I’m just rambling now, my logic may be faulty here. Anyway…

    Thus, down the line the logical question at some point becomes what would be, generally, the most fair tax, and discussing that require beliefs and assumptions about what a governments purpose is, freedom vs. equality, yada,yada, yada and as economists we don’t deal in that right ! 🙂

  • 10 Matt D. // Apr 21, 2009 at 4:16 pm

    By the way, the was a response to the comment by Tom. I have a terrible habit of reading the comments before the story in order to just provoke further discussion and review, and therefore any comment I make very rarely draws on the originally idea. 🙂

  • 11 Tim Cullen // Apr 21, 2009 at 7:26 pm

    Taxing the poor to pay for welfare type programs defeats the entire purpose of welfare. The poor already have good incentives to work, they are called wages. The problem with welfare type programs arises when the programs are either too generous and/or not tied to the poor attempting to become productive; such as holding a job, seeking a job, retraining etc. This creates bad incentives where the poor actually benefit more by not increasing their productivity at the point they would become ineligible for their benefits. One solution to this could be a kind of negative income tax with brackets of something like, -50/5/15/25. Say everyone on their first 8000 dollars would be assessed a tax of -50%, receiving a $4000 check. This way the poor get aid, but only by working and don’t loose access to it by increasing their income creating a pretty strong incentive to earn those first 8000 dollars.

    The possible economic problem with this is that if we go back to the “libertarian paternalism” discussion the poor may not spend that money in the way that best achieves the public good objectives the aid was intended to provide. The poor might just go out and buy booze rather than housing, so while we may achieve our “equity” obligation to the poor we don’t achieve our “efficiency” goal, at least under some definitions. An interesting solution to this is available under the “fair tax”, or a national sales tax. The poor could receive a check in the mail equal to the amount they are expected to pay due to an unadjusted national sales tax (including many of the exempted goods), and at the same time necessities would be exempted and luxury taxes would remain; resulting in the poor getting more “bang for their buck” when they purchase things like food, education, and housing.

    Note this is only paternalism if the goal is the helping the poor for their own sake, not if the goal is reducing crime or encouraging an educated populace; also I don’t want to imply that the poor are the only people that may behave irrationally, they are just the discussion here.

    None of this will ever happen because of the political problems though; as armies of lawyers, accountants, bureaucrats and politicians benefit from the loopholes and ability to choose winners and losers that results from a complicated tax code. In addition, many bureaucracies have grown up around serving the poor and they would be much less needed if the poor were simply given transfers and incentives to spend it on the things those agencies provide. Think vouchers and charter schools with respect to public education, Lord forbid the poor be able to spend their allotted education dollars on sending their kids to the same school as Obama’s children.

  • 12 John S // Apr 23, 2009 at 11:03 am

    A negative tax and a subsidy check from the government? Giving people money simply for being poor does not create an incentive to get a job and become productive members of society. It creates the incentive to stay poor, work less, and collect money from the government. Giving aid has never worked in the history of giving aid. If it did, the continent of Africa would be growing at unprecedented rates.
    The idea of taxing the poor is the same as taxing cigarettes. To get people to stop smoking the government imposes a large tax on tobacco. This large tax dissuades people from buying cigarettes since the price will be much higher. By having a high tax rate for people with low incomes and a low tax rate for people with high incomes, it will give the poor an incentive to make more money. With more people earning large wages, the national income level will increase, raising the standard of living.
    Also, the government wasn’t designed to coddle its citizens. It was designed to protect them so they could succeed, not to protect them from failure.

  • 13 Tom // Apr 23, 2009 at 9:21 pm

    very good example John S. i didnt think of cigarettes but they work perfectly.

  • 14 Lee C. // Apr 24, 2009 at 4:48 am

    First post- nice to be here with all of you.

    To take a stab at the questions posed (in)directly, 1. To what extent does this discourage the portly potential passenger from purchasing portage (I couldn’t help myself)? If that discouragement is significant, will United be able to sell the seat to a less-corpulent commuter?
    If the portly passenger still chooses to fly regardless, or if the seat is easily filled by a slender passenger, I’d gamble United is on to something.
    You ask the question, what should regulators do? That leads me to ask 2 questions of my own; 1. are there externalities, and 2. why doesn’t my spell-checker recognize the word “externality?” Considering the externality of pollution, regulators should REQUIRE higher prices for those who need more fuel burned for transport!
    To second Philip’s comment, what the heck took so long United? Southwest was charging for a second belt at least 4 years ago, when I studied some of their strategies as a Managerial Accounting student.

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