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):
- The left places a higher priority on equity versus efficiency than does the right.
- 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.