When Inequality Ruins The Analysis

Last week, Uber temporarily jacked up prices in Sydney, Australia in response to a demand spike caused by a hostage-taking event in the city. Many people complained about this price hike, which caused pundits to write thousands of words explaining that the price hike was good and that the complainers are stupid. Then, I pointed out that these pundit arguments don't actually work because, among other things, they fail to account for the way background inequality blows up the Econ 101 analysis that pundits were relying on.

Subsequently, Matt Yglesias put up an interesting post at Vox that explains this egalitarian argument in more general terms and shows how it does successfully undermine the economic analysis pundits reach for in these situations. I think this is a very important point and so I want to underscore it here and build on Yglesias' post.

The Problem

In theory, using prices to allocate scarcity is efficient because it ensures the scarce good goes to those who need/want it the most. If you are willing to pay $100 for some good, while I am only willing to pay $90, then, the theory goes, you must get more utility out of than I would. We can know this because you are willing to give up $100 worth of other stuff for the good (since you could spend that $100 elsewhere in the alternative) while I am only willing to give up $90 worth of other stuff for the good.

But, as Yglesias admits, this analysis collapses once you recognize that money has diminishing marginal utility, i.e. the more money you have, the less utility any given unit of it provides to you. If you and I have similar economic resources, then it's likely that your outbidding me for a certain good shows you really need/want it more than I do. But if you have way more money than me, the calculation changes. A very rich person who is willing to pay $100 for the good almost certainly gets less utility out of it than a poor person who is willing to pay $90. In that scenario, prices allocate the good inefficiently.

In general terms, what this means is that, in an unequal society, you cannot assume, as so many do, that prices allocate scarcity efficiently, not even in theory. In fact, the more unequal a society is, the more likely that using prices in any given situation leads to an inefficient allocation. This is true for any given good (prices will allocate the good to the wrong person) as well as for what goods are produced in the first place (prices will cause firms to create the wrong stuff, like luxuries for the rich).

The Solution?

The most obvious way to ensure prices have the highest chance of allocating scarcity efficiently is to ensure that people have fairly similar economic resources. Distribute the national income with egalitarian economic institutions and you can largely avoid this issue.

Yglesias concludes somewhat similarly:

To the extent that inequality undermines arguments for efficient price-based schemes, the correct conclusion is to reject inequality, not reject pricing.

However, there is a practical problem with this solution. That problem is that, in the US, the odds of the government rejecting inequality any time soon are very low. The powers that be prefer imposing extremely inegalitarian economic institutions instead.

If we assume that the "just cut inequality as is easily done" solution is not forthcoming, then we are immediately thrust into Theory of the Second Best considerations. The optimal conditions might be equality + prices, but if equality is negated, then the second-best combination of conditions might involve negating prices as well, at least in some circumstances.

For instance, one of Yglesias' hobby horses has been to use congestion pricing to clear up roads that are prone to traffic jams due to overuse. Where there is equality, this price-based approach seems to make a decent amount of sense. Using prices in such a manner saves wasted time and emissions by decongesting the road of those who get the least value out of using it. Where there is severe inequality, however, this price-based approach just decongests the road of the poor, creating a new express driving experience for the rich. You may still prefer doing it (e.g. for environmental reasons), but it's a much harder question to analyze if the goal is maximizing utility, and harder still if the goal is maximizing the well-being of the bottom (as is my main interest).

Broader Problem

Just as Yglesias expands the point from Uber surge pricing to all pricing of scarcity under inequality, I think this is all just a subset of a broader set of problems caused by our society's private market fetishism.

For example, many people, especially conservatives, viciously oppose government administration of welfare programs (by which I mean things like health insurance, paid time off, maternity leave, and so on). The net effect of this opposition is that employers end up administering millions of tiny welfare states throughout the country for their employees, which creates a long list of problems. Then, with the employer welfare state model established and insisted upon, reform naturally takes the form of trying to regulate employer welfare states, including imposing mandates on them. Tears flow at this point, but with the government welfare state option foreclosed, these reforms become second-best.

For another example, many people, especially conservatives, oppose efforts to provide robust benefits to the unemployed. In an ideal setting, you'd have unemployment benefits that replace a fairly high percentage of income, retraining/reschooling benefits to help those made redundant, and even perhaps wage insurance to make sure their redundancy doesn't totally disrupt long-term financial planning. In that institutional environment, resistance to "disruptive" innovation would be lower because the damage to those laid off as a result of it is not that high. But in a society that fetishizes the market to the degree that it hates these kinds of benefits, resistance to innovations that cause redundancies is going to be high, as legislators and the public more generally correctly observe that the change will totally devastate those affected.

I could give many other additional examples, but the point should be clear enough by now. Opposition to certain egalitarian social democratic institutions create situations where fairly unsatisfying and sub-optimal second-best solutions proliferate because they actually do make the most sense. You can say, as Yglesias does, that the appropriate response is to tackle the resistance to egalitarian institutions that causes these situations in the first place. But, that doesn't really tell us what to do in the interim period while the American government remains deeply commited to inequality and private markets more generally.