Market Failure, Behavioral Economics edition

Lynne Kiesling makes some points about what market failure isn’t, but doesn’t provide a diagnostic for what it is.. but does say that we’re better off saying “markets fail to exist”. Which reminds me of a problem which has perplexed me lately: why can’t you get a taxi on a rainy night in New York? Many people would pay handily for one….

Assuming we’re asking an economist, there are generally a few answers:

  1. Because taxi-cabs are a licensed and therefore restricted service, there is under-supply*.
  2. Because prices are fixed, they do not earn enough to make it worth their while, and supply does not expand.
  3. Because increases in demand cannot be met flexibly during peak vs non-peak times.

None of those responses rings true to someone who lives in New York. In fact, the common experience is to see many taxies with their “Off Duty” lights on driving around the city at that hour, despite many willing paying customers. So I’d like to add to those options:

  • Because taxi drivers do not think like economists

Nothing against taxi-drivers or economists. They just mis-understand one another. Except for Camerer, Babcock, Loewenstein and Thaler, who understand taxi-drivers:

We talked to cab drivers in New York City about when they decide to quit driving each day. Most of the drivers lease their cabs, for a fixed fee, for up to 12 hours. Many said they set an income target for the day, and quit when they reach that target. While daily income targeting seems sensible, it implies that drivers will work long hours on bad days when the per-hour wage is low, and will quit earlier on good high-wage days. The standard theory of the supply of labor predicts the opposite: Drivers will work the hours which are most profitable, quitting early on bad day, and making up the shortfall by working longer on good days.The daily targeting theory and the standard theory of labor supply therefore predict opposite signs of the correlation between hours and the daily wage.

To measure the correlation, we collected three samples of data on how many hours drivers worked on different days. The correlation between hours and wages was strongly negative for inexperienced drivers and close to zero for experienced drivers. This suggests that inexperienced drivers began using a daily income targeting heuristic, but those who did so either tended to quit, or learned by experience t o shift toward driving around the same number of hours every day.

Daily income targeting assumes loss-aversion in an indirect way. To explain why the correlation between hours and wages for inexperienced drivers is so strongly negative, one needs to assume that drivers take a one-day horizon, and have a utility function for the days income which bends sharply at the daily income target. This bend is an aversion to losing by falling short of an income reference point.

To the individual standing on the corner in the rain, willing to pay 1.5x market rate for a ride home, this represents a market failure. The market does generally exist, it just doesn’t exist well when you really want it to.

*I would not let my wife get into an unlicensed taxi-cab – that’s not worth the risk.

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