Subsidies and queuing

Today: Some methods that either hurt or improve

efficiency

Previously…

We expanded from supply and demand theory Elasticity Price controls Efficiency

Today

More on topics related to the Efficiency Principle Subsidies Queuing and first-come, first-served

policies

A subsidy for renters?

Recall that last time, we concluded that rent control had few (if any) winners and many losers

Suppose that we wanted to find another way to help I.V. renters How about a $500 check per month

for each renter of I.V.?

Think, think, think

As aspiring economists, we need to examine whether a subsidy is a good idea

We must keep in mind Subsidy is not a “benefit” in economic

terms, but a transfer Money for subsidy must be raised

from somewhere

Short-run analysis

In this case, we will look at the short-run consequences Assume for the near future, nobody

can build new apartments or convert apartments to condos

Supply is vertical

What happens? Initial demand is

D After subsidy is

given, each person is willing to pay $500 more than before, changing demand to D’

What happens? Before the subsidy,

price is P2; quantity is Q1

With subsidy, quantity demanded at price P2 is Q2

In short-run, notice new price for apartments is P1

This price is $500 higher than before

What happens? All of the subsidy

goes to the apartment owners (and we have not even found money for the subsidy yet!)

First-come, first-served policy

This is essentially what happens today When a vacancy occurs, the manager

accepts applications If the rent is at the market-clearing

price… Each person willing to pay the price

should find an apartment Each apartment should be rented

First-come, first-served policy

What if the apartment is not at the market-clearing price? If the rent is below the market-

clearing price, long lines develop If the rent is above the market-

clearing price, the apartment will sit unoccupied

The inefficiencies of long lines: An example In 1978, airlines adopted a voluntary

approach to overbooked flights Before this, people were allowed to board

on a first-come, first-served basis Even Southwest Airlines now lets you buy

Business Select, which includes boarding priority

Remember to think like an economist: Waiting time is a loss to society that nobody benefits from

The inefficiencies of long lines

Each person has a value of her/his time

People on vacation typically have lower values of time than those traveling for work However, people on vacation can

often arrive for their flight before business travelers

The inefficiencies of long lines

Let’s look at a tale of two people for a concrete example Max, who is ready to go on a skiing

trip Jill, who has a business meeting

tomorrow in Denver at Noon

Max, a single guy who likes to vacation in style

Jill, a busy executive at a local firm

They book seats on 6 am flight to Denver tomorrow

A tale of two people: Max Max has shopped at Vons

for the last 12 years in order to accumulate enough miles to book his free flight

He stays in Denver for one night before embarking on a two-week ski tour of Colorado

A tale of two people: Jill She receives a call

tonight at 10 pm She must be in Denver

tomorrow for a Noon meeting tomorrow, or else her local firm loses a $2 million contract

She books an Economy seat to Denver for $775

Check-in for United flight 6682

Max and Jill are the last two people to check-in for the flight

Jill is right behind Max in line Unfortunately, only one seat is left Should Jill be bumped?

The efficiency principle

As economists, we want to find a way for the most efficient outcome to occur

As an airline, we want to make ALL of our customers happy

How do we do this?

Suppose that United cannot overbook its flight

Empty seats Higher ticket prices Jill becomes desperate to find a

way to Denver

With overbooked flights

Voluntary system to find a person with a low value of time

Offer an incentive so that someone is willing to travel on a different flight Fly through San Francisco, get a first

class seat from SFO to DEN, arrive at Noon instead of 9:30 am

Cost-benefit analysis of incentives

Max’s value of time is low, since he was just going to check into his hotel and eat a nice dinner at a local restaurant $10 cost per hour, or $25 total

Jill loses a big contract if she does not make the flight $50,000 total cost

Cost-benefit analysis of incentives

Assume that either Max or Jill benefits the same from a First-class seat $200

Max gains $175 by offering to give up his seat in order for Jill to attend her business meeting on time He instantly volunteers to give up his

seat for Jill

Cost-benefit analysis of incentives

Going from a first-come, first-served policy to a voluntary incentive system has improved the outcomes of both Max and Jill Max has improved by $175 and is

traveling in style, just the way he wants

Jill is able to make her meeting and save the contract

Pareto improvements

When one or more people are made better off without making anyone else worse off, these are known as Pareto improvements

In our previous example, both Max and Jill were made better off without making any other passenger worse off

Hypothetical cost-benefit analysis from United’s point of view

United Airlines has determined in its computer system that the probability of the last First-class ticket being booked for the SFO-DEN flight is 0.05, at a price of $1200

The marginal cost of an a First-class passenger over an Economy passenger is $50

Cost-benefit analysis from United’s point of view Marginal benefit of booking Jill’s ticket:

$775 Marginal cost of booking Jill’s ticket:

Possible loss of First-class ticket being booked on the later flight, $60

Additional First-class cost of Max’s trip, $50

Total, $110 United is better off with this policy, too

Conclusion of Jill/Max example

People with low reservation prices will voluntarily accept the airline’s offer if the individual’s MB of the offer exceeds the MC of the time lost and inconvenience Max has a low reservation price, due

to his flexibility

What have we learned today?

A subsidy, like rent control, is not a good solution for the I.V. rental market

Voluntary incentives can be used to improve the efficiency of some markets Airlines also use price discrimination to

improve efficiency (More on this in Ch. 8)