One small study that explodes the myth that inequality is efficient

If you want people to consume less water, there are roughly two ways you could do it. One is to raise the price of water, and the other is to simply mandate that everyone cut back on their water consumption.

Either will work, but they work in different ways. And an important recent study from Casey Wichman, Laura Taylor, and Roger von Haefen suggests that the difference in how they work has crucial implications for how we think about a wide variety of issues. When economic inequality is really severe, using prices to regulate the distribution of scarce goods can be seriously unfair. At the same time, using non-price mechanisms can be seriously inefficient.

That means that inequality is preventing us from adopting efficient solutions to a wide variety of problems, ranging from drought response to traffic congestion to climate change.

First, the study. The authors got their hands on a dataset of monthly water consumption for almost 2,000 households across six municipalities in North Carolina over a 30-month period. That data lets them compare municipalities that responded to droughts by raising the price of water to those that took different approaches. The authors also know the income and lot size of each household, which lets them seem whether poor or rich households bear more of the burden of water conservation.

From this, they were able to empirically demonstrate something that non-economists probably think is obvious — when you cut water use by raising prices, most of the cutting is done by the poor and almost none is done by the rich. As they put it, “the conservation burden falls primarily on lower-income households” while “high income households are significantly less responsive to price.”

By contrast, a command-and-control approach — that is, just mandating that people use less water — cuts water use across the board, among both rich and poor households.

This is an important example of a case where, as economist David Glasner puts it, microeconomics needs macrofoundations. Microeconomics is the study of individual markets and how to make them operate effectively. While economists have deep disagreements about macroeconomic topics like recessions, economic growth, and the distribution of income, the basic tenets of microeconomics are not very controversial inside the economics profession. When people say that “economics 101” supports something like Uber’s surge pricing during a terrorism panic, they are talking about microeconomics.

Microeconomics tends to tell us, again and again, that life is best when sellers can set prices to rise and fall with the ups and downs of supply and demand. The idea is that markets should “clear.” Everything that’s produced should be sold, but you shouldn’t have shortages that force people to wait around forever and ever.

This is an appealing idea, but as Steve Randy Waldman has written, it tends to brush distributional issues under the rug.

When people say that a price-based scheme for rationing water is most efficient, they mean that prices will deliver the most efficient distribution of dollars and water. The idea is that how much people are willing to spend on something is a good proxy for how much they care about it, or how important it is to their well-being. Different people like different things, but you can buy all kinds of different stuff with dollars, and seeing what people choose to spend their money on tells you a lot about their preferences.

But dollars aren’t a perfect proxy for well-being, because money means different things depending on how rich or poor you are. To a middle class American, $5,000 is a really big deal. To a multi-millionaire like Mitt Romney or Hillary Clinton, it’s totally trivial — the value of their stock portfolios bounces up and down by that much all the time. To a person living paycheck-to-paycheck with no access to credit beyond very expensive payday loans, $5,000 could be a life-changing amount.

The technical term here is the “declining marginal utility of money.” A given dollar produces less happiness in the pockets of a rich person than a poor one. That means that in a society with substantial economic inequality, an efficient distribution of dollars and water isn’t going to be the same as an efficient distribution of happiness and water. This is what we’re seeing in the North Carolina water case — the dollars are just a lot more important to the poor than the rich, so all the burden of adjusting to reduced water usage falls on them.

For contrarians, trolls, and Uber-haters the analysis can stop here. A tiny dose of complexity refutes the Econ 101 argument, so the world is safe for economist-bashing and conceptual arguments in favor of price controls.

And yet it continues to be the case that allocating scarce goods through prices is much more efficient. Joseph Stromberg’s recent piece about the advantages of demand-responsive parking is a case in point. By charging more when parking spaces are in high demand, cities can eliminate pointless (and environmentally destructive) circling for parking. They can also capture revenue that can be used to cut taxes or boost services. Roughly the same is true of “congestion pricing” to alleviate traffic jams, and carbon taxes to tackle the even bigger problem of climate change.

Even back to the water case, the argument in favor of prices really does seem sound. Different people care a different amount about being able to use water lavishly — why shouldn’t the reductions be done disproportionately by the people who don’t care so much, while those who care a lot pay more?

To the extent that inequality undermines arguments for efficient price-based schemes, the correct conclusion is to reject inequality, not reject pricing. It’s probably no coincidence that the three countries to really embrace congestion pricing are either egalitarian (Norway and Sweden) or dictatorial (Singapore). Efficiency-enhancing economic schemes often simply assume a background where there’s not too much inequality, in part because, in many cases, they were hatched during the decades when the income distribution was much more even. But to actually implement these schemes in the real world, we need to also deliver the equality.

There’s an old saw in the economics profession that there’s a tradeoff between egalitarian outcomes and efficient ones, but empirical research consistently fails to find evidence that inequality boosts growth or redistribution slows it. One reason is that needs conditions of macro-equality to make micro-efficient schemes tolerable.