ECON101 via Josh Hendrickson.

Or rather: weird quirks of price theory applied to mundane, real-life events.

Exhibit A:

On the one hand, it waslegal to buy and sell fireworks. On the other hand, it was illegal to set off fireworks. Violations were subject to a fine. (In fairness, this isn’t completely true. There were certain days in which one was exempt from fines. I believe that New Year’s, Memorial Day, and Independence Day celebrations were exempt from fines.) It seemed contradictory to allow people to buy and sell fireworks, but that lighting off the fireworks on most days of the year resulted in a fine. Why allow people to buy something and then fine them when they consume it?

Exhibit B:

Another thing that I’ve long found perplexing is the parking situation on university campuses. I’ve spent a lot of years on university campuses and the one thing these campuses have in common is that there never seems to be enough parking to satisfy demand. This is such a problem that universities often have meetings about how to solve the parking problem that involve discussions about whether to build a new parking garage, but rarely about price. One would think if the objective was to solve an excess demand problem, the obvious solution would be to increase the price. Yet, somehow this never comes up in the meetings.

Enter price discrimination: the "two-part tariff"Enter price discrimination: the "two-part tariff"

Think Costco (fixed subscription plus cheap unit fee) or cover charges at bars (fixed, plus unit fees for drinks)

for us non-psychopaths who prefer English over Greek:

What this shows is that if the fines and/or the probability of getting caught is sufficiently high, then the university is actually better off with the two-part tariff. The necessary magnitude of the fine depends on the elasticity of demand for permits and the magnitude of the discount. All else equal, the bigger the discount, the bigger the necessary fine.

The basic idea here is that the university is able to price discriminate. Those who have a higher willingness to pay will not only buy the permit, but they will continue to park on campus even when there are no spots available and incur the fine whereas those with a lower willingness to pay will tend to arrive earlier to make sure that they get a spot.

FIREWORKS:

Charging a tax on each unit "drives a wedge between the price that consumers pay and the price that sellers receive that is equal to the size of the tax. Because of this wedge, both consumer surplus and producer surplus are lost."

aside: beautiful rendition of "DEAD-weight loss" lol:

The deadweight loss is the residual. It is the total loss in surplus to consumers and producers minus the revenue that went to the government. Given this definition, it is not hard to understand why it is referred to as a deadweight loss. It is the foregone surplus that is lost and goes to no one. It is the value of the gains from trade that are simply foregone because of the tax.

After another round of algebra:

Tax revenue is proportional to t, but the deadweight loss is proportional to t^2. What this means as a practical matter is that the deadweight loss from taxation grows much faster as the size of the tax grows than tax revenue grows. This is where the Laffer curve comes from.

Alas, the (stationary) roving bandits we call governments figure out that maximizing revenue via the Laffer curve peak can be supplemented by some additional tax income:

you know that you cannot vary the size of the tax to generate more revenue because it would distort behavior in the market. If the state has already set the tax rate at the height of the Laffer curve, then this would be self-defeated. All is not lost for this revenue-maximizing government. What it could do is institute a two-part tariff. The government could combine a lump-sum tax with the per unit tax. Given that the per unit tax maximizes revenue, the government could levy a lump-sum tax on consumers less than or equal to the remaining consumer surplus and a lump-sum tax on producers less than or equal to the remaining producer surplus.

The thieves, like the boomers, are parasitic sneaks!

A-ha!A-ha!

The fine for setting off fireworks is the same no matter the quantity of fireworks that have been lit. One way to interpret the fine is as a lump-sum tax to collect at least some of the remaining consumer surplus. Michigan also levies a lump-sum license fee on retailers who sell fireworks. In order to sell fireworks, retailers effectively have to pay an entry fee. This is a flat fee that is again independent of the number of fireworks sold.

The consumers who really wanna set off fireworks (or wager that they can get away with it) self-select into a pool that probabilistically pay some fire -- i.e., extra gov revenue. Like the subscription/parking pass example.

what I have shown in this post is that both of these examples can be explained through some very basic price theory. If the objective of the state and of the university is to maximize revenue, then something like a two-part tariff can be optimal. In the case of the university, this is a straightforward application of price discrimination. The two-part tariff allows them to charge more to those with a higher willingness to pay. For the state, this is a way for the state to capture as much revenue as possible from a sometimes dangerous recreational activity.

Ah yes, very neat.