The taxi market is undoubtedly one of the best examples of something economists like to call rent-seeking. What does this phenomenon stand for and why do economists (particularly political economists) devote a lot of attention to it?
The classical definition was given by Gordon Tullock back in his 1967 seminal paper "The welfare cost of tariffs, monopolies and theft", even though the phrase itself was coined by Anne Krueger in 1974. Rent-seeking is a process of gaining private benefits through the political process (by lobbying or logrolling for example). It implies gaining protection for a certain privileged group, which in return promises political support, large campaign contributions, or even bribes. This protection varies from giving a monopoly status to a certain company, regulating market entry than hampers competition (such as introducing licences to specific occupations), imposing tariffs to import goods to protect the domestic industry, handing out subsidies to politically chosen "winners"; etc. Rent-seeking most precisely paints the picture of how politicians, when they follow their self-preservation incentives, create outcomes that reward special interests, very often at a huge cost to the 'public interest'. It is therefore a term that co-exists with the political economy analysis of interest group behavior. Interest groups are formed to seek (i.e. lobby for) rents; privileged benefits for the few at the expense of the many.
Rents are thus the inevitable monetary or non-monetary outcome of rent-seeking (quite different from the rents one pays to their landlord, which is the first thing that comes to mind). They are always created via the political system willing to hand out monopoly status or special privileges to certain businesses. It’s hard to achieve monopoly status in a competitive marketplace, as there will always be someone to offer a more efficient or customer friendly way to exploit the price differential and take over a portion of demand. So, governments, not markets, create monopolies.
Governments are the ones handing out licences that limit the supply and thus increase the price of the good/service. They are based on negative signals that allow a business to prosper simply because this business had enough money to pay for its privilege of being the only service provider. If you go back in history you will find out that most big corporations were founded as state monopolies (e.g. the British East India Company), or were founded as so-called natural monopolies (telecommunications, railways, power grids, water supply, sewers, public transportation, etc.). These companies were public to begin with, but very often in many countries their privatization didn't imply they got striped off their monopoly status. Herein lies the problem as these companies carry on with their legal (and legitimate) rent extracting behavior, all regulated under the state, and with multiple corruption incentives arising in the process. The outcome is of course mass inefficiency.
Licences for taxis
But let's stick to the licencing issue. The text started by referring to the taxi business and how they seem to be an excellent example of rent-seeking. Before I lay out how this works, consider the following paragraph from the Krugman and Wells "Economics" textbook (a very good Econ 101 textbook, if I may add):
"New York City is a place where you can find almost anything - that is, almost anything, except a taxicab when you need one or a decent apartment at a rent you can afford. You might think that New York's notorious shortages of cabs and apartments are the inevitable price of big-city living. However, they are largely the product of government policies - specifically, of government policies that have, one way or another, tried to prevail over the market forces of supply and demand."
Housing shortages are a natural consequence of rent control (something, I believe, Hayek was the first to write about in "The Constitution of Liberty"), while the problem of the taxi market is serious lack of competition that's pushing the price up and limiting the supply.
Here is how it works on the taxi market. Drivers of taxis decide to set up an interest group (a lobby organization, sometimes even a union), to lobby City Hall (since this is usually a local market), for the introduction of a taxi licence. This licence would restrict market access to any competitor that wishes to freely enter the market. The justification for introducing the licence is market regulation (setting up standards that only a selected handful of drivers can concur to), safety, etc. But the real logic behind it is to gain monopoly power, in order to be able to charge a high price for a sub-par quality service. This is what rent-seeking is all about. Seize a unique opportunity to charge a high premium for your low effort (picking the low-hanging fruit, as Tyler Cowen would say). Furthermore because of the licence supply is limited (read: inadequate to satisfy the market), which necessitates the drivers to charge high prices (low supply + high demand = high price).
There is another side of the story as well. The politicians. Why would such a scheme be worth it to them? Because they care for having the market regulated by licences in order to provide high standards to the customers? Certainly not. If this is the rhetoric they use to justify the licence, it's certainly not the reason why they do it. The reason is much more superficial - the opportunity for bribes. In order to give out a licence the city politicians establish a Commission (like this one in NYC). The Commission (or even a city legislature committee) oversees the distribution of licences and decides who gets to enter the market. The taxi drivers then lobby this committee to grant them the special privilege and in the process bribes can be made. As a spilover effect legislators try very hard to get placed in the licence committee (it works like this in Congress/Parliament as well - some committees are simply more attractive than others; it's not always due to bribes, it's also to do with power and the size of the budget at their disposal). Furthermore, the overall welfare effect of the licence is negative (a deadweight loss) since higher prices of taxis imply people spend less in other markets. The relative prices get distorted (the same thing happens with taxation or tariffs, there is always a welfare loss for the consumers and for the society as a whole). It's a classical monopoly story:
How to fight this?
In theory, easy - liberalize the taxi market. In practice, much harder. It involves the politicians to willingly reduce some of their own benefits (bribes or power). For the taxi market example these need not be very high (which is why we do in fact observe liberalizations of taxi markets in some countries), however in general, curbing rent-seeking and monopoly power of state enterprises can be very difficult. It rests upon first and foremost reducing political power and therefore their inherent ability to extract rents. This is the difficult part, particularly since there is a large veil of informational asymmetry operating on such markets.
The second problem relates to the other actor on the market - the drivers (i.e. the monopoly). And while it's easier to get public support to dismantle a public monopoly, it's harder if this includes protests. It's quite logical to expect protests - the people are protecting their jobs. After all, no one likes competition, particularly if you're operating as a monopoly.
But as in most breaking up of monopolies, the taxi market should follow the same pattern. Making barriers to entry smaller and licences cheaper would increase the size and the efficiency of the market. The oligopolists would be hurt. But this is a signal to them as well to reallocate and respond properly to the market forces. If in this process some taxi drivers lose their jobs, they will get hired by the competition. This is what usually happens in a skills-specific occupation such as this one (not that it's a very unique skill, but it's a specific type of job), once the licencing monopoly is broken. It happens with the break-up of other monopolies as well. People with a specific set of skills get hired by the new entrants to the market (who need these types of skills), while some re-specialize in another line of work. This very often leads to the rise of entire new industries and entire new careers. Nothing proves as a better example of this than the UK, and more specifically London, in the 1980s and 1990s.
What about political rents and the limit of political power? In my political agency research I call for the limit of political power. Politicians play a repeated tit-for-tat game with the voters in which they try and conceal their true type and the amount of their rent-extraction to get re-elected. Their success depends on their patience (one might even say greed), i.e. on how much are they willing to decrease their rent-extraction temporarily in order to win office for the next term. Their decisions determine the amount of rent-extraction and the amount of waste within a society. If this is too high, they lose office, if it's too low, then it's not enough to satisfy the basic needs of the voters. The trick is to balance between the right amount they would like to extract for themselves and what would keep them further in office. This implies the existence of an optimal threshold above which it isn't profitable to extract rents (in terms of utility maximization).
Therefore the only way to constrain and prevent the politicians from wasteful spending is by limiting their power. Here is where a number of factors need to be accounted for. The separation of power is one, the media is another. It matters to which extent those holding legislative or executive office can influence those holding judicial office or the media. If this power is substantial, then the voters are on a loss, as it will be hard to remove a wasteful politician from office. If liberties are restored and the media is not captured, then it will be much easier and the power of politicians will be substantially limited. So the problem of rent-extraction and rent-seeking can be solved in an institutional environment that will disable politicians from misusing it. How to achieve this is a bit more trickier. But that's another issue, left for another blog post.