Invisible Hand Revealed: How to Put a Lid on Traffic

China’s efforts to combat auto congestion and pollution through license plate restrictions are back in the news. Guangzhou, capital of Guangdong Province, will restrict to 120,000 the number of auto license plates issued for the year that began on July 1. This is well below the 330,000 cars added to Guangzhou’s roads in calendar year 2011. I have written about driving restrictions in China in the Fall 2011 issue of CKGSB Magazine, but this is a good time to revisit this issue because of the way in which Guangzhou is distributing the rationed plates.

Fifty percent of the 120,000 will be issued by lottery and 40% through public bidding (the remaining 10% have been set aside for new energy vehicles). This mix of methods is intended to balance social equality with the demands of local residents. This bifurcated approach raises a good question. Which is the best way to allocate a given number of license plates: a lottery or bidding? This is an important question as different cities in China have chosen different methods. Beijing and Guiyang use lotteries while Shanghai uses bidding.

I assume that, once issued, the licenses cannot be freely traded among potential drivers. If they could, then the licenses would end up in the same hands no matter how the government issued them. In a liquid secondary market-imagine licenses going up on Taobao after their distribution-they would trade until those who value driving the most get them. These are the same hands they would end up in if sold to the highest bidders upfront.

If trading is not allowed, bidding is the better way to distribute the licenses as long as the government uses the bidding proceeds appropriately. The problem with the lottery is that the people who value the licenses most do not necessarily end up with them. Anyone who is willing to pay above the license fee will enter the lottery and hope that they win. If they do and they can’t resell their license, they will use it even though there are losers who would be willing to pay more than they did. Bidding solves this problem by only issuing the licenses to those who value them the most.

What about the Guangzhou government’s desire for social equality? The same number of people will get to drive under either a lottery or bidding so there are the same number of winners and losers either way. The composition will be different however. Bidding will undoubtedly give a greater fraction of high-income people the right to drive. However, bidding will also raise more government revenue than the lottery. All this extra revenue could be directly handed back to those who are less fortunate to spend as they want (including bidding in future license auctions). A lottery with a secondary market would also distribute money back but would do so arbitrarily-lower-income winners could resell their license and reap the windfall but lower-income losers would get nothing.

Another alternative is that the additional money from the auction be used to make alternative transportation such as buses and subways as cheap, convenient, and pleasant as possible. This way we will have the same number of cars on the road as with a lottery but greater usage of cleaner transportation alternatives. This would more effectively accomplish Guangzhou’s third objective of the license plate restrictions-a better environment.

Update: Since my article two weeks ago (‘A Good Complement can go a Long Way‘) in which I touted the usefulness of firms promoting goods complementary to their core product, another excellent example surfaced in the media. Shanghai-based Giant Interactive Group, a large distributor of online games, announced that it would pay the cost of broadband upgrades for players of the new 3-D version of Allods, a massively multiplayer role-playing game (MMORPG). Since online games and broadband Internet access are consumed together, they are complementary goods and as I explained two weeks ago, reducing the price of a complement increases demand for a company’s core product. Allods is free-to-play but makes money from micro-transactions for purchases of in-game items. Giant will cover the upgrade costs for more than 50,000 gamers at a cost of RMB 300-500 per gamer so clearly it is banking on faster speeds stimulating enough demand for in-game items to cover these costs.