The Economics of Fire Protection
By Arnold Kling
Surely, someone has done this?
I assume that fire-fighting is an industry with declining average costs. Suppose that it takes $1 million in fixed costs per year to maintain the fire department (that includes normal profit, aka opportunity cost), the variable cost per fire is $10,000, and on average you put out 100 fires a year.
Your total costs are $2 million. If you try to make them back by charging $20,000 per fire, a competitor will come in and charge less. So you cannot sustain that price.
The cost structure implies natural monopoly. A two-part tariff is probably optimal. You charge a “membership fee” to cover the $1 million in fixed costs and then charge a fire-fighting fee of $10,000 to put out each fire, paid by the owner who has the fire. Some customers might want insurance against having to pay the fire-fighting fee, in which case they would prefer to pay a higher “membership fee” and a lower fire-fighting fee. Depending on the degree of moral hazard, the fire company might provide this insurance, perhaps even charging nothing for fighting the actual fire.
The more members a fire company has, the lower the membership fee. Hence the tendency toward natural monopoly.
The interesting question, in light of the recent controversy, is what happens when a consumer opts out. What would the fire company do about a non-member’s fire? In theory, it could charge the variable cost of $10,000, but that would eliminate the incentive to be a member. So it has to charge a lot more than that to non-members.
Suppose that there are two fire departments that can obtain enough members to be profitable (perhaps their services are slightly differentiated, so neither drives the other one out of business). Now, a fire breaks out at a home where the owner is not a member of either fire protection service. The owner offers to pay to have the fire put out. Do the two companies compete the price down to $10,000? If so, then how do they convince people to pay membership fees? If not, then how do they enforce what amounts to collusion?
Is there a libertarian solution for declining-average-cost industries?