What on earth is going on with the price of taxi medallions in NYC? Two of them just sold for $1 million apiece — that’s a 42% increase just since August, when conventional wisdom had it that $705,000 was a top tick and that medallions would soon plunge in value.

Derek Thompson reckons that this is a sign of how great New York’s economy is doing:

It’s all about supply and demand. The tailwind behind medallion inflation is a cap on taxi cab licenses. Even as the economy of New York City grew at a furious pace across three decades, the number of taxi plates stayed basically constant, despite wage growth and population growth and rising demands for cross-town transportation. As a result, their value rose tremendously.

One problem with this theory is that if you look at the chart of medallion prices, it doesn’t seem to bear much relation to the strength of New York’s economy. The majority of the rise in price has happened over the past ten years, which haven’t been particularly great, economy-wise. And certainly there hasn’t been any citywide boom in the past two and a half months.

Jacob Goldstein has a similar theory.

Every cab in New York City has to have a medallion. And the city strictly limits the number — currently just over 13,000. So as New York has prospered over the past few decades, the price of medallions has gone through the roof.

The economics of this, however, don’t make a lot of sense. Cabs might get a little bit busier when economic activity picks up, but most of that extra income is taken home by drivers, rather than the owners of corporate medallions. (Corporate medallions are the ones where the owners don’t drive the car; they’re the ones being charted here.) The income from a corporate medallion is pretty steady, and was spelled out in the comments to this post:

The maximum amount a cab leased out to drivers can earn over a year is $82,524. This assumes that the cab had a driver every day and every night and that it never breaks down. The day shift maximum charge is $105. The maximum night shift charge is $129 and that is only for Thursday-Saturday. Sunday-Tuesday is $115 and Wednesday is $120. You’ve also left out of your calcultions the cost of the car. Let’s call it $27,000 and you are required by law to buy a new one every 3 years.

This is the real reason why medallions are so expensive: good old-fashioned interest-rate calculations.

We’re basically talking about a real income stream, here, of about $75,000 per year. (Let’s assume, for the sake of argument, that the income from a taxi medallion rises at the same rate as inflation.) That’s a real yield of 7.5% on a $1 million investment — which isn’t half bad at today’s interest rates.

Put it this way: how much would a bond paying a real yield of $75,000 a year cost? At the most recent auction, the 29-year TIPS cleared at an interest rate of 0.999%. At a 1% real yield, an income stream of $75,000 a year would cost you $7.5 million.

Now you don’t actually get $75,000 a year if you own a medallion. You have to pay for maintenance, insurance, and workers comp; you also have to pay someone to manage your drivers. But even if you bring the income down to $50,000 a year, that’s still a pleasant 5% yield on your money, and what’s more it’s a yield which behaves much more like a real yield than a nominal yield. Paying $1 million for such a thing doesn’t seem silly to me, especially when there’s a lot of room for capital gains as well.

Of course, there’s risk here too. Any time you see a chart like the ones above, you have to worry that there’s a bubble. Plus, there’s political risk: the mayor can print new medallions, making the existing ones worth a little less (but not a lot less, given that the income from medallions is largely fixed).

That said, medallion owners have a lot of political clout, and historically they’ve been good at making sure that their income is maximized, rather than suffering anything which might reduce it. And when Goldstein starts dreaming of taxi deregulation, he quickly enters cloud-cuckoo land:

The medallions create a textbook example of what economists call rent-seeking behavior: Basically, gaining extra profits without providing extra benefits. If the number of taxis were allowed to increase (and if cab fares were unregulated), the number of taxis would increase and the price of a cab ride would fall.

No! if the number of taxis were allowed to increase, then the number of taxis would increase. Of course. That’s just a tautology. But the price of a cab ride would not fall, because that’s a separate piece of legislation — the price of a cab rate is set at a predetermined rate, and indeed has to be set at a predetermined rate. If you deregulated cab fares, utter chaos would result — New Yorkers would basically have to haggle over the cost of a fare every time they got into a cab.

Goldstein’s not the first person to have this cockamamie idea: Jim Surowiecki said the same thing in 1999. But in order to have a market where prices are set by supply and demand, people need to be able to choose how much they’re willing to pay to take a cab. And you can’t do that when you’re standing on the sidewalk (not in the bike lane, please!) sticking your arm out and trying to hail the first cab to turn up. In order to make that transaction work, the fare schedule has to be set, in advance, by the municipal government.

But I do worry that the way fares are set, too much money ends up going to medallion owners. If fares were brought down, the amount that medallion owners could charge drivers would also come down, and medallion prices would — finally — start to fall. Why does NYC ever raise taxi fares, when the income from those fares ends up going overwhelmingly to a handful of millionaire medallion owners? These medallions, right now, are licenses to print money. That’s why they’re getting extremely expensive. But it doesn’t need to be that way.