Globally, citizens from Guadalajara to Chengdu both love and loath ride sharing app, Uber.
We love it for the convenience, the ease with which we can pay, and the ability to avoid intemperate weather conditions— all though a few taps on our mobile phone.
But… we loath it when surge pricing is in effect. “Surge pricing” increases the cost of rides by many times the normal fare when demand is swelling, most commonly at rush hour, during inclement weather, or on a public holiday. In these cases, the supply of drivers is constant or even low, creating a shortage of available rides. By raising the price of each ride, Uber encourages more drivers to pick up passengers and rations the available supply of rides to the customers who value the service the most (those who are willing to pay more).
Nevertheless, while surge pricing may make economic sense, it feels like price gouging for many customers. The recent clampdown on surge pricing by the Delhi and Karnataka governments illustrates the intense debate over Uber’s policies that has been circulating worldwide. Delhi chief minister Arvind Kejriwal even called surge pricing “daylight robbery”.
The debate has polarized opinion not just in India, but also in cities as diverse as Sydney, Paris, New York and Budapest. The reaction is even more severe when there is an emergency, such as during the December 2014 hostage crisis in Sydney, where a masked gunman held people captive in a café. As the central business district was cleared out by police, surge pricing automatically kicked in. Customers were appalled by Uber’s apparent insensitivity to the situation. The outrage grew so intense that Uber was forced it to suspend surge pricing and offer free rides.
The rationale behind surge pricing
A 2006 paper by Mark Armstrong of Oxford University clarified the economic efficiency of surge pricing, stating that a firm offering a single price to all customers faces a trade-off: offering low prices raises sales but means also means a firm must offer a price cut to customers prepared to pay more. Conversely, raising profits can often mean lowering supply so that goods are not provided to penny-pinching consumers but more can be made from those willing to pay. Like many technology companies Uber’s business model relies on linking a service to the customer, in this case a ride to a rider. The model only works when successful matches are made. Spikes in prices raise the revenue of Uber’s drivers (they get 80% of any fare, if they drive their own car) so more cars are tempted onto the roads at times of high demand. In this way, prices are high at peak times not just because consumers are willing to pay more— but also because drivers don’t want to work then.
Uber commissioned a study in 2015 to analyze and explain its impact. The study, conducted jointly by two researchers and an assistant professor at the University of Chicago with ties to Uber, used Uber’s proprietary data to demonstrate how surge pricing helped to clear markets and reduce wait times by both encouraging drivers who were enticed by the higher charges and limiting demand from riders by signaling that a ride in that area at that time would be costly. They analyzed surge pricing for just a few minutes before normal fares were restored, contrasting this with another night when demand for rides spiked but surge pricing was not in effect due to technical problems. The authors point out that when prices surged, wait times decreased while in the latter case, wait times were long and several riders were left without rides.
Many microeconomics agree, suggesting that although Uber’s model is imperfect, its dynamic pricing model should be welcomed. In a 2015 research paper, economist Steven Suranovic writes that “public misunderstanding” of surge pricing rather than surge pricing itself is the problem. Suranovic contends that surge pricing is essential during times of peak demand, like emergencies, because it can prevent panic buying, hoarding, and wasting time when supplies run out and prices don’t rise.
Moreover, according to independent research by Nicholas Diakopoulos, an assistant professor at the College of Journalism, University of Maryland, surge pricing may be actually reallocating the supply of cabs or drivers rather than increasing the number of them. Using data available from Uber’s website for a duration of four weeks, Diakopoulos showed that when surge prices take effect at a certain locality, waiting times did fall in that area, but wait times in a nearby locality went up as drivers from that area moved to the former area to take advantage of the higher fares.
Uber claims that surge pricing has a long-term instructive effect on drivers as they learn to anticipate when and where demand is likely to surge. This aligns with what the company believes is its central function in the transport sector: to add and manage liquidity. In April 2016, The Guardian published an article, “How Uber conquered London,” which points out that the firm’s innovation lies in bringing liquidity to the transport management industry. Liquidity is typically associated with stock markets rather than the transport industry, but since Uber works as an exchange that matches drivers with riders, its emphasis on surge pricing as a mechanism to increase liquidity in the market makes sense.
What behavioral economics has to say
According to behavioral economists (or, really, anyone who understands people), firms fear that raising prices during a time of shortage will invite public contempt or a regulatory clampdown so they refrain from doing so, leading to long wait times or queues. In these cases, the absence of surge pricing may lead to economic inefficiencies but customer satisfaction is preserved.
In his latest book, Misbehaving: The Making of Behavioral Economics, Richard Thaler argues that temporary spikes in demand, “from blizzards to rock star deaths, are an especially bad time for any business to appear greedy” because they damage the long-term relationships that firms develop with customers. It’s important for companies to be seen as “fair”, which can involve giving up some short-term profits— even if some customers may be willing to pay more at a certain time— in order to maintain broad customer loyalty.
In a 1986 study conducted with Nobel Prize-winning colleague Daniel Kahneman and Jack Knetsch of Simon Fraser University, Thaler showed that community standards of fairness dictated when and how far companies could raise prices. Markets sometimes fail to clear in the short term because such ideas of fairness prevent firms from increasing prices as demand rises. The study was based on interviews in which scenarios were presented to subjects to determine how they viewed the outcome. In each scenario, a company changed prices or wages of those involved, for example raising the price of snow shovels after a snow storm or asking equally qualified job applicants to state the lowest salary they would accept. In most cases, notions of fairness were key to how they perceived the business transactions. Kahneman, Knetsch and Thaler wrote, “Community standards of fairness effectively require the firm to absorb an opportunity cost in the presence of excess demand, by charging less than the clearing price or paying more than the clearing wage.”
When a price is viewed as socially unfair or in violation of social norms, it leads to intense public disapproval. Nevertheless, as Kahneman, Knetsch and Thaler noted, social norms of fairness are not entirely immutable: “An initially unfair practice (for example, charging above list price for a popular car model) may spread slowly until it evolves into a new norm—and is no longer unfair.”
So what is the solution?
In many markets, ‘opportunistic’ price surges don’t occur because sellers and buyers recognize the long-term nature of their relationship. While individual Uber drivers and customers are not in a long term relationship with each other, Uber does have a long term relationship with both its drivers and its customers. If Uber does not come up with a better alternative to the dreaded surge pricing, one of its competitors might. As new ride sharing Apps emerge and flourish, Uber will need a more sophisticated economic approach to pricing that considers how customers feel.
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Photo of uber app by: Latrell G. via YouTube's Creative Commons license
Photo of uber protest by Aaron Parecki via Wikimedia Commons