Uber's Surge Pricing Strategy

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Uber, created in 2009, is a company that links passengers and drivers through a smartphone application. Thus, Uber is not a transport company but a software. Based in San Francisco, Uber is now operating in 62 cities spread over 22 countries around the world. Despite this success, notably based on a specific price discrimination system, Uber remains highly controversial. For some critics, Uber is a huge step in order to improve the taxi market, which is most often strictly regulated and inefficient in Western Countries. However, other critics argue that Uber is creating unfair competition since regular taxis still need to buy a licence before being able to start practicing. For instance, in Berlin and Brussels, Uber is prohibited. Uber is thus reactivating an old heated debate, especially in France, where Uber is currently being sued by regular taxi companies, that is to decide whether taxi market should be regulated or not. To examine this question, I have chosen an article from The Economist, called "Free exchange-Pricing the surge" and published in March 29th 2014. This article demonstrates that Uber price discrimination is surely improving taxi market, but that its inflexible 20% fee by ride is not the optimal strategy Uber can use. In this essay, I will focus on the issues entailed by the specific price discrimination Uber uses : dynamic pricing.

i. Uber : the "two-sided market strategy"

As I said before, taxi market is often dysfunctionning. The article thus highlights that entry in the taxi market is hamperred by barriers. The article states the case of London, where taxi drivers must pass a test in order to assess their knowledge of the city, which can take up to four years to be completed. Another good example is the case of Paris, where taxi licences cost at least €100 000.

Uber aims to "revolutionise" this, according to the article. Indeed, Uber connects drivers and passengers through a smartphone application thanks to a geolocalization system. Therefore, Uber's strategy is that of "two-sided" market: the market works like a platform that links buyers and sellers. This theory is that of Jean Tirole and Jean-Charles Rochet, two economists working at Toulouse University. However, the drivers in question are not official taxi drivers, but anyone that is willing to become a Uber driver. Not only is the comfort of consumers considerably improved as Uber's consumers do not have to wait in the street to hail a taxi, and to this regard Uber's application is an incentive to consume more, but also is the number of rides maximized as consumers can directly interact with drivers and not rely on the chance to meet. Furthermore, in 90% of the cases, Uber rides are 90% cheaper than regular taxi courses (see Notes 1).

ii. Uber's surge pricing strategy

Uber uses price discrimination at two levels. First, (this is not discussed in the article), Uber offers three different standards of rides. "Uber" is the most expensive of them and relies on luxury cars such as limos. "UberTaxi" has an intermediate cost and relies on regular taxi drives. Finally "UberPop" is the cheapest, and offer to anyone to become a driver. This is a second-degree discrimination price : the pricing is non-linear and depends on the quality of the ride. However, in many countries, regular taxis can actually use the same type of price- discrimination with regard to quality.

Second, as discussed in the article, Uber also uses a dynamic pricing system often called "surge pricing". This is the real difference with regular taxis, and the reason why Uber is said to create unfair competition with regular taxis as well.

Indeed, Uber's team noticed noticed that after 1:00 am on Friday and Saturday nights, they were an imbalance between demand and supply for taxi rides: demand largely exceeded supply. Thus, Uber's team had the idea to rise the price for Uber's drivers rides during these hours. After two weeks only, the results were significant: the number of Uber rides rose by 70% and over 60% of the unfulfilled requests were eliminated.

This was possible for two reasons. First, the supply curve is highly elastic: thus when the income of the drivers rise, drivers are willing to enter the market. Higher prices increase supply. Second, the demand curve is very elastic as well, consumers prefer to pay much more to get a taxi then not to get one: the article states that minimum fares of up to $175 can apply. Consumers are willing to pay more.

This is a dynamic pricing strategy: when demand increases, prices increase therefore more drivers are willing to enter the market. When demand begins to ebb, the prices decrease. Through this mechanism, Uber is able to maximize the number of rides completed. Furthermore, Uber is proud that its surge pricing algorithm maximizes the number of rides completed rather than its profits. This is because Uber uses a revenue sharing scheme rather than a traditional profits-maximization scheme. Formally, Uber maximizes its profits such as (see Notes 2):

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𝐦𝐚𝐱 𝜷 D(p) subject to D(p) ≤ S (p (1 - 𝜷)). 𝜷,𝒑

This constraint is because Uber commits itself to enable every passenger seeking for a ride to get one at the posted price. If Uber was using a traditional profits scheme, it would then maximizes its profits such as:

𝐦𝐚𝐱 p D(p) - w S(w) subject to D(p) ≤ S(w) 𝜷,𝒑

Hence, the first case is more restrictive than the second one, and shows mathematically that Uber's strategy is to maximize the number of rides completed rather than its profits.

 

With p the price of the ride, 𝛽 Uber's commission, w the wages of the drivers, D(p) the demand function and S(w) the supply function.

iii. Why regular taxis cannot do what Uber does?

There are two reasons why regular taxis cannot use the strategy of Uber.

First, in countries like France, there is only one type of pricing that regular taxis can use, which is implemented by regulators. In France, like in England or in the US, it is a time- distance pricing and there is no other way to charge a ride. Regulators decided to set a governement-unique price system rather than a free pricing system. Consequently, surge pricing is not possible.

Second, even if surge pricing was actually permitted by the law, regular taxis would not have the capacity to use it. Indeed, Uber is able to use surge pricing because drivers and passengers have the possibility to assess the real-time state of demand an supply. Therefore, consumers and drivers know the price of the ride before the ride begins and thus, they are able to discuss whether they will do it or not. This would not be possible with regular taxis; if people would negotiate the price of the ride right before getting in the cab, the taxi market would become highly disorganized.

Conclusion : is Uber improving the taxi market ?

To conclude, I will discuss whether Uber is improving the taxi market or not.

On the one hand, Uber is a platform that makes the taxi market more efficient because it helps demand and supply for rides to meet. During regular hour, the equilibrium between supply and demand is naturally reached. But when demand exceeds supply, Uber's higher prices increase supply and a new equilibrium is reached as well. Uber also enables more people to enter the market, both on the consumer side, as the rides are cheaper and that Uber uses a second-degree discrimination which allows consumers to chose between different standards of ride, and on the drivers side as well, as there is no barriers to entry (Uber offers to lend a car for people that do not own one, although the fee Uber requires by ride is higher in this case). This way, we can say that Uber improves social welfare, as it improves both consumers and producers surplus.

However, on the other hand, Uber also harms the taxi market because it creates an unfair competition for regular taxis, that have bought their licence and that suffer from the cheaper prices of Uber. Regular taxis are thus facing a decreased demand. On the long-run, we can therefore say that Uber harms the taxi market because supply for regular taxis is superior than demand for them. The ideal solution, to improve the taxi market, will be to first indemnify regular taxi drivers and then to deregulate the taxi market by suppressing entry barriers and thus let demand and supply adjust to each other. A perfectly competitive market might thus be achieved.

© Rosalie Calvet, October 2014


Notes

1 NB: this is not true in France though. Because of regulation, Uber rides are 30-40% cheaper than

regular courses.

2 Source : The leisure of the Theory class website - "Uber is not profit maximizing", 31st Oct