Tuesday 12 January 2016


Stephen King (the Monash economist) worries that Uber's surge pricing is ultimately unsustainable. Not because surge pricing fails to bring cabs into the market, but because people really don't like higher prices at times of peak demand.
It is not ignorance that leads to customer annoyance with surge pricing. Customers understand exactly what surge pricing does. And that is why they do not like it.

From the customers’ perspective, surge pricing does two things. First, it encourages more drivers and so makes it more likely that the customer can get home (or where ever else they are going) in less time (albeit at a higher - and possibly much higher - monetary price).

This is the economic ‘plus’ from surge pricing. Economists call this an allocative gain. It means that more mutually beneficial trade occurs because there are drivers who are only willing to drive for the higher price but there are also customers willing to pay that price. Setting a lower ‘normal’ price would just mean that the drivers stay at home and the customers don’t get home.

Second, however, surge pricing creates a transfer.

When I jump into the Uber car I don’t know if my driver only decided to work because of the surge pricing. He or she might have been out there anyway. And in that case, I just pay more even though the driver would have been there anyway. Of course, the driver also gets more. The money doesn’t disappear. It is a transfer. My loss through paying the higher surge price is the driver’s gain. So from an economic perspective, this transfer is neutral. But that doesn’t make the customer feel any happier.

So economists love surge pricing because it improves ‘allocative efficiency’. Customers tend to dislike it because it means all customers pay more, even if their driver would have been working regardless.
He notes that American bans on price gouging are fundamentally counterproductive: where customers really hate price hikes and would punish firms for it, firms already have incentive to avoid it - even if it's to the strong detriment of consumers. I've argued that this kind of reputational concern can induce a market failure in a post-disaster context. Christchurch really could have used some petrol price hikes post-quake, but nobody was doing it.

King rightly notes that, if surge pricing puts off customers enough, either Uber or a new competitor will come up with a better way of handling things:
For example, instead of surge pricing everyone, the price rise could depend on the customers history. Regulars get a lower price than those who have just downloaded the App due to the crisis. Of course, to encourage drivers, they would need to receive a uniform higher price. So Uber would have to sit in the middle and manage payments. This will most likely lead to lower profits for Uber in the short run. However, it will be a long run investment in goodwill.

And if Uber does not come up with a better alternative to its hated surge pricing, one of its competitors will.
Firms in other sectors behave as though they expect to be punished more for pricing to meet demand than for running out of product: stores run out of snow shovels in blizzards. And if some store always charged a premium so they could keep an emergency stock of snow shovels out back, well, that store would likely have no customers except during the blizzard.

King's mechanism would effectively save those emergency snow shovels for the regulars. But would taxi regulars really be willing to pay a premium on day-to-day traffic to ensure supply availability during peaks? Uber would have to be betting so. I'm not sure it's a bet I'd make - but it would depend on the premium they'd have to charge at off-peak times where they'd risk being undercut.

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