SimCity Capitalism

Uber economics: Sometimes the invisible hand slaps you in the face

December 18, 2013
December 18, 2013

Who can argue with supply and demand?

Even those of us who got through school without an introductory economics course tend to revere the simple logic of market equilibrium. When demand goes up, so does the price. More supply begets lower prices. Got it.

But faith, even in supply-and-demand curves, must be tested.

This past weekend in New York, the skies opened up to blanket the city with icy snow. Miserable weather. Hailing a cab was futile, so people turned to their phones. The mobile app Uber, now operating in 65 cities, has proven reliable for getting a lift at a premium price: Request a ride, and a livery car will pick you up shortly.

Lots of people had the same idea, though. Demand, in other words, was elevated. Supply was having issues, too, as drivers chose to stay off the treacherous roads. So it was that Uber customers were greeted with unpleasant news: “Demand is off the charts! Rates have increased to get more Ubers on the road.”

Uber calls this “surge pricing.” The company rightly notes that airlines, hotels, nightclubs, and other service firms also charge their customers more when demand is high. But Uber’s zealous commitment to the idea—giving it a name, loudly defending the policy, and adjusting prices in real time—has produced a kind of natural experiment in the limits of supply and demand. To what extent are people willing to submit to the whims of equilibrium?

Many Uber customers bristled at the “surged” prices they encountered as the snow fell in New York: from three to nine times the normal rate, with minimum fares that sometimes rose above $100. To a free market economist, however, that bristling is exactly the point. Of course many people won’t be willing to pay exorbitant fees for a ride across town, whatever the weather conditions. But enough will.

There’s another way of saying that: Uber charges what the market will bear. The problem is that Uber itself won’t say that. It insists surge pricing is intended to address the supply of drivers rather than the demand of customers. “Higher prices are required in order to get cars on the road and keep them on the road during the busiest times,” CEO Travis Kalanick wrote to an outraged customer in a note he posted to Facebook. The idea is that more drivers will be willing to pick up customers when fares are higher, which makes a certain amount of intuitive sense.

Within Uber, the nightmare scenario—to be avoided at all costs—is known as “zeroes.” That’s when no cars are available for a customer to request in the app. “We view consumer choice as being the most important consideration,” Nairi Hourdajian, the company’s head of communications, told me over the phone the other day. “If the price is 9x, the user has a choice as to whether to proceed or not. If the app has zeroed out, the user has no choice.”

In other words: Uber says it isn’t trying to charge as much as the market will bear. This has nothing to do with demand. It’s all about maximizing supply.

The distinction is important. Adding more drivers sounds like an all-around good thing. Charging as much as possible sounds like price gouging, an impression Uber obviously wants to avoid. The problem is that supply, demand, and price are functions of each other. You can’t mess with one without affecting the others.

Kalanick seemed to acknowledge this reality the very first time Uber experimented with surge pricing, during New Year’s 2011, when the company was only operating in San Francisco. “We’re doing this in order to substantially increase supply of Uber cars and limit out of control demand,” he wrote (emphasis added).

These days, with Uber generating more than $200 million in annual revenue, the message is different. “We really do think about this as an increase in supply,” Hourdajian said. “The way you characterized it in terms of what happens to demand is probably true, but that’s really not where we’re focused in terms of surge.”

But even the supply side is fraught. Uber’s surge prices are represented as a multiple of the typical fare: 2x, 3x, and so on. In a popular city like New York, the rate is set in real-time based on a formula, so it can shift rapidly throughout the night. That’s why customers over the weekend saw wildly different fares, including a few extreme multiples when demand must have been far outstripping supply.

What’s not clear is how responsive drivers are to changes in price. It makes sense that more of them would be willing to pick up customers when rates are higher. The incentive is undoubtedly even more important when streets are covered in snow. But are there really drivers who won’t get on the road when the fare is four times the normal rate but will gladly drive at six times? Could the supply of drivers truly be that elastic?

Drivers on the Uber platform, as the company puts it, are informed that surge pricing is in effect through the mobile app. They see “a range of multipliers,” according to Hourdajian, in part because the numbers may be rapidly changing.

Without firm data, it’s impossible to say whether the elasticity of supply of livery cabs works as well in practice as it does in theory. Uber obviously believes it does, and sets its rates accordingly. But sticker-shocked customers would rightly question whether the invisible hand froze up this past weekend in New York. At the extremes, Uber’s math may well get ahead of reality.

Another reason to be skeptical is that Uber continues to take its normal cut from drivers even when prices have surged. (The cut can vary, but for black cars in New York and other major cities, Uber takes 20% of the fare.) If surge pricing is intended merely to address supply, it would stand to reason that all of the surge should go to the driver. That would also, in theory, help keep the multiple from rising further than it needs to. Taking 20% of the entire fare smacks of maximizing revenue, which Uber insists it’s not trying to do.

Finally, while Uber’s prices sometimes surge, they never ebb. Surely there are times when demand for cars is lower than normal. In those cases, shouldn’t Uber offer fares at, say, 0.6x its normal rate?

Such are the complications of experimenting in public. Uber’s somewhat religious adherence to its pricing scheme makes it all far more interesting, if not any more palatable to customers. Choire Sicha, founder of the Awl, put it best when he called the whole thing “SimCity capitalism.”

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