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The Uber unstable equilibrium

I’m a big fan of Travis Kalanick. The Uber model doesn’t quite fit into any of the standard business models and hence has inspired several Uber for X start-ups.

However, debates have been raging across the world on the business practices of the company. Uber has been sued by several licensed cab unions and companies across the world. There have been several instances of strikes by Uber drivers in the recent past including here in India. However, without the same billions at disposal as Uber, it is unlikely that any of these actions will result in any significant changes.

Before I dive in and make my point about the unsustainable equilibrium of this model, I’d like to clarify that this is not about Uber versus Ola or any other copycats within the cab hailing space. What I say about Uber applies to all these other companies as well, for they too are Uber for X, where X stands for a country instead of a different service.

A debate has been raging in India about ‘capital dumping’ triggered off by a Medium post by Vani Kola of Kalaari Capital, an investor in the Indian Uber copycat — Ola Cabs. Several very learned people have challenged her core argument that foreign companies founded by Indian founders (and weirdly not companies running on Indian capital) need protection from foreign companies run by foreign nationals. While I agree that any such protection would be absurd and highly detrimental to the growth of other start-ups in India for obvious reasons, I disagree with the arguments put forth by several of these people to justify their opposition to such protectionism.

One of the popular arguments put forth has been that any intervention by the government would be anti-capitalism and anti-free-markets. The underlying assumption obviously is that the Uber model is a free-market model. In this post, I’m going to justify why I believe that is not the case and how governments and regulators can enforce a stable equilibrium model in the cab hailing space.

The supply

The supply side of the Uber model is a off-balance sheet model, where the asset in most cases is owned by the individual driving the cab and not Uber. There is no employee-employer relationship; however, several obligations exist. From my conversations with several Uber drivers, I’ve heard of rules like minimum number of trips a day, minimum daily working hours, no information on the destination before accepting the ride and heavy fines on cancellations. All sound like measures seemingly put in place to ensure there is no supply disruption, except when the drivers go on strike when these obligations get too cumbersome.

The demand

On the demand side, the Uber model is basically a standard reliable service. As a customer, I’ve never been too happy with the disproportionate surge pricing that depends not just on supply and demand, but also on the customer profile. I’ve also noticed instances where, for the same destination, the price shown to me is significantly lower than the price shown to my wife who uses the service more regularly than I do. Uber has a very large and mostly happy customer base, but not a loyal one.

The moat

The astronomical valuations of companies implementing the Uber for X model are based on two factors that sets this model apart.

  • It is an asset light marketplace that is hard to replicate
  • It gives them great pricing power

This is clearly a great place to be — outsized earnings with no assets.

The problem

With no visibility into their algorithms, a monopoly with such great power can seriously distort the markets. It is these very factors that make the Uber model anti-free-market.

The fundamental requirement of a free-market model is that buyers and sellers together determine the price at which the transaction happens. There is no uncertainty about who the buyer is — it is us, the Uber riders. However, the identity of the seller is not as obvious.

Is Uber the seller since they quote the price to me? Is it the cab driver who owns the car and provides the service? Uber would like for us, the customers, to believe that it is Uber that is providing the service. However, their contracts with the drivers which make it clear that they are not employees of the company, but merely independent contractors accessing the marketplace to find customers. They are intended to have the drivers believe that they are the sellers.

The price on one side obviously is determined by the buyers and Uber. On the other side, a different price is determined for the same service between Uber and the drivers. Only one party, Uber, has all the information.

If Uber were to take on the risk of one of the parties failing to honour the obligation, they could still be considered a standard middleman, susceptible to the whiplash effect, and is getting paid for taking on transaction risk. However, the Uber model penalizes the cancelling party and holds no risk or obligations.

Since the actual buyer and the actual seller never interact with each other to determine a fair price, what Uber runs is not a marketplace and therefore is not a free-market model. The beauty of the model however is that the risk (capital invested to buy a cab hoping the yield on the asset would pay for it) is with the drivers and the disproportionate returns accrue to Uber.

The sustainability of this model depends on ensuring that the parties involved never interact with each other before a deal is closed. Things get worse in a monopoly situation as Uber has far more to gain from pricing higher to extract the maximum profit possible from the customers while keeping its supply side perpetually underutilized. All they need to ensure on the supply side is that the drivers are paid just enough to keep them on the platform.

The solution

The solution to the problems being faced by both the sellers and buyers is for the regulators to enforce a true marketplace model on the Ubers of the world. When the buyers and sellers are individuals or small companies interacting in a marketplace, the need for regulatory protection increases.

One way to do this would be to enact regulations that force Uber to behave more like a stock exchange. The stock exchange model has survived for centuries and has largely been a profitable business.

Let’s assume that I need to travel from point A to B and a regular cab would cost me Rs. 500 to complete this journey. When I log into the Uber app, I should be able to see that a 1 star driver is offering this ride for Rs. 450 and a 5 star one for Rs. 550. I might still not be willing to pay that price. I should be able to place a limit order — say, I’m willing to pay Rs. 400 for a 1 star cab anytime within the next hour. Any driver in my area rated 1 star or higher should be able to accept my offer if they’re happy with the price. If within this hour no driver accepts my bid, I’ll either have to pay the offer price available at that time or find some other way to get to my destination.

Similarly, a driver should be able to see the distance and the bid that customers in the area have already placed. The driver either accepts any of the existing bids or just makes an offer that says, he’s willing to ride between 5 to 40 km for a price of Rs. 15/km. The driver’s offer will be shown to any rider whose requirements match these criteria. Like the customers, drivers too should be free to register themselves on several platforms and find the best option for each ride.

The surge in this case will be a result of true demand and supply meeting. Market forces will ensure that the price remains fair and balances supply and demand.

Uber and all other cab hailing companies should be free to offer any pricing model. It could be a certain percentage of the fare charged to both the seller and the buyer (5% of the fare), a fixed price per transaction (Rs. 30 a ride) or even a fixed price for a certain number of transactions within a given period (100 rides in 3 months for Rs. 2,000).

However, the biggest benefit would be that the competition in this market would shift from incentives and capital spending to the efficiency of their algorithms and liquidity on their platform. From our experience with stock exchanges, we know that their primary profit driver is their ability to ensure the availability of liquidity. When a marketplace has liquidity, the pricing will be fair and reliable. The stock exchange model is a stable equilibrium model that has survived for centuries and ensures a fair deal for both buyers and sellers.