Surge Pricing For The Win
The On-Demand Economy, Uber and start-up El Dorado
Uber, a successful transportation network company, has given the tech community many gifts. It has given inspiration to thousands of founders. It has sparked a spate of introversion regarding private market company valuations. It has broken records for growth and fundraising. The Uber juggernaut is even shaping and questioning legal systems that were unprepared and unchallenged by tech business models and marketplaces before it. The company regularly makes the extraordinary seem commonplace and no more so is this the case than with surge pricing. How Uber actually make their money is a lesson that can, and probably should, be applied to many more businesses.
A good deal of the coverage concerning Uber focuses on its interactions with 3rdparties and its place within the On-Demand economy. The company has raised more money (~$7bn) than the rest of the world’s taxi hailing tech, combined. The same is also true for Uber compared with all of the other US on-demand companies. The picture below shows Uber’s fundraising even before their most recent $1bn raise.
Outside of funding announcements and comparisons with related companies Uber regularly features in the broadsheets and redtops. It takes on legal frameworks, established orders and unions whilst its drivers battle neo-luddites and occasionally fail the professional and behavioural standards expected of them. Their business model and what it prescribes for the conception of ‘employment’ is now a feature in the lead up to the 2016 Presidential Election. Along with this, the phrase “Gig Economy” has been brought into common lexicon.
Uber’s young life has brought context, meaning and theatre to many parts of the world. Yet I’d like to discuss a key part of the business that doesn’t often get much attention: surge pricing.
With surge pricing, it seems that the tech world is joining other developed ecosystems and employing etymological hocus-pocus for their own benefit. Those who we now refer to as ‘activist shareholders’ were once known as corporate raiders. What we now know as surge pricing was (and still is) taught to economics students as price discrimination. It also exists in other guises: price customisation, dynamic pricing and many more.
When I first learnt about price discrimination it was presented to me as some sort of holy grail for businesses; where the seller charges each customer a price equalling the maximum price that they’d be willing to pay thereby resulting in the maximum profit that is possible to earn. This is called ‘perfect price discrimination’ and looks a bit like the graph below in textbooks: everything above the Demand function : Marginal Cost intersection is profit for the business.
Clearly Uber haven’t managed to achieve this. I’m fairly sure that even the wealthiest Uber user might know that something was up when she/he was being regularly being charged a 20x surge price, or that equivalent journeys were costing them more than their less well-off friend. What they have done is something that is arguably even more impressive. Price discrimination isn’t just a tactic for Uber, it’s a fundamental principle which the business uses to regulate itself and thrives upon.
The much-vaunted Uber algorithm is, like any good model, relatively simple and easy to understand. The model ensures that there is always a car available for you within (at least) 20 minutes. At times of high demand or low supply, prices increase. The price increase is relative to demand/supply estimations in the given area (which will continually improve with more data). Uber then splits fares 20:80 with their drivers at all times. These factors taken together mean that demand is regulated (fewer people want to take taxis at higher prices) and supply is increased (drivers earn more in surge zones so will come on to the road or migrate from areas of low demand). It is an extraordinarily powerful and transparent way to solve problems and create value on both sides of the marketplace as well as for Uber itself.
What does all this mean for startups? Well, it isn’t as if businesses haven’t employed price discrimination in the past. Air-fares are a good example, lunch deals at restaurants, even club entry prices or happy hours — anywhere consumers pay different prices for essentially the same good. Most of these measures are aimed at solving supply-side problems, rather than Uber’s approach which has two-sided effects. Amongst other things this is necessary for them; because the times of highest demand often coincide with lower than average supply. This is a similar problem to that which I’ve seen with many start-ups: they’ve validated an idea, they have a valued product, then they begin scaling and working growth levers only to find a restricted ability to fulfil requests and customer orders.
I’d encourage founders to consider where surge/dynamic pricing might be able to fit your business model. There’s probably a distinction to be drawn between the type of business and quite how dynamic your pricing should be. For high-frequency and relatively inelastic demand purchases (like taxis…or perhaps even coffee) a model like Uber’s works well. For lower frequency purchases a more explicitly tiered approach to pricing could work well to smooth out demand spikes and/or supply shortages whilst increasing profitability. As the business grows, you’ll have more data and experience to feed into your pricing.
Clearly this approach isn’t for everyone although it’s becoming increasingly acceptable. Uber has socialised the concept, even gamified it in certain regards: take a look at some word associations with the word “surge”. As consumers become more familiar with the concept, it yields a fantastic opportunity for startups to help deal with some growing pains.
This article was originally published on the Forward Partners blog on June 8th 2015