Overview of surge pricingUsually, staying up late somewhere, or going back home after the concert of popular artist, we take the smartphone to order an Uber taxi, and we find the following thing — the fare is n times the regular rate. This is surge pricing – Uber’s pricing system.Surge pricing is based on the repeated fluctuations in demand and supply for services in the market. This approach is sometimes used on motorways to regulate traffic or on energy markets in order to regulate prices. A “reduced” copy of this practice is the situation in which sellers inflate the prices of essential goods (water, batteries) after natural disasters. Obviously, consumers do not like these methods. They are offended by the fact that for the same trip they pay a different amount of money, depending on the day or even the hour.
Nevertheless, the pricing system described above provides evidence that the market is able to adapt to appearing situations. When the demand for taxi services in a certain area rises and the waiting time for the car increases, the client who orders taxi is informed that the fare will be more than the usual one. When tariffs grow, the market begins to work. Higher fare rationalizes the market and forms a queue for cars from those customers who are willing to pay: as a rule, they are wealthy consumers or those who do not have alternatives, and they are forced to go only by taxi. Boosting the price of travel for those customers who simply do not have a choice of another means of transportation sounds like a fraud, however, without surge pricing, these passengers will not have a chance to call a taxi, waiting in the general queue.Recently, Uber published a report in which it clearly showed how the surge pricing system works in practice by the example of two events in New York. So, after the end of one of the popular concerts in Manhattan, the number of activations of the Uber application in this area increased several times within a few seconds. The algorithm of price formation, which is used by the service program, allowed to increase the average waiting time of the car only slightly, and the percentage of completed orders did not fall below 100%.
On the eve of the New Year, the price surge algorithm did not function, and as a result, the average waiting time of the machine increased from 2 minutes to 8, and the percentage of completed orders fell to 25%.The above comparison may slightly overestimate the results of the Uber algorithm. All taxi drivers, even without the help of systems, know that in the places of various concerts and festivals, there is always a larger number of taxis. Nevertheless, the possibility of earning an additional tariff can motivate drivers to forecast high-demand places and prepare for an influx of customers.Surprisingly, the fact is that the more Uber will use the price surge algorithm, the less it will need it. “Proactive” tactics of drivers and miscalculation of places of potential excitement will help to eliminate the imbalance of demand, which causes the need for higher prices.Our group decided that it would be interesting from microeconomics point of view to model “surge pricing situation” on demand and supply curves.
Surge pricing modellingWhen demand on Uber taxi is regular, price remains the same for everyone. But during time when demand increases and the availability of drivers is less than the number of riders trying to place an order, surge pricing algorithm, employed by Uber in order to equilibrate supply and demand, takes place. According to this algorithm, multiple is assigned to the order and it derives “surge price”, multiplying the standard fare.To provide a real life example, let’s imagine a regular weekday. Supply and demand are at the normal level. Uber customer is able to open the app and get taxi at any given point at a time for an affordable price.
Graph 1 below shows market equilibrium during period of regular price and regular demand on Uber. The market situation is stable, so the equilibrium is at the point e — the intersection of D and S curves. Therefore, equilibrium price is P* and equilibrium quantity is Q*, as we can see it from the Graph 1.Let’s now imagine there’s a boost in demand after a popular music band’s concert. That’s when the surge pricing takes place: the demand curve moves up from D to D’ and price increases in n times up to P’.
High prices stimulate drivers to accept the rides and the supply increases accordingly. The supply moves up along the S curve, so the supply quantity rises from Q* to Q’, and we get a new equilibrium at e’.Here two notes about the equilibrium should be made.
Firstly, some drivers will not move in response to the surge price. They feel it is worthless, as the surge price is only a temporary tool. So the quantity of supply increases only to some extent. Secondly, not all passengers are willing to accept the surged price. Some of them may choose other options and means of transportation. That’s why the equilibrium is unstable and moving around between e and e’.Now there are enough drivers on the road to meet the demand, so the surge pricing stops.
Graph 3 below shows that the price goes back to the initial level P, but the supply cannot do the same thing quickly. The opportunity cost of driving is lowered. If a driver decided to leave all the alternatives and work, he is more likely to stay on the road longer even after the surge pricing is stopped.
Thus, we get the new supply curve S’ and the new equilibrium e”. Over some time, the situation will be stabilized and both demand and supply will go to the initial level.Economic influence of shared economyArising shared economy platforms, such as Uber or AirBnB, brought challenges to the established operating principles of many markets. In the past, transaction costs and barriers for the new entrants of taxi industry used to be high. Nowadays the old model is being disrupted by platforms which connect producers with consumers directly. There’s no need to process numerous ride requests, maintain the car fleet or pay regulatory fees for the Uber company. As a result, money, time and effort needed to facilitate the deal between customer and driver are decreasing.The most painful barrier for taxi industry is license, which is a governmental permission to work in a given industry.
For example, in New York City, taxi medallions sell for more than $1 million dollars each. These entry barriers are being eliminated, so sharing economy opens new opportunities for small entrepreneurship. Those car owners, who would be kicked off the market by expensive licenses, now can offer their services at much lower costs. Low-income segment of workers is able to operate at a legal market, and it can help to decrease poverty. (Network, 2017)However, established firms are fighting to preserve outdated business models, specifically because they benefit from entry barriers that keep potential competitors away. Taxi companies in Europe claim that Uber does not comply with the regulations and therefore creates unfair competition at the market.
So Uber is now prohibited or somehow restricted in Belgium, France, Germany, Italy, Spain and other countries. Such decisions have intensified the debate around Uber. (Petropoulos, 2017)Also shared economy platforms facilitate information sharing and reduce asymmetry. However, it is important for regulatory entities to ensure that the efficiency gains will be maximized and distributed fairly among all involved parties.Price discrimination conceptLast year Uber announced the (investigation) intention to change pricing policy to a more complicated one. New tariffs would consider such factors as whether a passenger travels to a wealthy district.
(Newcomer, 2017) This is an example of price discrimination practice, i.e. charging different “types” of consumers different prices for the same product or service, in order to exploit their willingness to pay.Price discrimination may have some positive effects on the overall society’s welfare.
It contributes to providing the necessary services and products where needed, which in case of Uber means reduced customer waiting times. Lower income or poorer consumers especially benefit from price discrimination as they now can afford to purchase the service (https://phys.org/news/2017-05-economics-uber-pricing.html#jCp).At the same time, the new pricing will lead to unavoidable tension with drivers.
Their main complaint is that Uber increases its profit margin by exploiting consumer surplus along with keeping the drivers’ stake low. Since Uber business relies fully on the availability of drivers on hand, it may be dangerous to mislead them about the company’s policies.Public relation issues are Another problem is that, unlike in a monopoly situation, consumers in taxi industry have a variety of options: web-based taxi services, traditional taxi, car sharing or simply public transportation. Thus, customers will easily switch to another way of commuting if they consider new pricing somehow too expensive or offensive.
This may also cast doubt on the success of the new pricing model.Also, specialists argue that such a model will not contribute to increasing Uber’s customer base, but will only undermine out drivers’ loyalty and trust towards the company. Some drivers may even change their taxi company, and Uber will not benefit from it obviously. Nonetheless, the model has been successfully tested and now applied in some cities where Uber operates.