There are two types of people: those who love Uber, and those who hate Uber. Businesses, municipalities, and cabbies alike have taken issue with Uber in cities across the world. Those who hate Uber have regularly criticized the ride-sharing company for what they perceive as shady business practices. But even those who are fervent supporters have complained about one aspect of its business—surge pricing.
Surge pricing occurs when the number of requests for rides in a designated area notably exceeds the number of available drivers. While some may see this as a shoddy way to exploit customers, it is actually an essential part of Uber’s business model that creates the most efficient outcomes.
Uber researchers and Chris Nosko of the University of Chicago recently demonstrated the importance of price surges in a case study. They used two examples: a glitch that made surge pricing fail for half an hour on New Year’s Eve, and the aftermath of a sold-out Ariana Grande concert in Madison Square Garden.
When its surge pricing mechanism failed for 26 minutes New Year’s Eve in New York City, Uber turned into a bad lottery with long wait times. Completed ride requests fell from 100 percent to below 25 percent, and the amount of time riders had to wait for completed rides went from about two minutes to eight minutes.
Supply and Demand Are Sophisticated Communication
Without dynamic pricing, the appropriate market signals were not in place to efficiently coordinate drivers and riders. When demand far exceeds supply, prices must go up. This naturally brings Uber’s market back into equilibrium by incentivizing more drivers to get on the road (increasing supply) and eliminating riders who don’t value Uber’s transportation enough to pay the surge price (decreasing demand).
The sold-out Ariana Grande concert provided a good counter-example. When crowds poured out after the show, demand increased four times the normal amount, and surge pricing went into effect.
People who valued their other transportation options more than they valued Uber at the surge price could take those options, and people who valued Uber at the surge price more than they did any other transportation option could take advantage of Uber. Uber drivers flooded the area, but wait times stayed the same and the proportion of completed ride requests remained at 100 percent.
What makes Uber such a useful app to millions of people around the world is its unparalleled convenience. Without its dynamic pricing mechanism, drivers who would be willing to drive if higher pay were offered won’t work, and riders who would be willing to pay higher prices won’t get a ride. Instead of allocating the limited supply of drivers to the customers who value the service the most, completed rides would be reduced to whoever randomly presses the button at the right time.
Uber acts as an intermediary between drivers, who are considered private contractors, and its customers, the riders. Both the supply and demand sides of this marketplace are highly elastic, meaning they quickly respond to price. This allows the marketplace to sort out the preferences of supply and demand in a remarkably efficient way through price signals that lead to the best outcomes overall.
Because Uber is just an intermediary, it does not have a fixed amount of supply in the same way that a hotel or traditional taxi company does. Drivers only work when the necessary market signals are in place. There probably wouldn’t be many Ubers on the road on New Year’s Eve if the fare were the normal rate and drivers had the option of being with friends and family.
Transparency in the Driver’s Seat
It is important to note that Uber does not mislead or deceive its customers. When surge pricing comes on, a surge icon appears clearly next to each product. The customer must type in the surge amount, and riders can even use a fare estimate to see how much their fare will total with surge pricing.
If the dynamic pricing mechanism weren’t so transparent, then the argument could be made that it is an unfair practice. That isn’t the reality, though, and evidence now shows how surge pricing is essential to Uber’s business because it allows the customers who value a ride the most to have convenient access to it.
Even if you still think surge pricing is just a way for Uber’s owners to squeeze out every last bit of profit, at least recognize that the only other realistic option for Uber’s customers is a “No Cars Available” screen.
Dynamic pricing is expected and welcomed in other industries, including airlines, hotels, and online marketplaces such as StubHub. With time and awareness, Uber’s dynamic pricing mechanism will be appreciated in the same way.