abovethecrowd.

com

A Deeper Look at Ubers Dynamic

Pricing Model
by Bill Gurley March 11, 2014 9 min read original

March 11, 2014:

Over the course of the past year, many writers have
offered their perspectives on Ubers dynamic
pricing strategy. Perhaps the only consistency is
that people have deeply passionate views on this
topic. However, there are still many misperceptions
about how the model works, and the purpose of this
post is to clarify some of those misperceptions.
I am an Uber investor and board member, and therefore expect that
many will dismiss these thoughts as naked bias. But consider that as a
result of my role I have access to more information that might enable a
deeper perspective. I also have quite a bit on the line, and as a result
have spent a great deal of time contemplating the policy as well as the
potential alternatives.

Clarifying Certain Specifics Regarding Uber

Before diving into Ubers dynamic pricing model, it is important to
clarify some of the key elements of how Uber is structured and operates.

1) Uber is a marketplace and Ubers drivers are all independent agents.

Ubers drivers are independent agents that are either self-employed, or
work for someone who owns multiple cars. Uber does not own cars and
does not employ drivers. Each day, and each hour for that matter, these
drivers decide whether or not to open the Uber application and accept
requests for rides from Uber customers. These drivers are not bound by
exclusivity. Many of them work on multiple services, and many have
regular customers that they engage off the Uber platform.
2) The majority of Uber fares go to these independent drivers. On
average, over 80% of gross fares end up in the hands of drivers. Whats
more, of the percentage that is retained by Uber, a large portion goes to
cover variable expenses within the service. These expenses include
payment processing, payment fraud, refunds, customer service, dispute
resolution, cellular handsets and service fees for the drivers, and local
regulatory efforts. The bottom line is that this is a low margin business
much more akin to Amazon than Google.
3) Uber is a committed to being a low-price leader. Some have suggested
Uber is a luxury brand. This confusion is understandable, as Ubers
initial focus was on traditional black-car services. However, since its
launch of the low-priced uberX brand over 18 months ago, Uber has been
laser-focused on leading at all price points. This goal is to expose Ubers
amazing customer experience to a much broader base. UberX is now the
companys most strategic and fastest growing offering, and has become
the companys largest offering in many cities passing Uber black in
number of daily rides. The company has also intentionally worked to
lower price on uberX as often as it can (in some markets it has already
lowered price four times). Despite this, some competitors still hold on to
the convenient delusion that Uber is solely a high-end service, perhaps
akin to CDNow assuming Amazon was only a bookstore.

4) Ubers dynamic pricing (surge pricing) affects a tiny minority of all

Uber rides, less than 10% of trips. Dynamic pricing is most common on
peak times on Friday and Saturday nights, on certain Holidays, such as
Halloween and New Years Eve, and during particularly big events and
bad weather conditions. All told, its a fraction of the time that Uber
drivers are operating. The vast majority of the time, Ubers increasingly
low basic rates (uberX is often 40% cheaper than the local taxi
alternative) are the primary price points for the service.
5) Uber is remarkably transparent about its dynamic rates. Ever since
the company first encountered feedback about its pricing model, the
company has gone out of its way to make sure that customers are aware
of the policy and how it works. They have inserted special splash
screens where the customer has to key in a specific confirmation of the
increased rate. Additionally, the company has gone out of its way to

publicize how and why the program works. This past New Years Eve, the
CEO even published a how-to video encouraging riders NOT to ride at
certain times.

The Origins of Ubers Dynamic Pricing

So why does Ubers dynamic pricing even exist? The answer lies in
understanding that Uber is fundamentally a marketplace, where supply
is controlled not by the company but by the legion of independent
contractors and transportation providers with whom they work.
Back in early 2012, Ubers Boston team noticed a problem. On Friday and
Saturday nights, around 1am, the company was experiencing a spike in
unfulfilled requests. The root cause was that drivers were clocking off
the system to go home, just before the weekend partygoers were ready to
venture home themselves. There was a supply-demand imbalance, and
the result was a lot of very unhappy customers. So the Boston team had
an idea. What if they offered the drivers a higher price to stay on the
system longer (until around 3AM)? Would more take home dollars for
drivers increase supply? In just two weeks they had a resounding
answer. By offering more money to drivers, they were able to increase
on-the-road supply of drivers by 70-80%, and more importantly
eliminate two-thirds of the unfulfilled requests. The supply curve was
highly elastic. Drivers were indeed motivated by price.
Based on the results from the Boston experiment, Uber implemented its
dynamic pricing policy to be used solely when demand is materially
outstripping supply. Dynamic pricing changes are driven
algorithmically when wait times are increasing dramatically, and
unfulfilled requests start to rise. In essence, there are two functions of
the increased price model. One is to increase supply. The second
function of the price increase is to temporarily intentionally reduce

demand. Through these two mechanisms, the company is able to (a)

increase supply, (b) assure reliability, a key tenet of the company, and (c)
maximize the number of completed rides.

Economics 101: Supply and Demand Curves

If you were to pick up a copy of any introductory economics textbook, in
either the first or second chapter you will find a description of the
supply-demand curve. It is the key operating model for economic
analysis, and is as fundamental to economics as DNA is to biology. If you
have never been exposed to these topics, I highly suggest Khan
Academys Microeconomics courses. As one might expect, the demand
and supply curves are the first two sections.

There are a few things to note about Ubers marketplace and the supplydemand curve. First, Ubers analysis and research has shown that both
the supply curve and the demand curve are highly elastic. The Boston

experiment, and every effort since then, confirms that higher prices
increase supply, all things being equal. This is true in every market the
company has entered.
On the demand side, the company has confirmed price-elasticity in two
different areas. First, when prices surge, they see an immediate
reduction in open-to-order ratios. As expected, higher prices do indeed
reduce demand. Moreover, as mentioned in this video interview with
Ubers CEO Travis Kalanick, the converse is also true. Ubers numerous
price decreases have all resulted in materially increased demand.
Basically, Ubers marketplace is highly efficient, and operates in the
exact way that your economics professor would expect. When you
consider that both sides of the model Ubers riders and drivers are
both large groups of fragmented independent agents, this is no surprise.
The market should operate efficiently.
Using the supply and demand curve as a model, Ubers dynamic pricing
model is rather straightforward. When demand outstrips supply,
dynamic pricing algorithms increase prices to help the market reach
equilibrium. Of course, these situations are always temporary,
eventually supply outstrips demand, and the price falls back to normal.
If demand were to spike with no resulting price increase, you would
have what is known as an economic shortage. Without a price increase,
Ubers unfulfilled rate would skyrocket, and most customers would be
left without a ride. With dynamic pricing however, the variable Q on the
graph is further to the right than it would be without. More absolute
rides are fulfilled precisely because supply increases.

Comparing Uber to Hotels, Airlines, & Rental Car Companies

Many of the articles about Ubers pricing model have noted that airlines,
hotels, and rental car companies frequently use dynamic pricing, and
typically at ratios (10X differentials in these industries are common)

that are very similar to Ubers highest peaks on New Years Eve. For a
hotelier, the demand for a room on New Years Eve is dramatically
higher than a random weekday two weeks later. With no ability to
increase supply, they are left with the alternative of selling to the
highest payer. This is a relatively well-understood and accepted
practice. No one appears even the least bit emotional about it, as it is
well understood and expected.
There is, however, one key difference that materially increases the need
for dynamic pricing in Ubers case. With hotels, airplanes, and rental
cars, supply is relatively fixed. One cannot build more rooms for New
Years Eve, and then take them down. Uber has a problem these
companies do not. At the exact time that riders want more availability
Friday and Saturday night, in a bad storm, on New Years Eve drivers
would rather not be driving. You see, while hotel rooms are fixed, Ubers
supply actually shrinks at these times, because the drivers would prefer
not to be working at those times either. The exact events that increase
demand for needing a driver also cause supply to shrink. In these cases
the supply curve is moving left at the exact same time that the demand
curve is moving right. As a result the need for a price catalyst to increase
supply in the Uber case is vital.
Another factor that impacts driver supply is substitute opportunities.
Drivers have lucrative alternative opportunities on event nights like
New Years Eve. Some party-goers are willing to book a single captive
driver for a flat rate which could be well over $1000 for the night. And in
this case, the driver enjoys quite a bit of downtime.

The Only Real Alternative No Cars Available

Some have argued that they understand the economic underpinnings of
Ubers dynamic pricing, but they suggest that the PR hit is so great
that the company should reconsider its policy. This single-step analysis

fails to consider the real alternative to dynamic pricing tons and tons
of unsatisfied customers complaining about a lack of
availability/reliability (two of the key tenets of the Uber customer
proposition).
The bottom line is that the only real alternative to
dynamic pricing is a ton of customers staring at
screens that read No Cars Available. This is the
fact that is least appreciated by Ubers critics.
Remember the PR hit that UPS took this Christmas
when they could not deliver packages as customers
expected? The idea that Uber could make its network available in a
normal state and at a normal price while demand is increasing and
supply is shrinking is quite simply unfeasible. And the argument that
Uber should keep prices flat in moments of peak demand is a de facto
argument that Uber should be comfortable stranding the majority of its
customers with the disappointing message: No Cars Available.
If this sounds to you like an apology for the price increases, try the
following experiment: the next time you see a message indicating that
Ubers surge pricing is in effect: immediately try an alternative other
than Uber. In other words, try to hail a cab, call a traditional black car
service, find a rental car, or jump on a bus or subway. You will find that
availability and reliability for all forms of transportation are under
stress at that same precise moment in time. At these times, a fixed price
taxi will be highly unavailable, and a fixed price subway will be
remarkably over-crowded. Relative to those choices, Uber prefers to be
reliable and available for the maximum number of customers it can
serve, and believes that the customer dissatisfaction from being
unavailable would be way worse than the limited customer
dissatisfaction with their dynamic pricing model.

Drivers Are People Too

Another point to keep in perspective is that the operator of each and
every car on the Uber service is a human just like all of the passengers.
Why should we expect that individual to be excited about working
precisely when we want to be out of the town? Do you enjoy working on
Friday and Saturday night? What about Holidays? What about New
Years Eve? Nurses and doctors routinely receive 2-3X overtime pay for
work at those times; is there a reason that a driver should not? What
about during really bad storms? Should the independent driver be more
concerned about your needs, or those of their own family and friends?
This is not a plea for you to be overly empathetic for the independent
drivers on Ubers system, but rather simply asking you to consider the
basic human reasons why they may chose not to drive at the exact same
time that you are most interested in not driving. Is it unreasonable to
expect higher fares if they are sacrificing their own time at the least
convenient moment?

Understanding Will Improve With Time

Uber is indeed sensitive to the perspective that some customers have
about dynamic pricing, and this is precisely why they work so hard to
message awareness to their consumers. Just last week, the company
announced a new feature called Surge Drop that will notify the customer
when surge prices have fallen, enabling someone to wait until the supply
and demand are more in balance, and avoid the higher fees.
As many have noted, dynamic pricing policies are well understood in
hotels, airlines, and rental cars. This awareness makes the changes
expected and less surprising. Increased awareness will help to reduce
the element of surprise that some customers may encounter. It will also
cause certain customers to steer clear of time windows when prices are

higher, and when they would then prefer not to transact. Basically, as
more people understand the model, they will become more comfortable
with what to expect, and can make informed choices.

Fundamentally, most critics of Ubers pricing model fail to recognize

that Uber is a true marketplace. The majority of leading Internet
marketplace companies use dynamic pricing as a solution when
confronted with a scarcity of supply. This was the fundamental premise
behind Ebays original auction model. It is also exactly how things work
on StubHub (ebays ticketing engine), as well as Airbnb and Homeaway.
Additionally, it is the key pricing algorithm behind Googles core
Adwords offering a service that has over one million customers, and
takes in close to $50 billion in revenue. Its usage is tried and true which
is partially why Ubers CEO has confidence that its the right model here

as well. Uber has no intention of abandoning dynamic pricing precisely

because it is in the consumers best interest, especially when one
understands the true alternatives.

Original URL:
http://abovethecrowd.com/2014/03/11/a-deeper-look-at-ubers-dynamic-pricing-model/