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How Uber Leverages Supply and Demand in Their Pricing Model

April 28, 2017

Come New Year’s Eve (or any major event or holiday that ensures lots and lots of people need transportation), Uber users flock to social media to complain about the insane surge pricing practices of the company.

Immediate responses to their aggravations revolve around the fact that Uber clearly tells users that surge pricing is in effect and it is the user’s choice to accept or deny that increased price.

Uber's Supply and Demand Pricing Model

Economists like to look at Uber as the embodiment of a functioning supply-and-demand economy.

Back in 2014, David Sacks, CEO and founder of Yammer, former CEO of Zenefits and current member of the PayPal Mafia, tweeted his napkin sketch of Uber’s network effect:

A network effect is the phenomenon in which a product or service gains more value the more people use it. A network effect is only as good as the levels of participations from both sides of the supply chain: the product or service and the people who use that product or service. And if Uber’s surge pricing system is any indication, the network effect is alive and thriving.

The Supply-and-Demand Strategy

Supply and demand is the concept that the demand of something depends largely on how much of it is available. Let’s look at the iPhone 7 as an example of the “thing.” The number of iPhone 7s that Apple manufactures makes up the supply. The number of consumers who are upgrading from the iPhone 6s or another phone makes up the demand. The market price of an iPhone 7 is a compromise of how much a consumer will pay to have the phone. Therefore, when demand of an iPhone 7 skyrockets—say, during Black Friday or a with the release of iPhone 7 (PRODUCT)RED™ Special Edition — supply can’t keep up. Accordingly, price is the first thing to reflect that unequal relationship.

But we’re talking about Uber here. Uber’s surge pricing, specifically, which leverages the concept of supply and demand. As Uber simply explains it: “When demand for rides outstrips the supply of cars, surge pricing kicks in, increasing the price. You’ll automatically see a 'surge' icon …. If you still want a ride, Uber shows the surge multiplier and then asks for your consent to that higher price. Surge pricing has two effects: people who can wait for a ride often decide to wait until the price falls; and drivers who are nearby go to that neighborhood to get the higher fares. As a result, the number of people wanting a ride and the number of available drivers come closer together, bringing wait times back down.

To summarize, Uber’s intent is to maximize the number of rides and drivers it can provide regardless of any manufactured or natural event that might hinder traditional forms of transportation from satisfying customers. Arbitrary price increase isn’t Uber’s endgame; it applies its calibrated model to respond to times and areas of high demand. Ideally, Uber’s surge equalizes supply and demand by re-allocating cars to those areas, ensuring that surge goes down because of the influx of drivers.

While Uber’s surge pricing algorithm is kept under wraps, many researchers and developers have tried their hand at reverse engineering it. They discovered that the Uber “system is responsive—surge prices seemed to be recalculated every five minutes.” What the public does know is that Uber’s supply-and-demand strategy is incredibly similar to the fluctuating price model in the price of flight tickets or hotel rooms during peak times.

However, the interesting part of Uber’s surge pricing is that the strategy combines with big data software to consistently provide users with the instant gratification aspect of the ride-hailing app that is so appealing.

Find the best Big Data software on the market →

There’s a reason why it’s become an industry stereotype to describe the Next Big Thing as “the Uber of…[fill in the blank],” particularly when an entrepreneur is creating a platform or marketplace for an on-demand service. It’s too easy to sell an idea of a new product or service by emphasizing its ability to automate or make easier an all-too mundane or uninteresting part of life. (This led to the short life spans of on-demand laundry and on-demand housekeeping services.)

Why Surge Pricing Still Exists

In May of 2016, NPR reported that Uber would kill off its surge pricing system. Turns out, that’s not true. True, Uber experimented with “dynamic pricing,” which was essentially the same as surge pricing but with another name slapped onto it, and then “upfront pricing,” which did away with the giant notification to accept or deny surge pricing. However, surge pricing still exists because supply and demand still exists. Some states and countries are going so far as to ban the existence of Uber in their cities, but Uber has changed the on-demand, shared economy game.

The company knows that its customers will continue to use its app, despite bad press and minor frustrations with inconveniences like surge pricing or UberPOOL. Both the drivers and riders are used to the ease and convenience of the ride-hailing app, and Uber knows that. Additionally, Uber’s freelance drivers are the most important element of the service. Sure, Uber may be experimenting with driverless cars, but until it finds a way to make driverless cars safe, reliable and, most importantly, affordable, it relies on the drivers. Drivers are compelled to stay for the long haul and wait to clock out after peak hours because the benefits received from surge pricing makes it worth their while.

The Future of Ride-Hailing Apps

In an effort to compete with Uber, other on-demand ride-hailing apps emphasize their no surge pricing as a selling point. Even taxis have begun to congregate around apps that promise to mimic Uber’s convenience of calling a car to your location as well as allowing payment for the ride via mobile device. Lyft has launched Lyft Line, an on-demand transportation service that combines the promise of upfront, fixed pricing with the familiarity of a carpool and the ease of a public bus.  

The future of ride-hailing apps is a bit unclear. For one thing, the animosity between taxi drivers and apps like Uber or Lyft won’t be dying anytime soon. Apps like Curb seem to be too-little, too-late measures. Additionally, Uber’s current tense climate only steers users towards a variety of other ride-hailing apps, which continues to take business away from more rigidly-regulated taxis.

We live in a world where our desire for instant gratification continually becomes gratified. You want your banh mi sandwiches delivered to you at the speed of Uber? There’s an UberEATS or delivery cyclist for that. You want your Amazon package delivered in 24 hours or less? There’s a drone for that. You want the newest Blu-ray DVD? There’s an earlier digital copy release for that. Why would mobile-savvy users revert back to pre-Uber days and rely on waving down regulated taxis to get them from place to place?

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