Frustrated by Surge Pricing? Here’s How It Benefits You in the Long Run

surge-pricing

Uber, Lyft and Airbnb are popular examples of businesses that are part of the new, techno-driven sharing economy that makes participating as simple as a tap on a smartphone. Consumers are drawn to the variety of products, ease of access and conventionally lower pricing offered in a shared-economy platform, while providers get an unconventional way to make money by using what they already possess — whether it’s a car, a spare bedroom or a couple of hours of time.

But these platforms have experienced a backlash recently for what is called surge pricing. When demand is higher, prices go up. Ruben Lobel, a professor of operations, information and decisions at Wharton, and Wharton Ph.D. Kaitlin Daniels, took a deeper dive into the topic of surge pricing and came up with some surprising results. In the paper, “The Role of Surge Pricing on a Service Platform with Self-Scheduling Capacity,” which was co-authored with Wharton operations, information and decisions professor Gerard Cachon, they found surge pricing is beneficial to consumers because it helps subsidize prices during off-peak times. Their research is important because it provides substantive data that can help leaders make better decisions about whether these platforms should be better regulated or even banned.

Lobel and Daniels recently discussed the research on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM Channel 111. An edited transcript of the conversation appears below.

Price Gouging? Or Good Business?

Ruben Lobel: Two years ago, we were thinking about why is there surge pricing, how is it affecting the market, how is that affecting providers, how is it affecting consumers? We were working on a previous project on electricity, and it kind of had a similar flavor about how a company can dispatch different customers to provide service. The sharing economy is another good application of how a company can centralize a network of providers to provide service. Now, the most distinctive feature of this market is surge pricing. It’s attracted a lot of attention with a lot of consumers who have complained that they’ve been price gouged. We’ve tried to investigate if that’s really the case. That’s where we started from.

Kaitlin Daniels: We can show that surge pricing is a good mechanism for coordinating this decentralized system. A key feature of Uber is that drivers get to decide for themselves when and how much they work. This is very different than what we’re used to seeing in a typical employee-employer relationship. Typically, we have a firm that hires workers and assigns them to shifts. The key, at least from Uber’s perspective, is that surge pricing allows Uber to offer incentives for drivers to drive when Uber wants them to. So, surge pricing is a good mechanism for coordinating that behavior in terms of maximizing Uber’s profit.

“Surge pricing allows service to expand to consumers. But also it allows Uber to offer lower prices to consumers in a normal demand setting, such as your average Monday morning, and that’s actually where the consumer benefit comes from.”–Kaitlin Daniels

But we can also show that surge pricing can also benefit consumers in certain cases. Our research uses a benchmark where Uber is required to charge a price that is fixed. We compare consumer outcomes in that setting to consumer outcomes under a surge-pricing model. We find that in markets where consumers are underserved under a fixed price — like having a hard time hailing a cab on a rainy night — those are the markets where consumers benefit from an Uber-like surge-pricing model. Surge pricing allows service to expand to consumers. But also it allows Uber to offer lower prices to consumers in a normal demand setting, such as your average Monday morning Twitter , and that’s actually where the consumer benefit comes from.

Lobel: The main part of the consumer welfare that is created is from the cheaper prices that you get on a regular day, so the high-end prices on New Year’s Eve is in a way subsidizing the cheaper fares that you get on a normal day. We can also tie this to different cities that have different characteristics. One of the key reasons why a city would have a lack of service on a high-demand case would be, for example, that potential drivers have a high opportunity cost to join the network. A city that has very low unemployment or a high cost of living is the type of city that tends to underserve the markets, and those are the ones where surge pricing would most benefit consumers because it’s hard to get potential providers into that network. In a market where unemployment is already pretty high and the potential drivers are plenty, what you see surge pricing doing is mostly extracting more surplus from consumers and giving it to the platform.

The Demographics of a Sharing Economy

Daniels: We’re absolutely interested in thinking of our results as applying more generally to other sharing economy companies that allow workers to decide for themselves when and how much to work. This is a phenomenon that we call self-scheduling, and it’s representative of a lot of companies’ relationships with their workers. The ride-sharing services have certainly gotten the most attention in the media. Postmates [a food delivery service] is another that both allows its workers to self-schedule and also offers dynamic pricing like a surge-pricing policy. There are a lot of sharing economies that are in very different industries that use different pricing policies. Notable examples are Airbnb and TaskRabbit. Unlike a hotel or a typical cleaning service, Airbnb and TaskRabbit members get to decide when and how often they’re going to rent their room or do chores for someone else.

Lobel: This is not exactly what our research is trying to tackle, but what has been observed is that the people who are mostly hurt by the entrance of Uber and Lyft are the people who own [taxi] medallions and see the value of their medallions going down — not necessarily the cab drivers themselves because they could potentially transition into one of these platforms if they don’t own their own medallion.

But what we are trying to do is shed a little bit of light on the effect of surge pricing. If a cab company were allowed to do it, how much value would that bring to the system or would it be damaging to consumers or to providers? That’s exactly what we are trying to tackle. It could be the cab company or it could be the platforms like the sharing economy platforms. That particular aspect has brought a lot of discussion in the policy circles, like should we even ban it? Should we allow this to happen? What we are trying to show is, no, you shouldn’t ban this. This is actually beneficial and a key element to why these platforms add value to the system.

Uber Drivers Unite?

Daniels: There’s a portion of our research where we’re trying to understand from Uber’s perspective whether it is beneficial to allow these drivers the flexibility to set their own schedule. We don’t take into account the benefits that go along with being considered [full-time] employees. But what our research can show is that drivers do, in fact, benefit from having this flexibility of setting their own schedule. Not only that, but this arrangement is profitable for Uber. So, there is a good reason for Uber to consider its drivers independent contractors.

“What we are trying to show is, no, you shouldn’t ban this. This is actually beneficial and a key element to why these platforms add value to the system.”–Ruben Lobel

Lobel: It is also profitable for drivers to be able to set their own schedule. A good chunk of the Uber drivers have part-time jobs and/or preferences for which times they want to work. That’s something that was specifically modeled to try to understand what would happen to the system, both to the provider and to Uber, if Uber were to decide that you’re going to drive on this time and you’re going to drive on that time. That can be very hurtful to both sides. When people talk about potentially unionizing drivers, we don’t have a position on that. What we are afraid of is that it is going to damage the self-scheduling. If Uber becomes a company that employs drivers and can dictate the schedules of its drivers, then that’s going to be worse for both the companies and the drivers.

When Surge Pricing is Beneficial

Daniels: Surge pricing is a benefit any time in which demand is higher than your average day, so this could be a game night, or a night where there is a lot of precipitation or seasonal fluctuations. When it’s cold, more people want rides versus when it’s mild and they might rather walk. Also, Friday nights versus Monday afternoons, there’s going to be more demand. Those are all times in which a surge price could be beneficial.

Lobel: We have to say that the reason why this is beneficial is also because it subsidizes the low-demand cases, the regular days. What you observe happening on the high-demand days is that more consumers who were trying to get a cab, before they couldn’t get a cab, they couldn’t get a service. That’s what we call demand rationing. There’s a probability that they’re going to try to request a ride, and if it was a fixed price they wouldn’t get it. But now that there is surge pricing, if they’re willing to pay, they can get a ride with a 100% chance. The fact that you take away this rationing, this randomization, and you just allocate the service to the people who need it the most, is how you get to maintain that consumer surplus, the consumer welfare.

A Model of Success

Daniels: I definitely think that self-scheduling is an appealing thing. I’m an academic, and part of what I like about that is that I have flexibility in my work hours, so I can certainly see the value. I think that there are a lot of ways and industries in which this could be expanded to apply to. One kind of buzzy thing that I’ve heard is the “Uber-ization” of health care, bringing doctors to patients or allowing some sort of self-scheduling around the provision of health care. I think that would be a big thing if people could figure out how to do it.

Uber’s Advantage

Daniels: Consumers get to review their drivers and vice versa via Uber, which is not an aspect that we see in the taxi industry. I understand that Uber has pretty stringent restrictions on the average ratings that Uber drivers can have. If the rating falls too low, they get kicked out of the pool. So that might have something to do with it.

Lobel: I think that there are two elements to why Uber is doing so well. One aspect is the technology. It’s the fact that you can click on your phone and get the cab there and you see where your cab is moving. A lot of millennials are attracted to the fact that they are clicking and don’t have to hail a cab on the street. But cabs can do that, too. There’s Easy Taxi, for example, that does that with taxis. So, that aspect of the technology is not really the competitive advantage. That’s not what’s going to move this type of economy forward. What’s really driving this type of business model forward is the self-scheduling nature of the providers and the ability to surge the prices when demand is high. These are the elements that really differentiate it from the traditional business model of the cab companies.

Daniels: I don’t know if you’ve come across this, but there are even a couple of competitors that explicitly advertise that they do not surge in response to this consumer dislike of surge pricing. And these companies have even taken to subsidizing consumers that have been victims of surge pricing who switch to their service.

“What’s really driving this type of business model forward is the self-scheduling nature of the providers and the ability to surge the prices when demand is high. These are the elements that really differentiate it from the traditional business model of the cab companies.”–Ruben Lobel

Millennials Drive the Market’s Growth

Daniels: If millennials are sufficiently comfortable with using Uber instead of owning a car and driving themselves, then I think there could be vast expansion in the industry as a result of the attraction to this business model.

Lobel: If you just look at prices here in Philadelphia, if you try to go from the University of Pennsylvania campus to Rittenhouse Square, it’s a $7 to $8 cab ride. It’s $5 on Uber, so that price is subsidized by the surge. If you try to do the same ride on Friday night, it will be more expensive to do it on Uber, twice the price of the cab. I’m just guessing these numbers here, but this is the point we’re trying to show.

Daniels: I think that part of the hurdle is that consumers use the baseline price as a reference. So to them, prices rise. This is something that we actually talked to the folks at Uber about, but they explicitly chose to call pricing surge pricing even though they anticipated that consumers wouldn’t respond particularly well to this strategy. But the idea being that surge should stand out to drivers as an increase in their wage, and so it attracts drivers to drive when demand is high. We’ve gotten used to this kind of dynamic pricing in other industries, like airlines, for example. Personally, I think it’s just a matter of time and consumers will get used to this, too.

Lobel: One thing we specifically don’t model is this behavioral response of consumers. Lyft, for example, puts a cap on twice of the surge, so they try to pander to this behavior of adverse effect on consumers that get pissed off at the surge and will stop being a customer altogether. There is a potential for losing customers when you’re doing the surge. But like Kaitlin said, as people get more used to it, get more familiar with it and they see over the long run they’re actually benefiting by relying on a surge-pricing service, the behavioral effect can get maybe smaller. That’s something that these companies are actively researching, trying to understand what are the behavioral responses and trying to improve.

For example, when Uber first started surging they just hit you with a surge and people got really pissed off. Now, they put verifications and if your surge is more than two, they make you retype the number of the surge so that makes sure that you really read it correctly and you’re not just drunk and clicking that surge-pricing button.

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