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Business News/ Mint-lounge / Mint-on-sunday/  Surge pricing and the battle for our future
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Surge pricing and the battle for our future

If Uber wins the battle of perceptions on its pricing model, it will open the doors for similar market-clearing mechanisms in other sectors

Photo: ReutersPremium
Photo: Reuters

The recent clampdown on surge pricing by the Delhi and Karnataka governments has ignited an intense debate on the model’s pros and cons and efforts to curb it. Surge pricing refers to the extra charge that kicks in during peak hours in areas when demand for cabs spikes sharply.

Delhi chief minister Arvind Kejriwal has gone so far as to claim that surge pricing is nothing but “daylight robbery", while the spokespersons of cab aggregators such as Uber have claimed that it is just a market-clearing mechanism to ensure cabs are available for their customers who value them most at a particular point of time (and are willing to bear the extra cost).

The debate has already polarized opinion in the country, but it is important to understand why it evokes such intense passions in cities as diverse as Sydney, Paris, New York and New Delhi.

Uber has not just annoyed its rivals in the transport industry (such as auto and taxi unions) who quite understandably want to see a regulatory clampdown on cab aggregators, but also its own customer base. New Delhi is not the first city where customers have expressed outrage over surge pricing, and it is unlikely to be the last.

Many customers who accept surge pricing when they are faced with that option end up bitching about the firm, often on social media. The reaction is even more severe when there is an emergency, such as during the December 2014 hostage crisis in Sydney, where a masked gunman held people captive in a café.

As the central business district was evacuated by the police, surge pricing automatically kicked in. Customers were appalled by Uber’s seeming insensitivity to the situation, and the outrage forced it to suspend surge pricing and instead offer free rides.

According to several economists, such outrage springs from ignorance: many customers are simply not aware of the logic of markets, and get upset when prices surge, forgetting that they benefit from a lower waiting time because of this feature.

In a 2015 research paper, economist Steven Suranovic of the George Washington University writes that “public misunderstanding" of surge pricing rather than surge pricing itself acted as a market imperfection. Suranovic contends that surge pricing is even more essential during emergencies since it can prevent panic buying, hoarding and time wasted when supplies run out and prices don’t rise.

For instance, snowstorm warnings are known to empty shelves of milk, eggs and bread in US towns where snowfalls are irregular even when it is known that the storm’s effects may last no more than a day or two, he points out.

“... Higher prices in emergencies seem especially egregious because the people who must pay the higher prices to the profiteering merchants are already suffering from the negative impacts of the emergency," writes Suranovic. “It seems that the market adds insult to injury. In fact, though, something very different happens. In these situations, the higher prices actually serve the people in the market by sending the appropriate signal of sudden scarcity. That signal forces consumers to self-assess whether their own need for the good is as high as the current price and inspires alternative suppliers in other regions to move products into the area. These responses are what help everyone by allocating the available supplies fairly from greatest to lowest need and by reducing the scarcity with new supplies. Thus, while it may seem as though people are being injured even more with the high prices, it is keeping prices low that will increase the distress of the people in need."

Fearing public condemnation and regulatory action (many states in the US have anti-price gouging laws), retailers and other companies avoid raising prices even when they anticipate that supplies will run short. But this leads to inefficiencies, Suranovic says.

In such instances, the ability to access such goods is a matter of luck, and many people are penalized for not being able to reach stores in time. Suranovic argues that companies such as Uber can help educate the public by demonstrating to them and explaining through public relations campaigns how price increases can ameliorate market shortages more effectively.

To address the growing criticism against its surge pricing model, Uber commissioned a study last year to help analyse and explain its impact. The study, conducted jointly by two Uber-affiliated researchers and an assistant professor at the University of Chicago, used proprietary data to show how surge pricing helped in clearing markets and reducing waiting times by both encouraging suppliers (drivers) who were enticed by the higher charges, and limiting demand (from riders) by signalling that a ride in that area at that point would be costly.

In the example they analysed, surge pricing was operational for just a few minutes before normal fares were restored. Contrasting this example with another night when demand for cabs spiked but surge pricing was not in effect (owing to technical problems), the authors of the study point out that in the latter case, waiting times were long and several demanders (or riders) were left without cabs. The absence of surge pricing was economically inefficient, the study concluded.

According to independent research by Nicholas Diakopoulos, an assistant professor at the College of Journalism, University of Maryland, surge pricing may be actually reallocating the supply of cabs or drivers rather than raising them.

Using data available from Uber’s website for a duration of four weeks, Diakopoulos showed that when surge prices kicked in at a certain locality, waiting times did fall subsequently in that area, but waiting time in a neighbouring locality went up, presumably because drivers from that area moved to the former area.

In response to Diakopoulos’s analysis, an Uber spokesperson claimed that an analysis of such “a small, short-term sample of data cannot capture long-term patterns".

Diakopoulos contended that surge pricing may not always have the intended effect on supply (or drivers), especially if the surge lasted only a few minutes, and ended even before drivers could reach their destinations.

Uber claims that surge pricing has a long-term educative effect on drivers, signalling to them when and in which areas demand is likely to surge. Such a view fits in with what the company believes is its central function in the transport business: to add and manage liquidity.

As this interesting article in The Guardian about Uber’s conquest of London points out, the firm’s innovation lies in bringing liquidity to the transport management industry. Liquidity is typically associated with stock markets rather than the transport industry. But then, Uber is not really a transport company. It is more like an exchange that matches the needs of those using its platform: drivers on one side and riders on the other. Hence, its quest for managing liquidity and its emphasis on surge pricing as a mechanism to do so.

This also explains why the tribe of economists and investment bankers admire Uber and are rooting for the success of its surge pricing model. For them, this is what the future looks like, or at least should look like. One such enthusiast even argued that surge pricing can be applied to price smoothies in the future.

According to most economists, the absence of surge pricing leads to economic inefficiencies: it denies users products and services that they are willing to pay for. When firms fear that raising prices at a time of shortage (or emergency) will invite public condemnation or a regulatory clampdown, they refrain from doing so, and this leads to long waiting times or queues, which in their view is avoidable.

Uber’s customer base is mostly middle class or rich. It is a class that engages in a range of market-based transactions daily and has gained most from the rise of capitalism. It is unlikely that they have no appreciation or understanding of the forces of demand and supply that determine market prices.

They are often quite willing to pay “surge" prices while buying a highly valued share from the stock market or a masterpiece from an art auction. Yet, many among them appear to be unwilling participants in Uber’s experiment to carry the logic of markets to its natural conclusion.

To understand why, we need to perhaps turn our attention to the insights of behavioural economists, who, unlike conventional economists, seem to have more empathy for Uber’s customers than for the company.

One of the pioneers of the field, Richard Thaler of the University of Chicago, argued in his latest book Misbehaving: The Making of Behavioral Economics that temporary spikes in demand, “from blizzards to rock star deaths, are an especially bad time for any business to appear greedy".

Thaler argues that to build long-term relationships with customers, firms must be seen as “fair" and not just efficient, and that this often involves giving up on short-term profits even if customers may be willing to pay more at that point to avail themselves of its product or service.

“I love Uber as a service," writes Thaler. “But if I were their consultant, or a shareholder, I would suggest that they simply cap surges to something like a multiple of three times the usual fare. You might wonder where the number three came from. That is my vague impression of the range of prices that one normally sees for products such as hotel rooms and plane tickets that have prices dependent on supply and demand. Furthermore, these services sell out at the most popular times, meaning that the owners are intentionally setting the prices too low during the peak season.

“I once asked the owner of a ski lodge why he didn’t charge more during the Christmas week holiday, when demand is at a peak and rooms have to be booked nearly a year in advance. At first, he didn’t understand my question. No one had ever asked why the prices are so low during this period when prices are at their highest. But once I explained that I was an economist, he caught on and answered quickly. ‘If you gouge them at Christmas, they won’t come back in March.’ That remains good advice for any business that is interested in building a loyal clientele."

Thaler’s insights are based not just on anecdotes, but spring from a long body of research on these issues. In a landmark 1986 study conducted jointly with his Nobel Prize-winning colleague Daniel Kahneman and Jack Knetsch of Simon Fraser University, Thaler showed that community standards of fairness dictated when and how far companies could raise prices.

Markets often failed to clear in the short term because such notions of fairness prevented companies from raising prices when demand rose, they pointed out. The study was based on interviews that elicited the views of people on several scenarios where a company changed prices or wages. For instance, an overwhelming majority of participants considered it unfair of a hardware store to raise the price of snow shovels when faced with a sudden increase in demand the morning after a snow storm.

In her 2008 book, The Price is Wrong, Sarah Maxwell of Fordham University writes that a “fair" price is one that is seen to be both acceptable and just. In other words, a price is deemed fair not only because it meets one’s personal standards but also because it meets society’s standards.

When a price is seen to be socially unfair or deemed to be in violation of social norms that companies are expected to follow, it leads to an intense emotional response. If the outrage does not force the company to behave in line with acceptable norms, consumers can often go to great lengths to punish such firms.

When Amazon was found to be charging different prices to different customers, it led to an outcry against such price discrimination. The company said it was merely testing its discount strategy and offered to refund all of the customers who paid a higher price.

Even Apple Inc. felt obliged to offer compensation after trying surge pricing in 2007. The first iPhone was sold at $599 for two months, then the price was cut to $399. Steve Jobs had to apologize for charging different customers differently.

“Conventional economic analyses assume as a matter of course that excess demand for a good creates an opportunity for suppliers to raise prices, and that such increases will indeed occur," wrote Kahneman, Knetsch and Thaler in the above-mentioned paper. “The profit-seeking adjustments that clear the market are in this view as natural as water finding its level and as ethically neutral. The lay public does not share this indifference. Community standards of fairness effectively require the firm to absorb an opportunity cost in the presence of excess demand, by charging less than the clearing price or paying more than the clearing wage."

Conventional economists have, of course, taken cognizance of the reluctance of companies to alter wages and prices in many markets, but they have largely considered this to be a “rigidity" that prevents markets from working as they should. What behavioural economists see as a feature of human society, conventional economists view as a bug. They would much rather have a society in which we behave exactly as economics textbooks predict!

Uber’s battle to make surge prices acceptable is, therefore, a test case, as Suranovic points out. If Uber’s model becomes widely accepted, it will open the doors for similar “market-clearing" mechanisms in other industries.

Maybe restaurants will experiment more with dynamic pricing. You may find your favourite pizza priced at Rs300 one day and at Rs3,000 on another.

Maybe theatre tickets will be priced dynamically and instead of just the weekend premium that you are expected to shell out, you will find prices varying for each show depending on whether the demand is high or low for that slot.

Maybe hospitals will begin to adjust charges for surgeries based on demand. Such a world, even if uncertain, will be more economically efficient.

Would you like to live in such an Uberized world, where each market increasingly resembles the stock market? Ultimately, it is us who will decide what the future will be like through our choices of the kind of products and services we consume, and the kind of companies we choose to reward or punish.

If enough of us really want to live in such a society, we will also elect governments that allow such a society to flourish, and not one that acts against price-gouging.

As Kahneman, Knetsch and Thaler noted, social norms of fairness are not entirely immutable: “An initially unfair practice (for example, charging above list price for a popular car model) may spread slowly until it evolves into a new norm—and is no longer unfair."

It is possible though that Uber loses the battle of perceptions and gives up on surge pricing. One recent report suggests that it might do just that. It will then go the way of Amazon and Apple and end up enforcing rather than disrupting prevalent social norms of fairness.

In either case, it will be an exciting battle to watch, and one that holds the key to what future markets will look like.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

Comments are welcome at feedback@livemint.com

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Published: 07 May 2016, 11:26 PM IST
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