Surge Pricing: The importance of focusing on the supply side

The Delhi Government, Karnataka Government, and even the Union Transport Ministry in India has been sieged with this issue of surge pricing by taxi aggregators. While there has been a lot written about surge pricing (see my earlier post, more than a month back), a lot of what I read is incomplete, misleading, and sometimes even biased. Here is adding to the debate, by clarifying what surge pricing and how it differs from other models of price setting. And I draw policy implications for dealing with the phenomenon by focusing on the supply side, rather than focus on just the price.

What is surge pricing?

Surge pricing is an economic incentive provided to the suppliers of goods and services to enhance the supply of products/ services available in times of higher demand in the market by (a) incentivising those suppliers who provide them, (b) ensuring that these suppliers do not go off the market in such times, and (c) rationalise demand through fulfilling only price inelastic demand. As a driver in a taxi aggregator system, it makes economic sense for the driver not to take his breaks during the peak demand times, and ensuring that only those riders who desperately need the service, and are price inelastic avail the service. A price sensitive customer should ideally move off the aggregator to a road-side hailing service (if available, as in Mumbai) or simply take public transport.

Who is a typical surge pricing customer?

A recent study talked about riders being more willing to accept surge pricing when their phone batteries are about to die, and they need to conserve the same (read here) before they reach home. A city with good public transportation infrastructure that is designed for peak hour loads should ideally witness the least surge pricing (please don’t ask me about Bangalore, or should I say Bengaluru?). In most Indian cities, the typical cab aggregator rider is someone who is a regular user of cabs and autorikshaws (three wheel vehicles) to commute short and medium distances. Typically either the origin or destination of the ride is in the city centre or a high-traffic area (like a train station or airport). It is when the public transportation infrastructure fails that these riders are forced to use cabs for their regular (predictable) transport needs.

Let us take an example of an entrepreneur (call her Lakshmi, named after the Hindu Goddess of Wealth) whose work place is in the city centre and she commutes about 15km every day. She should ideally use public transport, or if her route is not well connected she should have her own SUV or a sedan (remember her name!). She would possibly have a driver if her work involves driving around the city to meet customers/ partners, or her daily work start and close time are not predictable. The only time she would use a cab aggregator is when she is riding to places with poor parking infrastructure, for leisure, or say a place of worship. She is price inelastic.

Take another example of a front office executive at a hotel. Let us call him Shravan. His work times are predictable, he works on a fixed remuneration, and is most likely struggling to make ends meet. He is most often taking public transport to work, or self-driving his own budget car/ 2-wheeler. He would only take a cab aggregator for his leisure trips with his young family during the weekends; and when the entire weekend out with family is an experience in itself, he is unlikely to be price sensitive to a limit. However, when surge pricing kicks in beyond a limit, he would baulk out of the market, and take public transport or other options.

As a policy maker, the demand side (riders’) welfare should be higher on priority than that of the supply side (drivers and aggregators). The demand side is large in numbers, is fragmented, and has very few options (especially in times of high demand). Price ceilings are justified when riders who are desperate to reach are price elastic. In other words, those who need the safety, security and comfort of the taxi services cannot afford it. Like the sick desperate to reach a hospital or children reaching school/ back home on time. These are segments best served by other modes of transport, rather than taxi aggregators – the Governments of the day should invest in and/ or ensure availability of good quality healthcare transport services (ambulances) and public/ private school related transport infrastructure.

Surge pricing is dynamic pricing

Dynamic pricing is not new to the Indian economy. Almost the entire informal economy or the unorganized sector works with dynamic pricing. What the rate per hour of plumbing work in your city? Depending on the criticality of the issue, the ability of the customer to pay (as defined by the location/ quality of construction and fixtures), and the availability of plumbers, the price varies. So is the case with domestic helps, and every other service provided by the informal sector. Why even professional service firms like lawyers and accountants use dynamic pricing based on ability to pay and criticality of the issue.

What surge pricing by taxi aggregators do is to take the entire control of dynamic pricing out of the suppliers’ hands and places it with the platform. The drivers may be beneficiaries of the surge price, but they do not determine the time as well as the multiple. Plus, given that the surge price is announced at the time of cab booking, the riders have a choice to wait, change the class of service (micro, sedans, or luxury cars in the system), choose an alternative aggregator, or choose another mode of transport. A fallout of the transparency and choice argument is that the “bargaining” for price is done before the service provision, and not after the ride. This transparency and choice empowers the riders, and as long as the multiple is “reasonable”, we could trust the riders with rational economic decisions. What is reasonable may vary across riders and the criticality of the context. While Lakshmi may be willing to pay a 4x multiple on her way back from work at 9pm in Hyderabad, Shravan may only a 4x multiple at 9pm when he has to reach the hospital on time to visit his ailing mother.

Data is king

The amount of data collected by the cab companies about individual behaviour and choices can enable the aggregator design appropriate pricing structures, customised to each customer, a segment of one. For instance, Uber can run micro-experiments with surge pricing and tease Shravan with different multiples at different points of time/ origin-destination combinations, and learn about Shravan’s willingness to pay, far more than what he can articulate it himself. Powered with the data, Uber should be able to define something like ‘Shravan will accept a surge price of at most 2.2x, as he is trying to return home from his workplace at 10.30pm on a Friday evening.’ Over long periods of time and large number of transactions, this prediction should mature and get close to accurate.

Given that the aggregator platform would be armed with this data, it is for the policy maker to ensure that such data is not abused to further its own gains. How does policy ensure this? By capping the multiple through a policy decree, no! Rather ensuring a market mechanism that caps the surge pricing multiple would generate significant welfare to all the parties. In order to ensure a market mechanism that makes profiteering out of surge pricing unviable, the Governments must focus on developing robust public transportation infrastructure. As attributed to a variety of leaders on the Internet/ social media, ‘a rich economy is where the rich use public transport’. These investments would provide significant alternatives to attack supply shortages in the market, and make them more efficient. This supply side intervention would do the market a lot of sustainable good, by ensuring that the Shravans of the city need not use the taxi aggregators more frequently, and thereby increasing the price inelasticity.

Policy recommendation

In conclusion, the entire analysis of the demand-supply situation leads me to recommend one simple thing to the policy makers – focus on the supply side. Get more and more public transport (greener the better) on the road; provide better and efficient alternatives to all segments; and in the short run, just ensure that there are enough ‘vehicles available for hire’ on the road.

Comments welcome.

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Author: Srinivasan R

Professor of Corporate Strategy at the Indian Institute of Management Bangalore. All views are personal. The views and opinions expressed here are of the author, and not those of the Indian Institute of Management Bangalore; and are not intended to endorse, harm, malign, or defame any individual, group, or organisation.

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