This post comes to you from Friedrich Alexander Universitat Erlangen-Nuremberg, where I am visiting for the past one week. I have been teaching a course on Platform Strategies here for the past four years. While in Nuremberg, the question has always been about food, how does a vegetarian, teetotaler survive in Franconia, Bavaria, Germany? To be fair, I have had great vegetarian food here in Nuremberg over the past so many years, and this year has been exceptional – we (my teaching assistant and I) have found great Indian restaurants, that I have had an Indian vegetarian meal for dinner every day of my stay here (except one night of Italian food). Thank you, Nuremberg.
Coming back to food, I was intrigued when I read in the Uber company blog (read it here) that Uber Eats (Uber’s food delivery service) would begin charging customers surge pricing. Much like the way they charge for their ride-hailing services. I began looking for when and how surge pricing can work. I believe it is a function of customer willingness to pay in part, but most importantly, the platform’s ability to scale up and down service levels at will on the other part.
Economics of the surge
A market is made up of demand, supply, pricing and the norms around exchange. For a market to function, the norms of exchange should be fair and acceptable to the transacting parties. Some markets are defined by the actions of intermediaries who set the norms of exchange, like a stock exchange, a municipal council, or a platform like Uber. In most cases, these intermediaries are third parties in the true sense of the word, “third”, meaning independent of the transacting parties. And in a ‘efficient market’, the intermediary sets the boundaries of behaviours of the transacting parties, and let them transact with little or no involvement. However, in platforms like Uber, the intermediary takes a much larger role, say in pricing. It not only decides the prices of the rides (for both riders and drivers), it also uses pricing as a tool to modify demand and supply conditions. Surge pricing is used as a mechanism to increase supply of cars (by motivating more driver partners to join the system at that point of time), and decrease the demand for cars (by getting riders to either postpone their rides to off-peak times or move away from Uber to other modes of transport, like bus or train). There is enough that has been written about surge pricing, including in this very blog, previously.
Surge pricing in food delivery
Alison Griswold wrote in the Quartz online magazine about why surge pricing for food delivery by Uber Eats is a bad idea (read his article here). She definitely writes wonderful stories about the sharing economy. She argues that once Uber Eats introduces surge pricing, customers would shift away from Uber, and move on to other services, may be even Amazon (with its Prime services). Given that food delivery services do not have high multi-homing costs (customers can simultaneously affiliate with multiple service providers at the same time), and some services may cater to special preferences like a specific cuisine, customers might surely switch in terms of choosing their delivery partner, their restaurant choice, or both. But that can be overcome by just simple speed and other aspects of service quality.
However, her main argument is that the economics of surge pricing might work for increasing more delivery partners to join the system in times of peak demand, but might not get the restaurants to produce more food. She avers that increasing the supply of food available for delivery is not the same as increasing the supply of delivery partners. Fair point. But, don’t restaurants anyway plan for increase in food supply during lunch and dinner times? Don’t they build in some buffer of raw material, ingredients, and/ or semi-processed food before they toss them on the stove? Aren’t there some limits to which they can extend?
Where does surge pricing not work?
Surge pricing works in markets where the intermediaries can, at least at the margin, increase the supply of goods and services and/ or decrease the demand for goods and services. In the case of ride-hailing services, surge pricing can shift people away from ride-hailing to use buses/ trains or just walk. Surge pricing works best when there is idle capacity not available to the users – when the driver partners are present but are themselves taking a break (not logged in) and are not available to take rides. Surge pricing motivates these ‘idle’ capacity to join the market, and restores the balance. In summary, surge pricing works when the demand side has ‘substitutes’ and the supply side has ‘excess capacity’.
If either of these conditions are not met, surge pricing might not work. Take an instance when a cricket/ football game or a concert ends in the middle of the night, and there are no public transportation options. Any amount of surge pricing is unlikely to reduce the demand for cars. Or try surge pricing of rail tickets in Indian trains. Any amount of surge pricing is not going to motivate the rail authorities to increase capacity to balance the market (I am not even convinced it should be called surge pricing – it is just differential pricing of different tickets, depending on whether I am the first person booking the seat or the last). In both of these conditions, differential pricing might be grudgingly accepted by the transacting parties, without any impact on the demand-supply mismatches. Take for example, Kayani Bakery in Pune, India, where by noon they are sold out! Surely, no amount of surge pricing is motivating these businessmen to increase supply. In fact, the scarcity increases the demand for these biscuits.
What are the welfare effects of surge pricing?
Scarcity principle tells us that when supply is far less than demand, prices will rise to ensure that supply matches demand. In an ideal world, both supply will increase and demand will fall. However, in contexts where supply is limited or inelastic, it will be demand that has to come down. In the case of essential goods and services (inelastic demand), prices continue to rise to point where only the wealthy could afford it. This is precisely the reason why governments indulge in market intervention mechanisms. For those interested in how commodity prices can bring down governments, read this!
The lesson for platform business firms: engage in surge pricing only when you can work towards increasing supply, or your demand side has (at least imperfect) substitutes.
(c) 2016. Srinivasan R