Dynamic Pricing Is A Market Place Reality

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Dynamic pricing is increasingly going to be the way the world operates. The majority of leading Internet marketplace companies use dynamic pricing as a solution when confronted with a scarcity of supply.

Dynamic Pricing is a Market Place Reality

Image Source: http://blog.airbnb.com/

Uber and Ola may be a good place to start the rejection of surge pricing but it seems difficult to understand whether we are objecting to just Uber and Ola or are we against the concept of dynamic pricing in general?  Because if we are, then it would be unfair for us to stop at the radio cabs and attack other industries like airlines and hotels as well.  After all  if we are vehement about the principle then the principle we must realise applies equally to other industries as well.  And that raises a more philosophical question on how much should we allow to interfere with market dynamics and pricing in a free market based democracy?

After all one could take the stand that consumers resent paying more for their rooms during Diwali and Xmas and New Year when room rents are known to rise to even 10x.  Or that airlines fares are often becoming so unaffordable that people are changing flight times, to accommodate for better prices. 

Dynamic pricing is increasingly going to be the way the world operates. The majority of leading Internet marketplace companies use dynamic pricing as a solution when confronted with a scarcity of supply. This was the fundamental premise behind Ebay’s original auction model. It is also exactly how things work on StubHub (ebay’s ticketing engine), as well as Airbnb.  It is also the key pricing algorithm behind Google’s core Adwords offering. 

So trying to ban Ola and Uber is one thing.  How far we will take the tirade against dynamic pricing is quite another question.

How does Dynamic Pricing really work?

Dynamic pricing, sometimes also called real time pricing, is an approach to setting the cost for a product or service that is  flexible. The goal of dynamic pricing allows a company to sells goods or services over the Internet to adjust prices in real time in response to market demands.

Changes are controlled by pricing bots that gather data and use algorithms to adjust pricing according to demand and supply conditions. Typically, the business rules take into account such things as the customer's location, the time of day, the day of the week, the level of demand and competitors' pricing.  By collecting and analyzing data about a particular customer, a vendor can more accurately predict what price the customer is willing to pay and adjust prices accordingly.

The origins of Surge Pricing

But where did surge pricing  originate for Uber?  'Back in early 2012, Uber’s Boston team noticed a problem. On Friday and Saturday nights, around 1am, the company was experiencing a spike in “unfulfilled requests.” The root cause was that drivers were clocking off the system to go home, just before the weekend partygoers were ready to venture home themselves. There was a supply-demand imbalance, and the result was a lot of very unhappy customers. So the Boston team had an idea. What if they offered the drivers a higher price to stay on the system longer (until around 3AM)?' says Bill Gurly one of the investors in Uber who is also a board member.

Classical Economics

classic economics

The concept of surge pricing is quite easy to understand from a graphical point of view.  After all  this is classical economics. The demand shortage is needs to be equalised by the supply which naturally means a rise in price.

Unfortunately Uber has made this a black box model by saying they use a surge pricing algorithm.  And algorithms are mysterious  things that you can't see immediately raising your suspicion.

In the case of the radio cabs like Uber surge pricing can do the following:

1.  Bring more drivers online to take care of the increased demand.  We may have to assume that these drivers were off the road for whatever reason, and the increased price now becomes a motivation to start plying the cab.

2.  If there is a shortage of cabs in one areas, the surge pricing in that area could drive more cabs to that area satisfying the increased demand in that area

3. Or this is a peak office hour where too many people want to leave a certain area at the same time.

4. Surge pricing has the effect of keeping waiting times low in a given area. When demand is exceeding supply of cabs, customers may have to wait indefinitely for demand and supply to equalise.  Surge pricing by putting more cabs on the road equalises the demand-supply equation.

This for example is a chart of surge pricing for New Years Eve.

busy hours

The thing about Surge Pricing is that prices tend to tick down in bigger steps than they move up. If one looks at surge pricing from this simplistic point of view it is nothing but classical economics playing out in today's world through an algorithm and a mobile app.

Comparison with other Industries

There is one thing about Ola and Uber and that is that they are true marketplace models.  They don't own cars and they don't own drivers.  Each driver has the option of opting for more than one service.  In fact many of them have both the apps with them and they take the most convenient or profitable  customer.

Surge pricing does genuinely motivate drivers to go on the road, if they are off the road for any reason or not near a locality that needs cabs.  So surge pricing does have the effect of increasing the supply of cabs in an area either bringing down waiting times, by making more cabs available on the road.  On the other hand dynamic pricing in hotels does make more rooms available or in the case of airlines it does not make more airline planes or  seats available.

Chief Mentor
HGS Interactive,
Priya Mathur (Guest) Interesting article. The pricing is always going to change in the market according to the demand in the market. It's inevitable. 
03 May 2016 Reply