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Wednesday, September 21, 2016
Uber’s Pricing Formula Has Allowed Economists to Map Out a Real Demand Curve
Uber has created more than a booming ride-sharing market. It’s given economists a treasure trove of data to understand one of the fundamental concepts of economics: the demand curve.
Steven Levitt, author of the best-selling Freakonomics, and other researchers at the University of Chicago and Oxford, along with Uber itself, have mapped out the Uber demand curve, showing U.S. consumers alone are reaping billions of dollars a year in benefits, far greater than the losses borne by taxi owners.
Every economics student knows the quantity of a good or service demanded rises as the price falls, all else being constant. But as the father of microeconomics himself, Alfred Marshall, noted in 1890, everything else is not constant: “We cannot guess at all accurately how much of anything people would buy at prices very different from those which they are accustomed to pay for it.”
That is, it is near impossible to pin down the effect of price changes alone on how much people buy. In the case of transport services, for instance, the time of day, weather, and availability of competing providers will affect both the price paid and quantity demanded.
Uber’s data is unique in two crucial ways. It records not only the time, place, price, and demand-and-supply conditions of every paid ride (encapsulated in a surge factor), but also of every occasion where a customer declines the offered price.
Second, to keep things simple for customers, Uber rounds up or down to one decimal place the surge factor Uber generates to decide how much to charge customers for a given trip. Customers facing practically the same supply and demand conditions, say 1.249 and 1.251, therefore face quite different pricing of 1.2 or 1.3 times, a quirk that enables the authors to isolate the pure price impact on rides demanded across the range of potential prices.
Using data for 48 million interactions over the first 24 weeks of last year from Uber’s four biggest U.S. markets—New York, San Francisco, Chicago and Los Angeles—the authors show customers follow through 62% of the time without surge pricing (which is almost 80% of the time), and 39% when the surge is above 2 (3.5% of the time).
Consumers’ demand curve for Uber rides is, in economists’ speak, quite inelastic–that is, not especially responsive to price. Doubling fares reduced demand by around 40%. That’s why surge factors can be so large—reportedly up to 10 times on New Year’s Eve. It takes a big price changes to prevent shortages.
The authors use their curve to put some flesh on another theoretical economic concept, too: consumer surplus, what Mr. Marshall, who generated the idea, said was “the excess of the price which [a person] would be willing to pay rather than go without the thing, over that which he actually does pay.”
Uber riders enjoyed $1.57 in consumer surplus for every $1 they spent in 2015, the study said. That equates to $6.8 billion in consumer surplus across the U.S. last year, or $18 million a day. This was double what the drivers were paid, and six times what Uber itself earned. “These estimates of consumer surplus are large relative to the likely gains or losses experienced by taxi drivers as consequence of Uber’s entrance,” the authors said.
The free-market system has long ensured goods providing very high consumer surplus—including water, basic food, or, for Mr. Marshall, “matches, stamps and newspapers”—are cheap.