Leave it to Uber Surge Pricing to bring me out of blogging semi-retirement.

If you haven’t heard of Uber… where have you been? It’s an amazing app/service that allows you to order a black car to your current location, be dropped off where you like, and pay automatically via stored credit card. You don’t have to book in advance. You can see in real time how far away your driver is. You don’t even tip! It’s all included.

I don’t have any biases here, I’m not on the board and unfortunately I’m not an investor. I’m just a very regular (read: daily) user of Uber’s great services. Whenever I introduce Uber to a friend who hasn’t been using it, I hear the same two words: life changing.

There are lots of interesting things about Uber, like the way they’ve revolutionized a stuffy old business, or the way they’ve been fighting (and winning) local regulatory battles against entrenched taxi and limousine interest across the globe. But those things don’t get me fired up enough to take to the blogs. What does is surge pricing.

Think for a minute about basic economics, the law of supply and demand. In a free market, as demand for a product or service increases, 2 things can happen to fulfill the demand:

(1) Supply could increase. If supply increases in line with demand, pricing stays flat.

(2) Price could increase. As price increases, demand sags.

A couple of examples of this (mostly) working. The price of a new basic iPad Air is $499. Apple (like most consumer product businesses) has decided to produce and sell as many iPad Airs as they can at that price. If demand for $499 iPad Airs went through the roof, Apple probably wouldn’t raise the price to try to reduce demand… instead they’d just make them faster (increase supply) to balance the demand.

An example of option 2 would be airline pricing. The number of flights to the Caribbean in December is basically fixed, but the demand is higher than normal. The average fare might be $500. As demand surges, it’s not logistically feasible for airlines to add supply (because of equipment costs, pilots & crew, availability of gates and takeoff times, etc.) So instead of increasing demand, airlines increase the price, which helps to balance out the demand. (More people can go on vacation when the fare is $500 vs. $2000.)

OK so we have our basic supply and demand principles. What’s the problem with taxis and limos? The problem is that they can’t do (1) or (2). There are a fixed number of taxis and limos in a given city (usually a number that’s been capped by government licenses.) So in peak demand, they can’t increase supply. And they can’t increase price, also because of government regulations. A yellow taxi ride in New York City costs the same amount on Monday at noon as it does on Saturday night at 11pm. Those people who are lucky (or patient) enough to get a taxi on Saturday night get a pretty good deal, but the thousands who can’t are stuck without any taxis at all at peak demand.

So how does Uber play into all of this?

If you’re a brand new black car service, you have to decide which side of the supply & demand equation you want to be on. At times of peak demand (say Saturday at 11pm, or a snowstorm,) do you want to fix the price (like Taxis do) and be out of supply for the majority of customers? Or do you want to try to balance supply and demand and give customers the option of getting a ride, albeit at a higher price.

Which is more frustrating to customers… having no ride available, or having the option of a ride, but at a higher price?

Uber has chosen option 2, and they’ve done so by implementing something called “surge pricing.” When demand is out of whack with supply, Uber charges a multiple of the normal fare. So if the supply/demand equation is slightly out of whack, you might be asked to pay 1.25x the price of a normal ride. When it’s EXTREMELY out of whack, you might be asked to pay 8x the price of a normal ride.

The impact of surge pricing on the supply and demand equation (and therefore the availability of cars to potential customers) is staggering. Surge pricing seems to BREAK the law of supply and demand by simultaneously increasing supply and reducing demand! How does that happen?

As the surge pricing multiple increases, demand is reduced. That part makes sense. If you wanted to go home but you saw that the price was 2x normal, you might wait a while, or you might take the subway. That reduces demand and allows others who might be less price sensitive to take your ride.

But the real magic is the ability to increase supply. Because black car drivers, like the rest of us, love money. So as the surge multiple increases, drivers who were sitting home start seeing a golden opportunity to hop in their cars and make some money. Or a driver who’s already worked an 8 hour shift might see the price surge and stay on for a few extra hours. I’ve talked to Uber drivers who have cancelled their dinner plans to stay in their cars and keep driving, because of the opportunity to make some money. Uber’s business model passes 80% of the cost of a trip through to the driver, so the higher the surge pricing, the more money the driver makes, the more incentivized he or she is to work. And on really big nights, like New Year’s Eve, surge pricing is the ONLY thing that keeps drivers from defecting to other, more lucrative offers.

So Uber’s surge pricing reduces demand and increases supply. What’s not to love? Well… of course it’s the customer who pays this increased fare. And sometimes, the final cost is a lot more than the customer thought it would be.

The first time that Uber implemented surge pricing, customers felt really betrayed. How come this thing that used to cost X now cost me 3X? There was both an education issue and a communication/clarity issue. Uber was quick to put in place additional confirmations. Now, when a user wants to request an Uber at 2x surge pricing or above, they have to actually key in the multiple, which is actually tricky and annoying. But there’s no mistaking what you’re doing, you clearly know that you’re agreeing to pay 2x the normal fare.

Uber is far from perfect. As a nightly user, I’ve noticed surge pricing more often at times that are not particularly “peak” in my book or at times that used to not have surge pricing. At a macro level, it’s Uber’s job to balance supply and demand so that most of the time surge pricing is NOT in effect. If surge pricing becomes too common, some users might begin looking for alternatives. (And of course Uber is aware of this and is recruiting drivers as quickly as possible)

But most of the arguments against surge pricing are just downright silly.

Here are some of my least favorite:

“They shouldn’t be allowed to charge more.”

-If Uber is prevented from charging more during peak times, the result will be less availability. During peak times it would be impossible to get a car.

“This is price gouging.”

-This was an argument made a lot around superstorm Sandy. But the important thing to remember is that black cars are a luxury, not a public utility. Black cars are comfortable and pricey. It’s a nice way to get around. But it’s not the Subway, or even taxis. Uber implementing surge pricing (which maximizes availability) during Sandy could be seen as much as a public service as anything else. Again: black cars are not food and water, they are luxury transportation.

“Uber is ripping off it’s customers.”

-If you don’t like the price, don’t take the ride. Simple as that. 

“Uber should pay the difference between the normal fare and the surge fare.”

-Again, Uber is a for-profit luxury transportation company, not a public utility. Leaked numbers suggest that Uber is doing about 125,000 ride per day at $25 per ride average. If a storm hit that caused average surge pricing of 3x, Uber would have to shell out $6.875m to drivers on income of $625,000. Not a good business model if you want them to be in business the next day for your ride home.

There are more arguments against surge pricing. But there aren’t any good ones. If you see any interesting ones, send them my way and I’d be happy to update the post.