11 Oct 2016 21:37 IST

Are we ready to embrace surge pricing?

Like it or not, the supply-demand driven algo is here to stay

When the Indian Railways introduced surge pricing on its Shatabdi trains, the announcement took many people by surprise. The normally staid organisation is proud of its heritage of bringing the nation’s people together and offers concessional fares to so many categories of travellers (students, disabled, aged, etc) that the list alone extends to four pages. Such a socially minded outfit seemed least likely to be a candidate to employ sophisticated algorithms to exploit supply and demand conditions for selling seats on its superfast trains.

Read Beyond The News The economics behind surge pricing

To be sure, surge pricing is not a new concept. At its core, it allows companies to sell scarce inventory at higher prices, almost as at an auction. In the US, airlines have adopted this method for more than 35 years using supercomputers to forecast demand and then adjust prices. Hotel chains market unsold bedrooms using a similar model, with room prices reported to change as often as multiple times an hour. The goal is the same: to extract the highest marginal revenue possible from these companies’ perishable inventory of assets (tickets, hotel rooms).

Supply and demand

The business idea behind surge pricing is also simple. The value of an unsold airline seat is inversely proportional to the time left until take off, although only up to a certain point. The day before a flight departs the value of a seat shoots up to astronomical heights because customers absolutely wanting to make the flight (business travellers, private travellers with emergencies) are willing to pay higher prices for it. This condition will prevail until about two hours before the flight as airlines continue to keep changing prices to adjust as per demand.

After general check-in for a flight has begun, however, the value begins to drop as fewer potential customers seek to buy a last-minute ticket. Once the aircraft door has closed, the value of that unsold seat drops to zero.

Consumers who are used to paying a fixed price for goods and services are sometimes confused by wild swings in prices when these surge algorithms take over. The most extreme example occurred earlier this year in Washington DC during a snowstorm.

The case of Uber and Ola

Bonnie Lieb agreed to pay an Uber surge price of 4.4 times the normal fare because she needed to get to Reagan National Airport from her home in Sterling, Virgina. When she got off at the airport, she was shocked to see Uber having charged her $640.94 for the 30 mile trip — a trip by regular taxi would have cost no more than $80. Uber said there wasn't any mistake because the customer had requested an SUV ride, whose base price is higher, and the surge multiplier was applied on top.

In India, surge pricing has entered the ordinary person’s lexicon because of taxi companies such as Uber and Ola. Their algorithms affect millions of customers every day as riders do not know the quoted price until the vehicle is just about to be booked.

So how fickle and varied are these taxi rates? On seven separate Uber rides in Bengaluru in September, I found that fares ranged from ₹8.17/km to ₹17.41/km — a range of 112%. The trips were taken at different times of the day through the week. During five rides, there were no co-passengers, although I booked a pooled trip. In one ride, a co-passenger was already in the car to pick me up; in another, I was driven to the location of another customer, adding precious minutes to my commute.

Sometimes, the pricing algorithms appeared counter-intuitive. One would think that fares would be highest on a Friday evening but I was surprised to find them to be the lowest. This was because with more drivers lurking around hoping to cash in on a Friday evening peak hour surge fare, the supply of seats was so high that the fare actually dropped. In contrast, the highest fare was on a lazy Sunday morning when not many drivers were around.

Intervention

Most people are turned off by such huge variations in prices, and some governments have stepped in to help. In April, the Delhi government banned surge pricing by taxi companies altogether. But Uber defends the practice saying that it is based on the age-old economic principles of supply and demand.

Without surge pricing, Uber says there would be too few cars available because drivers won’t turn on their apps to accept orders. This would cause wait times to rise as a large number of people would depend upon just a few cars. Uber says that by offering drivers the carrot of earning money in surge multiples, more drivers can be incentivised to ply routes. High availability of cars would then mean low waiting times for customers.

Most of us do not understand the technology behind cars, computers, electronic devices or even the internet, but we use these human inventions gladly. It is hard to imagine that pricing — the oldest of inventions dating back to barter trading — has joined the elite list of inventions that humans don’t understand but readily use. Surge pricing is unfortunately here to stay.

Recommended for you