Uber’s Surge Pricing a Study in Important Investment Topic: Consumer Surplus
Uber, the San Francisco–based start-up whose mobile app allows people to hail taxis on their smartphones, has had its fair share of bad press lately. (See: “Is Uber’s Surge-Pricing an Example of High-Tech Gouging?” and “Taxi Drivers Turn Violent against Uber in Paris.”) At the heart of the issue is something known as “surge pricing.”
Without commenting on the merits of Uber’s specific business plan or about the ethics of its economics, its story provides a case study in an important investment topic: the consumer surplus.
What Is Surge Pricing?
Those tracking the Uber story know that the company’s business model is to charge higher prices for taxi rides during peak taxi demand times. Taxi riders wanting to assure themselves of a ride in inclement weather or after the end of a sporting event can be assured of a cab if they are willing to pay up for the privilege. This pricing is known as surge pricing and is accepted by consumers in other venues, such as airline tickets. However, surge pricing for taxis is a new application, and many consumers and consumer rights groups are upset about the company’s unique pricing model. But, put in economics terms, Uber’s business model is simply capturing the consumer surplus.
What Is the Consumer Surplus?
Here’s an example that will make the consumer surplus easier to understand. Imagine you don’t own any shoes but have to commute to work. How much would you pay to rent a pair of shoes for the day, when your alternative is to go barefoot?
I have done this exercise with dozens of people over the years and most answer in the $2–$10 range. Now, if you had to do this each day for a full year (around 270 work days), you would have spent around $540 to $2,700 for the privilege of wearing shoes (depending on your perceived value for shoe wearing). Yet, most of us wear shoes that cost much less than $540–$2,700, usually in the $100–$150 range.
Consumer surplus is the difference between what you would be willing to pay based on your perceived value for a product and what you actually pay. In the shoe example, the consumer surplus ranges between $390 ($540–$150) to $2,600 ($2,700–$100). Graphically, the consumer surplus is shown as:
In the above graph:
P = price of a good
Q = quantity of a good
p1 = market clearing price for the good
q1 = market clearing quantity for the good
The shaded box framed by p1 − 0 − q1 − $ is the amount paid by consumers for the good, and hence captured by suppliers of the good. Yet if you look at the triangle framed by P − p1 − $, you can see that some consumers were willing to pay much more for the good (almost double, in fact); this crosshatched region is the consumer surplus.
Why Is the Consumer Surplus an Important Investment Topic?
Free money exists for businesses that can find a way to capture the consumer surplus. Why? Because the costs of production only go down when more quantity of a good is produced, yet the price charged for the same good goes up. Think: Starbuck’s charging $4 for a cup of coffee that previously sold for only $1.
This is not an endorsement for Uber, but it has found a way to charge more for the same good, a taxi ride, at different times and for different consumers. Only the market, including consumer preferences, will determine whether or not it is successful in the long run. But as an investor, it behooves you to identify companies that have found ways to capture a higher proportion of the consumer surplus.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: ©iStockphoto.com/ChrisSteer
Thanks Jason for a different topic and perspective. I was just wondering, isn’t this a case of producer surplus. As in normal price would have been below P1. By raising the price consumer surplus is being handed over to the producer. There was a consumer surplus once, but as the price goes higher the CS disappears.
Hello MA,
Yes, it depends on your context. What I was trying to communicate was that companies that are able to capture the consumer surplus, and by doing so they are increasing producer surplus. Nice catch!
With smiles,
Jason
Jason,Can we consider it, a case of differential pricing.I am not that aware of the competition that Uber faces .But what i could interpret is, it is in a Monopolistic Competition, and it being a prices setter rather being a taker and its banking on product differentiation.
Thanks
Hello Pushkar,
Uber faces tremendous competition; essentially every cab ride that is not facilitated using their app is competition. But the tug-of-war highlighted by price maker vs. price taker is the same tug-of-war as consumer surplus vs. producer surplus.
One of the advantages of thinking about things in terms of consumer surplus is that it allows you to look for businesses that are currently under-pricing their goods and services. This is exactly what Starbuck’s has done over the years. Essentially, they looked at the pleasure that people got from drinking coffee and realized that a good cup of coffee was worth more than $1 to people.
When you do your analyses of business you should examine where in the consumer vs. producer surplus battle a company’s products lie. I think this framework will provide you with some nice insights.
Best wishes for success!
Jason
Right, but as a whole society suffers.
If you are talking in particular context of a single investor or entity seeking wealth creation then you have empirical evidence. In fact investor or seller is rational who segmentises market for price discrimination.
Hello Arshad,
Actually that isn’t true. In the prior scenario more of the benefits flow to the customer base. In the latter scenario it flows to the business at its revenue line, then to the company’s suppliers at the cost of goods sold line (and then to the supplier’s stakeholders), then to its employees in the SG&A line, then to debt holders, then to citizens via taxes paid, and on to other stakeholders.
Capitalist transactions that do not contribute to productivity are all of this nature: who gets paid? The way to measure that productivity is to ask if each party’s return exceeds their all inclusive costs of capital.
Also, so long as both parties to any exchange have the ability to decline the transaction, then you have to assume they are comfortable with both the benefits and the costs.
Thanks for your comments!
Jason
Who is eligible to attend CFA annual conference?
Everyone is welcome to attend our Annual Conference. For more info, visit http://annual.cfainstitute.org/.
I think the main economics lesson here is that, in the short term, supply of cabs is relatively fixed while demand for cabs fluctuates. As long as prices are fixed (they’re usually regulated), there will be some periods of excess demand and other periods of excess supply. This mismatch involves a cost that economists call ‘dead weight loss’. Anyone that’s waited in long taxi queues has experienced this first hand. If prices cant adjust to changing levels of demand/supply, other mechanisms (eg queues or fights) will take its place. If prices are allowed to move with changes in demand/supply, this avoids dead weight loss and, in theory, maximises the sum of consumer and producer surplus. Ie, its in the best interests of both consumers (as a group) and producers (as a group).
The issue of producers capturing consumer surplus is probably more clearly illustrated with an example of price discrimination… This is where the cab driver charges a student $10 and an adult $20 for the exact same service.
Hello Matt,
Thank you for sharing your views. Price discrimination is certainly a tangential topic and perhaps also one worth discussing on The Enterprising Investor.
Businesses can and do look for ways of dipping their revenue cup into the consumer surplus. Some succeed, and others do not. But many investors do not have this kind of filter in their tool kit. It sounds as if you do.
With smiles,
Jason
Is there an econometric or financial model that can manipulate data for enterprises to estimate the consumer price?. I think such would be helpful for business managers to price correctly and maximise revenue
Hello Wasili,
I am not aware of any, but you are correct that such a tool would be very powerful. If you discover such a tool, perhaps you can post it here to the comments section for other readers.
With smiles,
Jason
I love all your write-ups, Jason. Have also followed you on twitter! 🙂 Thanks for sharing you knowledge! x
Hello Smriti,
Thank you for the praise and thank you for letting me know your future plans (i.e. you may be taking up meditation). Thank you, too, for following me on Twitter. I hope to deliver a curated list of stories worth your time and energy to read.
Best wishes of success for you!
Jason