Some Thoughts on Dynamic Pricing

Dynamic Pricing — which to me is establishing better price signals — is of great interest to me, as an entrepreneurial problem in various industries where there is some market failure.  Dynamic pricing can help cure market failures, leading to lower prices or otherwise better results for customers.  Uber’s New Year’s Eve issues are of interest in that regard.

Just to be clear, I have no issue with Uber charging whatever it wanted to as long as there was disclosure, which it seems that there was, although people raise fair suggestions on how the disclosure could have been even clearer.  Let’s get that out of the way.  My post is about how to design a well-working and sustainable (read: not causing customer ill will) dynamic price algorithm.

One challenge and necessity is to incorporate pricing signals from the entire market and not just from inside the individual firm’s demand system.  If you have limited supply available for a product that many others are also selling, the price signals from the other suppliers are also of relevance.  So, it strikes me as not enough for a well-working algorithm that it took the signal from what was happening to its own limited supply (a small subset of the entire market).  In the case of Uber, it’s not enough to get the signals from the several hundred cars it may have had in its fleet in a city like New York.  In terms of Manhattan, while it’s harder to get a cab on NYE, it’s far from impossible, and we got cabs within five minutes each time we looked for one on Saturday night.  There were taxis and numerous gypsy cabs working that night and those prices have to be incorporated into the algorithm even when you are selling a service at a premium.  The last available units of one supplier do not usually drive market prices when there is other supply available from other suppliers.

Let’s take an example as to why this is important.  If you run a corner store, and have one bottle of water left on a 100 degree day, you can sell it for 6.5X, say $13 bucks, and you’ll probably find someone to pay for it, but you’ll also have a hundred regular customers who will walk out of the store, walk the extra two blocks to the next corner store, and buy a bottle of water for a regular price.  A good number of those will also leave feeling gouged and treated unfairly, and those feeling that way may never come back.  While it’s certainly fine for the supplier to charge 6.5X (it’s a free market, and someone is willing to pay it in order to not have to walk the extra two blocks), it may not be the best way to maximize lifetime profits.  The reason customers will feel gouged is because they know this bears little relation to the market price, i.e. the other available taxis and black cabs.

(Relatedly, it’s probably a good idea if you are going to charge 6.5X that the customer is left with no doubt of the price, so he willingly makes the decision to pay the surge price, even if it means double and triple-checking with the customer.  While the customer should be responsible enough to know what he is paying, the business reality is that customers assume things even when you tell them, and fairly or unfairly, the complaints will cause your business grief that harms what you are trying to achieve.)