Thaler and Uber and surge pricing

I’m writing about Uber after a really long time on this blog. Basically I’d gotten tired of writing about the company and its ideas, and once I wrote a chapter about dynamic pricing in cabs in my book, there was simply nothing more to say.

Now, the Nobel Prize to Richard Thaler and his comments sometime back about Uber’s surge pricing has given me reason to revisit this topic, though I’ll keep it short.

Basically Thaler makes the point that when businesses are greedy and seen to be gouging customers in times of high demand, they might lose future demand from the same customers. In his 2015 book Misbehaving (which I borrowed from the local library a few months ago but never got down to reading), he talks specifically about Uber, and about how price gouging isn’t a great idea.

This has been reported across both mainstream and social media over the last couple of days as if Thaler is completely against the concept of surge pricing itself. For example, in this piece about Thaler, Pramit Bhattacharya of Mint introduces the concept of surge pricing and says:

Thaler was an early critic of this model. In his 2015 book Misbehaving: The Making of Behavioral Economics, Thaler argues that temporary spikes in demand, “from blizzards to rock star deaths, are an especially bad time for any business to appear greedy”. He argues that to build long-term relationships with customers, firms must be seen as “fair” and not just efficient, and that this often involves giving up on short-term profits even if customers may be willing to pay more at that point to avail themselves of its product or service.

At first sight, it is puzzling that an economist would be against the principle of dynamic pricing, since it helps the marketplace allocate resources more effectively and more importantly, use price as an information mechanism to massively improve liquidity in the system. But Thaler’s views on the topic are more nuanced. To continue to quote from Pramit’s piece:

“I love Uber as a service,” writes Thaler. “But if I were their consultant, or a shareholder, I would suggest that they simply cap surges to something like a multiple of three times the usual fare. You might wonder where the number three came from. That is my vague impression of the range of prices that one normally sees for products such as hotel rooms and plane tickets that have prices dependent on supply and demand. Furthermore, these services sell out at the most popular times, meaning that the owners are intentionally setting the prices too low during the peak season.

Thaler is NOT suggesting that Uber not use dynamic pricing – the information and liquidity effects of that are too massive to compensate for occasionally pissing off passengers. What he suggests, however, is that the surge be CAPPED, perhaps at a multiple of three.

There is a point after which dynamic pricing ceases to serve any value in terms of information and liquidity, and its sole purpose is to ensure efficient allocation of resources at that particular instant in time. At such levels, though, the cost of pissing off customers is also rather high. And Thaler suggests that 3 is the multiple at which the benefits of allocation start getting weighed down by the costs of pissing off passengers.

This is exactly what I’ve been proposing in terms of cab regulation for a couple of years now, though I don’t think I’ve put it down in writing anywhere. That rather than banning these services from not using dynamic pricing at all, a second best solution for a regulator who wants to prevent “price gouging” is to have a fare cap, and to set the cap high enough that there is enough room for the marketplaces to manoeuvre and use price as a mechanism to exchange information and boost liquidity.

Also, the price cap should be set in a way that marketplaces have flexibility in how they will arrive at the final price as long as it is within the cap – regulators might say that the total fare may not exceed a certain multiple of the distance and time or whatever, but they should not dictate how the marketplace precisely arrives at the price – since calculation of transaction cost in taxi pricing has historically been a hard problem and one of the main ways in which marketplaces such as Uber bring efficiency is in solving this problem in an innovative manner using technology.

For more on this topic, listen to my podcast with Amit Varma about how taxi marketplaces such as Uber use surge pricing to improve liquidity.

For even more on the topic, read my book Between the buyer and the seller which has a long chapter dedicated to the topic,

Who do you subsidise?

One basic rule of pricing is that it is impossible for all buyers to have the same consumer surplus (the difference between what a buyer values the item at and what he paid). This is because each buyer values the item differently, and is thus willing to pay a different price for it. People who value the item more end up having a higher consumer surplus than those who value it less (and are still able to afford it).

Dynamic pricing systems (such as what we commonly see for air travel and hotels) try to price such that such a surplus is the same for all consumers, and equal to zero, but they never reach this ideal. While the variation in consumer surplus under such systems is lower, it is impossible for it to come to zero for all, or even a reasonable share of, customers.

So what effectively happens is that customers with a lower consumer surplus end up subsidising those with a higher consumer surplus. If the former customers didn’t exist, for example, the clearing price would’ve been higher, resulting in a lower consumer surplus for those who currently have a higher consumer surplus.

Sometimes the high surplus customer and the low surplus customer need not be different people – it could be the same person at different times. When I’m pressed for time, for example, my willingness to pay for a taxi is really high, and I’m highly likely to gain a significant consumer surplus by taking a standard taxi or ride-hailing marketplace ride then. At a more leisurely time, travelling on a route with plenty of bus service, I’d be willing to pay less, resulting in a lower consumer surplus. It is important to note, however, that my low surplus journey resulted in a further subsidy to my higher surplus journey.

When it comes to markets with network effects (whether direct, such as telecommunications, or indirect, like any two-sided marketplace), this surplus transfer effect is further exacerbated – not only do low-surplus customers subsidise high-surplus customers by keeping clearing price low, but network effects mean that by becoming customers they also add direct value to the high surplus customers.

So when you are pleasantly surprised to find that Uber is priced low, the low price is partly because of other customers who are paying close to their willingness to pay for the service. When you pay an amount close to the value you place on the service, you are in turn subsidising another customer whose willingness to pay is much higher.

This transfer of consumer surplus can be seen as an instance of bundling, but from the seller’s side. Since a seller cannot discriminate effectively among customers (even with dynamic pricing algorithms such as Uber’s surge pricing), the high-surplus customers come bundled with the low-surplus customers. And from the seller’s perspective, this bundling is optimal (see this post by Chris Dixon on why bundling works, and invert it).

So the reason I thought up this post is that there has been some uncertainty about ride-hailing marketplaces in Bangalore recently. First, drivers went on strike alleging that they weren’t being paid fairly by the marketplaces. Then, a regulator decided to take the rulebook too literally and banned pooled rides. As i write this, a bunch of young women I know are having a party, and it’s likely that they’ll need these ride-hailing services for getting home.

Given late night transport options in Bangalore, and the fact that the city sleeps early, their willingness to pay for a safe ride home will be high. If markets work normally, they’re guaranteed a high consumer surplus. And this will be made possible by someone, somewhere else, who stretched their budget to be able to afford an Uber ride.

Think about it!

Cross-posted at RQ

Service charges

So the Indian government has said that it is not mandatory for customers to pay “service charges” at restaurants. It will be interesting to see how the restaurant industry will react to this.

The basic idea of a “service charge” is a “forced tip”. Given that Indians aren’t big tippers, restaurants, about a decade ago, started levying a service charge on top of the bill, ranging from 5% to 15%. Some restaurants mention this on the menu explicitly. In others, the print is fine. Some customers have come to accept the service charge. Others fight it.

The National Restaurants Association of India hasn’t taken too kindly to the notification, and has said they’ll take the government to court on this matter. It sounds like a rather extreme reaction, but illustrates the effect of behavioural studies.

Lower end eateries typically publish menus with “all inclusive” prices. If a cup of coffee is listed at Rs. 10, you pay Rs. 10 for it. Mid-priced and higher-end restaurants, however, have defaulted to showing prices exclusive of taxes and charges. With a 5% VAT, 15% Service Tax and (typically) 5% service charge, the final bill comes out to about 25-30% higher than the labelled price.

Now, frequent restaurant goers are aware of all these charges, and that the bill will be much higher than the sticker price. If they are rational, they should be taking into account these additional charges when deciding whether to go to restaurants, and when they do, what to order.

The problem, however, is that these charges are not immediately visible at the time of ordering, and so the customers end up ordering more expensive food than they had budgeted for (after controlling for the overall price level of the restaurant itself). It is a behavioural effect, where the customers’ minds are tricked by the number in front of them rather than what they will immediately end up paying.

The order that service charge is not mandatory will now push restaurants to include them in the sticker price of the food itself (it doesn’t matter what you call it – it’s ultimately revenue to the restaurant). The immediate impact of this will be that sticker prices will have to go higher, which will put a “bigger price” in front of the customers’ eyes, and they will order less.

How much less is not clear, but the fact that the restaurants association wants to take the government to court suggests it’s not insignificant. The high end restaurant business runs on extremely low margins (think what you may of the pricing), and even a less than 5% impact on revenues can have a significant impact on the bottom line.

It will be interesting to see if the government next mandates menus to print prices inclusive of taxes. It will be another behavioural nudge, but will end up ruining the restaurant business even more.

More on focal points at reunions

On Friday, just before the IIMB reunion started, I had written about reunions being focal points that help a large number of alumni to coordinate and meet each other at a particular date and venue. What I’d not written about there was the problems that could potentially be caused with the said venue being large.

In this case, the venue was the IIMB campus itself. While all official events, meals and accommodation for outstation attendees had been arranged in a single building (called MDC), the fact that people would explore the campus through the event made the task of coordination rather difficult.

The whole point of a reunion is to meet other people who are attending the event, and so it is important that people are able to find one another easily. And when the venue is a large area without clear lines of sight, finding one another becomes a coordination game.

This is where, once again, Thomas Schelling’s concept of Focal Points comes in. The game is one of coordination – to land up at locations in the venue which maximise the chances of meeting other people. While our class WhatsApp group enabled communication, the fact that people wouldn’t be checking their phones that often during the reunion meant we could assume there was no communication. So when you arrived at the venue, you had to guess where to go to be able to meet people.

Schelling’s theory suggested that we look for the “natural, special or relevant” places, which would be guessed by a large number of people as the place where everyone else would coordinate. In other words, we had to guess what others were thinking, and what others thought other others were thinking. Even within the reunion, focal points had become important! The solution was to search at those specific points that had been special to us back in the day when we were students.

On Saturday morning, I took about ten minutes after entering campus to find batchmates – I had made poor guesses on where people were likely to be. And once I found those two batchmates at that first point, we took a further twenty minutes before we met others – after making a better guess of the focal point. Given that the reunion lasted a bit more than a day, this was a significant amount of time spent in just finding people!

 

 

A simpler solution would have been to start with a scheduled event that everyone would attend – the venue and starting time of the event would have defined a very obvious focal point for people to find each other.

And the original schedule had accommodated for this – with a talk by the Director of IIMB scheduled for Saturday morning 10 am. It seemed like a rather natural time for everyone to arrive, find each other and go about the reunion business.

As it happened, revelry on the previous night had continued well into the morning, because of which the talk got postponed. The new starting point was to “meet for lunch around noon”. With people who were staying off-campus, and those arriving only on Saturday arriving as per the original schedule, search costs went up significantly!

PS: This takes nothing away from what was finally an absolutely fantastic reunion. Had a pretty awesome time through the duration of it, and I’m grateful to classmates who came from far away despite their large transaction costs.

The purpose of reunions

So later today and tomorrow, the class of 2006 at IIMB is going to have a reunion. Reactions to this have been mostly mixed. Some people have been excited about it for months together. Some have been dismissive, loathing the idea of meeting some people they used to know. Most have gone along with the flow, quietly registering and promising to turn up.

As I’ve dealt with people showing all these reactions, I was thinking of why reunions make sense. I had even tweeted this last year:

As the reunion has come closer, though, my views have become more nuanced. Yes, I’ve kept in touch with all those batchmates I’ve wanted to keep in touch with. However, transaction costs (have I told you I’m writing a book on that topic? Just wrapped up third draft) mean that it’s not been possible to meet many of them.

It is not feasible, for example, to schedule a trip all the way to London because a handful of people you want to meet live there. Nor is it possible that even if you visit Mumbai, regularly, you are able to put “gencu” with everyone you have intended to put gencu with.

And so it remains, that you keep putting off meeting those people you want to meet until a time when transaction costs are low enough for you to be able to meet.

There are transaction costs that operate in other ways as well – a scheduled bilateral meeting is a commitment to exclusively talk to each other for at least close to an hour. And sometimes when you want to meet someone for the purpose of catching up, you aren’t sure if you can spend an hour with them without either of you getting bored. And so you put off that gencu.

The beauty of a scheduled reunion is that it takes into account both these costs. Firstly, by ensuring a large number of people congregate at one place at one time, it amortises (among all the counterparties you meet) the cost of having travelled to the meeting. Secondly, given that there are so many people around there, you don’t have an obligation to talk to anyone beyond the time when it’s pleasant for both of you (sadly, IIMB has outlawed alcohol on campus during the last decade so “i’ll go get a refill” trick of walking away won’t work).

The other great thing about a scheduled reunion (organised by the Alma Mater’s alumni office) is that it acts as what Thomas Schelling termed as “focal points“. Focal points are basically solutions to coordination games where each player plays in a natural or obvious way, expecting others to play the same way as well, so that they coordinate.

Now let’s say that the IIMB Class of 2006 decided to all meet sometime during the course of the year. Coordinating on a date would have been impossible, with any arbitrarily chosen date attracting too few people for network effects to take effect.

With the alumni office proposing a date and venue, it now becomes an “obvious solution” to everyone coming together and going through a process on that date (anchoring is also involved). People are willing to make the investment to meet on that date because they expect others to be there as well. So I’ve registered for this weekend’s event with the expectation that a large number of my batchmates would have done so as well, and each of them would have in turn registered for a similar reason.

Over the next couple of days I expect to spend a lot of time with people I’ve anyway been in touch with over the last 10 years. I might also spend a small amount of time with people I don’t really want to meet. But there is a large number of people I want to keep in touch with, but can’t due to transaction costs, and that is where I expect the reunion to add most value!

Moving towards a cashless economy

In any transaction, the process of payment is a pain. It is a necessary step, of course, in that payment is what completes the transaction, but the process of payment is not something that adds any value to the transaction. If money could be magically be transferred from buyer to seller at the end of a transaction, both transacting parties would be happy.

In this context, any chosen method of payment, be it cash or credit card or cheque or bank transfer, involves some degree of pain for the transacting parties.

In case of cash, there’s the problem of counting out the money, cross checking it, finding exact change, being able to handle currency without the fear of being robbed, and making sure the currency is not counterfeit. Cheques have a credit risk, since they can bounce, not to speak of the time it takes to write one, and the time it takes for the money to get transferred.

Bank transfer requires parties to have bank accounts, and the ability of transacting parties to tell each other their account details. Credit cards have the most explicit pain of transaction – the transaction fees the merchants need to pay the acquiring bank – apart from the time and pain of swiping, entering the PIN, etc.

The reason India has so far been a primarily cash economy is that the pain of transacting through cash has been far lower than the pain through other means. Apart from the pains mentioned above, cash also has the advantage of anonymity, speed of transaction and ability to hide from the tax authorities.

So if we have to turn India closer to a cashless economy, as the current union government plans to do, we need to either increase the pain of transacting in cash, or reduce the pain of transacting through another means. The Unified Payments Interface (UPI), which was launched with much fanfare earlier this year but has spectacularly failed to take off, seeks to reduce pain of cashless transactions. The government’s efforts to get people open bank accounts through the Pradhan Mantri Jan Dhan Yojana (PMJDY) also seeks to reduce pain in non-cash transactions.

The government’s recent effort to withdraw legal tender of Rs. 500 and Rs. 1000 notes, on the other hand, seeks to increase the cost of transacting in cash – 85% of the current stock of cash in India needs to get banked in the next 50 days. This, however, is not a repeatable exercise – it can simply remove confidence in the rupee and drive people to alternate (formal or informal) currencies.

So what can be done to move India to a more cashless economy? The problem with small change has already played its part, with most auto rickshaw and taxi drivers in Mumbai supposedly willing to accept payment in digital wallets such as PayTM. If the stock for the new Rs. 2000 and Rs. 500 notes released is low, and most people have to transact using Rs. 100 notes, that will again increase the pain of transacting in cash, since the cost of handling cash might go up.

Perversely, if crime and robberies increase, that will again make people wary of handling cash. In fact, as this excellent piece in the New Yorker claims, the reason Sweden has moved largely cashless is that people got scared of handling cash after a series of cash robberies a few years ago. The cost of higher crime, however, means this is not a desirable way to go cashless.

It’s been barely three days since the new Rs. 500 and Rs. 2000 notes have been released, and there are already reports of counterfeiting in these notes. Given the framework I’ve proposed in this blogpost, it is not inconceivable that these rumours have been planted – when people become more wary of receiving large currency (thanks to the fear of counterfeiting), they want to reduce the use of such physical currency.

It’s perverse, I know, but nothing can be ruled out! As I’ve repeatedly pointed out, increased use of cash has a fiscal cost (in terms of printing and maintaining currency, apart from people not paying taxes), so the government has an incentive to stamp it out.

 

 

Dealing with loss of cash

Ever since Rs. 500 and Rs. 1000 notes ceased to be legal tender on Tuesday night, the internet has been full of “human stories” of people for whom tragedy has struck because they are not able to transact.

This is a valid concern – for there is a significant portion of the population without access to banking (numbers in a Mint piece I’ve sent but they’re yet to publish), and access to banking is necessary to do any transaction of reasonable size (there’s only so much you can pay with 100 buck notes).

One fallacy, though, is that people in rural areas, where access to banks and ATMs is lower compared to urban areas, are going to have it harder till the cash gets adequately replaced. While these places may be out of the way, what will help them tide it over is that everyone pretty much knows everyone else.

In Money: The Unauthorised Biography, Felix Martin argues that money is neither a store of value nor a medium of exchange. Instead, it is simply a method to keep track of debts, with the elegance being offered by the fact that money is “negotiable”. If I have a 100 rupee note, all it says is I’m owed 100 rupees. Who owes me those 100 rupees doesn’t matter. “I promise to pay the bearer the sum of one hundred rupees”, the front of the note declares. It just doesn’t matter who the “I” in question is.

In order to illustrate his theory of money, Martin gives the example of Ireland around 1970, when a six-month banking strike left the country’s financial system in tatters. Life didn’t come to a standstill, though, as people figured out ways of maintaining their credits and transferring them.

Initially, people wrote each other cheques. Despite the inherent credit risk, and the fact that they couldn’t be encashed in near future, people accepted them from people they knew. Then the cheques became negotiable, after “reputed community people” such as barmen started vouching for people’s creditworthiness. And so the economy moved along.

Debts were finally settled many months later when the banking system reopened, and people could cash in the cheques they held. A similar story played out in Argentina in the early 2000s when rampant inflation had rendered the currency useless – cities managed to invent their own currencies and life went on.

In a similar fashion, in small towns, and other communities where most people tend to know one another, people are unlikely to face that much trouble because of the cash crunch. Credit is already fairly common in such places, except that it will have to be extended for a longer period of time until the cash supply returns. It is similar in other remote unbanked areas, and perhaps even among tightly-knit communities of businessmen. Systems will spontaneously come up to extend and exchange credit, and life will go on.

The concern, however, is for the urban poor, since they tend to do a large number of transactions with people they don’t know well. In such situations, extension of credit is impossible, and people might find it hard.