## Incredible stupidity in taxi marketplaces

So it’s nearly a week since Uber and Ola drivers in Bangalore went on strike, and there’s no sign of it (the strike) ending. The longer the strike goes on for, the more incredibly stupid all parties involve look.

The blame for the strike should first fall on Uber and Ola, who in some hare-brained madness, forgot that running a platform means that both sides of the market are customers and need to be taken care of. They took good care of passengers, providing discounts and growing their market, but rather quickly pulled the plug on drivers, and there is no surprise that drivers are a rather pissed off lot.

The root cause of driver dissatisfaction has been falling bonus payments, and consequently, incomes. This is a result of Uber and Ola providing too great a subsidy during the time they built up the market.

I don’t fault them for providing those bonuses – when you are building a two-sided market, you need to subsidise one side to solve the chicken-and-egg problem. Where I have the problem is with the extent of bonuses, which gave drivers an income far in excess of what they could make in steady state. This meant that as the market approached steady state and incentives were withdrawn, once side of the market started getting pissed off, undermining the market (Disclosure: I’d once proposed to Ola that they hire me to help them with pricing and incentive structuring. the conversation didn’t go too far).

With Uber and Ola having done their stupid things, the next round has gone to the drivers. In a misguided attempt that a long strike will help them get better deals from the platforms, they are prolonging the strike. They’ve even ransacked Uber’s offices, and gone to the government for help.

What they don’t realise is that having invested what they have in their cars to drive on these marketplaces, their success is inextricably tied to the success of the marketplaces. And the more the jeopardise the marketplaces, the less their incomes in future.

A long strike reduces market size on two counts – it gives people time to adjust to the absence of service and get adjusted to alternate arrangements, and it decreases the reliability of the marketplaces in the eyes of the passengers. Thus, the longer and more frequent the strikers by the drivers, the less that passengers will look to use these services in the future.

A strike can work when the striking employees are protected by some form of labour laws, and there is no way ahead for their employers apart from a negotiated settlement. In case of a marketplace, the platform has absolutely no obligation to the drivers, and Uber and Ola can simply do what Uber and Lyft did in Austin, TX – pack up and move on. And if they do that in Bangalore, the drivers with their shiny new cars will be significantly worse off than they were before the strike.

The other act of stupidity on the drivers’ part has been to involve the government, which, as expected, has responded in a nandelliDLi (“where do I keep mine?”) fashion. The recent ban on shared rides (UberPool/OlaShare) came after a regulator read the rulebook after the last strike by the drivers. Given the complex economics of platform markets, any further regulation can only hurt the drivers.

All in all, the drivers’ stupidity can be traced back to not understanding platform markets, and protesting the way protests used to be done in highly unionised industries. Drivers, whose main skill is in driving cars, cannot be faulted so much for not understanding platform markets. Uber and Ola, on the other hand, have no such excuse!

## Pipes, Platforms, the Internet and Zero Rating

My friend Sangeet Paul Chaudary, who runs Platform Thinking Labs, likes to describe the world in terms of “pipes” and “platforms”. One of the themes of his work is that we are moving away from a situation of “dumb pipes”, which simply connect things without intelligence, to that of “smart platforms”. Read the entire Wired piece (liked above) to appreciate it fully.

So I was reading this excellent paper on Two-Sided Markets by Jean-Charles Rochet and Jean Tirole (both associated with the Toulouse School of Economics) earlier today, and I found their definition of two-sided markets (the same as platform business) striking. This is something I’d struggled with in the past (I admit to saying things like “every market is two-sided. There’s a buyer and a seller”), especially given the buzzword status accorded to the phrase, but it is unlikely I’ll struggle again. The paper says:

A necessary condition for a market to be two-sided is that the Coase theorem does not apply to the relation between the two sides of the markets: The gain from trade between the two parties generated by the interaction depends only on the total charge levied by the platform, and so in a Coase (1960) world the price structure is neutral.

This is an absolutely brilliant way to define two-sided markets. The paper elaborates:

Definition 1: Consider a platform charging per-interaction charges $a^B$ and $a^S$ to the buyer and seller sides. The market for interactions between the two sides is one-sided if the volume V of transactions realized on the platform depends only on the aggregate price level

$a=a^B +a^S$

i.e., is insensitive to reallocations of this total price a between the buyer and the seller. If by contrast V varies with $a^B$ while a is kept constant, the market is said to be two-sided.

So for a market to be two-sided, i.e. for it to be intermediated by an “intelligent platform” rather than a “dumb pipe”, the volume of transactions should depend not only on the sum of prices paid by the buyer and seller, but on each price independently.

The “traditional” neutral internet, by this definition, is a platform. The amount of content I consume on Youtube, for example, is a function of my internet plan – the agreement between my internet service provider and me on how much I get charged as a function of what I consume. It doesn’t depend on the total cost of transmitting that content from Youtube to me. In other words, I don’t care what Youtube pays its internet service provider for the content it streams. Transaction costs (large number of small transactions) also mean that it is not practically possible for Youtube to subsidise my use of their service in this model.

Note that if buyers and sellers on a platform can make deals “on the side”, it ceases to be a platform, for now only the total price charged to the two matters (side deals can take care of any “adjustments”). The reason this can’t take place for a Youtube like scenario is that you have a large number of small transactions, accounting for which imposes massive transaction costs.

The example that Rochet and Tirole take while explaining this concept in their paper is very interesting (note that the paper was written in 2004):

…As the variable charge for outgoing traffic increases, websites would like to pass this cost increase through to the users who request content downloads…

..an increase in their cost of Internet traffic could induce websites that post content for the convenience of other users or that are cash-strapped, to not produce or else reduce the amount of content posted on the web, as they are unable to pass the cost increase onto the other side.

Note how nicely this argument mirrors what Indian telecom companies are saying on the Zero Rating issue. That a general increase in cost of internet access for consumers can result in small “poor” consumers to not consume on the internet at all, as they are unable to pass on the cost to the other side!

Fascinating stuff!

## Market-making in on-demand markets

I’ve written a post on LinkedIn about the need for market-making in on-demand markets. I argue that for a market to be on-demand for one side, you require the other side to be able to provide liquidity. This liquidity comes at a cost and the side needs to get compensated for it. Driver incentive schemes at Ola/Uber and two-part electricity tariffs are examples of such incentives.

An excerpt:

In a platform business (or “two sided market”, or a market where the owner of the marketplace is not a participant), however, the owner of the market cannot provide liquidity himself since he is not a participant. Thus, in order to maintain it “on demand”, he should be able to incentivise a set of participants who are willing to provide liquidity in the market. And in return for such liquidity provided, these providers need to be paid a fee in exchange for the liquidity thus provided.

## Fragility of two-sided markets

Two-sided markets are inherently fragile for participation of each side depends on a certain degree of confidence in participation on the other side. Thus, small negative shocks can lead to quick downward spirals.

Following the ill-advised ban on Uber and other taxi aggregators in four Indian states (Delhi, Karnataka, Andhra Pradesh, Telangana), business for drivers who ply their services via such apps has dropped significantly. While on first inspection you might expect it to go to zero (given their services have been banned), the fact that enforcement is tough (there is nothing to identify a cab as “belonging to Uber”) means that apart from Delhi (where Uber has pulled its services) these cabs continue to ply.

In the days after the ban, various news reports have interviewed drivers who ply for Uber who complain about drastically reduced services. While numbers vary from report to report, the general sense is that so far the number of trips per driver per day has fallen by half. And I expect this to fall further unless drastic steps are taken – such as issuance of new regulations or removal of the ban.

In a “normal” market (where the owner of the market is also a participant), when demand for a particular good drops, price is expected to fall and availability is expected to increase. If demand for a particular item that you have in stock drops, you need to take steps to get rid of the excess inventory that you have. You are most likely to indulge in discounting or other such promotional activities, in order to make it more attractive for the buyers to buy, and thus take the inventory off your shelves.

In a “two-sided market” (one where the owner of the market is not a participant), however, things work differently. It is a popular saying that in such markets “demand creates its own supply”. A corollary to that is that “lack of demand creates lack of supply”. Let us take the case of Uber itself. Over the last few days, irrespective of whether the ban on the service is official or not, legal or not, the number of people who have been requesting for the service has dropped.

Now, if you are a driver using the app, you realise that your potential revenues and profits from continuing to use the app are not as high as they used to be. Thus, if there are other avenues for you to make money, you are now more likely to take those avenues rather than logging on to Uber (since the “hurdle rate” for such a switch is now lower thanks to lower Uber revenues). As many of you take the same route, the availability of cabs on Uber also drops – something that I’ve seen anecdotally over the last few days. And when availability of Uber cabs drops beyond a point, I start questioning my trust in the service – a week ago I would be confident that I would be able to hail an Uber from anywhere in Bangalore with very high confidence; that confidence has now dropped. And when my trust in the service drops, I start using it less, and when many of us do that, drivers see less demand and more of them pull away from the market. And this results in a vicious cycle.

Notice that things would work very differently had Uber been a “traditional” taxi service which owned its cabs and employed its drivers. In that case, falling demand would have been met with a response that would have made it easier for customers to buy – price cuts, perks, etc.

The point is that platforms or two-sided markets are inherently fragile, and highly dependent on confident in the system. I leave my car at home only if I have enough trust in the taxi platforms that I’ll be able to get a cab when I need one. A driver will forsake other trips and switch on his Uber app only if he is confident that he can get enough rides through the app.

The same network effects that can lead to a rapid ramp-up in two-sided markets can also lead to its downfall. All it takes is a small trigger that leads to loss of confidence in the service from one side. Unless that loss of confidence is quickly addressed, the “positive feedback” from it can quickly escalate and the market grinds to a halt!

Another good example of lack of confidence killing two-sided markets is in the market for CDOs and associated derivatives in 2007-08. There were standardised pricing models for such products and a vibrant market existed (between sophisticated financial institutions) in 2007. When house prices started coming down, some people started expressing doubts in such models. Soon, this led to massive loss of trust in the pricing models that underpinned such markets and people stopped trading. This meant companies were unable to mark their securities to market or rationalise their portfolios, and this led to the full-blown 2008 financial crisis!

So when you build a platform, you need to make sure that both sides of the market retain confidence in your platform. For in the platforms business loss of confidence can lead to a much quicker fall than in “traditional” markets. This dependence on confidence thus makes such markets fragile.