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Dynamic Pricing: An Economist’s Dream, And A Human’s Nightmare?

January 23rd, 2012 · 3 Comments
Buyer Beware · Econ 101 · Markets

A simple supply and demand analysis suggests that normal market forces cause prices to increase when demand increases:

The bottom line is that, after a demand increase, not everyone can get what they want at the old market price. Either the price can increase, which serves both to encourage firms to produce more and to curb demand, thus bringing supply and demand back into balance, or a shortage can persist at the old price and some willing consumers can be left out in the cold. Or, in picture form, this:

If the price of the item doesn’t increase, there will be a shortage in the amount of Qd minus Qs. Now, enter the concept of dynamic pricing. Dynamic pricing simply recognizes the fact that demand for an item is not constant over time and, as such, adjusts the price based on either forecast or actual demand so that supply and demand stay in balance. This, not surprisingly, results in higher prices when more people want something and lower prices when fewer people want something.

Economists generally like this concept, at least in theory, since shortages and surpluses are economically inefficient. Humans, on the other hand, often get frustrated by the practice, as evidenced by the experience of customers of the car service Uber:

On New Year’s Eve, Uber, a start-up in the city, adopted a feature it called “surge pricing,” which increases the price of rides as more people request them.

Although New Year’s Eve was very profitable for Uber, customers were not happy. Many felt the pricing was exorbitant and they took to Twitter and the Web to complain. Some people said that at certain times in the evening, rides had spiked to as high as seven times the usual price, and they called it highway robbery.

Rationally, I know that it’s better to have the option to get a good at a high price and decide whether or not I want to buy it than it is for the good to simply not be available. Also rationally, I know that the higher prices incentivize drivers to keep driving people around when cars are needed rather than go home and have some belated new year’s champagne instead. Humanly, I’m decently sure that I would be pissed if I ended up paying $135 to be driven one mile as the guy in the article had been.

On the surface, it seems that the people complaining either don’t understand economics or are acting “irrationally.” This is where a lot of economic analyses stop, and they tend to conclude that people just need to accept that dynamic pricing is efficient. Unfortunately, the situation isn’t that simple.

Let’s say you are trying to plan an evening- at the very least, you need to decide where to go to eat, where to go for drinks after, and how to get to these various locations and back home. In order to optimize your consumption, you need to know the relevant prices of all of your options, and acquiring this information isn’t free. Luckily, a lot of prices can be inferred from past experience when they are not readily available, but such inference requires that prices don’t fluctuate too unpredictably. Additionally, there is a degree of path-dependency in this series of choices- for example, not taking the car to go out precludes the option of taking the car to get home, so it’s important to know prices before you’re ready to consume an item. Therefore, there is a cost of uncertainty in prices that has to be factored into the efficiency calculation.

Does the inefficiency due to price uncertainty outweigh the inefficiency created by shortages and surpluses? I don’t know, and it’s a really hard thing to calculate. That said, if I wanted to increase efficiency, I would probably focus on reducing the consequences of price uncertainty by increasing the transparency of the pricing process and providing information that would help customers anticipate price fluctuations. Or, I could recognize that I don’t in fact work for Uber and start a futures market for Uber rides instead.

Tags: Buyer Beware · Econ 101 · Markets

3 responses so far ↓

  • 1 Jake Lopata // Jan 24, 2012 at 2:08 pm

    The answer to the Uber ride fare is to increase the supply of cars during periods of expected high demand.

    For example; rush hour.

    On the other hand, it might not be that simple, because increasing the size of a fleet of cars may prove not to be very cost efficient, thus adding to costs.

  • 2 Punditus Maximus // Jan 24, 2012 at 3:34 pm

    You’ve basically got it — people know that if prices change constantly and very quickly, they will not be able to make plans.

  • 3 Jay Wetmore // Jan 24, 2012 at 3:58 pm

    Is it safe to assume the Uber was only one option for a ride and that other providers using fixed price business models (say public transit). That way Uber users have choices. A monopoly based on dynamic pricing, especially if prices are only known after the fact would be unpleasant, even if efficient.

    If Uber prices do not become more predicable, and maybe less volatile, it may not be a viable business model.

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