04 Jun HOW DOES SURGE PRICING ENSURE THAT THE MARKET IS ALLOCATION EFFICIENT?
How does surge pricing ensure that the market is allocation efficient?
Question
Read the following excerpt from “Why Uber’s surge pricing is naive economics” and answer the following questions
Economists love Uber’s surge pricing. But it is doomed, because customers hate it. Why?
Surge pricing occurs when the supply and demand for Uber vehicles becomes unbalanced, for example, due to inclement weather, a public holiday such as New Years
Eve or some other event (public transport failure, terrorist attack, …). Supply is low (who wants to drive in a snow storm?). However, demand is high (how do I get home when the rail network is down?). So, by raising the price (sometimes very substantially), Uber aims to encourage more drivers to pick up passengers and to ration the available supply to the customers who value the service the most.
The result is a New Year filled with negative Uber articles, both in Australia and overseas. In the Harvard Business Review, Utpal Dholakia suggests that the near universal dislike of surge pricing is due to a lack of transparency and customers’ lack of understanding about its benefits. He suggests education and transparency. But Uber is already embracing these strategies, trying to warn customers when surge pricing is likely and to make sure customers understand and agree to the surge price when requesting a car.
So Dholakia misses the key point. It is not ignorance that leads to customer annoyance with surge pricing. Customers understand exactly what surge pricing does. And that is why they do not like it. From the customers’ perspective, surge pricing does two things.
First, it encourages more drivers and so makes it more likely that the customer can get home (or where ever else they are going) in less time (albeit at a higher – and possibly much higher – monetary price). ….
Second, however, surge pricing creates a transfer. When I jump into the Uber car I don’t know if my driver only decided to work because of the surge pricing. He or she might have been out there anyway. And in that case, I just pay more even though the driver would have been there anyway. Of course, the driver also gets more. The money doesn’t disappear. It is a transfer. My loss through paying the higher surge price is the driver’s gain. So from an economic perspective, this transfer is neutral. But that doesn’t make the customer feel any happier.
Author: Stephen King; Professor, Department of Economics, Monash University; The Conversation – January 11, 2016.
5a. Explain in detail using graphs how market forces will lead to conditions when surge prices can occur? Given these conditions in the market, why is the market inefficient in the absence of the surge price? (hint: talk about surplus and/or shortages as well as any deadweight loss that may exist in the absence of a price surge).
5b. How does surge pricing ensure that the market is allocation efficient? Explain how the consumer and producer surplus changes as a result of the price surge. Why would these changes upset customers?
5c. Provide one alternative to surge pricing.
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