Surge pricing has gotten somewhat of a bad reputation, but it is simply one among several types of dynamic pricing. Industries from home rentals, to grocery delivery, to airlines all use dynamic pricing. Dynamic pricing appears when there is a fixed limited supply, in other words the supply pool is limited in comparison with the demand, for example in businesses like Airbnb. Another scenario is when running auctions on a limited supply, letting the crowd set the price, also called price discovery. There is also the case of controllable supply, or supply that you can manufacture, such as the goods produced under the AmazonBasics label. And finally there is dynamic pricing in situations of unlimited supply, as in advertising.

Looking at surge pricing through a lens of dynamic pricing allows us to understand it as simply one type of pricing mechanism. It also helps clear up some misconceptions about the pricing mechanism.

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On why surge pricing is not about exploiting demand

Surge pricing is a dynamic pricing strategy, used to restore balance in an on-demand marketplace where demand is outstripping supply. It comes into play when demand is much higher than what can be served in the marketplace at that moment. How can a business ensure that either their demand decreases or their supply increases? Surge pricing, which essentially is a real time shaping strategy for supply and demand.

“This is where I think the consumer perception of what surge pricing is, is very different from the actual goal of surge pricing. This is the key insight to walk away with: the goal of surge is not really to maximize revenue by exploiting the urgency of demand. Actually, the goal of surge is to get out of surge as quickly as possible. It’s not to make more money. Because the marketplace is sort of in a panic, if you will. The demand side is in panic. The goal is to get out of that panic situation, and come back to a healthy equilibrium as fast as possible. That’s what surge pricing systems are solving for, to restore and maintain marketplace equilibrium, high liquidity, and a very high level of service quality.”

On why oversupply is not a bad problem

If there were an unlimited supply of rideshare drivers, surge pricing would not be necessary. While drivers in a gig economy might not be happy about oversupply — since they would find themselves idle while waiting for jobs — from a marketplace operations point of view, oversupply is a positive situation. In this case, supply is waiting at the ready, and whenever demand increases, the company can match it to supply. The demand would always get served.

“The bigger problem is undersupply, because demand is king, and when there is demand supply will follow. Being in an undersupply is actually the main driver for surge. So with surge pricing, when you raise prices, what does that do? It basically causes the non urgent demand to drop off, reducing the total demand that is in the system and mitigating the undersupply. You share the rising cost of surge with the supply side; you’re taking extra money from the demand side, and people who are willing to pay that premium are willing to stay in the marketplace. When you take some of that and you give it to the supply side, then it actually acts as a reactive gamification. 

“A surge is a reactive state, because you didn’t predict it. You didn’t want to be in surge. Surge just happens, like it suddenly started raining, flash flooding. Or, suddenly, maybe an earthquake happened, or a fire happened, out of the blue. This is a situation which was never anticipated. You can anticipate weather, you can anticipate snow, seasonality and all that, but you cannot anticipate an earthquake. In that case, you have to rely on surge systems to actually clear the marketplace. It helps activate and bring more supply online. Just like it helps demand to go offline, it helps bring more supply online and mitigate under supply as well because more supply is coming.”

On the basics of building a surge system

Surge pricing is related to clearing rates, which refer to the speed at which orders or requests are claimed and swept out of the marketplace. In other words, what is the speed of transactions? In rideshare platforms like Lyft and Uber, the clearing rate is the average time to pick somebody up. This can be thought of as a liquidity metric.

“When this liquidity metric deviates significantly above the baseline, then you are actually going to start to surge. So how do you surge? A simple surge price calculation can be built as the following. The base price is based on the cost of goods sold. So let’s say the duration of a ride is 20 minutes. Let’s say 20 minutes is multiplied by $1 per minute. So that’s $20. And let’s say that the business margin is 25%. In this case, let’s say the driver makes 75% of the earnings, just to keep it simple. 75% of that is $15. So you take $20 from the rider, you give $15 to the driver. 

“The surge multiplier is the additional demand, a portion of which goes to the driver. The higher cost friction on the demand side will actually cause many riders to drop off. And the attraction of getting more pay on the supply side — on the driver side — will actually motivate drivers to come online. And that’s how this equilibrium is managed. It’s not to make money. Generally speaking, the idea is to actually bring more supply and to balance the marketplace.”

About the speaker
Vishal Kapoor Shipt, Director of Product Member

Vishal is a Product Leader with 20 years of expertise in building, launching and scaling next-generation consumer products, and has been responsible for $Billions in revenue, opex, and P&L. His products have spanned marketplaces, transportation, advertising, search, messaging, gaming, and retail industries. He is passionate about solving audacious problems through a principled, outcome-oriented, and collaborative approach. Connect with Vishal on LinkedIn: https://www.linkedin.com/in/vee