Uber is in a market that may be fundamentally unwinnable, at least in the manner/value in which Uber appears to be trying to win it today. The on-demand ride market has significant network effects on both sides of the transaction, but it isn’t really a multi-sided market.
Problem statement for on-demand transportation:
- The value of an on-demand network (i.e. not scheduled) to the consumer is dependent on the number of unused nodes available for rides
- Without centralized employment, these unused nodes only get paid when they become used
- Legacy taxi schemes solve this by paying nodes “above market” rates when they become used, then insert various distortions into the free market (medallion caps, unified pricing structures, etc) to ensure drivers end up paid for the time when they weren’t used
Uber’s peer-to-peer “innovation” breaks #3 without appearing to provide a structure to replace it
My larger framework in the upcoming Part 2b explores the economic implications of executing Uber’s plan as I currently understand it, particularly how Uber’s cash flow will interact with their $50b valuation.
Even if Uber’s long-term plan is to use its knowledge of demand patterns to reduce the importance of #1 and #2, I believe Uber will still need to build protection for itself and drivers through shaping beneficial re-regulation, and/or evolve toward a different operating model. And even then Uber may struggle to maintain a substantial portion of its current valuation.
If this thesis is true, all the technical innovations and legal battles Uber is fighting today are arguably the equivalent of rearranging the deck chairs on the Titanic (a favorite analogy of consultants, not always used correctly).
Expert discussion framework: Three challenges for developing strategy in two-sided markets
Uber’s go-big-and-fast-and-destroy-the-economics behavior often makes sense for a two-sided market. Sometimes it doesn’t. In Oct 2006 the Harvard Business Review published an article on this topic by Harvard entrepreneurship Professor Tom Eisenmann et al: “Strategies for two-sided markets.”
We’ll use Prof. Eisenmann’s framework and words to illustrate how Uber’s structure and behavior seems to defy what I see as the conventional prescription for the type of challenges Uber faces in the on-demand ride market.
Note: Any errors of commission or omission here are entirely my own; I have not contacted Prof. Eisenmann about his article or this topic
Even though Uber’s press coverage seems to place it under the broad umbrella of “multi-sided markets” subject to “network effects,” strategies and tactics that lead to winning (differently structured) two-sided markets may not be appropriate for Uber’s highly commoditized on-demand ride market.
As we progress, you can compare elements of the on-demand ride market with what you know about other successful multi-sided market businesses to see how they’re very different from Uber. For a more recent analysis of peer-to-peer markets specifically, see Jon Levin et al here.
Challenge 1: Pricing structure depends on whether cross-side and same-side subsidies and network effects are positive or negative
Eisenmann describes six factors that impact pricing structure for multi-sided platforms. Uber’s design doesn’t seem consistent with the demands of #1, #2, #4, and #5:
- Ability to capture cross-side network effects.
- Eisenmann writes “Your giveaway will be wasted if your network’s subsidy side can transact with a rival platform’s money side.”
- With Uber, because the money side drivers can “wait” on multiple platforms due to their status as independent contractors, and users can “hail” on multiple platforms to conduct a quick price check, there is a tremendous amount of cross-platform leakage that will prevent long-run price-making by the platform
- User sensitivity to price
- Eisenmann writes “Generally it makes sense to subsidize the network’s more price-sensitive side and to charge the side that increases its demand more strongly in response to the other side’s growth.”
- Uber has proven that riders are very price sensitive, but because rides (unlike software) have marginal and opportunity costs, so are the drivers. As long as driver networks are essentially “shared” among platforms as independent contractors, there will be a strong incentive for rival networks to compete – they’ll transfer platform revenue to drivers once driver revenue has reached the equilibrium floor of marginal cost pricing
- User sensitivity to quality
- Eisenmann writes “High sensitivity to quality also marks the side you should subsidize. This pricing prescription can be counterintuitive: rather than charge the side that strongly demands quality, you charge the side that must supply quality.”
- This doesn’t seem to help us understand UberX; both sides seem to have a minimal expectation of quality (safety, getting paid) that’s better seen as table stakes than elastic.
- To the extent demands for quality exist, Uber segments into different markets (UberBlack, etc). Uber takes a higher commission, on a higher rate – and seems to be capping the number of drivers and contracting mainly with fleet owners rather than individual drivers
- Output costs
- Eisenmann writes “Pricing decisions are more straightforward when each new subsidy-side user costs the platform provider essentially nothing…. when a giveaway has appreciable unit costs, as with tangible goods [rides], platform providers must be more careful. If a strong willingness to pay does not materialize on the money side, a giveaway strategy with high variable costs can quickly rack up large losses.”
- Uber began their ramp up by subsidizing both sides – and in the process eroded drivers’ ability to subsidize the riders. Unless Uber can find a new side to this network, it will have to subsidize the riders themselves.
- In the long-term, possibly by replacing drivers with autonomous vehicles.
- In the short-term, there are few options that don’t first begin with making at least some of the drivers employees (e.g. to use detailed knowledge of ride demand patterns to preposition cabs in order to reduce the number of empty nodes required to operate the on-demand network at a given service level)
- Same-side network effects
- Eisenmann writes “Suprisingly, sometimes it makes sense to deliberately exclude some users from the network…. platform managers must assess the possibility of negative same-side network effects, which can be strong.”
- Uber’s driver count is uncapped and often “wait” on multiple networks. The ability for drivers to jump onto the UberX network erodes earnings for other drivers, creating negative network effects beyond a certain point.
- It’s probably not a good idea for Uber to exclude drivers from its own network unless it can first ensure the drivers it lets on aren’t still “driving” on multiple networks at the same time
- There may be incentive mechanisms (decline rates, ratio of “regular” driving to permit “surge” driving) that could at least partly accomplish this goal without hiring drivers full-time
- Users’ brand value
- Eisenmann writes “The participation of “marquee users” can be especially important for attracting participants to the other side of the network… a platform provider can accelerate its growth if it can secure the exclusive participation of marquee users in the form of a commitment from them not to join rival platforms.”
- Factor doesn’t seem relevant to Uber, outside of regulatory agreements (eg only Uber at the airport) and perhaps one-off event partnerships
Bottom line for Challenge 1: Uber’s pricing and design doesn’t seem consistent with #1, #2, #4, and #5 above. In part, this is because hewing to these principles would be inconsistent with Uber’s decision to use independent contractors as a second side to the platform.
Challenge 2: Winner-take-all (WTA) dynamics
The only reason to bet-the-company on winner-takes-all is
(a) if the market is destined to be served by a single platform and
(b) the risk-adjusted cost of the fight is less than the monopoly profits accrued by winning it
2.a Eisenmann’s three factors argue against a single platform winner in the on-demand ride market
2.a.1 Your market might be WTA if… Multi-homing costs are high for at least one user side
- Uber homing costs for drivers and riders are essentially zero. Homing costs could be increased by forcing drivers to pick a side, or by charging customers an “access fee” to the platform. It’s possible this could be done while maintaining contractors, but more likely means employing at least some of the drivers. This factor argues against a single platform winner under the current peer-to-peer industry structure
2.a.2 Your market might be WTA if… Network effects are positive and strong – at least for the users on the side of the network with high homing costs
- Uber network effects are in conflict: Cross-side network effects are strong to a certain limit, then decrease. Beyond this point, each side’s cross-network preferences are in opposite preference to same-side network effects: riders benefit from more drivers but few riders; drivers benefit from more riders and few drivers. This factor argues against a single platform winner
2.a.3 Your market might be WTA if… Neither side’s users have a strong preference for special features
- Uber’s growth depends on special features: There is a limit to the size of point-to-point on demand rides that is much smaller than Uber needs to support its valuation. Additional demand at lower price points will be drawn from carpool-like and bus-like services, which Uber has already launched. It seems like vehicle cost structure will be different enough in each of these markets to make them specialized. This factor seems unsupportive of a single platform winner.
2.a.BottomLine: None of the above three factors in 2.a indicate the on-demand taxi market is winner-takes-all
2.b Eisenmann says that only winnable battles should be fought, and even then only fight if your win would enable monopolistic pricing that covers the cost of winning
Eisenmann says “to fight successfully, you will need, at a minimum, cost or differentiation advantages.”
With Uber relying on third-party contractors, there is no clear cost advantage. Any differentiation feature that appears successful can be easily copied by a competitor – at least at this stage of the game.
If the battle were winnable (which 2.a suggests its not), and if Uber had the minimum 2.b requirements to fight successfully (which it doesn’t, at least today), Uber appears to have at least two of the three factors required to win the battle on its side:
2.b.1 Pre-existing relationships with prospective users would help win a battle
- Uber doesn’t have pre-existing relationships with drivers or passengers, which in part is what drives the high startup costs in a new city. While Uber recently announced a partnership with Hilton, that is more about mutual reinforcement of brand image rather than a concrete reduction of Customer Acquisition Costs, which is what this element focuses on
2.b.2 High expectations generate momentum, which helps win a battle
- Uber has high expectations and momentum. No doubt about it – fundraising, press… CEO Kalanick will actually be among of Stephen Colbert’s first guests (the second night, along with Elon Musk) when the new Late Show premiers next week
2.b.3 Deep pockets matter when winning battles
- Uber has deep pockets… for now. One of the biggest unanswered questions about Uber is how optional their $500m/month burn rate is. If Uber ran into a cash crunch, are the “mature” cities cash flow positive enough on their own that Uber would simply scale back their expansion rate? Or would Uber be forced to re-trench in a smaller number of cities until the funding started to flow again?
Challenge 2 summary: Uber’s prize of WTA may not be worth the chase:
Uber is spending a lot of money to (a) win something that doesn’t appear to be winnable, particularly at this stage of technological evolution; and (b) depends on significant external funding – which can be challenging for any platform business to weather but particularly for one with such a high existing valuation.
Uber’s scaling seems to involve a lot of payments to drivers, passengers, regulators, and lawyers that to date have benefited the whole industry, not just itself.
The way Uber, spending so much money to win what seems to be an unwinnable market, makes sense is if you believe building a global network of marginal-cost-priced rides is a means to some other business end. My framework in Part 2b goes into these possibilities in more detail.
Challenge 3: The threat of envelopment means your “win” might not stay “won”
Uber’s threat of envelopment seems low at the moment; if anything Uber are the ones seeking to blur the boundaries around other ride services – personally owned cars, carpooling, bussing, and potentially even mass transit.
In the interest of completeness, I offer Eisenmann’s prescription for companies facing envelopment:
3.1 – Change business models. Switch money sides, add new sides.
3.2 – Find a bigger brother. Ally with groups whose interests align with yours, including with whom you share enemies
3.3 – Sue. “Anti-trust law for two-sided networks is still in dispute. Antitrust law was conceived to constrain the behavior of traditional manufactuing firms and does not fully reflect the economic imperatives of platform-mediated networks. For this reason, dominant platform proivders that offer bundles or pursue penetration pricing run the risk of being charged with illegal tying or predation”
Uber is spending lots of money to win something that may not be winnable under current conditions. This raises questions about the strategic imperatives of their valuation
The on-demand ride market doesn’t actually seem like a two-sided market when you look at it closely. Undifferentiated drivers as contractors seems like a (useful) legal fiction. Treating them as a “money-side” to the market seems to undermine some of the operating aspects of the on-demand business.
It would be an interesting exercise to determine if this is rational – in other words, if the extra cost of drivers as employees is more than the extra cost savings that would accrue to Uber.
Most likely, as long as drivers are willing to work for very low wages (which is where this structure heads in equilibrium if it’s not there already), Uber’s incentive is to keep ride prices low to maximize the total dollar value of rides which accrue to it and hence their platform fees.
Once that equilibrium is reached, though, perhaps there would be room to use predictive analytics to take some empty cabs off the street. Could drivers spend less time waiting, and make the same total wages paid hourly, without raising customer pricing? This would also limit competitors’ ability to piggyback on the network.
Said differently, could Uber make better use of a limited number of “medallion 2.0s” than their competitors if the industry were re-regulated?
Would employing their drivers also enable Uber to implement a two-tier pricing structure – fixed fee for access to the Uber network at marginal cost pricing, or no-fee access to higher rate rides? Uber could probably do this without employing the drivers.
Is two-tier pricing possible under competitive conditions? Would that reach as many users as Uber needs?