CMI Briefs: The Rise of Uber

Updated: Sep 9

Uber’s growth

Uber’s rise has been meteoric. Founded in 2009, within a decade the firm was generating $13bn in revenue from a global “regular user” base of 110m. Even in the face of slumping demand during a global pandemic, the firm managed an impressive annual revenue of $11.1bn from 5bn trips (Uber yearly report, 2020). The firm’s revenue is small relative to trip volume because most of the booking value is pocketed by drivers. From this, Uber takes a 25% commission in exchange for ancillary services and the use of the app itself.

Platforms and network effects

Uber’s rise is due to its positioning as a platform and its capitalisation on the network effects inherent to its service offering. What does this mean?

Platforms are environments connecting different groups who derive benefits from each other’s participation. Uber is a platform because the more drivers there are, the shorter our wait time for a ride to arrive, and the better the chance of UberXLs etc. being available. From the drivers’ perspective, more riders mean their car spends more time generating income as opposed to costs. These are network effects, which characterise platforms like Uber.

The best examples of network effects are social media sites. Why does anyone use Facebook? We don’t enjoy the missing dog posts clogging our timelines, nor the questionable message requests from bots. We make Facebook accounts because “everyone else has one”. We don’t want to miss out on the freshers group chat. We need a way of contacting acquaintances whose phone number we don’t want. These are network effects – the more users on the platform, the more attractive it is.

Harnessing network effects

Uber offers multiple versions of its service to deliver more value to consumers. The platform hosts economy and premium services, from Uber Pool (shared trips) to Uber Exec (using luxury cars). This allows the firm to capitalise on variations in customer needs and price sensitivity, in a way that traditional taxi firms cannot. Through this feature Uber has harnessed its network effects; as Uber’s customer base explodes, the demand needed for niche segments to become profitable for drivers has been met. The firm has been fast to react, for example offering services like Uber Green (electric vehicles). Customers are willing to pay more money for services closely aligned to their needs, and Uber achieves this alignment better than its black cab rivals.

Uber has also leveraged its network effects through integrating food delivery services via Uber Eats, which utilises three sources of network effects – eaters, drivers, and restaurants. As Uber already had a large customer base, there were strong incentives for restaurants to offer their products through this distribution channel. The success of this expansion has been augmented by the firm offering friend referral codes for heavily discounted first meals. This an effective tactic to overcome the customer inertia of creating an account, and generates further network effects by increasing the consumer base.

Uber Eats’ revenues are growing at an increasing rate, jumping 152% from $1.9bn to $4.8bn 2019-2020. That said, the service is still loss-making, as is the firm overall. Uber’s CEO, Dara Khosrowshahi, has acknowledged that Uber has pursued “growth at all costs”. The firm’s focus on building a large user base rather than achieving profits highlights the value they place on network effects.

Quality and quantity

The development of network effects is a necessary, but insufficient condition of success for platform firms. These firms must maintain the platform’s interaction quality as well as quantity, otherwise the value users derive from the platform can freefall. Imagine if any user of Tinder could message you, not just people you’ve swiped right on – a scary thought indeed. The match requirement maintains interaction quality (or at least is supposed to).

Uber’s chief moderator of interaction quality is its rating system. It raises transparency, and allows parties to avoid low-quality interactions if they wish to do so. This in turn encourages parties to be courteous, augmenting the other’s experience. This is a key advantage Uber holds over traditional taxi models. Your Uber driver has strong incentives to make your ride as enjoyable as possible. Some let you control the air conditioning, some offer you snacks, some even let you aux your awful music. These are all features which, at no cost to the rider, improve user experience and thereby retention.

Competitive advantages over incumbents

There are competitive advantages Uber enjoys over incumbent taxi firms, besides its network effects.

One of these is a more closely integrated and effective use of data and technology. Uber uses “surge pricing”, whereby an algorithm offers riders personalised prices at levels which balance demand with supply. This is useful as both demand and supply vary temporally and geographically, for example demand rising during peak hours or in dense urban areas. The app’s pricing algorithm extracts more revenue from those willing to pay for convenience, and increases accessibility to those more concerned with minimising price.

Similarly, Uber’s interface means riders only need their bank card when making an account, as subsequent payments are automatic via the app. This payment integration adds value in a cashless society, where many people see carrying cash or a bank card as an inconvenience. Younger customers hate having to carry cash for a cab ride home after a night out – Uber understands this.

This article would be remiss without mentioning Uber’s cost structure. Its business model had allowed drivers to be classed as self-employed, rather than employees of the firm. This resulted in lower labour costs because Uber is under no obligation to ensure that its drivers receive the minimum wage, allowing the pricing algorithm to operate more efficiently. Similarly, the lack of unionisation or paid holidays available to Uber’s drivers helped it price more competitively than traditional taxi firms.

Looking forward

Looking under the hood of Uber reveals it is more than a taxi service holding a competitive advantage of lower labour costs. Its rise has been fuelled by powerful network effects, which the firm has harnessed through feature implementation and delivering a streamlined user experience. The key has been continually developing its competitive advantage, rather than leaning more heavily on it.

So, Uber’s value proposition is not destroyed by the Supreme Court ruling that its drivers are employees, entitled to minimum wage and paid holidays. However, its surge pricing algorithm will require adjustment, needing to squeeze as many rides as possible out of drivers to justify their minimum wage. Further, the firm faces the key decision of whether to pass on increased labour costs to customers via higher prices, or accept a lower commission from each ride.

Because Uber creates more customer value than its rivals, as explained in this article, it should raise prices. It should also seek to fully understand the competitive advantages generated by each of its service versions, in order to inform future resource allocation and prioritisation.