It has been a big year for Uber and Lyft as both companies broke into new cities, raised new capital, and continued to attract media attention for disrupting the black car and taxi market. The year also brought about large price drops for both companies. Between January and February of this year, Uber rolled out a 15-34% price drop for its UberX service in cities across the United States and Canada. Lyft responded in April with a 20% price cut after raising a new $250M fund. Such significant drops have sent the media into a frenzy – they can’t stop reporting about this “intense war”.
I’m going to argue the opposite: Uber and Lyft are more likely working in unison rather than against one another. The “price war” is an illusion to fool one into thinking that the competition is hot, when in fact, Uber and Lyft are working hard to create their own ideal market. To better understand why this is the case, we need to look at basic game theory models.
Game Theory and the Prisoners’ Dilemma
Game theory as described by Wikipedia is:
A study of strategic decision making. Specifically, it is “the study of mathematical models of conflict and cooperation between intelligent rational decision-makers”.
One of the most basic models of game theory is the prisoners’ dilemma. Suppose two individuals are caught by the police for robbing a store. They are both held in separate interrogation rooms that stop them from talking to one another. The police talk to each prisoner individually to try to convince the prisoners to rat the other out. What are the incentives for ratting out your fellow prisoner? Less time in jail of course!
As we can see from the diagram, if both prisoners do not confess, they will each do one year of time (see the bottom right quadrant). However, if Prisoner A confesses, while Prisoner B stays silent, then Prisoner A gets to walk away without time, while Prisoner B does 20 years in prison (ouch). The same applies if Prisoner B tells, but Prisoner A does not. Finally, if both prisoners tell, then both are guilty, and sentenced 10 years in prison each.
The ideal situation for Prisoner A is to tell and hope that Prisoner B stays silent, but Prisoner B has the exact same idea and motivation. In the end, both prisoners will talk and they will both do 10 years in prison. It clearly would have been better if both prisoners did not talk, and therefore would have been released in one year. The problem with this is that both prisoners cannot talk to one another and coordinate such a plan, making it likely that both prisoners will always rat the other out.
Game Theory and Price Wars
Price wars are not too different from what we saw above. With a price war, we once again have firms that need to make a decision over whether to drop prices.
Once again, we have four quadrants with two players in this game: “You” and the competitor fighting it out in the hot bubble gum market. Your decision is to either hold your price, or drop it. If you drop your price, and the competitor maintains his/her price, then you reap the difference through increased market share; however, if the competitor responds by cutting its own prices, then both players lose revenue as there is no price differentiation (looks like the beginning). Ideally, the best option is drop prices and hope that the competitor does not. Unfortunately, no one likes to lose market share, and the competitor will follow suit. Once again, it is better if both players work together to hold prices. In the real world, any form of communication like this is considered collusion, which is highly illegal. Most recently Nestle Canada and Mars Canada, along with their fellow distributors, were fined for keeping chocolate prices artificially high.
Are Price Wars Inevitable?
Price wars occur in industries that involve many competing businesses fighting over a saturated, commoditized market. The packaged food industry is a great example. Brands are constantly fighting one another on razor thin margins to sway customers from one cereal box to the next. Because there are many different competing brands, it becomes hard to watch one another very closely. As a result, some businesses will try to lower prices to reap market share gains while other businesses aren’t watching. This does not work for long, as other businesses will react, causing prices to steadily drop.
In industries where there are few players (think 2-3), it becomes much easier to watch one another. When one player reduces prices, the market notices, and players immediately follow suit. As a result, in an industry with few players, holding prices becomes easier as each player can silently agree with one another by simply doing nothing. It is always easier to get two players to agree on something rather than five, ten, or even 15. Look at the Canadian telecommunications scene where Rogers, Bell, and Telus are dominant players in many provinces. A phone plan in Toronto with unlimited talk, text, and 2GB of data costs $90/month! Not only have the carriers maintained prices across their industry, but they have even managed to increase them as well. On the other hand in Quebec, Videotron is a controversial fourth player that is causing trouble. Aggressive pricing by Videotron has brought plans down to $75/month.
Coming Back to Uber and Lyft
For silent cooperation there are two main criteria: a small number of players within the market, and a commoditized or near commoditized product. We can argue that Uber offers different services such as black cars and SUVs, but if we focus on UberX vs. Lyft, the products are nearly identical. They both offer ride-sharing options by pairing drivers and their cars with demanding passengers. Next, Uber and Lyft are by far the two primary competitors in North America. By valuation, Uber rings in at $18B, while Lyft is in a distant second at ~$700M. Others including Hailo and Sidecar both combined have raised around $112M – far less than Uber and Lyft’s most recent funding at $1.2B and $250M. Therefore, with only two players really competing in the ride-sharing market, and a commoditized product, it would make sense that a price war would not fit this industry. When Uber made an announcement to drop prices between January-February, Lyft came out with an announcement shortly afterwards in April about its own price drop. In essence, because its very easy to monitor one another, arguing that the price drop is a “pricing war” may not make sense. If that’s the case, then why are Uber and Lyft dropping prices aggressively?
The answer is clear when we look at what both companies have been talking about lately. Uber has an entire page dedicated to announcing price drops. You’ll notice in each blog post, Uber references how its new UberX service is now 20%, 40%, or even 50% cheaper than a taxi depending on the city. Even Lyft mentions that its price drops aren’t necessarily targeted at Uber, but rather to create “the best transportation option”. Therefore, it becomes pretty clear that the main goal for these price drops is to lure customers away from the existing market for taxis. By offering an easier way to order a car, handle payment, and enjoy a friendlier experience, all at a cheaper price, Uber and Lyft are using price drops to grow the market rather than to compete with one another.
It does not stop there as Bill Gurley, General Partner at Benchmark Capital, further explores the definition of what is the total addressable market (TAM). I agree with his view that the total addressable market does not just stop with the global taxi and car-service market. Instead Uber and Lyft could become replacements for driving your own personal car, as well as public transportation if the price of ride-sharing can go below the breakeven cost of the alternatives. This opens the market up immensely and becomes one argument for the massive $18B valuation that Uber currently holds.
Competition or Playful Partnership
Those who believe we are seeing ruthless competition will point to Uber’s street teams whose roles include ordering and canceling Lyft cars, as well as persuading drivers to switch over to Uber. However, these tactics are short-term effects on an emerging market with a long-term vision. Both Uber and Lyft want a bigger market to play in. Of course, neither company may actually like the other, hence the short-term efforts to disrupt each others’ service, but in the end both companies are working towards a similar goal. By dropping prices, they start to look more appealing to individuals and create use cases that were not present in the past. Furthermore, the media reports of ruthless competition help keep competitors out while Uber and Lyft continue to gobble up more market share for themselves.
Afterthought: Lyft and 2nd Place
I think it is important to end this post by saying that no one really likes being in second place. Lyft is by no means happy with its current standing and I’m sure is has every desire to take on Uber. However, as stated, dropping prices will not gain market share. As Uber is a much larger organization, the company has the ability to replicate almost any move Lyft makes. If Lyft enters a new city, Uber will be there. If Lyft can reduce wait times to seconds, Uber will do that too. If Lyft creates partnership deals with companies to transport employees, Uber will too. In the end, I think the only way Lyft can escape the clutches of Uber is if it offers a new service that Uber isn’t interested in at all. At least, not until Lyft can monopolize that segment of the market.
Going back to the Rogers, Bell, and TELUS example, TELUS is in third place with revenues of $10.6B in 2013. TELUS has and will continue to compete by offering the same services and products that Bell and Rogers do. If TELUS offers a new product within the realm of wireless, broadband or TV, you can bet that Rogers and Bell will be right behind it. With that in mind, TELUS made an attempt in 2007 to outmaneuver Rogers and Bell by going into something that the other carriers were not interested in at the time, eHealth. The move to eHealth was driven by TELUS’ CEO, Darren Entwistle, who watched his father die in December of 2004 as doctors injected the man with penicillin to stop an infection, unaware that he was actually allergic to it. On a mission to improve the communication of information, TELUS has sought to build solutions that will help bring the ancient healthcare system from paper and pens, into the new age of networks and databases. This focus on healthcare compliments TELUS’ existing business of connecting people, devices, and information. As of February 2013, TELUS is the largest provider of electronic medical records in Canada, giving it a chance to reap profits in a potentially lucrative market. The division has roughly $500M in revenue, but that figure is projected to grow and become an important revenue stream as businesses adopt eHealth solutions. If Lyft can do something similar, not only will it be the second largest provider of transportation, but it can also become the largest provider of complimentary market services that are just as valuable.