How the Unit Economics Illuminate the Business Model

Why are Taxis not able to compete with Uber?

Taxi drivers feel threatened by Uber. I haven’t seen much hard data about how much market shares Uber has taken from taxis yet. Yet, if you read the media it surely feels like Uber is taking market share from taxis like Amazon is taking market share from bookstores. Uber is able to offer transportation for as little as almost half the price of a taxi on certain routes. At the same time, Uber drivers are said to earn up to three times as much as a cab driver.

Legislators of various cities and countries are putting bans on Uber in order to protect taxi drivers. And to protect customers; as they claim. Most recently, a German court ruled, that Uber’s low cost UberPop service could no longer take on passengers due to a lack of public permission.

Now why do regulators feel the need step in, and why are taxis not as competitive as Uber? It is often cited in the media, that Uber is disruptive, but why exactly is the company able to disrupt the taxi market?

The superficial answer is that taxis are regulated. Yet, that doesn’t explain the full picture. What’s the sense of the regulation of taxis if makes them vulnerable to more efficient competitors? Imagine you have to explain to your frustrated cab driver why Uber is able to offer lower fees to customers while paying higher ‘salaries’ to drivers. More important, he might be puzzled why a company that doesn’t own a car is valued at up to 18bn.

One market? Not quite.

To understand Uber’s business model, we first need to understand that the taxi market is not single market. The taxi market actually consists of different market segments. Each market segment is characterized by different needs of customers and by different economics. A study by the Institute of Transport Economics describes the four segments of this market as street hail / cruising, rank-stand, pre-book and contracts. For illustration purposes we will look at two of them, street hail/cruising and pre-book.

The street hail / cruising segment includes those customers who flag a taxi at the street. Those customers need a taxi right now. In order for the transport system to function, it is necessary to ensure that a constant supply of ‘flaggable’ taxis is available at any time. As you can imagine, it is not trivial to match supply and demand perfectly in this market. If there is an undersupply of taxis, a taxi is likely to have a good bargaining power. Imagine a customer in a hurry, standing in the rain. He might be tempted to pay a good premium on the fare when a taxi driver takes advantage of him.

To ensure this constant supply for customers, there needs to be an oversupply of taxis in the market. Taxis will need to drive empty for a significant part of their time. Aircraft operators call these trips empty legs. Think how often you see an empty taxi waiting or cruising. These empty legs will result in a low capacity utilization for taxis. For any asset-heavy industry; for any industry that has to acquire or lease expensive assets, the utilization of those assets is a key driver of its profitability. If you own a restaurant, your monthly rent for the building will be a major cost factor. Having lots of traffic in your restaurant, will have a major impact on your profit margins. This, of course, applies to taxis in a similar fashion. Thus if taxis want to operate profitably, they need to charge higher prices to compensate for those empty legs.

There is another problem in this market. Customers cannot assess the reliability of drivers. Ensuring safety therefore is critical.

In order to solve both problems – to ensure a sufficient supply of taxis at constant rates, and to ensure the safety of passengers – this market is usually regulated. One must be licensed to operate a taxi.

Uber is not a taxi operator. It is a match-maker who helps operators increase capacity utilization.

However, this goes only for the taxis that are flagged on the streets. A different part of the market, which is also served by the regulated taxis, has different unit economics. There are customers who do not need a taxi right now. Think of customers who need to go to the airport. They are able to pre-book their ride. In addition, mobile phones have made pre-booking possible at even shorter notice today. We are speaking of 10-minutes pre-booking if you want to call an Uber. This pre-booking segment is a completely different animal than the street hail segment. The pre-booking provides the opportunity to increase the capacity utilization by matching supply and demand. This matching of supply and demand is a major part of the value, which Uber creates. Through this matchmaking, Uber enables drivers to increase their utilization rates, which in return enables them to operate more profitable. They can pass this higher profitability on to customers in the form of lower fares.

Think of aviation as an example. Private jets are expensive, because they fly only for a few hours, followed by a waiting time of several hours. Their capacity utilization is very low. Scheduled airlines on the other hand are able to maximize capacity utilization. This results in lower fares for customers. Simply put, taxis are the private jets, while Uber is the scheduled airline.

Since it is possible to balance supply and demand in Uber’s market, the pre-booked and mobile phone-supported market, no regulation is needed to make it efficient.

picture credits: Mikhail Starodubov, Pinkcandy / Shutterstock

picture credits: Mikhail Starodubov, Pinkcandy / Shutterstock

Legal requirements for taxis also try to ensure safety of passengers in the street hail segment of the market. Again, no regulation is needed in Uber’s market segment. Uber is able to ensure safety and quality standards by providing ratings of drivers. Why is this possible? Because Uber’s business model is built on return-customers. Uber can only operate profitably, if customers return frequently to Uber. Acquiring customers is expensive for Uber. In order to recoup that cost of customer acquisition, they need to ensure that the customer takes many rides with them. Uber therefore is incentivized to generate happy customers. They do this by ensuring quality standards for its drivers. If the driving style of an Uber driver is inspired by Nascar racers he won’t stick with Uber for long.

If you have ever been in a restaurant in a holiday destination, you know that you might have to expect lousy food for high prices. Why? Because the owner knows that no matter how good or bad the food, you will not come back once you have ended your holiday. This is the street hail segment, where a driver is very unlikely to meet you again. In contrast, if you go to your local restaurant in your home town, the owner will be motivated to keep you happy. Why? Because he knows you might come back for his excellent food and service.

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