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Yves here. Hubert Horan has graciously offered to add one more post to what was originally a four-part series. He will discuss reader comments and issues not addressed in the series proper in an additional article. Part four and his extra piece will run Monday and Tuesday of next week.
By Hubert Horan, who has 40 years of experience in the management and regulation of transportation companies (primarily airlines). Horan has no financial links with any urban car service industry competitors, investors or regulators, or any firms that work on behalf of industry participants.
This is the second of a series of articles that will use data on industry competitive economics to address the question of whether Uber’s aggressive efforts to completely dominate the urban car service industry has (or will) increase overall economic welfare.
A positive answer to this question requires clear evidence that Uber can (or is on the verge of being able to) operate on a sustainably profitable basis in a competitive market, clear evidence that Uber can produce urban car service significantly more efficiently than the traditional operators it has been driving out of business, compelling evidence that Uber’s business model is based on major product/technological/process breakthroughs that create huge competitive advantages incumbents could not match, and that Uber can earn returns on the $13 billion its investors have provided within the normal workings of open, competitive markets, while ensuring that the gains from its efficiency and service breakthroughs are shared with consumers.
To state the question another way, does Uber’s meteoric growth and unprecedented $69 billion valuation reflect an efficient reallocation of resources from less productive to more productive uses?
The first article presented evidence that Uber is a fundamentally unprofitable enterprise, with negative 140% profit margins and incurring larger operating losses than any previous startup. Uber’s ability to capture customers and drivers from incumbent operators is entirely due to $2 billion in annual subsidies, funded out of the $13 billion its investors have provided. That P&L evidence shows that Uber did not achieve any meaningful margin improvement between 2013 and 2015 while the limited margin improvements achieved in 2016 can be entirely explained by Uber imposed cutbacks to driver compensation.
Thus there is no basis for assuming Uber is on the same rapid, scale economy driven path to profitability that some digitally-based startups achieved. In fact, Uber would require one of the greatest profit improvements in history just to achieve breakeven.
Unlike other well-known tech “unicorns,” Uber has not created a totally new product or dramatically redefined a traditional market; it is not “disrupting” incumbent operators with a totally new way of doing business but is driving passengers from point A to point B in cars, just like traditional urban car service operators always have. To achieve the overwhelming industry dominance that Uber is seeking it would need to find ways to provide service at substantially lower costs.
This article presents evidence about the cost structure of traditional operators, and evaluates, based on Uber’s actual practices and historical industry evidence, whether Uber has a meaningful cost advantage in any of these cost categories, or the potential to achieve substantially lower unit costs as it grows. Can Uber’s massive losses and investor subsidies be justified as an “investment” that will yield returns in the near future once its potential efficiency advantages (and scale economies) kick in?
Uber Extended the Industry’s Longstanding Segregated (Corporate/Driver) Business Model
When considering financial and cost data, keep in mind that taxi service is provided under a two-part business model, with drivers classified as independent contractors. Since the 1970s most traditional taxi companies have actually been leasing companies; drivers pay a fixed lease fee covering the costs of vehicle ownership and maintenance and corporate overhead services such as dispatching, branding/marketing and credit card processing. Traditional drivers retain all of the money paid by passengers, but pay for gas and bear the risk that fare revenue on a given shift might not be enough to provide meaningful take home income after covering the leasing fees and the workman’s comp and health insurance costs taxi companies do not pay for.
The Uber model takes the contracting model further by additionally shifting all vehicle costs and capital risk to drivers. Uber takes 30% of passenger revenue but only provides corporate overhead services. To evaluate questions of efficiency and competitiveness one needs to consider the entire (corporate+driver) business model since neither business model can work in the marketplace unless both the corporate entities and their driver contractors can achieve reasonable earnings.
85% of Taxi Costs Are the Direct Costs of Vehicles, Fuel and Drivers
There are four major components of urban car service costs: driver compensation (take home pay plus the benefit costs they must cover), fuel and fees directly related to passenger service (credit card fees, airport access fees, tolls, cell phone charges), vehicle ownership and maintenance, and corporate overhead and profit (including dispatching and branding/marketing). Detailed cost data from studies of traditional operators in Chicago, San Francisco and Denver showed that 58 cents of every gross passenger dollar (fares plus tips) went to driver take home pay and benefits, 9 cents went to fuel and direct fees, 18 cents went to vehicle costs and the remaining 15 cents covered corporate overhead and profit.  These percentages can vary slightly depending on fuel price swings and local practices, but reasonably reflect the relative size of the four cost categories at traditional operators under current conditions.
Uber is the Industry’s High Cost Producer
Can Uber produce urban car services more efficiently — at sustainably lower cost — than traditional operators? Can Uber’s success in driving incumbents out of business and achieving the largest venture capital valuation in history be explained by a powerful competitive efficiency advantage?
If one examines the four components of industry cost it becomes apparent that the opposite is true. Uber not only lacks the major cost advantage that a company seeking to drive incumbents out of business would be expected to have, but actually has higher costs than traditional car service operators in every category, except for fuel and fees where no operator can achieve a cost advantage.
These structurally higher costs are fully consistent with the ongoing, multi-billion dollar losses documented in part one of this series, and the finding that Uber’s rapid growth is driven by massive investor subsidies, and not by superior service or efficiency.
The first two rows on Exhibit 1 quantifies the difference between the two business models. Traditional taxi leasing companies pay 33% of these costs (vehicle and corporate costs) plus the vehicle capital risk; since the Uber model shifts vehicle costs and risks to drivers, they are only covering 15% of the total cost structure and bear none of the capital risk. .
Higher driver compensation. Recent in-depth studies from Chicago, Boston, New York and Seattle show that the 58 cents retained by traditional taxi drivers provides hourly take-home rates in the $12-17 range (in 2015 dollars) and that full-time drivers can only realize those hourly averages if they work 60-75 hours a week. True pre-tax earnings are even lower since workman’s compensation, health insurance and some miscellaneous expenses must be covered out of take-home pay. Recognizing that big city taxi drivers are forced to work much longer hours than typical drivers, this data is consistent with Census Bureau analysis which estimated the average wages in the broad category of taxi and limousine driver as $32,444 per year and $13.25 per hour (in 2015 dollars).
Uber needed extraordinary traffic and revenue growth in order to fuel the growth of its (now $69 billion) financial valuation. In addition to the massive subsidies for uneconomical fare and service levels needed to shift passengers away from traditional operators, Uber needed to subsidize uneconomical driver compensation premiums large enough to get hundreds of thousands of drivers to abandon other operators and sign up with Uber.
Uber’s above-market driver compensation meant its drivers were often more professional and drove better maintained cars than their lower paid counterparts. In a competitive market drivers would have no incentive to drive for Uber if it paid the same as traditional operators (why take on all the vehicle expense and risk for the same $12-17/hour Yellow Cab pays?) And it would be impossible for Uber to ever achieve a driver cost advantage over incumbents without paying significantly less than traditional operators, which would require pushing average take-home wages down to (or perhaps below) minimum wage levels
Higher vehicle costs. It is inconceivable that hundreds of thousands of independent, poorly financed Uber drivers Uber could ever achieve lower vehicle ownership, financing and maintenance costs than professional fleet managers at a reasonably managed traditional operator, or do a better job balancing long-term asset costs against local market revenue potential. Shifting operating costs and capital risk from Uber’s investors onto its drivers does not eliminate them from the overall business model, and actually makes them higher.
Every other transport industry depends on highly centralized management using highly sophisticated systems to ensure that capital assets are highly utilized and tightly scheduled around market demand. The Uber business model implies that all these industries are horribly wrong; decentralizing asset purchasing, maintenance and scheduling to isolated low-wage workers would not only reduce costs, but create an efficiency gain large enough to drive all incumbent operators out of business. No one has produced any economic evidence demonstrating that the Uber view might be correct.
Higher dispatch and corporate costs. Traditional taxi owners take 15 cents of each passenger dollar to cover dispatching, corporate overhead and profit while Uber currently takes 30 cents. But Uber’s costs are much, much higher; even though they provide less than half the service of traditional companies. The P&L data clearly shows these charges come nowhere close to covering Uber’s actual corporate expenses. Unlike traditional cab companies, Uber fees need to cover the cost of global marketing, software development programs, branding and lobbying programs, the huge market development costs of Uber’s expansion into hundreds of new cities and must also fund a return on the $13 billion its owners have invested.
Uber Used “Strategic Misinformation” To Elide Its Catch-22 Problem With Driver Costs
Uber’s above-market drive pay premiums created a competitive Catch-22; they fueled the rapid growth that was critical to its unprecedented valuation and established the perception that Uber had better drivers and vehicles. However, that also meant Uber would have a hopelessly large cost disadvantage in the biggest and most important cost category. Cutting driver compensation back to previous market levels would also halt growth and undermine Uber’s perceived quality advantage.
Uber dealt with this Catch-22 with a combination of willful deception and blatant dishonesty, exploiting the natural information asymmetries between individual drivers and a large, unregulated company. Drivers for traditional operators had never needed to understand the true vehicle maintenance and depreciation costs and financial risks they needed to deduct from gross revenue in order to calculate their actual take home pay.
Ongoing claims about higher driver pay that Uber used to attract drivers deliberately misrepresented gross receipts as net take-home pay, and failed to disclose the substantial financial risk its drivers faced given Uber’s freedom to cut their pay or terminate them at will. Uber claimed “[our} driver partners are small business entrepreneurs demonstrating across the country that being a driver is sustainable and profitable…the median income on UberX is more than $90,000/year/driver in New York and more than $74,000/year/driver in San Francisco” even though it had no drivers with earnings anything close to these levels.
After these claims were readily debunked Uber responded with allegedly “academic” research (which Uber administered and paid for) which claimed Uber drivers earned more than traditional taxi drivers but made no effort to calculate actual net earnings, and concealed the fact that Uber salaries were massively subsidized while traditional taxi salaries were constrained by actual passenger revenues.
In mid-2015, after hundreds of thousands of drivers were locked in to vehicle financial obligations, Uber eliminated driver incentive programs and reduced the standard driver share of passenger fares from 80 to 70 percent. This transfer of passenger dollars from Uber drivers to Uber investors drove all of its 2016 margin improvement, but also eliminated much (if not all) of the economic incentive that got drivers to switch to Uber in the first place.
An external study of actual driver revenue and vehicle expenses in Denver, Houston and Detroit in late 2015, estimated actual net earnings of $10-13/hour, at or below the earnings from the studies of traditional drivers in Seattle, Chicago, Boston and New York and found that Uber was still recruiting drivers with earnings claims that reflected gross revenue, and did not mention expenses or capital risk. In the absence of artificial market power, it is not clear how Uber could sustain either higher driver compensation, or the misinformation that created the false impression that it pays significantly better than traditional operators.
Uber Cannot Grow Into Profitability
Many successful startup companies experienced large initial losses but used scale and/or network economies to dramatically improve cost competitiveness and margins as they grew, although Uber’s losses to date ($2 billion a year) are significantly larger than any previous tech startup. But as noted in the first article in this series, the urban car service industry has never displayed evidence of significant scale economies, Uber’s actual financial results show none of the rapid margin improvements that would occur if strong scale economies actually existed, and Uber has none of the characteristics of the digital companies that were able to “grow into profitability.”
Exhibit 2 summarizes scale economy issues for each major cost category. There are no scale economies related to the 85% of costs related to direct operations; each shift involves one vehicle and one car regardless of the size of the company. This is why there has never been any natural tendency towards significant concentration in individual taxi markets, and why taxi companies rarely expanded beyond their original markets.
The revenue productivity of drivers could increase if more off-peak and backhaul passengers could be found, but revenue productivity is not a function of company size. Uber’s decentralized business model precludes the efficiencies integrated operators can achieve such as volume purchasing of vehicles and insurance and the use sophisticated systems to optimize asset acquisition and utilization against volatile demand patterns.
Uber’s economics are fundamentally different from other well-known startups that successfully used scale economies to grow into profitability. These were companies in fields such as social media or online retailing whose purely digital products could be expanded globally (and into new markets) at extraordinarily low marginal cost. Unlike an urban car service provider, direct labor was a tiny component of these companies’ overall cost structure, and most had no competition (entirely new products like EBay or Facebook) or were facing competition with enormously higher direct operating costs (online retailers vs. brick-and-mortar incumbents).
Unlike digital companies, Uber actually faces negative expansion economies since each new market raises entirely unique competitive, recruitment and political lobbying challenges. Uber’s unit expansion costs appear to have increased dramatically as it expanded outside the United States.
Uber also has no potential to exploit the network economies that some purely digital companies used to drive major profit improvements. In these cases (EBay’s exchange market, Google’s search function, Facebook’s social media product) the development of a strong user base makes the product significantly more efficient and more attractive to other users. This locks-in existing users, fuels growth, and makes it nearly impossible for later entrants with smaller user bases to compete.
By contrast, neither Uber’s ordering app, nor the ordering apps of other operating companies create these network economies or locks-in users the way EBay and Facebook and Google have. In a competitive market, people will use the app of companies like Uber or American Airlines if they can profitably provide good prices and service, but no one will abandon Yellow Cab or JetBlue just because a lot of other people have the bigger company’s app on their phones.
Will the growth of Uber increase or decrease overall economic welfare?
The first post in this series laid out the evidence of Uber’s staggering losses. Uber has grown because consumers have been choosing the company that only makes them pay 41% of the cost of their trip; there is no evidence that taxi customers in a competitive market would pay more than twice as much for the service quality advantages Uber investors have been subsidizing. Incumbent operators have been losing share and filing bankruptcy because they cannot compete with Silicon Valley billionaire owners willing to finance years of massive subsidies as they pursue industry dominance.
This post focused on the cost structure of the urban car service industry in order to demonstrate that Uber has structurally higher costs than its competitors, and lacks the scale economies other startups have used to rapidly reduce unit costs. In the absence of the massive scale economies that digital companies enjoy, there is a fundamental contradiction between incurring the cost of providing higher levels of capacity and service quality, and achieving costs low enough to drive incumbents out of the market.
If one examines the components of urban car service costs, there is no basis for claiming Uber could ever eliminate its structural cost disadvantage, much less achieve the massive cost advantage needed if its march to industry dominance is to be justified on economic welfare terms. The findings that Uber is the industry’s high cost producer and lacks any meaningful scale economies are entirely consistent with the P&L data presented in the first post.
In most industries, years of evidence about massive losses, the lack of margin improvements, and structurally uncompetitive costs would be sufficient support for the conclusions that the displacement of incumbent companies by the new entrant had not increased economic welfare, and that the capital markets that had funded the new entrant were not allocating society’s resources to more productive uses. Silicon Valley funded tech unicorns have regularly claimed that these traditional financial standards are inadequate because they have been introducing massive product/technological/process innovations that totally “disrupt” traditional industry economics, and the public discussion of Uber has been dominated by claims about its innovative breakthroughs.
In reality, if the alleged innovative breakthroughs have not made major impacts on service, efficiency and profitability, then they are not really innovative breakthroughs. In the case of Uber the question becomes why haven’t these “disruptive innovations” yet produced competitive cost advantages or profits?
The next installment of this series will examine a range of claimed Uber “innovations”—sharing economy efficiencies, market growth, Uber’s app and surge pricing—and examine whether any of these could constitute the type of large, sustainable competitive advantage that could eventually justify Uber’s growth and industry dominance in economic welfare terms.
 Seattle Consumer Affairs Unit, Seattle Taxicab Industry Revenue And Operating Statistics (2010); and Taxicab Industry Revenue Flow Diagram; San Francisco Municipal Transportation Agency, Meter Rates & Gate Fees, prepared by Hara Associates (Aug 2013); author’s analysis of Denver taxi operators annual financial reports to the Colorado Public Utility Commission. All data was restated in 2015 dollars. Seattle data assumed the use of Ford Crown Victoria and higher 2010 fuel prices and were adjusted to reflect the higher original cost of hybrid vehicles and the lower 2013 fuel prices reflected in the San Francisco and Denver data. Driver take-home pay must cover workman’s compensation and any health insurance costs drivers incur.
 Chicago Business Affairs and Consumer Protection, Taxi Fare Rate Study, prepared by Nelson Nygaard Associates (2014); Boston Taxicab Consultants Report, prepared by Nelson Nygaard Associates and Taxi Research Partners (2013); Seattle Consumer Affairs Unit supra note 15; New York Taxi and Limousine Commission, New York City Taxicab Fact Book, prepared by Schaller Consulting (2006). Seattle drivers earned $12.14/hour working 10.2 hours per day; Chicago drivers earned $12.94/hr @ 12.8 hrs/day; Boston drivers earned $14.61/hr @ 15 hours/day and New York drivers earned $17.51/hr @ 9 hours/day. All pay data adjusted to 2015 dollars.
 Census Bureau American Community Survey data excluding drivers working 40 hours or less. Transportation Research Board, Between Public and Private Mobility, Examining the Rise of Technology-Enabled Transportation Services, 52-3 (2015)
 Uber was claiming that its drivers made more than double the actual earnings of traditional New York taxi drivers, and more than the average wages of workers in the tech industry., McFarland, M., Uber’s Remarkable Growth Could End The Era Of Poorly Paid Cab Drivers, Washington Post, 27 May 2014.
 “In several months of reporting on Uber, I have yet to come across a single driver earning the equivalent of $90,766 a year…. despite broadcasting the $90,766 figure far and wide, Uber has so far proved unable to produce one driver earning that amount.” Griswold, Alison, In Search of Uber’s Unicorn: The Ride-Sharing Service Says Its Median Driver Makes Close To Six Figures. But The Math Just Doesn’t Add Up, Slate, 27 Oct 2014. These figures appeared to have resulted from extrapolating the hourly receipts of drivers who only drove a handful of peak-demand hours a week.
 Kedmey, D., Do UberX Drivers Really Take Home $90K A Year On Average? Not Exactly, Time, 27 May 2014. Rail, T., Fact checking Uber’s claims about driver income. Shockingly, they’re not true, Pando Daily, 29 May 2014. Singer, J., Beautiful Illusions: The Economics of UberX, Valleywag, 11 Jun 2014.
 The academic was Alan Krueger of Princeton, a former White House colleague of Uber executive David Plouffe. Issac, Mike, Hard-Charging Uber Tries Olive Branch, New York Times, 1 Feb 2015.
 Huet, Ellen, Uber Tests Taking Even More From Its Drivers With 30% Commission, Forbes, 18 May 2015.
 O’Donovan, Caroline & Singer-Vine, Jeremy, Uber Data And Leaked Docs Provide A Look At How Much Uber Drivers Make, Buzzfeed, 22 Jun 2016.
 Academic studies found limited scale economies (i.e. to cover the fixed costs of dispatching equipment) that would limit the ability of very small firms to compete with mid-sized firms in the same city, but none large enough to drive high levels of concentration within a given city. Pagano, A. M., & McKnight, C. E., Economies of Scale In The Taxicab Industry: Some Empirical Evidence From The United States. Journal of Transport Economics and Policy, (1983).299-313; Dempsey, Paul, Taxi Industry Regulation, Deregulation, and Reregulation: The Paradox of Market Failure. Transportation Law Journal, 24(1),115-16 (1996)