Economics 101 with Lt. Surge

Malt Liquidity 129

“Bad news, detective. We got a situation.”

“What? Is the mayor trying to ban trans fats again?”

“Worse. Somebody just stole four hundred and forty-seven million dollars’ worth of bitcoins.”

The heroin needle practically fell out of my arm. “What kind of monster would do something like that? Bitcoins are the ultimate currency: virtual, anonymous, stateless. They represent true economic freedom, not subject to arbitrary manipulation by any government. Do we have any leads?”

“Not yet. But mark my words: we’re going to figure out who did this and we’re going to take them down … provided someone pays us a fair market rate to do so.”

“Easy, chief,” I said. “Any rate the market offers is, by definition, fair.”

This, of course, is a discussion about Wendy’s “surge pricing” headline:

CEO Kirk Tanner told investors on a call this month that starting as early as 2025, Wendy's would begin testing features including "dynamic pricing and daypart offerings".

Unfortunately, he used the word “surge pricing”, which set off a fiasco where our resident wind-up regulator clock in the corner immediately set the record straight.

Price is never “fixed”, hence the concept of liquidity:

The “simple Econ 101” explanation of price as the equilibrium of supply and demand has a problem in reality: it assumes infinite liquidity. The price of an asset is defined by where the bid meets the ask, but I cannot simply buy as much of the asset as I want at this price unless there are enough sellers willing to provide me the supply. Liquidity, as a result, is both a measure of how true the price that the discovery mechanism has given us is, and the ease with which you can increase or decrease exposure to the asset.

The price for a Baconator is not fixed. It may have a sticker equilibrium price for a specific store location or neighborhood, but that is a function of the CoGS, the labor, how much demand they expect in a day, a waste threshold, and more. The cost is necessarily dynamic and the price is a volatility-stabilizing way to run a business. Which makes sense! A real-time updating algorithm to reprice menu items intraday seems largely unnecessary because all the things mentioned above are highly predictable and have very little variance. It’s already an optimized process. Rather than dynamically pricing the menu, the method to trigger demand is to discount through coupons, push notifications on “instant deals”,“happy hours” and “lunch specials”, which are cheaper and more effective way to time-bucket demand incentives without getting too fancy.

Surge pricing, on the other hand, refers to a rapid spike in price due to an excess of bidside liquidity vs supply. It’s a nonlinear phenomenon rather than the fixed linear input/output of meals demanded = meals sold. Refer to my post on how Uber pricing works:

Really think about what Uber’s supply-demand sensitivity actually is — it’s just market making cab rides rather than options trades. A certain route has a given bid (whenever the user puts in their desired location for a price quote) and an ask (what price is offered to the driver), with Uber collecting the spread in between. Imagine this process in a vacuum, where there is only one rider and one driver: internally, Uber has to have a relative pricing mechanism for that route, but it will be quite wide because of uncertainty. As more riders populate the area with “real” bids for rides, rather than relying on the pricing mechanism directly, the relative pricing mechanism (e.g. the “market making algo”) can congregate bids and asks to create a “real demand sensitive” price. This is why rapid quoting of a single ride ups the price so quickly — it’s not gouging, but when you quote a ride from KGB bar on 4th to Martiny’s twice, you’ve created 2 real bids for a route that previously had zero. The spread has become more expensive due to your own bid (say, $25 x 0 to the rider, $20 x 0 to the driver —> $29 x 2 to the rider, $20 x 0 to the driver) — what’s the probability of having two rides being demanded from the exact same stop, outside of an airport? You’re competing with your own bid in a remarkably thin spread.

The Uber “surge” is much more noticeable because it’s nonlinear — it’s a rapid escalation of the bid such that suppliers (drivers) are willing to fill the book to fit the demand. Remember, every trade consumes liquidity.

So why does Wendy’s feel the need to do this given the low volatility nature of selling burgers? It’s not like any of the other costs are variable: your CoGS has been accumulated in bulk well in advance, your employees have fixed hours, and the time and day of week progresses in an n=1 forward manner. It’s not like a Baconator meal is going to start seeing a bid/ask spread or be tradable as a result.

Think about this entire burger ecosystem though — it’s independent. Wendy’s fully controls the flow of a customer that shows up and places an order in line, but with the proliferation of external 3rd party delivery, they lose control of the equation. Uber rears its head again — everyone knows how much a delivery app amps up fees for the end users such that a $20 meal costs $40 to get delivered. Uber/Doordash squeeze themselves into areas where margins don’t really exist, by taking both from the food provider and the delivery driver to create revenue for themselves. Both of these businesses are notoriously low margin/unprofitable on their own! It’s why I’m so bullish on Tony Delivers cutting the middleman out.

With the sheer volume of delivery orders, one realizes you can’t fully shut down from delivery entirely. For example, that drunk order at the empty Wendy’s in the middle of the night is extremely profitable for every party involved. But you can’t solely restrict Uber orders to when they’re most profitable for you as the volume wouldn’t be enough for them to justify the service. Concurrently, if delivery orders become too large of a percentage of your orders, then they control your network.

All orders are not created equal. A family sitting down on a road trip is more profitable than the family ordering through a drive-thru (packaging costs are not negligible at scale AT ALL) is more profitable than a blogger ordering through the native app is more profitable than a delivery order where 20-30% goes to the 3rd-party-app. But to keep the delivery apps happy, they need their cut. If you price those orders so that your margins are preserved, they might cut you off from their app network — which you do need when demand is slow/dead in-store. McDonald’s has a pretty workaround to this — their market power is so high that they raise their sticker menu price while their app contains regular discounts that reduce the price of offerings significantly. Then they list their food on delivery apps at sticker. While there might be kvetching from people who look at the menu without looking at the app, I promise you, it’s ridiculous to not be ordering from their app.

Wendy’s is attempting to do the same thing here. By dynamically allowing themselves to adjust prices, they can create an imbalance between their in-store menu price versus what is listed on the app. Lunchtime demand is already at-capacity — what’s the point of taking mobile orders here if they’re already selling everything they’re making? It’s bad for them to lose capacity from their more profitable orders to give apps a cut during their busiest times. I’m fairly certain that this would benefit the in-store customers. Most likely the end result is Uber/Doordash coming to the table and settling with Wendy’s to pay them off for a % of the lunch demand that gets sucked into the app flow.

This is just Economics 101. I’ve always wanted to say that! Supply and demand are not created equal or distributed evenly, and liquidity is never infinite. But I can promise you that this isn’t “predatory pricing” at all. It’s just another game between large players where the small size wins.