By CEIBS Professor of Management Practice Gong Yan

The long battle between Uber and Didi Chuxing ended in July with a $35 billion megamerger that was expected to put an end to the subsidy war that had left both sides haemorrhaging cash. In the days after the merger, market watchers and passengers kept a hawkish eye out for any jump in prices. Instead, both companies said they would keep the subsidies in place, with Didi going as far as to backtrack on an earlier pre-merger attempt to stop providing discounts in a number of cities. Ahead of the deal with Didi, I took a look at why it will be virtually impossible for Uber to ever stop giving special deals to its passengers and drivers. The lessons still apply post-merger.

There is no denying that Uber has logged an impressive number of rides in China, a market which is now home to four of Uber’s top five cities by ride count. While it took Uber U.S. four years to reach current monthly ride levels, the Chinese market reproduced this performance in just one year. However, a problem lies behind the figures.

In China, any Internet business that offers subsidies is certain to be affected by fraudulent transactions. According to industry insiders, the proportion of fraudulent Uber transactions in China stood at 20% in 2015, although the true figure could be much higher. Contrary to expectations, it may be some time before this problem can be fully resolved. In addition, fraudulent transactions only tend to affect market latecomers, who have to offer subsidies to gain market share.

Uber Global is valued at US$60 billion. Although a dizzying figure, this high valuation is underpinned by strong business performance. The company has tapped into 300 cities around the world, 66 (20%) of which have profitable operations, while those remaining have bright prospects. In some major cities (including San Francisco, London, Washington, New York, Boston and Paris) Uber maintains profit margins in excess of 10%. This is a striking achievement, as it means that every US$100 spent on the Uber platform yields US$10 of net profits for Uber Global.

In Shanghai, Uber China operates an 80/20 fare distribution model with a generous US$139 subsidy. This means that Uber must pay drivers US$119. Together with operating costs, this translates into US$157 of expenditure for every US$100 of transactions. 

In its pre-merger financing plan, Uber expressed the hope that its Shanghai business could follow in the footsteps of San Francisco, New York and London to realize a profit margin of 10% without subsidies. However, this was an unrealistic goal, even in a large market like Shanghai.

Merging was the only option

There are a number of factors which set China’s ride-hailing market apart from the overseas market. For one thing, without subsidies, Uber rides cost more than taxis in China, while the opposite applies in other countries.

If Uber phases out subsidies in China, the number of Uber drivers will plummet, paralyzing the business. The only other way to maintain driver supply is to raise fares, which would narrow the price gap between Uber cars and taxis, resulting in a drop in demand. Uber’s [pre-merger] business model is like a see-saw unable to strike a healthy balance between supply and demand.

Moreover, Uber must deal with a unique characteristic of the Chinese market: if Uber ups its prices, competitors will not follow suit. Rather, they will seize the opportunity to grab market share from Uber, possibly by cutting prices.

The Chinese market is unique in that it doesn’t adhere to the rules of game theory. Most outsiders would assume that if Uber raised its fares, rivals would also push up their prices to make more money. However, in China, this isn’t the case. Instead, a winner-takes-all mentality reigns. Chinese businesses operate according to principles of ‘cutthroat competition’ and often go to unreasonable lengths to seize market share. The business model is: I cut my own throat, my rival cuts his throat then we wait and see who is lucky enough to be rushed to the hospital.

In a market of irrational players, if one player raises prices, others will scramble to seize market share at all costs. The Chinese ride-hailing company Yidao serves as a case in point. The company took an aggressive approach towards subsidies. For example, Yidao users were offered an RMB100 cash reward and entry into a smartphone prize draw if they top up their account by RMB100. With such fierce competition, emulating the strategies of your rivals is clearly the only option.

Is this cutthroat approach by market players inevitable? What is certain is that there are two prerequisites for any subsidy strategy to produce desirable effects: First, it must change customer behaviour; second, it must increase customer loyalty (stickiness).

Interestingly, in the ride-hailing market, subsidies have changed customer behaviour, but burning cash has failed to create sticky customers. Instead, customers simply pick the provider which offers the largest subsidies. If they are unable to generate customer loyalty, market players will have no choice but to continue offering subsidies. Hopefully the newly-merged entity from the Uber-Didi merger has deep pockets.

This article was first published by The Economist Intelligence Unit