The impact of the Internet on the prices of goods and services

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U10988The Economics of the Internet (ENET)

• Lecture 4
• The impact of the Internet on the prices of goods
  and services

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Todays objectives

• To consider three important issues relating to
  the pricing of goods and services on the Internet
• Price competition and the Internet has the
  Internet led to lower prices via lower search
  costs, better product and price information and
  more competition? Have we got frictionless
  commerce?
• Differential Pricing how has the Internet
  enabled sellers to fight back? Is it always bad
  for consumers?
• Dynamic pricing what is it and how is it being
  implemented on the Internet?

3
Reading and further references

• Some additional notes are provided for this
  topic see my ENET web page and blog.
• Key references are given there, which are also
  on my biblio.html file - click on the links or
  access the online journal articles via the
  university website.

4
Follow up work for the week

• Practical 4
• Read two of the starred articles in the list of
  references on this weeks additional notes and
  links sheet.
• Provide a 200 word summary of each paper.
• (You are encouraged to share your findings)

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Some terms you will meet Do you know what they
mean?

• Search costs
• Menu costs
• Transactions costs
• Switching costs
• Shopbots
• Price discrimination
• Differential pricing
• Willingness to pay
• Consumer surplus
• Value-based pricing
• Brands, trust and loyalty
• Virtual location
• Pricebots

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Price levels and price dispersion online and
offline (1)

• In the early years of e-commerce it was predicted
  that the Internet would lead to a frictionless
  economy
• Hypothesis The Internet would lead to lower
  prices for consumer goods and services. Consumers
  would have lower search costs and better
  information this would increase competition
  between firms and hence lead to lower prices -
  and greater price convergence see Bakos (1997,
  2001)
• There have been a huge number of empirical
  studies, mainly on homogeneous products such as
  books and CDs - see especially Brynjolfsson
  Smith (2000) - but other studies have looked at
  cars, consumer electronics as well as wine,
  perfumes, airline tickets, life insurance etc.

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Price levels and price dispersion online and
offline (2)

• Some studies distinguish three categories
  pure-play Internet, bricks-and-mortar
  (traditional shops) and bricks-and-clicks
  (multichannel retailers)
• A recent study of CDs and books in Italy by
  Ancarani and Shankar (2004) provides a full
  bibliography
• These authors remind us that shopping comparison
  sites provide information not only about product
  prices, but also product characteristics and
  independent product reviews this should enable
  consumers more easily to get the best deals and
  force retailers (online and offline) to be more
  competitive

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Price levels and price dispersion online and
offline (3)

• Most studies have found lower price levels online
  than offline, even when shipping and other costs
  are included for example Brynjolfsson Smith
  (2000) found that CD and book prices were 9-16
  lower online than offline - depending on whether
  additional costs (taxes, shipping and shopping
  costs) are included.
• But as well as comparing price levels they also
  looked at the frequency of price changes and
  price dispersion
• Internet retailers price adjustments were up to
  100 times smaller than those of conventional
  retailers reflecting lower menu costs on the
  Internet
• They find a surprising amount of price dispersion
  on the Internet 33 for books and 25 for CDs
  (although after adjusting for market share this
  is reduced, reflecting the dominance of certain
  well-known brands)

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Price levels and price dispersion online and
offline (4)

• Contrary to what might be expected, the cheapest
  online suppliers dont attract the most customers
  - Books.com was found to be on average 1.6
  cheaper than Amazon.com but had less than 2
  market share compared with 80 for Amazon
  similar results for CDs where CD Universe prices
  1
• BS identify two main reasons awareness and
  trust
• Just having a web presence doesnt mean that a
  consumer will find your site. Häring (2004) has
  introduced the notion of a virtual location.
  Just as some physical stores are prominently
  located on the high street or shopping mall, in
  the virtual world some sites are highly visible
  while others are more difficult to locate
• With the increasing importance of shopping search
  tools (e.g. Kelkoo, Froogle) what Baye et al.
  call Information Gatekeepers it has become more
  important for online retailers to advertise to
  establish brand awareness, to foster consumer
  loyalty and to appear high up any list of search
  results

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Price levels and price dispersion online and
offline (5)

• This may explain why a well known company like
  Amazon has a greater volume of sales than some
  less well known but cheaper rivals
• But the issue of trust also comes into the
  equation consumers wary of scams may not be
  confident that less well known companies can be
  trusted to deliver, replace faulty goods, or
  protect customer confidentiality and security
• However this tends to prevent the erosion of
  market power and allow companies to charge higher
  prices and also practise price discrimination or
  differential pricing (charging different
  consumers different prices for the same product)
• Retailers have also developed other strategies
  for combating the competitive pressures that they
  face

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Price levels and price dispersion online and
offline (6) retailers strategies

• Retailers strategies for maintaining market
  power
• Price discrimination (differential pricing)
  segmenting the market by objective customer
  characteristics (involuntary selection) and
  through versioning (voluntary self-selection)
• Loyalty programmes to increase switching costs
• Bundling to reduce transparency in price
  comparisons
• Other forms of price obfuscation include high
  shipping or handling costs not shown in the
  initial quote

12
Price levels and price dispersion online and
offline (7) search cost models

• A recent paper by Pereira (2004) has asked the
  question Do lower search costs necessarily
  reduce prices and price dispersion?
• In a game theory setting he shows theoretically
  that there can be two types of equilibrium
  competing equilibrium and segmentation
  equilibrium (in the latter higher search costs
  for some consumers give high cost firms market
  power and the market segments)
• Paradoxically a reduction in search costs can
  lead the market to jump from a competitive
  equilibrium to a segmentation equilibrium
  resulting in a greater dispersion in prices

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Differential pricing segmenting the market

• segmenting the market by objective customer
  characteristics (involuntary selection) by age,
  demographic or other factor (e.g.
  business/consumer)
• segmenting the market via voluntary
  self-selection the customer decides which
  version is worth the price asked
• by differentiating products suppliers decrease
  their substitutability and increase revenue
• versioning - a form of customisation
  especially relevant for online information
  (digital) goods the additional costs of
  producing different versions can be very small
  while the additional revenue extracted from
  customers can be large
• tip for producers make sure you design your
  product so that it can be versioned - damaged
  goods!
• from goldilocks pricing to tailor-made
  pricing. Let customers create their own version
  rather than just choose from a list (mass
  customisation)

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Willingness to pay and consumer surplus

• Here there is no possibility of price
  discrimination. Everyone pays the common price Pc
  even though some are willing to pay more. The
  green area represents the firms revenue and the
  yellow area represents the consumer surplus.

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Third degree price discrimination

• Here the firm can discriminate between to groups,
  charging group A a higher price - up to its
  members maximum willingness to pay (reservation
  price) of Pa.
• This is called third degree price discrimination.
• The firm can capture a little more revenue (the
  darker green rectangle).

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First degree price discrimination

• Here the firm can discriminate between every
  single customer, charging each its reservation
  price. The firm can capture all of the consumer
  surplus (the darker green area).
• This is called first degree price discrimination.

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Differential pricing is it always a bad thing
for consumers? Varians view.

• Varian (1996) explained that differential pricing
  can sometimes be good for consumers in that it
  can lead to the supply of products that would
  remain unprofitable and therefore unavailable if
  the producer was forced to charge all consumers
  the same price (unserved markets)
• This is particularly relevant to goods with a
  high fixed cost and low (perhaps even zero)
  marginal cost as with many digital goods (audio
  and video files, electronic games, online news,
  information and other services) - dangerous
  economics
• There would be a welfare loss if differential
  pricing were not permitted market regulators
  need to understand that there are cases where
  marginal cost pricing is inappropriate on both
  efficiency and welfare grounds

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Differential pricing is it always a bad thing
for consumers? Odlyzkos recent example

• Odlyzko (2004) looked at the case of electronic
  publishing, especially of scholarly journals
• He provides a simple example to illustrate a
  situation in which a journal publisher would be
  unwilling to publish a journal unless it was able
  to price discriminate among subscribers
• In this example price discrimination
  (differential pricing) is essential to ensure
  that the product is provided

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Differential pricing the details of Odlyzkos
example

• Suppose a journal publisher has two potential
  libraries as subscribers.
• Library A is willing to pay a maximum of 700 per
  year, while library B is willing to pay up to
  1000 annually
• However the publisher needs at least 1500 to
  cover costs and therefore enter the market
• If the publisher is obliged to charge the same
  price it will not be able to create the journal.
  If the price does not exceed 700 both libraries
  would be willing to subscribe, but at only 1400
  the revenue would be insufficient to persuade the
  publisher to publish
• If the price exceeds 700 library B would be
  willing to subscribe but library A would not
  the journal wouldnt be published
• But if the publisher was able to charge library A
  say 650 and library B 950 both libraries would
  subscribe and the total revenue of 1600 would be
  enough to make the journal profitable

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Differential pricing and dynamic pricing The
essential differences

• Differential pricing relates the price to the
  customer (or group of customers)
  variations across customers
• Dynamic pricing relates the price to changing
  market conditions (shifts in the demand and/or
  supply curves)
• variations over time
• Although these are logically different there may
  be cases where dynamic pricing looks like
  differential pricing
• Both can be described as flexible pricing systems
  and both can be implemented more effectively
  using web-based software agents

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Dynamic pricing the contrast with static pricing

• Static pricing (also known as posted, catalogue
  or menu pricing)
• The seller attempts to determine the best price
  for the product before selling the price
  remains fixed over the whole period (except in
  the face of severe demand or supply shifts)
• Dynamic pricing (responsive pricing)
• The seller constantly monitors supply and demand
  conditions and regularly modifies the price to
  respond to changing conditions the aim is to
  minimise disequilibrium transactions
• Several authors e.g. Kannan Kopalle (2001)
  have noted that the pricing of goods and services
  sold over the Internet channel is becoming more
  dynamic.

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Perishable goods, volatile prices and unclear
prices

• Perishable (time-sensitive) products dynamic
  pricing ensures that the price rises or falls
  over time to ensure that no units are left unsold
  at the end of the period (e.g. fruit, airline
  seats)
• Volatile prices In a market with unpredictable
  supply and demand movements the price is
  constantly adjusted to ensure that the market
  clears (e.g. share prices)
• Auctions In the market for unique or rarely
  traded products where the equilibrium price is
  unclear the seller can use an auction to get the
  best price e.g. antiques

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Dynamic pricing an old idea given new legs

• In traditional markets the high transactions
  costs associated with dynamic pricing mechanisms
  have limited their adoption (except in specific
  circumstances e.g. shares and commodities)
• But the Internet provides instant and cheap
  communication and information updating
• Hence the development of dynamic pricing systems
  on the web, including online auctions which may
  be considered to be a form of dynamic pricing
  system

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Dynamic pricing with intelligent software (1)

• Early efforts were based around Excel
  spreadsheets, dynamically linked to information
  sources, which could be used as a decision
  support tool
• Now intelligent software is available
  commercially that can track market conditions and
  automatically change prices without the need for
  human intervention. Examples of companies
  supplying this software are Talus (now part of
  Manugistics), Azerity, Maxager and PROS Revenue
  Management
• Experiments are being conducted with intelligent
  software agents (pricebots) see Kephart et
  al. (2000) on the IBM Information Economics
  project could move beyond just pricing humans
  could delegate responsibility to agents to
  negotiate with each other

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Dynamic pricing with intelligent software
(2) problems

• Todays dynamic pricing software is only as good
  as the information fed into it which is not
  always current. Even enthusiasts admit that it
  can depend on sales force staff entering the data
  and they do ..a pretty wimpy job, to be honest
  (Fred Jones, whose company MicroTechnologies,
  uses Azeritys ProChannel software agent)
• Hence the interest in developing pricebots that
  autonomously collect and update information
• But there are concerns about potential pitfalls
  their collective behavior may not closely
  resemble that of humans (Kephart et al.)

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Dynamic pricing with intelligent software
(3) Simulation experiments

• Market simulators can be used to determine the
  best agent strategies for each type of market
  (see Morris2001 who describes the Learning
  Curve simulator)
• Better than purely theoretical solutions that may
  be difficult to apply numerical solutions may
  also be easier to interpret
• Inputs market scenario buyer behaviour, seller
  strategies
• Types of seller strategies explored by Learning
  Curve
• Derivative Following
• Myopically Optimal
• Dynamic Programming
• Reinforcement Learning

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Dynamic pricing did Amazon experiment?

• In early 2001 stories were circulating on
  bulletin boards and mail lists that Amazon was
  charging different prices for the same product,
  perhaps based on customer profile information
  (frequency of purchase on Amazon, date of last
  purchase etc.)
• ManagingChange.com carried out a survey (July
  2001-June 2003) to test for links between prices
  and these factors asked for responses on 4
  items (a book, a music CD, a video DVD and a PDA)
• No evidence that price was linked to customer
  characteristics but there were lots of price
  fluctuations which were attributed to seasonal
  effects and special promotions
• So it looks like it was just dynamic pricing
  not differential pricing

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Dynamic pricing inhibiting factors

• Moral and ethical issues customers may perceive
  it to be unfair for firms to charge different
  people different prices (although they have done
  for years price discrimination and discounting)
• Unacceptable excessive price variations? too
  much variation in price may be counterproductive
  customers may not accept it
• May cut across established customer relationships
• Set up costs there may be a high set up cost in
  terms of purchasing and customising the software
  and integrating it into the business will it be
  worth it?
• Not always appropriate to product and market
  for example where distribution cost is high
  relative to other costs

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Types of auction

• English auction open cry bids increase
• Dutch auction opening price gradually
  discounted
• Vickrey auction sealed bids winner offers the
  highest amount but pays the second highest amount
• Used in disposing of excess inventories
• Use in valuing unique or rarely traded products
• Reverse auctions for procurement invitation to
  bid to supply inputs RFQ (Request for Quote
  sales)
• Revenue Equivalence Theorem

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Request for Quote (RFQ) systems

• buyer posts an RFQ for a product, identifying
  certain minimum requirements
• sellers respond with a single closed bid within
  an agreed time period
• possible subsequent renegotiation
• example for B2C is Lycos Merchant Match
  (Request-a-Quote) they use their
  request-response technology to search for
  offers
• they e-mail quotes to you within 24 hours

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Priceline.com

• Priceline.com is not a shopping service it is a
  bidding service (reverse auction). Customers are
  asked for their highest bid (maximum WTP)
  priceline searches for a suitable deal
• airlines use it as an independent clearing house
  to unload cheap last minute deals (they dont
  like to advertise this) also available for car
  rentals. Holidays and hotel rooms
• founded by the excellently named Jay Walker
• Walker calls it his buyer-driven commerce
  business model
• but customers have to be flexible may have to
  compromise on product specification

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eBay

• began as C2C auction system (although now used
  by small businesses to sell their products)
• you place a bid for the item you want (maximum
  amount)
• eBay bids for you up to your limit
• most sellers accept payment by PayPal
• seller ratings help you decide who is trustworthy
• sellers ship items to you
• eBay now integrates Internet telephone calls into
  the process following its acquisition of Skype

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• Thats all folks!
• Any questions?