Wednesday, March 08, 2006

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

In the early years of e-commerce it was predicted by some that the Internet would lead to a "frictionless economy". Lower search costs and better information provided via the Internet were expected to increase competition in retail markets and thus lead to lower price levels. It was also expected that there would be greater price convergence, that is a lower dispersion of prices for online transactions (see Bakos (1997).

"The explosive growth of the Internet promises a new age of perfectly competitive markets. With perfect information about prices and products at their fingertips, consumers can quickly and easily find the best deals. In this brave new world, retailers' profit margins will be competed away, as they are all forced to price at cost." [The Economist (1999)].

Since then a great many empirical studies of the issue have been published, mainly looking at homogeneous products such as books and CDs. Perhaps the best known and most often cited is Brynjolfsson and Smith (2000). They found that book and CD prices were 9 to 16% lower online than offline - depending on whether additional costs (taxes, shipping and shopping costs) were included.

A wide range of product markets have now been examined including videos and DVDs, computer games and software, computers and other electronic products and new cars. Brown and Goolsbee (2000) have also looked at the life insurance industry and Clemons et al. (2002) have examined packaged travel products. There has even been a study of wine bought via the Internet (Lynch and Ariely (2000)). Most studies are based on US data but there have been some using data from other countries; see for example the paper by Ancarani and Shankar (2004) looking at book and CD prices in Italy.

Most studies have found lower price levels online than offline, even when shipping and other costs are included. Some studies distinguish three categories of retailer: pure-play Internet, bricks-and-mortar (traditional shops) and bricks-and-clicks (multi-channel retailers). There has been some suggestion that the gap between online and offline prices has been reducing over time. Ancarani and Shankar remind us that shopping comparison sites provide information not only about product prices but also on product characteristics and independent product reviews, and that this can affect offline prices as well as online.

There is a lot of evidence that consumers research products online even if they subsequently purchase them offline. A survey in the United States - the American Interactive Consumer Survey, conducted by the Dieringer Research Group - found that nearly 15% of the the total US retail spending is influenced by online research, even through the proportion of retail sales that is completed online is much lower [see this report on the web page].

But price dispersion remains as high online as offline. Indeed many of the recent papers have focussed on this issue. Why should a consumer not buy from the cheapest source? How can an online retailer (sometimes called an e-tailer) get away with charging a higher price than its rivals?

Various explanations have been put forward. One approach broadly identifies the phenomenon with the concepts of trust and confidence - with brand loyalty also coming into the picture. The work of Michael Baye and his associates at is important here - see for example Baye and Morgan (2003). Buying via the Internet carries with it various risks and uncertainties not associated with purchases from a traditional high street retailer. The transaction is not synchronous, that is the exchange of goods and money doesn't take place at the same time. Buyers may have concerns about whether a product purchased over the Internet will be delivered, or at least whether it will arrive within an acceptable period of time. Sometimes goods that are delivered might be faulty or damaged, or may not exactly match the description provided on the website. Essentially we are talking about the after sales policies and practises of the companies concerned. From the customer's point of view there may be a willingness to pay a premium to cover these risks. Effectively by paying such a premium they are taking out insurance to guarantee that that they can be sure of getting what they want. This can help explain the dispersion of prices. Some consumers are less risk averse than others and they may just seek out the lowest price supplier, irrespective of the company's reputation ("name").

Another related issue is whether the customer has confidence in the supplier to provide a secure and confidential transaction, with no risk of his financial or personal information being passed on or falling into the hands of third parties. There may be concerns about whether a company that is advertising a product via the Internet is fraudulent. There have been cases of Internet fraud where payment has been accepted but there has been no intention of providing goods. This occurs most frequently in the area of products that are illegal or where a consumer might be ashamed to admit to buying. In these cases there might be less chance that the fraud will be reported (firearms, drugs, sex products etc.). Of course these points apply to purchases made via other remote retail channels such as those from catalogues or magazine offers, and whether the order is made by post or over the telephone.

Just having a web presence doesn't mean that a consumer will find your site. Haring (2004, 2005) has introduced the notion of a "virtual location". Just as some physical stores are prominently located on the high street or in a shopping mall, in the virtual world some sites are highly visible while others are more difficult to locate. They might have a highly promoted brand name that customers will easily remember (e.g. Amazon) or they might feature high up on search results lists provide by shopping comparison sites such as Kelkoo or Froogle. Baye et al. (2001,2002) call these sites "information gatekeepers". There is evidence that consumers rarely look beyond the first couple of pages of search results ("hits") so it has become vitally important for retailers to make sure that their site is well known. Some sites - not Froogle - accept payments from firms in return for their site appearing high up a hit list. Even if the algorithm for displaying results is based on some other more indirect factor, such as the number of sites that link to the retailer's site, it becomes important for the retailer to advertise and promote their brand.

Pereira (2004) provides a theoretical argument as to why online prices might remained dispersed, based on the assumption that search costs may differ among consumers. In a game theory model where firms may also have differing cost structures he finds two types of equilibrium. In the competing equilibrium case high cost firms will be forced to charge the same price as low cost firms so that competition is effective. In the segmentation equilibrium case high cost firms will sell to high search cost consumers while low cost firms will sell to low search costs consumers. Costly search gives firms market power since it leads consumers to accept prices above the minimum charged in the market. But it depends on the relative importance of what Pereira calls the "volume of sales" effect and the "per consumer profit" effect. Paradoxically in this model a fall in search costs can even lead to higher prices and greater price dispersion. Unless all consumers benefit fully from these low search costs we may find that the market moves from a competing equilibrium to a segmentation equilibrium.

Brynjolfsson, Dick and Smith (2004) consider the following hypothesis relating to price dispersion on the Internet: consumer preferences may differ over price and non-price attributes of the transaction (delivery time, reliability, security). Consumers who search more intensively (i.e. not just comparing prices) are more concerned about trading off price reductions with retailer trust factors.

So we can see a number of reasons why consumers might be willing to pay a price above the lowest one that is advertised on the Internet. They might not find this low price if the hit list from the search tool doesn't place it high up the list. Or they might be wary of dealing with a company that they haven't heard of, or used before. If online retailers can develop customer loyalty they can exploit the market power that this gives by charging higher prices than their less well known competitors. Effectively the more loyal are customers the less price sensitive they are, that is their price elasticities of demand are lower. Retailers can keep their prices high without fear of losing trade.

Another point that comes up in these studies is the degree of transparency (or seeing it from the other side the "obfuscation") that online retailers provide in their price information. The headline price quoted may not always represent the full cost of acquiring an item. Costs that are "hidden" until the final checkout stage of a transaction include the shipping costs (postage and packing), tax or duty that is liable, or for car rentals additional insurance payments that must be made. Efforts have been made in some juristictions to standardise the way that such information appears and indeed the shopping comparison sites have been helpful here in providing full and comprehensive statements about the cost of products purchased online. But there are still some unresolved issues concerning local taxes and import duties that must be paid.


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