A few years ago, online shoppers could buy hit CDs for $9.99 or less with free shipping, best-selling books for 30 to 50 percent off the cover price, and all manner of apparel, electronics, toys, and pet food for substantial discounts over their real-world prices (and did we mention the free shipping?).
Those bargains are now long gone. What happened? The most common explanation is that venture capital dried up, so dotcoms could no longer use VC money to subsidize their deep discounts. (Thank you, Kleiner Perkins, for subsidizing the growth of my CD collection.)
That’s a partial explanation, but it doesn’t fully answer the question. Competition remains fierce among e-commerce vendors, so why have they stopped using discounts and free shipping to gain an advantage and win customers? Paradoxically, it turns out that the Internet’s efficiency as a marketplace actually keeps prices up, rather than pushing them down, as many experts once predicted it would.
That’s the conclusion drawn by Charles Wood, an assistant professor in the department of management at the University of Notre Dame, who has studied pricing in e-auctions and among online retailers. In both cases, Wood found, the sophistication of online buyers and sellers has resulted in more stable, and often higher, prices.
In the first study, Wood, together with University of Minnesota professor Robert Kauffman, looked at coin auctions on eBay (EBAY) between 1999 and 2001. They discovered some surprising factors that influenced the final selling price of an item. Articles that sold on a weekend, for instance, tended to go for about 2 percent more than goods at auctions that closed on a weekday. Items that included a picture usually sold for about 12 percent more than those with only a text description.
Wood and Kauffman also found that having a large number of bidders tends to drive prices up, which makes sense — greater demand generally leads to higher prices. More significantly, though, they found that this effect is getting less pronounced over time. In other words, the market of potential buyers is growing, but prices are leveling off. Wood postulates that the market “depth” is increasing, meaning the Internet is attracting more — and more sophisticated — buyers and sellers. The result is that prices quickly reach the optimal market level, and items rarely go for much above or below that price point.
Outside the auction realm, e-commerce retailers are getting savvier about setting prices as well. In a study of online book and CD retailers such as Amazon.com (AMZN), Barnes & Noble (BNBN), and CDNow, Wood found that despite stiff competition, these retailers do not really compete on price. “Market depth is increasing in e-commerce, and that does affect what people can charge. You’ll find prices converging a lot more, in a collusive manner,” Wood says.
Wood is quick to explain that he doesn’t mean actual, illegal collusion, where executives call one another and agree to fix prices at a certain level. Instead, what happens online is more tacit. If one online book retailer shaves a dollar off the price of a popular title, competitors will quickly take note and respond with a similar discount, eliminating the first retailer’s advantage and hurting everyone’s margins. Eventually everyone realizes that the price wars aren’t gaining them anything. Instead, they start competing on other factors, such as service, bundling, personalization, or special features. As discounts disappear, prices tend to go up (or at least stay level), and “we don’t even have to talk about it on the golf course,” Wood quips.
The Web’s staggering efficiency in conveying information makes all this occur, because it’s difficult for companies to lower their prices without competitors knowing about it. (It’s also hard to offer special prices to certain customers and not to others, as both Amazon.com and Priceline.com (PCLN) learned through pricing mini-scandals in 2000.) In other words, the Internet makes a wealth of information available to your customers and your competitors alike. You can no longer base your business on the assumption that either party is in the dark about what you’re doing.
The lessons for online retailers are clear: Pay attention to what your competitors are doing by tracking their websites very closely. Find ways to differentiate your company through customer service instead of price. And never underestimate the sophistication of online customers.
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