17 E-commerce 2

Aaron SchiffECON 204 2009

Reading: Deak p. 3-5, p. 27-32, p. 35-36, p. 44, p. 260-268

Introduction

• Objectives of this lecture: Understand what’s special about e-commerce, and the basic effects of e-commerce on markets and competition between firms.

What’s Different About E-commerce?

• Compared to other technologies, transmission and duplication of information on the Internet is:– Faster– Cheaper– Larger capacity– Better quality

• Firms can also collect a lot more detailed information about behaviour and characteristics of their customers.

• What are the economic implications? – First we review the “ideal market” (benchmark)– Then examine how Internet technology affects markets relative

to this benchmark.

Perfect Competition

• Perfect competition is an idealised benchmark of competition in a market.

• Under perfect competition, suppliers compete as “intensely” as possible.

• The outcome is that the market price equals marginal cost, and suppliers make zero economic profits.

Perfect Competition

• Conditions for perfect competition:– Free entry and exit

• Firms can costlessly enter when there is positive economic profit to be made, and costlessly exit when economic losses are being made.

– Many small sellers• No individual seller has any power to influence the market price.

– Perfect information• All buyers and sellers know all information that is relevant to the

market.

– No transaction costs• Instantaneous and costless exchange

– Homogeneous products• Every seller sells an identical product, so buyers buy from the

cheapest one.

Perfect Competition

• Equilibrium of a perfectly competitive market is efficient:– Social surplus generated by the market = Consumer surplus +

Producer surplus– Perfect competition maximises social surplus.

• This is why a perfectly competitive market is desirable, from a welfare point of view.– But, firms’ profits are lower compared to monopoly or oligopoly

where they have some market power.

• When any of the conditions for perfect competition are violated, social surplus may not be maximized. – There is dead-weight loss (economic inefficiency).

Perfect Competition

• Improving one of the conditions: – Bring market closer to perfect competition.– Increases social surplus = Reduces dead-weight loss.– Improves efficiency.– Reduces profits.– Increases consumer welfare.

• More intense competition is:– Good for consumers.– Bad for firms.– Good for welfare.

Example 1

• Suppose demand in a market is Q = 100 – P.

• Marginal cost is 20.

• Questions:– Calculate the monopoly price and monopoly mark-up

over marginal cost.– Suppose the mark-up in the market is some fraction

m of the monopoly mark-up, where m is between 0 and 1 (m = 1 represents monopoly; m = 0 represents perfect competition).

– Calculate total welfare, consumer surplus and profits as a function of m.

– Interpret the results.

E-commerce and Competition

• Online markets have freer entry and exit – Information dissemination faster and cheaper– Lower cost of setting up business

• Computer + internet access• No need to hold inventory (no store fronts, warehouse)

– Easy (cheaper, faster, more) to access new consumers.– Should result in many competitive sellers.

• Closer to perfect information– Buyers can obtain better information (cheaper, faster) about:

• Available sellers• Attributes of products• Prices

E-commerce and Competition

• Physical location is less important.– Can compete without a store on “Main Street”.– Opens markets to more competition from foreign

firms.

• Lower transaction costs– Lower opportunity cost associated with transacting,

from better, faster information transmission.– Easier / cheaper to find the right store, right product,

right price (lower search costs).– Easier to complete transactions.

E-commerce and Competition• All these factors combine to make online

markets more competitive than offline markets.

• Everything else equal, this should make e-commerce less profitable than traditional commerce.

• However, e-commerce also allows firms to:– Reduce costs, e.g. inventory / sales staff / retail space– Increase productivity through better communication

and information sharing internally and with suppliers.– Get better information about consumer tastes and

behaviour, to design products and set prices more effectively.

E-commerce and Competition

• E-commerce may also raise new entry barriers compared to offline commerce.

• E-commerce firms have the ability to collect and analyse a lot of information about their customers.– Track browsing / purchasing history over time.– Analyse patterns among consumers.

• This information gives e-commerce firms better ability to customise products (product differentiation) and prices (price discrimination) according to individual consumer preferences.– Both product differentiation and price discrimination can increase

firms’ profits.

E-commerce and Competition

• Information about customers becomes a source of competitive advantage (or an asset) for firms.– A firm that has better information about its customers and/or can

analyse this information more effectively can perform better at product differentiation and price discrimination than its rivals.

• Because of this, larger firms may have an advantage over smaller firms.– More customers or more sales = more information generated.– Small / new firms may find it difficult to compete with large /

established firms, unless they are highly specialised.

• This may drive e-commerce markets towards concentration (few firms), to maximise the profits from data collection and analysis.

E-commerce and Competition

• In some sense, online transactions are also more risky than offline transactions.– Easy for someone to set up a website, rip you off, and then

disappear.

• Because of this, reputation is also an important asset for e-commerce firms.– A firm is less likely to rip people off if it cares about its future

reputation.– Consumers will be willing to pay more for a product from a firm

with a good reputation, everything else equal => reputation is a source of profit.

• Lack of reputation may therefore also be a barrier to entry for new firms.

E-commerce and Competition

• Overall, e-commerce has some aspects that make firms compete more intensely, and some aspects that reduce intensity of competition.

• E-commerce firms need to be aware of all these aspects.– Some factors increase the intensity of competition,

but firms can offset these by using customer information collection and analysis to do better product differentiation and price discrimination.

– Firms that do not maximise the advantages of e-commerce are unlikely to succeed, even if they were successful offline businesses.

Case of “Touching the Void” • In 1988, a British mountain climber named Joe Simpson

wrote a book called Touching the Void, a harrowing account of near death in the Peruvian Andes. It got good reviews but, only a modest success, … soon forgotten.

• …a decade later, … Jon Krakauer wrote Into Thin Air, another book about a mountain-climbing tragedy, which became a publishing sensation.

• Suddenly Touching the Void started to sell again. Random House rushed out a new edition to keep up with demand.

• A revised paperback edition, … spent 14 weeks on the New York Times bestseller list. …Now Touching the Void outsells Into Thin Air more than two to one.

Case of “Touching the Void”

• Why did this happen?

• Amazon.com recommendations: The online bookseller's software noted patterns in buying behaviour and suggested that readers who liked Into Thin Air would also like Touching the Void. People took the suggestion, agreed wholeheartedly, wrote rhapsodic reviews. More sales, more algorithm-fuelled recommendations, and the positive feedback loop kicked in..

• Source: Chris Anderson, “The Long Tail” http://www.wired.com/wired/archive/12.10/tail.html

The “Long Tail”

• Traditional retailers face product-specific fixed costs for each different product that they stock.– Costs to add an extra product, regardless of the

quantity sold– Examples: Cost of shelf space, cost of inventory

management / spoilage.

• E-commerce retailers have much lower product-specific fixed costs.– Adding an extra product to a website costs almost

nothing.– Goods can be stored in inexpensive warehouses

rather than expensive retail stores prior to being sold.

The “Long Tail”

• This allows e-commerce retailers to stock a much broader range of products than traditional firms.– A large bookstore carries around 130,000 different titles.– Amazon has millions.

• Not only can e-commerce retailers stock a wider range of products, but a significant fraction of their sales actually come from less popular products.– One-third of Amazon’s revenues comes from sales of books

outside the top 130,000 titles.

• In aggregate, sales of products in the “long tail” are an important source of revenue for e-commerce retailers.

The “Long Tail”

• Example: Music sales (March 2006).

Source: http://www.longtail.com/the_long_tail/2006/06/latest_rhapsody.html

The “Long Tail”

• Stylised distribution of products in a category (e.g. songs) by sales:

Sales

Products

A few products are verypopular.

But total sales of the lesspopular products can add upto a significant amount.

Head Tail

Example 2

• Suppose a monopoly store has a range of products that it can stock.

• Demand for a product is given by Q = A – P, where A varies across products (high A = high demand).

• Marginal cost of selling a unit of any product is 1.

• Stocking a product entails a fixed cost of f.

• Questions:– Find the profit-maximising output for a product that is stocked

and the profit that it generates.– Find the range of products that will be stocked as a function of f.– Interpret the result in terms of e-commerce.

The “Long Tail”

• The long tail introduces a new problem: “findability”.– With millions of different products and millions of customers with

different tastes, how can consumers find the products that they like best?

• E-commerce stores often use recommendation algorithms and rating systems to promote specific products to customers.– Better algorithms can be another source of competitive

advantage of one e-commerce retailer over another.

• Netflix prize: Netflix is offering a US$1m prize to anyone who can come up with a movie recommendation algorithm that does 10% better than its own algorithm.– http://www.netflixprize.com/