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The Microeconomics of E-Commerce

Sandeep KapurBirkbeck College, Londonskapur@econ.bbk.ac.uk

E-Commerceunbundling the economic implications

The Cambridge Econometrics Annual Conference 20006-7 July, 2000

Robinson College, Cambridge

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Introduction

The idea that we live in an unusual age is now a recurrent theme. We tend to locate

ourselves at the cusp of a new era, in which fundamental breakthrough in technology

forces us to reorganise our business practices and calls for new methods of

economic analysis. Much of what is happening in the age of the internet seems to

assault our notions of natural economic order. To a generation that had come to

accept inflation as normal, talk of steadily falling prices seem hard to comprehend.

Objects that were previously expensive to acquire are now available free. The

leather-bound copies of Encyclopaedia Britannica, which had graced our living-

rooms, seem to be redundant. The encyclopaedia is now available as a free online

service, supported by advertising revenues. Of course, like the leather-bound

versions that only gathered dust, the online version does not have many readers.

There is wealth of information on the web, but our access to information exceeds our

ability to make sense of the information. In the words of a commentator, the wealth of

information creates a paucity of attention. Another has seized on the idea of scarcity

of attention to argue that in the new economy, attention will come to represent value

and ultimately replace money.1

To put it simply, there is growing belief that the advent of e-commerce cannot be

understood accurately through conventional economic theory, which remains tied to

the presumptions of the old order. A completely novel approach is needed: throw out

the old economics, and bring in the new. As individuals and business organizations

adapt their behaviour to the possibilities created by e-commerce, a case is made for

a new microeconomic theory to describe their behaviour. As the valuation that

financial markets place on the dot-coms comes to confound our senses, there is a

call for new models of financial valuation. And thus, over time, we should witness a

growing demand for a new macroeconomics, for new monetary theory, and so on.

Of course the idea that changes in the mode of production require a new

economic theory has strong pedigree. Marx, writing more than a century ago, in an

era whose economic turbulence was arguably no less than ours, postulated that the

process of economic analysis is specific to the production relations on which a 1 See Michael Goldhaber, ‘The Attention Economy and the Net, First Monday.

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society is built. For him, the transition from feudalism to market capitalism required a

change in economic theory. By extension, the rules of the New Economy in the

twenty-first century cannot be understood through the lenses that were devised to

study twentieth-century capitalism.

I do not insist that the rules of economic theory are invariant but only that the

present case for a new microeconomic theory is premature. Rumours of the death of

traditional microeconomics are exaggerated. Much of what has come to be known as

the New Economy had begun before the arrival of the internet: the present day

growth of e-commerce may have accelerated the trend. Importantly, economics has

been grappling with some of these conundrums for an embarrassingly long time. A

lot of disenchantment with economics springs from the fact that we have come to

identify the entire discipline with a handful of shibboleths: i.e., that supply equals

demand, or that free markets maximize welfare. Economists themselves must take

the primary responsibility for this state of affairs.

I will argue that we need the anchor of conventional microeconomic theory to be

able to speculate on future developments in the market place. To do so with any

degree of confidence, we must aim to understand how changes in production

technologies alter existing economic themes.

The Economics of the Invisible Hand

The classic version of microeconomics is based on an economy not very different

from that described by Adam Smith more than two centuries ago. One essential

feature of the traditional economy is that the market prices of goods and services are

closely related to their cost of production. In the pin factory that Adam Smith wrote

about, each pin is costly to produce. Pins, once produced, can be transferred or sold

to buyers through market exchange. In a world with only a few manufactured goods,

buyers know what they want and how much they are willing to pay for them. Any

consumer who is willing to pay more than the market price of pins will obtain them,

while others will be priced out of the market. Competition among rival pin

manufacturers will ensure that clumsy pin manufacturers, whose costs of production

are high, will be forced out of the market and the price of pins will fall to the marginal

cost of producing another pin.

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At this competitive outcome, any person who is willing to pay more for a pin than

its cost to produce an additional pin will obtain it through the market. And those who

are not willing to pay as much will be excluded. This market outcome is socially

efficient, even though it may not necessarily be egalitarian.

Of course, the growth of mechanisation and other improvements in the methods

of production meant that this pen-picture was not accurate for long after Adam Smith

wrote. Once economies of scale became important, the unit costs of production were

sensitive to scale of output: to produce additional units does not cost as much as it

does to produce the first unit, so that unit costs of production fall with output. This

was especially true of Henry Ford’s manufacture of motor cars. In such cases,

perfect competition of the sort described above is not the norm. You get at most a

few producers dominating the market, and prices partly come to reflect the market

power of these producers. But rather than dwell of these, let me turn to a more

extreme issue.

Invisible hand in the weightless economy

One feature of the new economy is the growing dominance of information goods.

This category includes not just newspapers and software but also many other things

like recorded music, movies, etc., or indeed, this conference. Of course e-commerce

is not confined to such goods – you can buy cars and refrigerators too -- but

information goods may soon come to comprise a sizeable chunk of the value of

online transactions. This tendency is sometimes captured in the idea of a weightless

economy.

The production of information goods does not quite fit the description of pin-

manufacture. Consider an information good such as a feature film. The cost of

producing a Hollywood feature films runs into millions of dollars. Once the first

physical print has been produced, it is possible to make a near-perfect copy of this at

negligible cost – the cost of the second copy need not be much more than the cost of

the physical storage medium. This feature – that information goods are costly to

make but extremely cheap to reproduce – is key to the problem. To supply the movie

to many individuals does not cost much more than the cost of providing it to just one

individual. In the jargon of economic theory, most information goods have the

property of non-rival consumption. The problem is that if the (marginal) cost is indeed

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zero, or close to zero, pricing based on marginal cost is not in the producers’ interest.

While economic efficiency dictates that anyone who is prepared to pay the marginal

cost of production should receive the good (or that market price should equal

marginal costs), a producer who sets his price close to zero will not be able to

recover her fixed costs. Clearly, the link between costs and prices cannot be as

simple as in the competitive case outlined earlier.

And even when the producer of information goods sets price above the negligible

cost of reproduction, there may be a further difficulty. If the producer can duplicate

the information good at low cost, so can anyone else with the right mixture of

duplication facilities and scruples. Naturally, copyright laws aim to check the

indiscriminate duplication of information goods but these do not always work well.

Where the storage format is digital and there are multiple channels of distribution, it

will prove hard to exclude people, even when they have not paid for the good. Piracy

in software and music has been an old bug-bear: the arrival of the internet has made

the process easier and also raised the stakes. The likes of napster.com are treated

as the new scourge of the online industry. Regardless of who wins and who loses in

the world of e-commerce, lawyers will not have difficulty placing bread on their tables.

If the prices of information goods are not anchored to costs, what will they

depend on? Prices will depend, of course, on buyers’ willingness to pay. To

maximise their revenues, sellers will charge each buyer whatever he or she is

prepared to pay. Of course this is not easy to pin down. From the buyers’

perspective, the value of any individual piece of information is hard to determine prior

to receiving the information. After you have the information, there is no incentive to

pay or to acknowledge its value. If you must pay for information prior to receiving the

good, the seller may not have sufficient incentive to supply something valuable.

Smooth informational exchange requires a mix of many devices to circumvent the

two-sided problem. We should expect many more free samples and previews to

reassure ourselves about the quality of what we are about to pay for; information

trade will occur within long-term relationships between the buyer and seller, or

restriction to reputable traders.

If prices are to depend on buyers’ valuations, there is another issue. Buyers

usually attach different valuations to the same good, and if prices depend on

valuations, we should expect prices to vary across consumers. Price discrimination is

not unique to e-commerce but as a form of pricing is likely to flourish in an online

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world. Even as the web promotes greater price transparency in some dimensions,

the notion of the market price may become weaker, if not obsolete. The growth of

business-to-customer auctions sites to sell standardised goods at different prices to

different customers are a step in this direction.

Price Discrimination

What kind of price discrimination should we expect in the world of e-commerce? On

the face of things, the greater price transparency that the web affords – through its

numerous price-comparison sites – seems to militate against price-discrimination. If I

can readily check the price paid by others, why would I ever pay more? To

understand this, we need to study price discrimination more carefully.

Price discrimination works only when the underlying market satisfies some

features. First, to charge some buyers a higher price than others, the seller must be

able to identify the buyers who are prepared to pay more. In other words, the firm

must be able to sort according to their willingness to pay. Second, for discriminatory

pricing to work, those who are allowed to buy the product cheaply should not be able

to transfer it to those who are willing to pay more. In the absence of some means to

segregate the different strands of the market, arbitrage will erode the rents from price

discrimination. 2

Some markets lend themselves more than others to this kind of sorting and

segregation. Typically, price discrimination was built around geographic attributes. It

may be well known that the citizens of one country are prepared to pay more, on

average, for a new car, so that you could charge a higher price in that country.

Customers are then sorted by geography. The segregation of markets is not perfect,

but affected by the relative immobility of the good in question. Even within a country,

a retailer may sell through multiple channels: regular channels might sell at a ‘list

price to retail customers’, while an alternative channel may be used to sell to fleet

buyers. Likewise a regular outlet might sell at a ‘list prices’ while discount stores may

sell more cheaply. Buyers who value their time a lot (and this is highly correlated with

how rich you are) will be willing to pay more for the convenience of buying the goods

easily. Others with more time and willingness to pay not as much will track down the 2 See Varian, Hal , "Differential Pricing and Efficiency., 1999

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discount stores. In this example, customers are sorted by the value that they attach

to their own time.

Of course, it is precisely these forms of price discrimination that begins to fray

with e-commerce. Geographic distances do not matter when people order online,

provided delivery costs are not sensitive to distance. Search ‘bots’ make price

discovery easy, so that everyone can track down the discount outlet with ease.

If so, retailers must find other attributes to base price discriminate on. We should

expect more price discrimination based on the time of delivery. The person who is

eager to experience a new movie or novel soon after its release can be made to pay

more than those who are willing to wait. The early hardcover version of a novel costs

significantly more than the paperback version released months later: the price-

differential does not reflect the cost of binding but is a form of price discrimination.

Movies can be seen more cheaply through video-rentals if you are prepared to wait a

few months. Unlike geographic price-discrimination, this temporal price-discrimination

is not undermined by e-commerce (though illegitimate e-commerce, say violations of

copyright laws, may restrict its depth). In short, in the world of e-commerce,

geographic price discrimination might diminish even as temporal price discrimination

grows.

Versioning

Another means to increase revenue might involve price discrimination along the

quality dimension. A seller may choose to sell an information good in mutiple

versions. As a buyer you may face the choice between an expensive, high-quality

version, and a cheaper, low-quality version. Differential pricing for different qualities

does not necessarily amount to price discrimination; it does when the two versions

cost the same to produce. In that case the price-differential is artificial, even though it

is perfectly rational for the seller to do so. It allows the seller to capture more revenue

from quality-conscious buyers (by selling to them at a high price) AND at the same

time mop the bottom of the market through a cheaper, inferior version. A single

version, if the high-quality, expensive variety, would lose potential revenue from the

lower end of the market, while a single version of the low quality would unnecessarily

compromise revenue from the upper end of the market.

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Once again, the idea that you have to pay more for quality is hardly surprising.

What matters is that, in many instances, the price differences is not based on any

additional cost associated with supplying the high quality version. Sometimes it may

even pay to deliberately reduce the quality. The IBM Series E Laser Printer was

deliberately slowed down, by inserting wait-states in the chip designed for the regular

printer. Software publishers often produce their cheaper student version by

degrading, even at some cost, (the routines in) the professional version. Bizarre as it

may sound, the rationale is straightforward. It reflects careful attention to how buyers

choose from a range of versions, and how the optimal mix of versions can maximise

revenue. To see this note that, for any range of versions available, there might be

some customers who are just indifferent between buying the inferior, cheaper version

and the expensive, superior version. Degrading the inferior version may persuade

some of these people to the more expensive version. In sum, the greater the

acceptability of the inferior version, the few will be willing to pay for the superior one.

Degrade the inferior version, and many more will be persuaded to upgrade. Less

legroom on the economy sections in airplanes makes passengers more inclined to

upgrade. My point is versioning is not novel even though it is likely to become

common-place in an era of e-commerce.3

Bundling

Another means by which firms can increase revenue involves the bundling of

products. Many of the products we buy are bundles. The newspaper I buy each

morning is a bundle of pages. I do not value the elements of this bundle in equal

measure: I like the sports pages but do not care much for the finance pages.

Someone else might value the finance pages more than the sports page. But we both

end up buying the bundle, because that’s how the newspaper is sold. To consider

another example, this e-commerce conference – another information good -- is a

bundle of different sessions. It is likely that each of you value the various sessions in

different way. Of course if your precise valuations for each bundle were known to the

3 Emile Dupuit, writing in the 19th century observed that.. “It is not because of the few thousandfrancs that would have to be spent to put a roof over the third-class carriage or to upholster thethird-class seats that some company or the other has open carriages with wooden benches ...What the company is trying to do is to prevent the passengers who can pay the second-class farefrom travelling third class; it hits the poor, not because it wants to hurt them, but to frighten therich.. And it is again for the same reason that the companies, having proved almost cruel to thethird-class passengers and mean to the second-class ones, become lavish in dealing with first-class customers. Having refused the poor what is necessary, they give the rich what issuperfluous.” (quoted in Hal Varian, Versioning Information Goods, 1997.)

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organisers, they could tailor-make the prices for every participant for every session,

in order to maximise their revenue. However this informational assumption is

extreme. More realistically, even if the organisers do not know your individual

valuations, they may have a good idea of the distribution of valuations in their target

audience. If so, bundling may help to increase revenues, especially when there is

some heterogeneity in the relative valuations.

To see how imagine that there were two only potential participants and two

possible sessions to choose from.

Session 1 Session 2

Delegate A £100 £150

Delegate B £150 £100

Imagine, for the sake of argument, that the conference organisers are trying to price

every session to maximise total revenue and there are no capacity constraints. They

do realise that one delegate values session 1 at £100 and the other at £150, but they

do not know if delegate A or delegate B has the higher valuation. Without that

information, they cannot charge discriminatory prices to A and B.

They then face a dilemma. They can either set the price of the stand-alone

session 1 at £100: at that price both delegates will choose to attend, with aggregate

revenue of £200. Alternatively, they could set a higher price. At £150 only one

delegate will turn up. Clearly from the point of revenue maximisation, it is better to

charge £100 per person for the stand-alone session 1.

A similar analysis suggests that the revenue-maximising price for a stand-alone

session 2 is £100 per person. Total revenue from the two sessions is then £400.

Selling the two sessions as a bundled product can increase the outcome. If the

organisers believe, correctly in this case, that people who value session 1 more care

less for session 2, and vice versa, they realise that the delegates have similar

valuations for the bundle even though they value the sessions differently. Now each

delegate can be asked to pay up to £250: both will choose to attend, which delivers

total revenue of £500. Indeed, regardless of anything that the title of this conference

may suggest, unbundling is a bad idea. Bundling works here because while the

individual valuations of the sessions are relatively dispersed – the delegates value

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the sessions differently – their valuations for the bundle of two sessions are similar.

Indeed, it may be even better from the point of revenue maximisation to have mixed-

bundling: where in principle you can buy the individual components separately but

the bundled version costs less than the sum of individual prices.4

What lessons does this present for the future of e-commerce? The newspaper

that is delivered my doorstep is a bundle of all pages because the conventional

production and distribution channels – starting at the editorial desk and ending up

with the delivery person – would find it too cumbersome to sell me only the pages I

value. Given the fixed costs of travelling to this conference, it makes sense to stay for

more than just one session. In each case, if the delivery mechanism was electronic,

there is a temptation to believe that we could pick only the specific product we want.

Would e-commerce allow this unbundling? Could I buy just the newspages I want?

(Indeed, when it comes to free newsletters from established news services, this

seems to be the trend. The Financial Times will allow me to customise the news

update I receive every morning, allowing to pick and choose while sections are

included in my newsletter). However, with paid service, the lesson is that even if

unbundling become technically feasible, it will not always be commercially desirable.

The Issue of Trust

Let me speculate on another possible development. The simplest kind of market

exchange involves face-to-face interaction between a buyer and a seller. The good

being traded might be simple in the sense that its quality can be ascertained by direct

inspection prior to sale. If the buyer and seller come to an agreement, the seller

hands over the good and buyer hands over some money. A lot of our transactions

are not simple in these senses. Often the buyer and seller may be distant from each,

and for that reason any inspection of the good may not feasible. Perhaps the quality

of the good cannot be ascertained through a one-off inspection, even if one could be

arranged. In reality, there may be unavoidable lags between when you hand over the

good as a seller and when your receive the money.

Even before the arrival of e-commerce transactions were not simple in the above

senses. E-commerce enhances the complexities. Even as it delivers the ability to

4 For a more detailed discussion see Y Bakos and E Brynjolfsson "Bundling and Competition onthe Internet: Aggregation Strategies for Information Goods," 1999.

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shop remotely from great distances, it makes buyers and sellers faceless.

Inspections of quality prior to purchase are harder. For information goods,

assessment of quality can be made after the good has been experienced. The value

of a movie is uncertain till after you have seen it. The worth of software is not known

for till you have used it; in fact till the first time you contact their customer helpline.

The implications of quality uncertainty in market transactions have been studied

carefully by economists. It results in the familiar problem of adverse selection, where

good quality products are driven out of the market. Those who would like to sell high

quality products cannot convince buyers of the true quality, so choose to remain

outside this market. The buyers infer, correctly, that those willing to sell must be

selling low quality products.

This is one of the barriers to the growth of e-commerce. Apart from the

exaggerated concerns about my credit-card details being circulated, I worry if I will

ever receive the goods I order online. If the good is anything other than a standard

product – a book or a CD, I worry about the quality of the product I will receive. Of

course, the problem of trust is two-sided. Online retailers could have worries too. If I

promise to send them a cheque after receiving the goods, will I stick to my promise?

Is my credit card genuine? This two-sided nature of the problem is pretty obvious in

consumer-to-consumer auctions. The problem is quite serious, because outright

regulation of e-commerce is made difficult by the fact that it often spans multiple

jurisdictions. 5

To prevent opportunism from undermining trust, markets participants adapt their

strategies in various ways. One, it is rational to build a reputation for quality and to

invest in brand names. I may worry about being short-changed by an opportunistic e-

tailer, but feel that amazon.com is unlikely to jeopardise their reputation by ripping

me off by a few bob. The problem of trust is mitigated. Two, with digital goods it may

be possible to convince potential buyers of the true quality by letting them sample the

product, as shareware products. Movie previews try to convince potential audiences

of the quality of the product.

5 See Francis Fukuyama, "E-Commerce and the Challenge of Trust", a Merill Lynch Forum report,1999.

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This has direct implications for the kind of goods that will migrate to e-commerce

and the market structure and trading arrangements that will come to support it.

Standardised goods, whose quality is transparent, have migrated to e-commerce

quite readily. Books and ordinary CDs led the way. Online trade in domestic services

will need to be supported by reputation-building devices.

Where reputation is not enough, or if reputation-building is not feasible, there may

be a role for third-parties to intervene and serve as impartial guarantors of trust in the

transaction. To some extent, credit card companies do precisely that. They allow

exchange between buyers and sellers who do not know each other by replacing an

isolated exchange relationship by two long-term relationships: one that exists

between the buyer and the credit card agency and the other that exists between the

seller and the credit card agency. It is frequently argued that e-commerce will lead to

dis-intermediation: buyers and sellers will cut out middle-men. Where online

transactions are inhibited by lack of trust, trusted-third-parties (TTPs) will arise as the

new intermediaries..

The future of business organizations

Not surprisingly, the greatest impact of online commerce may be on the managerial

organisation of firms. The structure of firms is shaped by information flows and e-

commerce affects the flow of information within and outside organisations.

Ronald Coase was the first to formalise the crucial distinction between market

transactions and transactions within firms.6 Activity within a firm is directed by a

hierarchical command structure. Transactions in markets are directed through

contracts. For any form of economic activity, the relative costs of using these

alternative ways of directing activity determine whether a transaction is carried out

within a firm or through the market. This determines the boundaries of a firm. A firm

is a collection of those activities that are too costly or difficult to transact through the

market.

Of course, informational costs are a major component of the transaction costs. If

markets cannot be relied to capture all the informational details, they had to be all 6 See Ronald Coase, "The Nature of the Firm," in Williamson and Masten (eds.), The Economics ofTransaction Costs, Edward Elgar

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collected within a firm. The need to co-ordinate all stages of the production process

created the vertically-integrated firms that dominate the landscape. As EDI enable

firms to outsource certain activities, firms began to rely on core-competencies. The

growth of the internet, and in particular the arrival of a common class of languages

such as HTML allowed firms to exchange information in the market place, there has

been a strong tendency towards vertical disintegration. The methods used by Dell for

managing it supply-chain are a case in point. At the same time, economies of scale in

inherent in the new technology and economies of scope will create a tendency

towards horizontal expansions and integration. Consider Amazon.com, for instance:

it started as a retailer of books but graduated into music, videos, and retailing. Over

time we will probably see flat rather than deep organzations.

Competition and Regulation

There is a general presumption that e-commerce has created a more competitive

environment. The ability to compare the prices of goods online, and to buy goods

from the cheapest retailer wherever they might be, suggests a new competitive

phase in the economy. Goods whose prices are determined by cost conditions will

increasingly be sold at prices close to cost. That may well happen but we must be

careful to distinguish between the short-run and long-run implication of this

phenomenon. In the short run the tendency for chipping prices tends to be a move

towards greater competition. And it expands choice in the market place: the idea of

grandmothers selling home-made preserves by accessing the client base of an

established player like Yahoo.com certainly catches our imagination. But the in a

world of fierce price-competition, the erosion of profitability undermines the prize that

attracts new entrants. Once profitability has been eroded drastically, the threat of

new entry is eroded too, and small advantages or economies of scale will result in

giant monopolies.7

This tendency is even more pronounced in industries whose network

characteristics provide great economies of scale. The monopoly advantages of those

who come to control the prevailing standards must worry the champions of the

market system. The fact that Microsoft has a substantial share of the market of

7 Also see Bakos, Y. "Reducing Buyer Search Costs: Implications for Electronic Marketplaces,"Management Science, 1997.

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operating systems must, at some fundamental level, diminish the incentives for the

next Bill Gates to invest in operating systems. To those who believe in the

Schumpeterian gale of creative destruction, i.e. the dynamic advantages of serial

monopolies, the idea of a permanent dominance must be worrying indeed.

Conclusions

Most of the ideas that I have described here are not new to economics. Many are

buried in any reasonable economics textbook, somewhere in the footnotes and later

chapters. In many cases, the text in bold fonts still pays lip-service to Adam Smith

and his successors. The rise of the New Economy has forced us to reassess the

relative emphases we place on various economic themes. It is not so much that

economics textbooks will have to be rewritten, but the order in which ideas are

presented may have to respect the new realities. What used to be exceptional may

increasing become the norm. In short, we may end up binding the chapters of

economic texts in a new order. Hopefully this task will be made easier by the fact that

the next generation of economics text-books will be produced on electronic media.

At the same time it throws up new challenges for the design and conduct of policy

and the social organisation. Notions of governance that were tied to property rights

may have to spend more time discussing copyright. Regulatory authorities will have

to discuss new notions of market power and to assess what forms of firm behaviour

is inimical to economic progress.