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Internet Market Efficiency
Kris Ananthakrishnan
Friday, January 31, 2003
E-COMMERCE PUNDITS HAVE BEEN KNOWN TO claim that ‘if there exists a “perfect” market, it is the Internet’—where perfect competition and frictionless commerce combine to squeeze out all market inefficiencies. Is this claim really true? Are the prices charged on the Internet generally lower? Are consumers more sensitive to small price changes on the Internet? Do retailers adjust the prices more finely or more frequently on the Internet? Is there a smaller spread between the highest and the lowest prices on the Internet? The answers to these questions may surprise you, or at the very least, get you thinking differently the next time you go surfing for the best price for that CD that you have been meaning to buy.

Market Efficiency
Market efficiency is a term that needs some explanation here.
Fifteen years ago, when Cyberabad was just a twinkle in Chandrababu Naidu's eyes, farmers in Andhra Pradesh gathered every night around the community TV set, eagerly awaiting the eight o’clock “Farmers News” program. The highlight was a segment where retail prices of rice, grains, and a host of other commodities were announced for about a dozen local markets. Armed with this information, they would head to the wholesale market the next day. Wholesalers, who until then lowballed the farmers with ridiculously low prices, now faced a new reality.

What does this have anything to do with Internet market efficiency? Plenty, as it turns out. It’s all about information and its availability. Intermediaries (like the wholesalers) thrive on information imbalance. Take that imbalance away, and now you have a much leaner supply chain. Throw in a good measure of market transparency into this mix, and suddenly information asymmetry vanishes. As the asymmetry of information reduces, there would be lesser and lesser need for middlemen, and the market could potentially progress towards an ideal trading environment that imposes little cost or restraints on transactions! Isn't this what the information revolution is all about? The Internet as a medium of information exchange has definitely had an effect on the dynamics of trade. The question is, whether the entire business landscape, currently dominated by infomediaries, be ever dramatically altered into a 'frictionless' medium. Maybe in the future, but don't hold your breath, say researchers at M.I.T.'s Sloan School of Business.

Dimensions of Market Efficiency
To get a clear picture of efficiency of electronic markets, M.D.Smith, J.Bailey, and E.Brynjolfsson, professors at Sloan suggested four distinct parameters—Price level, Menu cost, Price dispersion, and Price elasticity. Each of these parameters would essentially provide efficiency readings for a particular dimension of the market. Juxtapose these with corresponding data observed in the conventional market, and a picture would begin to emerge.
Price Levels: Are the prices charged on the Internet lower? Even though initial research suggested that it is not, subsequent reexaminations have clearly established that prices are generally lower in electronic markets than in the conventional market. For instance, researchers at the National Bureau of Economic Research observed that car buyers saved an average of between 1 and 3 percent when they used Autobytel.com, an online referral service. Amazon.com charges 10 to 15% lower for the same books that are available for a higher price at other brick-and-mortar bookstores. These figures are not surprising considering that e-businesses face lower infrastructure costs in comparison to that of regular storefronts.

On the flip side, even though prices of books and CDs were observed to be lower online than offline, the same was not the case with products such as multi-vitamins and used cars. This suggests that price levels depend substantially on product category.
Price Elasticity: Are consumers more sensitive to small price changes on the Internet? It appears so. The term “Price Elasticity” refers to the change in demand with respect to change in prices. If demand for a product drops rapidly as the price of the product increases, the price elasticity of demand is said to be high for that product. Conversely, if a change in the price does not affect demand, the demand is said to be inelastic. Since the Internet provides a variety of tools to comparison shop, the consumers indeed display a tendency to undertake a search for better prices. One study conducted in 2001 focused on observing demand elasticity for prices of computer parts (memory modules and motherboards). For low-quality items, demand elasticity was high as expected. However when it came to high-quality and more expensive items, consumers paid more attention to brand name and product innovation rather than price.

An example of increased price elasticity is the world of electronic securities trading. Demand elasticity has driven customers in droves from the “full service” brokers to the “discount brokers,” since most of the brokerage services provided by discount brokers are perceived to be close substitutes to the ones from the full service brokerages.
Menu Costs: Do retailers adjust the prices more finely or more frequently on the Internet? A resounding “Yes” on both counts. An interesting behavior of the Internet market is its potential for superior price flexibility. What this means is that Internet marketers could adjust product pricing much more frequently than retailers in traditional markets, where prices tend to be more “sticky.” In other words, the Internet market is so well tuned to buyer behavior that retailers could actually react very quickly to changes in demand. If there is a sudden surge of interest in Harry Potter, you can guarantee that all of J.K.Rowling's books would be priced a notch higher.

The retailers tend to constantly match the supply (and the offer price) with demand. Witness airline fares, both online and offline. They change almost by the minute, based on consumer demand. This demand is factored in while setting a price. The demand becomes immediately obvious in the Internet, and hence the consolidators and retailers such as Orbitz and Expedia adjust their prices constantly.

Empirical studies have consistently proven that prices are changed more than twice as often online than offline, and the magnitude of online adjustments are up to 100 times smaller than those offline. Typical price increments are in the range of 1 to 2 cents online, whereas in the offline world, it is around 35 cents.
Price Dispersion: Is there a smaller spread between the highest and the lowest prices on the Internet? Paradoxically, the answer is No. With search costs being so low, one would expect prices of identical products across the market to converge and the “law of one price” to quickly take hold in the Internet market. But contrary to this, studies found that prices for identical books and CDs differ by more than 40% at different Internet retailers. The maximum difference between the highest and lowest price for one item in the sample was 47%.

The dispersion may be explained by the fact that consumers place a higher premium on a product when it is procured from a trusted source. Another reason could be that even though the products being purchased were identical, different sellers bundled different services (such as shipping, additional warranty, return charges etc.) with these products. Consequently, the prices for the same product varied widely from retailer to retailer.

So going back to our original question—Is the Internet market really a perfect market? In many ways it certainly seems like it is as good as it gets. The Internet market is unique in its ability to offer customers a vastly expanded array of choices, all accessible with the click of a mouse button. Its shopbots, spiders, and agents trawl the databases to provide a quick and easy way to comparison shop. It offers a frictionless information medium that, to a great extent dispenses with intermediaries—providing a way for consumers to directly deal with manufacturers. It presents a platform where carrying costs are lower for the sellers, and search costs are lower for the buyers. By adjusting prices more finely and frequently, the online market has the capacity to capture more “value” from each transaction. By capturing additional value, the Internet market overcomes inefficiencies (production inefficiencies and allocation inefficiencies) that have dogged traditional markets.

Having said all that, it is still a bit too early to declare victory, considering how long the general markets have been around, and the gyrations they have been through. The Internet market introduces its own set of complications. Rules of frictionless commerce seem to apply only to commoditized or digitized products and services. The online consumers today may feel giddy with a newfound feeling of power while dealing with e-businesses. But the marketers are definitely not taking all these lying down. They have responded with countermeasures that have proven to be quite successful. Raising brand awareness, bundling products, building trust, and innovating furiously, e-tailers are racing to maintain their edge.

In the long run, consolidation in the e-tail market space is inevitable. Not every e-commerce venture but the most efficient will survive. Established retailers with high brand recognition have been successful in using the online market to supplement their existing distribution channels. New e-tailers may have no option but to wring out economies of scale and scope by consolidating or forming alliances. Otherwise, they will meet the same fate as flameouts such as Value America, Peapod and Webvan.

In the final analysis, we cannot deny the potential that Internet market has in improving market efficiency. The winds of change may well turn into a hurricane, but for now, it is just a gentle breeze.

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