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Article on Electronic Commerce with a few too many assumptions
I haven't had time to do more than skim over the following article,
but I can already see some problems with it. For instance, he mentions CD
places not allowing agent searching - but with increasing development of
anonymization and like technology, will they have any choice?
-Allen
[Permit me to recommend that you read this very interesting draft paper
and send its author, Andrew Odlyzko, detailed comments.]
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Date: Fri, 9 Aug 96 14:17 EDT
From: [email protected]
Subject: electronic commerce article
Enclosed is the draft of an invited paper for the WebNet '96 conference
to be held in San Fransisco, Oct. 16-19, 1996, URL
http://aace.virginia.edu/aace/conf/webnet.html.
Comments are invited.
Andrew Odlyzko
The bumpy road of electronic commerce
Andrew Odlyzko
AT&T Labs - Research
[email protected]
Preliminary version, August 9, 1996
Abstract: Electronic commerce is widely expected to promote
"friction-free" capitalism, with consumers sending software agents to
scour the Net for the best deals. Many distribution chains will
indeed be simplified and costs substantially reduced. However, we are
also likely to see the creation of artificial barriers in electronic
commerce, designed by sellers to extract more value from consumers.
Frequent flyer mileage plans and the bundling of software into suites
are just two examples of the marketing schemes that are likely to
proliferate. It appears that there will be much less a la carte
selling of individual items than is commonly expected, and more
subscription plans. Therefore many current development plans should
be redirected. Electronic commerce is likely to be even more
exasperating to consumers than current airline pricing, and will be
even further removed from the common conception of a "just price." As
a result, there are likely to be more attempts to introduce government
regulation into electronic commerce.
Footnote: This paper incorporates material from an earlier article
on electronic publishing, [Odlyzko].
1. Introduction
Electronic commerce (or ecommerce for short) is still small, at least
if we consider only online consumer transactions, such as ordering a
book from amazon.com over the Internet. In a broader sense, ecommerce
is much larger, since financial, news, and legal information services
such as Bloomberg, Reuters, and Lexis have total revenues in the
billions of dollars. In a still broader sense, electronic funds
transfers are already huge, with daily transactions in the trillions
of dollars. All these types of transactions are expected to grow, and
to become part of a much larger and uniform system of electronic
transactions.
While we are rapidly moving towards the Information Age, food,
shelter, and clothing will remain our most important needs. However,
their shares of the economy are decreasing, and the information
content of their goods is increasing. This is an old trend.
Agriculture has moved from being the largest segment of the economy a
century and a half ago to a relatively minor industry, dwarfed by the
medical sector, for example. Furthermore, the cost of the basic
ingredients in cereals and other foods is a small portion of the total
price. As a further example of the decreasing value of raw materials
and factory labor, a single celebrity is often paid as much for
endorsing an athletic shoe model as all the workers in the undeveloped
countries who assemble those shoes. We can expect a continuation of
this trend, with the work of the "symbolic analysts" (who, in Robert
Reich's terminology, include lawyers, software writers, and
advertising executives) making up increasing fractions of the economy.
The main concern of this essay is electronic trade in information
goods, such as news, novels, software, music, movies, as well as
legal, medical, and credit information. How will these goods be
distributed, and how will their production be financed? Esther Dyson
[Dyson] predicts that almost all intellectual content will be
available for free. In her view, some content production will be
supported by outside advertisers (who already pay for most of the cost
of newspapers, for example, as well as all the costs of the commercial
TV networks). Some content will likely be made available for free, as
a form of advertising for other services by the producers (as the
Grateful Dead do in encouraging people to tape their performances, in
the hope this will bring more people to their concerts). While
Dyson's vision will come true for a large part of the material on the
Net, it seems unlikely that it will be universal. Movie studios such
as Disney attract large paying audiences to theaters and purchasers to
their videotapes through the quality of their products, and are likely
to do so in the future. While some novelists make more money from
selling movie rights to their plots to Hollywood than from royalties
on books, this is rare. Each year, over a hundred times as many books
are published as there are movies produced, and the sales of books are
much higher than movie theater revenues. Thus we can expect that
content producers will usually want to be paid directly for their
work, as that will be the only feasible route to earning a living.
Furthermore, Dyson herself [Dyson] emphasizes that much of the value
on the Net "will go to the middlemen and trusted intermediaries who
add value - everything from guarantees of authenticity to software
support, selection, filtering, interpretation, and analysis." How
will these middlemen be paid? It seems likely that often they will
wish to collect payment directly from consumers, just as the online
legal information service Westlaw collects fees from attorneys who use
it. The basic data in Westlaw is court opinions, which are freely
avaialable. What gives Westlaw its lock on the market is the control
of its citation system.
Many of Dyson's predictions are likely to come true. In particular,
huge amounts of intellectual property will be available for free.
However, it seems likely that there will also be a flourishing
ecommerce sector, with individuals purchasing goods and services. The
question is, how will ecommerce be conducted?
The usual expectation is that ecommerce will promote "friction-free
capitalism," (cf. [Gates]), with distribution costs reduced. It is
easy to see how this can happen, as the older communication systems
such as the post office, the telegraph, the telephone, and the fax
have all served to make the economy more efficient. The Internet
creates many more possibilities. Classified ads, for example, bring
in a large fraction of the revenues of the newspaper industry, but can
be replaced by a much cheaper and easier to use electronic system.
Other part of the common vision of ecommerce are more questionable,
however, and that is what the rest of this essay will discuss. It is
often thought that instead of buying an entire newspaper, readers will
pay for those individual stories they are interested in. Someone
wishing to purchase a VCR might send an "intelligent agent" into the
Internet to collect bids from suppliers for a unit that meets desired
specifications, and then select the best choice. While such scenarios
will be feasible technically, it is extremely unlikely they will be
dominant. Instead, we are likely to see a proliferation of policies
such as those of current music CD retailers who sell on the Internet.
Most of them do not allow software agents to collect their prices. We
are also likely to see a strenthening of the trend towards
subscription services and bundling of products, as is done in software
suites today. This will often require redirection of development
efforts.
This essay is devoted largely to an explanation of the economic
reasons that are likely to lead to the creation of "bumps" on the
electronic superhighway. These reasons operate already in the current
economy, and are responsible, for example, for the U.S. airline
pricing system, which is a source of frequent frustration and
complaints. In ecommerce, frustration and complaints are likely to be
even more frequent. The reasons for this are twofold. On one hand,
the economic incentives to create artificial barriers will be greater
in ecommerce than today, since essentially all costs will be one time
costs of creating goods, and distribution will be practically free.
On the other hand, it will be much more transparent that the barriers
are artificial. This will often collide with popular notions of what
is fair, and is likely to lead to attempts at much more intrusive
government regulations than we have seen so far. In the past
governments have been involved primarily in security issues of the
Net, and more recently have gotten concerned about pornography.
However, in the future they are likely to attempt to regulate the
conduct of business on the Net as well.
If the predictions of this essay come true, then some of the current
development efforts will turn out to be misdirected. In particular,
there is likely to be much less use of micropayments for individual
transactions, and more subscription services, which require different
systems. Also, it will be necessary to prepare to comply with edicts
from various governments which will be changing and will often be
inconsistent.
2. Natural and artificial barriers in commerce
Capitalism is excellent at inducing people to reduce barriers to
commercial activities. However, it also produces incentives to create
artificial barriers. Some of the barriers are created by government
action, such as those of patent and copyright laws, which give owners
of intellectual property a limited legal monopoly on the uses of their
creations. Other barriers are created by merchants. It is common for
an airline passenger to have paid 5 times as much as the person in an
adjacent seat, with the only difference between the two being that the
first one is not away from home on a Saturday night. The airlines
would like to charge the business travelers (who are presumed to be
able and willing to pay) more than vacationers (who might drive a car
instead or not travel at all), but do not have a direct way to do so.
Therefore they impose the Saturday night stopover restrictions to
distinguish between those two classes of customers. There have been
several attempts by airlines to move towards a simpler system of
uniform pricing (sometimes by newcomers, such as People Express,
sometimes by established carriers), but they all collapsed. This
suggests that there is an underlying economic logic behind this
system, however exasperating it might be. If that is so, though, we
can expect similar moves in ecommerce.
The general tendency in the marketplace is to avoid "commoditization,"
in which there are many almost equivalent products and services, and
where price is the only consideration. Ford does not compete with
Honda in producing the most inexpensive Accord. Instead, it offers
the Taurus as an alternative, and there are many features in which the
Accord and Taurus differ. Sometimes commoditization is hard to
resist. In some cases this happens because consumers learn there is
little to differentiate products. As an example, oil companies have
pretty much given up on trying to convince people that gasoline
differs in anything other than octane ratings. In other cases,
commoditization is forced on an industry by government edict or
effective private monopoly. Intel and Microsoft have reduced the
IBM-compatible PC industry to a commodity business, in which they
collect almost all the profits, and the other players scramble to find
a niche that will enable them to do more than just break even.
However, those are the exceptions. The general ecological principle
is towards evolution of species that fill different roles. Zebras do
not attempt to compete with giraffes, but exploit a different part of
the ecosystem, and evolution does not lead to a convergence of those
two species. Similarly, in the world of business, companies try to
differentiate their products. Workstation producers could never in
the past agree on a common version of Unix, even under the threat of
being overwhelmed by PCs, since that would have required giving up the
distinctive features that bound them to their customers. Even
airlines, which are basically in the commodity business of moving
people from one city to another, try to differentiate themselves
through frequent flier plans and special pricing schemes.
Ecommerce is likely to lead to a proliferation of pricing plans that
will seem to most people to be much more frustrating and less rational
than even today's U.S. airlines. There will probably be a niche
market for people who care most about their convenience, and will use
their intelligent agents to do their shopping for them. However, what
Sony, for example, might do is sell to that market only models of VCRs
that are not available elsewhere, and are hard to compare to those
sold in other places. Stores that have physical buildings are likely
to serve a different clientele, and might also take further steps to
differentiate themselves to prevent comparison shopping, which will be
much easier with many people sharing their experiences on the
Internet. There is likely to be a proliferation of frequent-shopper
plans. Further, Sony VCRs sold in Sears stores might be slightly
different from those sold in WalMart, and model numbers and features
might change rapidly to inhibit consumer rating services (such as
Consumer Reports, or various Internet-based group-rating schemes that
are beginning to develop). There are already artificial barriers to
free information flow. Grocery stores routinely bar employees of
other stores from collecting extensive data on prices. The policy of
Internet CD stores of preventing software agents from collecting
prices for comparison shopping is just an extension of such barriers
to free information flow to ecommerce. We can expect more such
barriers.
While barriers to commerce of the type discussed above are usually
perceived as unfair (an issue that I will deal with more extensively
in the last section), they can increase not just the producers'
wealth, but economic efficiency and social welfare. As a simple
example, consider an independent consultant who can produce a
technical report that two different customers might be willing to pay
$3,000, and $2,000 for, respectively. If she has to charge a uniform
price to the two customers, the most she can get is $4,000, obtained
by pricing the report at $2,000. However, if she charges the first
customer $3,000, and the other $2,000, she will earn $5,000. If the
consultant's time and expenses to prepare the report are worth $4,500,
she will not undertake the effort if a uniform price is required.
>From an economic viewpoint it is therefore advantageous to allow her
to charge different prices to different customers. However, the
customer that pays $3,000 is likely to resent it if somebody else
obtains the same product for $2,000, and often will not agree to the
deal if all conditions are publicly known. This is caused by a
conflict between notions of economic efficiency and fairness.
There are many examples in the marketplace of behavior that appears
even less fair. For example, in 1990, IBM introduced the LaserPrinter
E, a lower cost version of its LaserPrinter. The two version were
identical, except that the E version printed 5 pages per minute
instead of 10 for the regular one. This was achieved (as was found by
independent testers, and was not advertised by IBM) through the
addition of additional chips to the E version that did nothing but
slow down processing. Thus the E model cost more to produce, sold for
less, and was less useful. However, as Deneckere and McAfee show in
their paper [DeneckereM], which contains many more examples of this
type (referred to as "damaged goods"), it can be better for all
classes of consumers to allow such behavior, however offensive it
might be to the general notions of fairness. Consumers who do not
need to print much, and are not willing to pay for the more expensive
version, do obtain a laser printer. Consumers who do need high
capacity obtain a lower price than they might otherwise have to pay
since the manufacturer's fixed costs are spread over more units.
Barriers in commerce are an essential part of the current marketplace.
Consider the book trade. Although people do not think of it this way,
current practices involve charging different prices to different
users, and thus maximizing revenues. A novel is typically published
in hard cover first, with the aim of extracting high prices from those
willing to pay more to read it right away. Once that market is fully
exploited, a somewhat cheaper trade paperback edition is made
available, to collect revenue from those not willing to pay for the
hardbound copy. Finally, a regular paperback edition is published at
an even lower price. The used book market develops in parallel, for
those willing to read books marked up by previous owners, and so on.
How will ecommerce affect book publishing? Eventually we can expect
that all books will be available electronically (and will evolve
towards new forms, made possible by digital communications). Costs of
publishing will come down, and this is going to increase the supply,
and lead to many works distributed for free, by aspiring authors
hungry for the recognition that might lead to fortune. What about
those electronic books that people will be willing to pay for? With
publishing costs reduced, we can expect that the authors' share of the
revenues will rise, say from the current 15% or so royalty rate to 50%
or more, and so in effect the authors might become much more
influential than the publishers (or might become the publishers
themselves). However, since publishers obviously benefit from the
present system of differential pricing, they (and the authors) are
likely to have an incentive to institute a similar system in the
digital arena. The issue is how to do this. Bits are bits, after
all, and are easy to copy. If we make only simple extensions of
current copyright laws, we are likely to see a great change in the
marketplace for information goods. For example, when I buy a book, I
cannot make a copy of it and sell that copy to somebody else. On the
other hand, I can sell, rent, or give away the book I purchased to
anyone I wish. Suppose we carry over exactly the same rights to the
digital world, with some combination of cryptographic techniques and
laws guaranteeing that unauthorized copies of digital "books" cannot
be made. The ease of transactions on the Net (which is what leads to
the dreams of "frictionless capitalism") would then force major
changes. With physical volumes, there are substantial barriers to
trade in books. Most people do not like reading books that are
tattered or marked up by others. They take their time reading books,
and (especially for the ones they enjoy) like to retain them in their
libraries to be reread any time they wish. As a result of these
natural barriers, a single copy is usually read by only a few people.
The economics of the present book publishing business depend on this
phenomenon. In the digital world, though, with high bandwidth
networks and efficient intermediaries, I could buy a copy of a book an
hour before bedtime, read a new chapter, and then, just before turning
off the lights, send that copy off for resale. Instead of a million
copies of a printed book, a thousand electronic copies might suffice.
This would force a dramatic change in the structure of the book
publishing industry, and explains why there is an intense interest in
the creation of artificial barriers to ecommerce, either through
revisions to copyright laws or through technological methods.
3. The bumps on the electronic highway
Some types of barriers to commerce are accepted as natural when
dealing with physical goods. It would be prohibitively expensive for
the New York Times, say, to distribute 100 little sheets each day,
each one with a separate story, and having readers buy just the ones
they were interested in. The accepted wisdom is that ecommerce will
lead to the electronic equivalent of just that, with readers selecting
and paying for individual stories. It will certainly be possible to
do so, as micropayment systems are being developed that will allow for
processing of tiny transactions, such as payment for a single story in
the New York Times, or a "hit" on some aspiring poet's Web page that
contains his sonnets. However, the economic argument is that while
such schemes might exist, and may be used in some situations, they
will not be dominant. The example of book publishing in the previous
section shows why producers of information goods benefit from the
natural barriers that exist in the physical world. Their incentives
to create artificial barriers in the digital world will be even
stronger. It will be harder to distinguish between consumers, since
transactions will tend to be impersonal, and arbitrage will be easy.
Most important, distribution costs will be negligible, so that only
the "first copy" cost of creating a work will matter. Hence
traditional, commodity-market type of competition, in which the market
price equals the marginal cost, will have to be avoided, since
marginal prices will be essentially zero. The incentive that low
marginal costs provide to create barriers in commerce can already be
seen in many high technology fields. The "damaged goods" studied in
[DeneckereM] come primarily from such areas. The pharmaceutical
industry is notorious for selling products for hundreds of times more
than the cost of producing them, and for selling the same chemicals
for human use for ten times the price charged for veterinary purposes.
While the incentives to erect artificial barriers will be large in
ecommerce, there will also be novel possibilities created by the
electronic medium. What kinds of barriers are we likely to encounter
in ecommerce? The four most important ones will probably be bundling,
differential pricing, subscriptions, and site licensing. Hal Varian
[Varian3] discusses the first two in detail, and argues convincingly
that they will be prominent in ecommerce. In the rest of this section
I will present some additional arguments for these techniques, and
will also show why subscription services (which are a form of
bundling, but are important for other reasons as well) and site
licensing are also likely to be common. There are additional
arguments in favor of subscription and site licensing plans. For
example, security problems are likely to be easier in those cases.
However, this essay will deal only with the economic arguments.
The basic assumption in the economic analyses below is that for each
information good, an individual consumer will purchase it only if the
price is below some threshold (that consumer's valuation of the good).
For simplicity, I will only consider items that are independent of
each other (such as stories in a newspaper). Much of the economic
literature cited below is concerned with goods that are related in one
way or another. (For example, if I buy a spreadsheet from Corel, I am
unlikely to purchase another one from Microsoft. On the other hand,
if I buy a presentation package, I am more likely to buy a CD-ROM of
pictures than I would otherwise.) I will not take these factors into
consideration, to keep the presentation simple, and bring out only the
main factors that are likely to influence the development of
ecommerce. I will also assume that producers cannot in general find
out what an individual is willing to pay for a product, but can,
through test marketing, say, obtain an accurate statistical
description of the valuations that the whole population of potential
buyers place on that product.
3.1 Bundling
Bundling consists of offering several goods together in a single
package, such as combining a word processor, a spreadsheet, and a
presentation program in a software suite (such as Microsoft Office),
or else printing many stories in a single newspaper. Bundling is
common, and often seems natural. For example, right shoes and left
shoes are invariably sold together, and just about the only time
anyone might regret this is when a dog chews up one of a new pair of
shoes. I will concentrate on bundling of goods that are almost
unrelated, such as a word processor and a spreadsheet program. Why
should the pair of them together sell for much less than the sum of
their separate prices? It is useful to have seamless integration of
the two, to make it easier to move material between them, to have
common command structure and icon layouts, and so on. That seems to
argue for charging more for the bundle than for the pieces! However,
bundling, with a lower price for the bundle than for the components,
or even without any possibility for purchasing the components
separately, is extremely common. The reason is that it allows the
producer to increase revenues by capturing more of the "consumer
surplus" that arises when customers pay less than they are willing to
do. Since in general prices have to be the same for all customers,
bundling can be used to smooth out the uneven preferences people have
for different goods and services. For example, suppose we were
dealing with a proposal to start a newspaper that would have two
sections, a business page and a sports page. Suppose also that there
were just two potential readers, Alice and Bob. Suppose also that
Alice needs to keep up with the business world, and so is willing to
pay $0.50 for the business page, but only $0.20 for the sports page,
since she does not particularly care about sports, but might like to
keep up with lunchtime conversations. Suppose that Bob's preferences
are reversed, in that he is an eager sports fan, willing to pay $0.50
for the sports page, but only $0.20 for the business page, since all
he cares about is occasionally checking on his retirement fund. Under
those conditions, how should the proposed newspaper be priced? If
each section is sold separately, then a price of $0.20 for each will
induce both Alice and Bob to buy both sections, for total revenues of
$0.80. If the price is set at $0.50 for each section, then Alice will
buy only the business page, and Bob only the sports page, for total
revenue of $1.00. On the other hand, if the two sections are bundled
together, then a price for both of $0.70 will induce both Alice and
Bob to purchase the newspaper, and will produce total revenues of
$1.40. Thus the economically rational step is not to offer the two
sections separately, but only bundled together.
Bundling has been studied extensively in the literature, starting with
the paper of Burnstein [Burnstein]. Other references are [AdamsY,
Bowman, Economides1, KrishnaKA, Schmalensee, Stigler, Varian2,
Wilson1, Wilson2]. Unfortunately there is no simple prescription that
can be given as to when bundling is better than selling items
separately. Depending on the distribution of consumer preferences,
bundling can be either more or less profitable for the producer, as
was already shown by Adams and Yellen [AdamsY]. However, there are
some general guidelines. One is that bundling becomes more profitable
as marginal costs decrease (which may be part of the reason for the
spread of software suites as the amount of unpaid support provided to
users by software houses decreased). Another is that bundling becomes
more attractive when consumer preferences are negatively correlated
(as in the example above, where Alice and Bob had almost opposite
tastes). However, negative correlation in valuations is not necessary
for bundling to be profitable, as was first pointed out by Schmalensee
[Schmalensee], and as will be shown in the example below. Random
variations in preferences are sufficient as a result of the law of
large numbers.
How much of a difference can bundling make to a producer's bottom
line? Unfortunately the published literature is practically silent on
this point, for reasons I will discuss later. (There is an intriguing
computation in [Stigler], based on reported revenues of movie theaters
in different cities.) Let us therefore consider some artificial
examples, a bit more realistic than the Alice and Bob one presented
above. Consider two books, A and B, say "The Tannu-Tuva Cookbook" and
"Sherlock Holmes in Antarctica." Suppose that among one million
potential customers, book A is valued at $1 by 100,000, at $2 by
another 100,000, and so on, up to $10 by 100,000, and suppose the same
distribution of valuations applies to book B. Suppose further that the
valuations of the two books are independent. Thus there are about
10,000 customers who value book A at $3 and simultaneously book B at
$5, and similarly about 10,000 customers who place values $9 and $2 on
A and B, respectively. Under these conditions, if the publisher is to
sell these books separately, revenue will be maximized when the price
of each is set at $5. About 600,000 people will purchase each book,
for total revenue from sales of both books of $6,000,000. (This
maximum is not unique, as the same revenue can be achieved by pricing
each book at $6, in which case about 500,000 people will buy each.)
However, if the two books are sold together, revenue can be made much
higher. Since there are 10,000 people who value the bundle at $2
(exactly the 10,000 who value each book at $1), while there are 90,000
who value it at $10, a short calculation shows that the
revenue-maximizing price is $9. At the price of $9 per bundle,
720,000 people will purchase it, for total revenue of $6,480,000,
exactly 8% higher than if the books were sold separately. Since
profits would be the revenues minus the fixed costs of producing the
books, they would increase much more dramatically.
What weakens the case for bundling is that most people have no
interest in most goods. In the example of the books "Sherlock Holmes
in Antarctica" and "The Tannu-Tuva Cookbook," a more realistic
assessment might be that in a population of 1,000,000, each book would
be valued at zero by 90% of the population, with 10,000 valuing it at
$1, 10,000 at $2, and so on. If the 100,000 people who do place a
positive value on book A are distributed independently of those who
value book B at $1 or more, then there would be only 10,000 people who
place positive values on both A and B. Bundling under these conditions
would not produce much benefit. However, even in cases of extreme
indifference, bundling can work if there are enough goods. Consider
an information service with 1,000 items (news stories, pictures, or
songs). Suppose that in a large population, each individual is
totally uninterested in 900 of the items, and values 10 at $0.01 each,
10 at $0.02 each, and so on, with 10 valued at $0.10 each. If the
items are to be sold individually, the revenue-maximizing price will
be $0.05 for each (or $0.06 each), and each customer will purchase 60
items for a total of $3.00. However, if the collection is sold as a
whole (which involves no extra cost to producers of information goods,
and also no cost of tossing out mounds of unwanted boxes to
consumers), then a price of $5.50 will induce each person to buy, for
a gain of 83% in revenues (and much more in profits).
So far we have compared only sales of unbundled products (pure
unbundling) to those of bundles (pure bundling). However, it is often
advantageous to use mixed bundling, where both bundles and separate
goods are offered. In the example of the books "Sherlock Holmes in
Antarctica" and "The Tannu-Tuva Cookbook," with the distribution of
valuations assumed above, a price of $10 for the bundle and $5 for
each book separately would produce revenue of $7,400,000, about 14%
higher than pure bundling, and over 23% higher than pricing the books
separately. (Note that the optimal combination above has the
paradoxical property that the price of the bundle is exactly the price
of the pieces. Under the assumption of the model, people who value
book A at $7 and book B at $3 will purchase the bundle, but if the
bundle is not available, will only purchase A.) Adams and Yellen
[AdamsY] have shown that mixed bundling is always more advantageous to
the producer than pure bundling.
Toy models like the one above are amusing to play with, and help
illustrate the advantages to producers of bundling. If the
distribution of consumer valuations is known, one can determine
numerically what the optimal policy is for the producer [Wilson1,
Wilson2]. Unfortunately the basic assumption that consumers know what
value they place on various goods, and purchase them precisely when
the price is below their value, is questionable. In practice people
behave in much more complicated ways. An old joke illustrates this:
Waiter: And for dessert, we have chocolate mousse, apple pie,
and ice cream.
Customer: I will have apple pie.
Waiter: Oh, I forgot to mention that we also have Peach Melba.
Customer: In that case I will have the mousse.
While this is a joke, actual behavior is often just as paradoxical.
Catalog merchants have learned that the attractiveness of an item is
affected strongly not just by its price and description, but also by
its placement among other offers. Consumer choices are complicated.
Some of the seemingly irrational behavior can be explained on the
basis of different consumers having different sensitivities to prices.
For example, the phenomenon of regular sales has been modeled
successfully this way in [Varian1] and later papers. Other
interesting phenomena emerge if one assumes that consumers do respond
to price signals in an economically rational way, but with some delay
(see [RichardsonR], for example). However, there is no complete
theory. Experimental economics has shown that economically optimal
solutions can be attained even with small groups of agents, provided
they are working in a constrained environment and are trying to
optimize their wealth, although even there paradoxes abound (cf.
[CookL, HagelR]). In general settings, though, human behavior is hard
to model. There are nontransitivities in preferences, choices are
determined by behavior of others (so a person is more likely to see a
movie that colleagues have seen to have something to talk to them
about), and so on. Companies collect extensive data from test
marketing, but that data is noisy, and typically involves only small
variations in test parameters. There seems to be no unambiguous
empirical demonstration that a well defined demand curve exists. Thus
economic models discussed above do indicate that bundling is likely to
be advantageous to producers, but do not prove this.
What happens in the real marketplace, with a variety of customers and
competitors, and where there is already much experience with a variety
of marketing plans? What we see there is extensive evidence of
bundling. In many situations, such as that of physical newspapers,
there is an obvious motivation for bundling to reduce costs. However,
there is also evidence of bundling's success when there are
practically no physical costs involved. Software suites such as
Microsoft Office are just one example. Cable TV does not charge for
each channel separately, but for packages (bundles) of them. Finally,
the big and profitable online information services in the financial
and legal arena, such as Reuters, Bloomberg, and Lexis, all operate on
a subscription basis or appear to be moving in that direction. (The
"pay-per-view" approach made more sense when the computing
infrastructure for online access was expensive, and therefore there
were high marginal costs of providing access.) All this evidence
confirms that bundling is likely to be common in ecommerce.
3.2 Differential pricing
Charging different prices to different consumers is already common.
Various senior citizen or student discount programs are just some of
the most widely spread practices. Scholarly journals typically charge
much higher prices to libraries than to individuals, sometimes 10
times higher. For a thorough discussion of such price discrimination
and its economic and legal status, see the survey [Varian2]. A
producer would like to charge according to the consumer's willingness
to pay, but the consumer will usually be reluctant to reveal such
information. However, it is sometimes possible to correlate
willingness to pay with other features. Airlines offer much cheaper
tickets for those willing to be away from home on Saturday night. The
theory is that business travelers, who are willing to pay a lot, will
not be willing to put up with such inconvenience. In information
services, online services such as Prodigy and CompuServe offer stock
market quotes that are delayed by 15 or 20 minutes for no extra cost,
beyond the basic subscription. Real-time quotes uniformly cost extra,
on the theory that those who need them for their trading will pay
more. The software industry relies on differential pricing in many
products. Student or demo versions typically are the same as the main
product, except for artificial limitations on what they can do. They
either cannot produce large executables, or cannot handle large files,
or cannot use extended precision. We are likely to see many more
examples of such differential pricing. Electronic publications may
offer high-resolution versions at one price, a lower-resolution
version at a lower one, and sometimes they might offer a fax-quality
version at no charge. There are already interesting experiments going
on in book distribution, with authors making some parts of their
manuscripts freely available on the Internet, to advertise their work,
to update it with lists of current errata, and to make available
features that draw on the unique capabilities of the electronic
medium. There are also likely to be differentials based on
timeliness, as with stock market quotes; old issues might be offered
at low or no charge. There might be extra charges for links to cited
works or other desirable features.
Differences in quality of offered products might be the only way to
preserve some of the features of public libraries. In the digital
realm, without some artificial barriers, there would be practically no
difference between buying and borrowing. Hence the traditional
library policy of unrestricted lending is not compatible with
ecommerce, and we are likely to see artificial barriers. Databases
might be available to library customers but only inside the library,
at special terminals, for example. Librarians would then have to
become gatekeepers, restricting access to material more than making it
freely available.
3.3 Subscription vs. pay-per-view
Offering access to a database or a movie channel on a subscription
basis is a form a bundling. The alternative is to charge for each
movie, or each download of a Web page. There is much discussion of
how such "a la carte" shopping might become prevalent. One attraction
of programs consisting of small applets that can be downloaded on
demand appears to be the perception that this would allow producers to
charge according to how frequently the software is used. However,
past experience with pay-per-view systems has been discouraging.
Except for a few events, such as championship boxing matches, they
have not succeeded in attracting much revenue. All the arguments in
favor of bundling apply, and suggest that pay-per-view systems will
not be common. Furthermore, there are additional arguments, supported
by empirical data on consumer behavior, that argue against
pay-per-view schemes. Consumers appear to have a strong predilection
for reducing risk, even when this predilection results in lower than
optimal expected financial payoff. A certain $10 gain is usually
preferred to a wager with a 90% chance of winning $15, and a 10%
chance of losing $20. People also tend to use small deductibles when
purchasing fire or casualty insurance, even when they could easily
bear the loss from a larger deductible. (Since few insurance
companies operate with an overhead of less than 30%, a larger
deductible would almost surely lead to savings in the long run.)
Similarly, consumers appear to have a strong preference for
subscription services. To a large extent this is probably explainable
by general risk aversion. I may prefer to pay a higher price for a
word processor now, even if I do not need it much, to have free use of
it when I lose my job, and need to send out lots of job applications,
but will not be able to afford extra charges. This preference for
subscription services is present even among librarians, who are not
spending their own money, and with a large number of users of their
resources might be expected to have a stable usage pattern. Even so,
they have often expressed their unease about paying "a la carte" for
access to databases, since they feared they could not predict what
this would do to their budgets. It is difficult to quantify the
strength of this preference for subscription services, but it exists
and is strong. In the 1970s, the Bell System first experimented with
charging for local calls. Typically, customers were given a choice of
the traditional flat rate option, which might cost $7.50 per
month, and allow unlimited local calling, and of a measured rate
option, which might cost $5.00 per month, allow for 50 calls at no
extra charge, and then cost $0.05 per call. Anyone making fewer than
100 local calls per month would be better off with the measured rate
option. However, in the numerous trials that were carried out, typically
around 50% of the customers who were making almost no local calls at
all, and thus would benefit from measured rate service, still stayed with
the more expensive flat rate service. The preference for flat rate
pricing for Internet access is another example of this phenomenon.
The main conclusion to be drawn from this discussion is that
subscription services do offer substantial value to consumers, even if
that value may seem to be irrational. As a corollary, they also offer
value to producers. People are willing to pay a lot just to be able
to occasionally use certain features. Software producers complain
about all the heavy users of their products who do not pay for their
high usage. However, these producers benefit from the many users who
hardly ever use their system. I seldom use Microsoft Word, but when I
do use it (typically because somebody sends me a Word document), I do
need it, and so am willing to purchase it for just such occasions.
Hence we can expect that even if large systems consisting of
downloadable applets do become practical, they will be available on a
subscription, and not on a per-use basis.
3.4 Site licensing
Site licensing, in which a company or a university pays a flat fee to
allow everyone in that institution to use some program or access a
database, is very common in the computer and online information
industries. In some forms, it has been present for a long time in
other areas as well. For example, scholarly publishing can be thought
of as an example of site licensing. Typically a university will buy a
single copy of an esoteric journal, which is then placed in a library,
to be consulted by anyone on campus.
In software, site licensing has many attractive features. It
simplifies the enforcement problem (which is nontrivial, since many
corporations report they spend more on policing software use than on
the purchase of that software). It also encourages new users to try
out a package, and thus stimulates more usage. In addition, though,
site licensing has a strong direct economic argument behind it. We
can think of site licensing as a variant of bundling. In ordinary
bundling, a producer assembles together several goods into a bundle,
to smooth out the differences in valuations that individual consumers
place on those goods. In site licensing, a producer assembles
together a group of consumers to smooth out the differences in
valuations that different people place on a single product. As an
example, suppose that in a company of 1,000 employees, 900 are totally
uninterested in a software package, but 10 feel it is worth paying $10
for it, 10 feel it is worth $20, and so on, up to 10 who feel it is
worth $100. If the software manufacturer had to sell copies of the
package to individuals, the best price would be either $50 or $60 for
a copy, and the revenue in either case would be $3,000. However, if
the management of the company has an accurate impression of how much
the employees value the product, it should be willing to pay $5,500
for a site license. This would be a much better deal for the
producer, even though it would bring in only $5.50 for each person
entitled to use the product. Hence we can expect further spread
of site licensing.
4. Fairness, legality, and efficiency
Economic arguments show that there is value to many of the artificial
barriers in commerce. It is value not just to producers of the goods
and services, but to society. Moreover, the incentives to create such
barriers apply to individuals as well as large corporations. If Alice
plays the piano, and Bob performs magic tricks, they might be able to
obtain higher income by bundling their services through offering a
combined act to nightclubs. The result might be the difference
between starvation and relative comfort. In ecommerce, a group of
budding poets might collect larger revenues if they sell access to
their combined works, instead of working individually.
While economics will lead to the creation of barriers in ecommerce,
this will frequently clash with popular notions of what is fair.
There is already much grumbling about airline pricing and senior
citizen discounts. Moreover, many of the grumbles result in laws
restricting commerce. Several cities in the United States have passed
laws decreeing that women's shirts should not cost more to launder
than men's. There is a general perception of what is fair, often
codified into laws. Some of it goes back to the ancient notion of a
"just price," which is supposed to reflect a modest markup over the
producer's costs. However, in ecommerce, even more than in the modern
physical economy, cost is a poorly defined concept.
In ecommerce, the concepts of "increasing returns" [Arthur], in which
producer profits increase as usage increases, and customer lock-in, in
which someone trained in using a particular spreadsheet faces a major
barrier of retraining in switching to another one, are the ruling
ones. This means that the standard tests of illegal monopolistic
behavior do not apply. It can make excellent sense to give away a
software package, since the major benefit to the producer will come
from sales of upgrades. Other examples of economically sensible
behavior that is not accepted by society exist. U. S. courts stopped
IBM from requiring users of its tabulating machines to purchase their
punched cards from IBM [US1936]. Today, most economists would argue
that this decision was a mistake, since in effect what IBM was
attempting to do was to charge the heavy users more than the light
ones, to enlarge the market. (See [Stigler] for economic arguments
against another decision, [US1962], which barred movie distributors
from requiring movie theaters to book whole series of movies instead
of selecting them individually.) While the general issue of what
practices are legal is not entirely clear (cf. [Bowman, Varian2]),
there may be legal problems with some of the barriers that are likely
to be erected. Even when there is no legal difficulty, there can be
extensive public action, as in recent protests against pharmaceutical
firms' pricing, and against use of child labor in less developed
countries. (With reputations, whether of celebrity endorsers or
producers themselves, becoming increasingly important, public protests
can be powerful weapons.) Issues of fairness (see [Zajac] for
extensive discussions of their influence on public policy) are likely
to be much more pronounced than in the past. One reason is that the
barriers on the electronic superhighway are likely to be frequent.
Another is that those barriers will be much more visible as
artificial. (In print book publishing, most people seem to think that
hardcover books sell for more than paperbacks because they cost more
to produce. However, the differences in costs are minor, and the
price difference is just a form of price discrimination. On the Web,
it will be clear that a low resolution version of a work is just a
degraded version of the high resolution one.) It will also be much
easier to organize protest movements than in the past.
Public perceptions of what is fair depend on culture, are often
inconsistent, and do often clash with economic incentives.
Furthermore, the rapid evolution of technology, markets, and laws,
will lead to a continuation of the unstable situation we have.
Therefore there will likely be increasing temptation to ask
governments to intervene, and that will produce serious difficulties
for ecommerce. Barlow's "independence declaration" [Barlow] might
appeal to many, but is totally unrealistic. Government has been
involved in setting up the Internet, and is getting more involved all
the time, through issues such as the fair use of Scientology documents
on the Net, assignments of names, and provision of wide access to the
Net. The U. S. Telecommunications Act of 1996, which nominally
deregulated telecommunications, also brought in extremely intrusive
government regulations, to deal with thorny issues of setting up a
"level playing field." We should be prepared for more intervention of
this type, whether they are successful or not.
Many issues will be complex. As an example, only a tiny fraction of
the public understood any of the arguments about the U. S.
telecommunications deregulation debate, with its technical points
about access to local wires. Also, few people follow the details of
the debate about revisions to copyright laws. As was argued in an
earlier section, ecommerce requires some revision. However, there are
a variety of ways to do this, and the precise ways in which different
proposals affect different players is not clear to the public. (See
the discussions by Samuelson [Samuelson1, Samuelson2] of the proposed
revisions to U. S. copyright law [USPTO1995], as well as the survey
paper [Okerson] and the book [PattersonL].) Therefore we can expect
an increased demand for lobbyists, lawyers, and public relations
experts. Even in the non-governmental arena, it is reported, for
example, that "in preparing a commemorative CD-ROM for the 500th
anniversary of the first Columbus voyage to America, IBM spent over
$1M clearing rights, of which only about $10K went to the rights
holders; everything else went into administrative and legal fees"
[Lesk]. Although systems are being developed for automatic tracking
of rights to copyrighted material and the automatic payment of fees,
it is unlikely that such systems will see wide usage. Content
owners will probably be reluctant to rely on them, and possibly
let valuable rights slip away.
The conclusion to be drawn from this essay is that electronic
commerce will increase the efficiency of the economy. However, it
will also create artificial barriers, and we will have to learn
to live with them.
Acknowledgements: I thank Greg Blonger, Hsueh-Ling Huynh, Bill
Infosino, Steve Lanning, Peter Linhart, Gerry Ramage, Ryan Siders, Hal
Varian, and Ed Zajac for their comments and the information they
provided.
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