DRAFT
COMMENTS WELCOME
Understanding Digital Markets:
Review and Assessment
Michael D. Smith
MIT Sloan School
Joseph Bailey
University of Maryland
Erik Brynjolfsson
MIT Sloan School
July 1999
(Revised: September 29, 1999)
Available at http://ecommerce.mit.edu/papers/ude
Forthcoming in Erik Brynjolfsson and Brian Kahin, eds, Understanding the Digital Economy,
MIT Press, 1999.
Acknowledgements: We thank Allen Barbieri, Susan Desanti, Howard Frank and participants at
the Conferences on “Understanding the Digital Economy” (Washington, D.C., May 25-56,
1999), “Current Issues in Managing Information Technology” (MIT, June 14-17, 1999),
“Reinventing Commerce at Net Speed” (Stanford University, June 21-22, 1999), and “Measuring
E-Commerce” (Brookings Institution, September 24, 1999) for valuable comments on this
research. The Center for eBusiness@MIT provided generous financial support under a grant
from Fleet Bank. Atish Babu and Mohsin Naqvi provided valuable research assistance.
, Understanding Digital Markets:
Review and Assessment
Abstract
As the Internet develops into a robust channel for commerce, it will be important to understand
the characteristics of electronic markets. Businesses, consumers, government regulators, and
academic researchers face a variety of questions when analyzing these nascent markets. Will
electronic markets have less friction than comparable conventional markets? What factors lead to
dispersion in Internet prices? What are the major electronic commerce developments to watch in
the coming years? This paper addresses these questions by reviewing current academic research,
discussing the implications of this research, and proposing areas for future study.
We review evidence that Internet markets are more efficient than conventional markets with
respect to price levels, menu costs, and price elasticity. However, several studies find substantial
and persistent dispersion in prices on the Internet. This price dispersion may be explained, in
part, by heterogeneity in retailer-specific factors such as trust and awareness. In addition, we
note that Internet markets are still in an early stage of development and may change dramatically
in the coming years with the development of cross-channel sales strategies, infomediaries and
shopbots, improved supply chain management, and new information markets.
,1. Introduction
A basement computer room at Buy.com headquarters in Aliso Viejo, California holds what some
believe is the heart of the new digital economy. Banks of modems dial out over separate ISP
accounts, gathering millions of prices for consumer products: books, CDs, videos, computer
hardware and software. Specially programmed computers then sift through these prices,
identifying the best prices online and helping Buy.com deliver on its promise of having “the
lowest price on earth.”
Buy.com’s model seems to represent the economic ideal for frictionless markets: low search
costs, strong price competition, low margins, low deadweight loss. However, the $1 trillion
dollar question1 for Internet consumer goods markets is: “Will strong price competition prevail
in electronic markets or will other market characteristics allow retailers to maintain significant
margins on the goods they sell?”
This paper approaches this question by exploring three aspects of business to consumer
electronic commerce markets. Section 2 discusses several ways to measure efficiency in Internet
markets and discusses the empirical evidence relating to these hypotheses. Section 3 focuses
more specifically on several potential sources of price dispersion in Internet markets. Section 4
introduces important developments to watch in electronic commerce markets and discusses how
they may effect efficiency and competition in the coming years. The appendix also includes an
extensive, if necessarily incomplete, bibliography of related research.
2. Characterizing Competition in Electronic Markets
There are a variety of ways to analyze the level of friction in Internet markets. Some studies in
this area compare the characteristics of electronic markets to conventional markets while others
analyze behavior within electronic markets. In this section, we identify four dimensions of
efficiency in Internet markets when compared to brick and mortar markets: price levels, price
elasticity, menu costs, and price dispersion.
1
The market capitalization of the 55 stocks that comprise Hambrecht and Quist’s “Internet Index” was
$1,000,489,700,000 at the time this paper was written.
1
, 2.1 Price Levels
In the classic economic models of social welfare, efficiency is maximized when all welfare
enhancing trades are executed. In retail markets where sellers set prices, efficiency occurs when
prices are set equal to the retailer’s marginal cost. Marginal cost pricing is the efficient outcome
since pricing above marginal cost excludes welfare enhancing trades from consumers who value
the product at a level between the price and the marginal cost.
The most cited reason why one might
expect electronic markets to be more
Table 1: Four Dimensions of Internet
efficient than conventional markets is a
Market Efficiency
reduction in information asymmetries
Price Levels: Are the prices charged on the
that arise from lower search costs.
Internet lower?
Economic theory predicts that high
consumer search costs will lead to prices Price Elasticity: Are consumers more sensitive to
above marginal cost in equilibrium small price changes on the Internet?
(Hotelling 1929, Salop 1979 for
example). If electronic markets allow Menu Costs: Do retailers adjust their prices more
consumers to more easily determine finely or more frequently on the Internet?
retailers’ prices and product offerings,
Price Dispersion: Is there a smaller spread
these lower search costs will lead to
between the highest and lowest prices on the
lower prices for both homogeneous and
Internet?
differentiated goods (Bakos 1997).
More advantageous retailer cost structures may also contribute to lower price levels in electronic
marketplaces. Better cost structures may lead to more efficient pricing in two ways. First, low
market entry costs may limit the price premiums sustainable by existing market participants by
increasing actual or potential competition (Milgrom and Roberts 1982). Second, favorable cost
structures can lead to lower equilibrium price levels in a long-run equilibrium by decreasing the
underlying costs on which any price premiums are based.
Lee (1997) conducted one of the first studies involving pricing in electronic markets. His study
analyzes prices in electronic and conventional auction markets for used cars sold from 1986 to
2
COMMENTS WELCOME
Understanding Digital Markets:
Review and Assessment
Michael D. Smith
MIT Sloan School
Joseph Bailey
University of Maryland
Erik Brynjolfsson
MIT Sloan School
July 1999
(Revised: September 29, 1999)
Available at http://ecommerce.mit.edu/papers/ude
Forthcoming in Erik Brynjolfsson and Brian Kahin, eds, Understanding the Digital Economy,
MIT Press, 1999.
Acknowledgements: We thank Allen Barbieri, Susan Desanti, Howard Frank and participants at
the Conferences on “Understanding the Digital Economy” (Washington, D.C., May 25-56,
1999), “Current Issues in Managing Information Technology” (MIT, June 14-17, 1999),
“Reinventing Commerce at Net Speed” (Stanford University, June 21-22, 1999), and “Measuring
E-Commerce” (Brookings Institution, September 24, 1999) for valuable comments on this
research. The Center for eBusiness@MIT provided generous financial support under a grant
from Fleet Bank. Atish Babu and Mohsin Naqvi provided valuable research assistance.
, Understanding Digital Markets:
Review and Assessment
Abstract
As the Internet develops into a robust channel for commerce, it will be important to understand
the characteristics of electronic markets. Businesses, consumers, government regulators, and
academic researchers face a variety of questions when analyzing these nascent markets. Will
electronic markets have less friction than comparable conventional markets? What factors lead to
dispersion in Internet prices? What are the major electronic commerce developments to watch in
the coming years? This paper addresses these questions by reviewing current academic research,
discussing the implications of this research, and proposing areas for future study.
We review evidence that Internet markets are more efficient than conventional markets with
respect to price levels, menu costs, and price elasticity. However, several studies find substantial
and persistent dispersion in prices on the Internet. This price dispersion may be explained, in
part, by heterogeneity in retailer-specific factors such as trust and awareness. In addition, we
note that Internet markets are still in an early stage of development and may change dramatically
in the coming years with the development of cross-channel sales strategies, infomediaries and
shopbots, improved supply chain management, and new information markets.
,1. Introduction
A basement computer room at Buy.com headquarters in Aliso Viejo, California holds what some
believe is the heart of the new digital economy. Banks of modems dial out over separate ISP
accounts, gathering millions of prices for consumer products: books, CDs, videos, computer
hardware and software. Specially programmed computers then sift through these prices,
identifying the best prices online and helping Buy.com deliver on its promise of having “the
lowest price on earth.”
Buy.com’s model seems to represent the economic ideal for frictionless markets: low search
costs, strong price competition, low margins, low deadweight loss. However, the $1 trillion
dollar question1 for Internet consumer goods markets is: “Will strong price competition prevail
in electronic markets or will other market characteristics allow retailers to maintain significant
margins on the goods they sell?”
This paper approaches this question by exploring three aspects of business to consumer
electronic commerce markets. Section 2 discusses several ways to measure efficiency in Internet
markets and discusses the empirical evidence relating to these hypotheses. Section 3 focuses
more specifically on several potential sources of price dispersion in Internet markets. Section 4
introduces important developments to watch in electronic commerce markets and discusses how
they may effect efficiency and competition in the coming years. The appendix also includes an
extensive, if necessarily incomplete, bibliography of related research.
2. Characterizing Competition in Electronic Markets
There are a variety of ways to analyze the level of friction in Internet markets. Some studies in
this area compare the characteristics of electronic markets to conventional markets while others
analyze behavior within electronic markets. In this section, we identify four dimensions of
efficiency in Internet markets when compared to brick and mortar markets: price levels, price
elasticity, menu costs, and price dispersion.
1
The market capitalization of the 55 stocks that comprise Hambrecht and Quist’s “Internet Index” was
$1,000,489,700,000 at the time this paper was written.
1
, 2.1 Price Levels
In the classic economic models of social welfare, efficiency is maximized when all welfare
enhancing trades are executed. In retail markets where sellers set prices, efficiency occurs when
prices are set equal to the retailer’s marginal cost. Marginal cost pricing is the efficient outcome
since pricing above marginal cost excludes welfare enhancing trades from consumers who value
the product at a level between the price and the marginal cost.
The most cited reason why one might
expect electronic markets to be more
Table 1: Four Dimensions of Internet
efficient than conventional markets is a
Market Efficiency
reduction in information asymmetries
Price Levels: Are the prices charged on the
that arise from lower search costs.
Internet lower?
Economic theory predicts that high
consumer search costs will lead to prices Price Elasticity: Are consumers more sensitive to
above marginal cost in equilibrium small price changes on the Internet?
(Hotelling 1929, Salop 1979 for
example). If electronic markets allow Menu Costs: Do retailers adjust their prices more
consumers to more easily determine finely or more frequently on the Internet?
retailers’ prices and product offerings,
Price Dispersion: Is there a smaller spread
these lower search costs will lead to
between the highest and lowest prices on the
lower prices for both homogeneous and
Internet?
differentiated goods (Bakos 1997).
More advantageous retailer cost structures may also contribute to lower price levels in electronic
marketplaces. Better cost structures may lead to more efficient pricing in two ways. First, low
market entry costs may limit the price premiums sustainable by existing market participants by
increasing actual or potential competition (Milgrom and Roberts 1982). Second, favorable cost
structures can lead to lower equilibrium price levels in a long-run equilibrium by decreasing the
underlying costs on which any price premiums are based.
Lee (1997) conducted one of the first studies involving pricing in electronic markets. His study
analyzes prices in electronic and conventional auction markets for used cars sold from 1986 to
2
