Dolan 2000

PRICING AND MARKET MAKING ON
THE INTERNET
PROFESSOR ROBERT J. DOLAN Robert J. Dolan

and PROFESSOR YOUNGME
prepared this note as the basis for
Youngme Moon
class discussion rather than to
illustrate either effective or f
ineffective handling of an
administrative situation.
Copyright © 1999 by the President

and Fellows of Harvard College. To INTRODUCTION
order copies or request permission The emergence of the Internet raises important price manage-
to reproduce materials, call 1-900-
ment issues. Many observers see the Internet creating downward
545-7685, write Harvard Business
School Publishing, Boston,
pressure on price levels. Potential buyers can speedily search the
MA 02163, or go to net, perhaps employing shopping agents to check prices. These
http://www.hbsp.harvard.edu. No low consumer search costs will lead to greater price competition
part of this publication may be and ultimately lower prices and better value for customers. Some
reproduced, stored in a retrieval have proclaimed that the Internet economy means “inflation is
system, used in a spreadsheet, or dead— dead as a doornail” or even “an era of negative inflation.”1
transmitted in any form or by any The specter of price pressure and resulting slashing of margins
means— electronic, mechanical,
has cooled many’s enthusiasm for e-commerce. They perceive
photocopying, recording, or
otherwise—without the permission
doing business on the Internet to be a necessary evil. Thus, an
of Harvard Business School. important question is whether lower prices and margins are the
inevitable conclusion of doing business on the Internet—in all
situations, in some, and can the seller do anything about it? In
addition, there is a second, more general issue. The same tech-
nology behind customer search power enables other important
Published by John Wiley & Sons, Inc. and

Direct Marketing Educational Foundation, Inc.
JOURNAL OF INTERACTIVE MARKETING

VOLUME 14 / NUMBER 2 / SPRING 2000
56
1
W.A. Sahlman, “The New Economy Is Stronger Than You Think,” Harvard Business
Review, November–December 1999, pp. 99 –107; J.N. Sheth and R.S. Sisodia, “Consumer
Behavior in the Future,” in Electronic Marketing and the Consumer, R.A. Peterson, ed., SAGE
Publications, 1997.
PRICING AND MARKET MAKING
phenomena driving how the e-commerce mar- ways of transacting more broadly feasible. As
ket operates, for example, the Internet: shown in Figure 1, the mechanisms are of three
fundamentally different types. Type I is the set
● Facilitates a buyer’s acquisition of quality price mechanism. Within this, there are two
information for various goods. subclasses. First is the I(a) situation shown
● Enables suppliers to update prices dynam- where prices are updated only periodically, like
ically in response to observed demand. at McDonald’s. A second subclass is shown as
● Allows a seller to create a meaningful mar- I(b) wherein the set or “take it or leave it prices”
ket of potential buyers with price being the are updated continually, for example, as the
outcome of an auction process rather than airlines do. Type II is the negotiated price
prespecified by the buyer. mechanism. In a negotiated price situation,
● Permits a prospective buyer to specify in there can be either: II(a) a specified starting
detail the product’s requirements and put point for the negotiation (e.g., the seller’s ask-
fulfillment out to bid to an organized mar- ing price on a house, the dealer’s “list price” on
ket of potential sellers. a new car) or not, II(b). Type III is a class of
mechanism which relies on competition across
These impacts may be more fundamental buyers and sellers to produce prices. Here there
than any effect of more customer price infor- are three subclasses.
mation. They change how exchanges between In an auction system, III(a), the seller does
buyers and sellers take place. The how of a not specify a price; but, rather provides an item
transaction, that is, the connecting of a buyer which buyers compete for the right to buy in a
and a seller, has many forms. bidding process. III(b) is “reverse buying”
For example, consider a couple buying a new where the customer takes the lead in organizing
home: the pricing process. An example of this is when
the buyer develops a Request for Proposal on an
● During a break in the home hunting trip,
item or service and price is determined via a
they walk into a McDonald’s, see 99¢ as the
competition involving a bidding process among
posted price for a hamburger and decide
potential sellers. This is termed a “Reverse Auc-
whether to buy it or not.
tion.” Finally, in III(c), there is a coming to-
● Finally finding a desirable house, they hear gether of multiple buyers and multiple sellers
the seller’s $695,000 “asking price” and be- and a price determined by the interaction on an
gin to negotiate downward from that price. exchange to “clear the market.”
● Having bought the house, they go off to an One impact of the interactive nature of the
Estate Auction to bid on needed furniture. Internet is that market mechanisms of Type III
● Needing to move some personal belong- can be very efficiently organized. For example,
ings to the new home, they contact several the owner of a 1955 Coca-Cola sign could not
moving companies requesting proposals. really conduct an auction for that single item
The companies submit bids for meeting pre-Internet. The Internet, and sites such as
the couple’s requirements. eBay, make this possible. Generally, the Inter-
● Needing to come up with a down-payment net makes the choice of market mechanism a
for the house, they instruct their broker to salient question in many situations. The chal-
sell 500 of their shares of IBM stock on the lenge of managing price on the Internet is not
New York Stock Exchange. only how to set price in an era wherein the
consumer has more information; but also, how
The couple has thus transacted through five to select the most advantageous combination of
different market mechanisms. These same five market making mechanisms via which to trans-
market mechanisms can be found in business- act exchanges.
to-business situation in the real world and also This note describes the operation of each of
on the Internet. The Internet makes certain the three market mechanisms on the Internet.
JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000
57
We describe the rationale for each, examine the across every available retailer on the Internet.
determinants of economic efficiency, and assess Of course, none of the existing tools are cur-
pressure mdash;upward or downward— on rently capable of searching the entire Web uni-
prices. The goal is to provide insight to guide verse, and several online merchants have even
price management, not only in a set price situ- succeeded in “blocking” search agents from
ation but also to illuminate when an alternative mining their sites for data. Nonetheless, these
market mechanism is desirable. Throughout search agents are becoming increasing sophisti-
the note, reference will be made to currently cated. Some of the more popular tools include:
operating sites of interest.
● Third-party price comparison sites. Price
comparison sites like MySimon.com, Com-
TYPE I: THE SET PRICE MECHANISM pare.Net, and DealTime.com perform au-
tomatic price and feature comparisons in a
Are Set Prices Lower on the Internet? matter of seconds. Potential buyers simply
visit the site, indicate the item of interest,
In the “set price” scenario (see Figure 1, Type
and the search agent scans product and
I), the seller simply sets a fixed price, and the
pricing information from a list of hundreds
buyer is expected to either accept or reject that
of online sellers stocking the item. Many of
price. Negotiation is not an option; the seller’s
these sites charge merchants a fee to be
attitude is “take it or leave it.” This mechanism
part of their searches. Other sites, such as
has some advantages, viz., (i) low transaction
MySimon.com, earn a commission every
costs (no haggling, for example) and (ii) per-
time a buyer accesses a merchant site and
ception of fairness (since every buyer must pay
ultimately buys an item, through the
the same price).
search.
Numerous Internet retailers, including Ama-
zon.com and eToys.com, have adopted fixed ● Third-party price comparison agents. Imag-
pricing mechanisms. These leading Internet re- ine someone infiltrating the checkout line
tailers are often perceived as having lower fixed at an OfficeMax, peeking into people’s
prices than their real-world counterparts. In- shopping baskets, and telling them exactly
deed, as mentioned above, the conventional how much money they could be saving on
wisdom is that the Internet tends to drive prices the same products at Staples. Several com-
down, primarily because online consumers have panies including ClickTheButton, DealPi-
easier access to accurate information about the lot, and R U Sure have developed a new
market. breed of online search agents that do ex-
In traditional retail markets, buyer ignorance actly that: Offer shoppers better deals on
is often a source of profit for companies. Firms whatever merchandise they happen to be
set prices with reasonable confidence that the viewing on a webpage. Once a user has
majority of buyers is unlikely to spend a large downloaded software from one of these
amount of time and effort comparison shop- agent services, the software is activated any-
ping. But on the Internet, several factors have time the user’s Web browser is open. A
begun to bite into this “ignorance premium.” consumer viewing a book on, say, Amazon.
For one thing, potential buyers no longer have com, is then automatically given price com-
to physically travel from store to store in search parison information on the same book
of the best deal; rather, they can comparison from competing retailers.
shop a number of Websites from the comfort of ● Retailer price comparison agents. Some
their own computer. In addition, a number of online merchants have become so resigned
Internet search tools have made online compar- to the prospect of comparison shopping
ison shopping even more efficient. These that they offer their customers a compara-
search agents (also called “bots” or “spiders”) tive pricing feature within their own Web-
can theoretically compare prices and features sites, as a means of building customer trust.
58
Online computer merchant NECX, for ex- a splash in 1998 by “giving away” computers to
ample, offers buyers a “Price Comparison” consumers who agreed to view advertisements
feature. Click on the price comparison, every time they used their computer. Today, it is
and the buyer finds the competitors’ price possible to find merchants in almost every prod-
of the item being considered at NECX. In uct category willing to sell products at or below
some cases, these competitive prices are cost.
lower than NECX’s and for those shoppers But despite these rather conspicuous exam-
wishing to take their business to one of ples, there is to date no conclusive evidence that
these competitors, NECX even provides a prices on the Internet are lower per se than
direct link. prices in conventional outlets. In fact, the re-
sults of studies conducted on Internet pricing
Classic economic theory predicts that if elec- have yielded mixed results.2 In addition, the
tronic tools allow consumers to comparison long-term sustainability of zero-margin Internet
shop more easily, the end result will be greater businesses remains to be seen. For example, on
price competition and ultimately, downward the verge of going public, Buy.com recently
price pressure. A number of high-profile, “zero announced that it was moving to a more con-
margin” Internet businesses seem to be bearing ventional pricing strategy of offering certain
this prediction out. Perhaps the most well items at a loss to draw traffic and promote the
known of the zero margin businesses is Buy.Com. sale of higher-margin items. Onsale.com, which
Currently the fourth-largest retailer (by reve- recently merged with Egghead.com, also ap-
nue) on the Internet, Buy.com pioneered the pears to be moving toward a more conventional
strategy of selling its products at or below cost to “loss leader” pricing strategy, lowering prices on
lure customers. The company is betting that it some items while keeping prices high on others.
will eventually be able to make money by selling Perhaps most tellingly, some of the most pop-
advertising on its Website. In the meantime, its ular online retailers do not offer the lowest
proprietary software works 24 hours a day to prices. Amazon.com is a good example; it con-
gather millions of prices for books, CDs, com- tinues to grow marketshare despite dozens of
puter hardware and software, and other prod- competitors offering lower prices. Clearly, mer-
ucts from hundreds of competitors. In order to chants are able to leverage other dynamics—
circumvent attempts to “block” its gathering such as branding and trust, the shopping
of price information from competitors’ sites, “experience,” and lock-in—maintain healthy
Buy.com enlists hundreds of individual, anony- margins on products.
mous accounts from Internet Service Providers
to conduct its price comparison searches. All of Branding and Trust
this technology is designed to sniff out the Branding and trust may take on added impor-
cheapest bargains online and help the company tance in electronic markets for several reasons.
deliver on its advertising promise to have “the First, buyers are often purchasing from sellers
lowest prices on earth.” they have not seen and whose physical location
Critics describe Buy.com’s business model as is either unknown to buyer or quite distant.
“selling dollar bills for 99 cents.” There appears Second, most online transactions are not instan-
to be some truth to this: Over the past year, the taneous; they typically involve a delayed ex-
cost to Buy.com of the products it sold actually change of money and goods. Buyers usually
exceeded the amount of sales it generated by have to submit their payment and then trust
several million dollars. But the company’s
growth has been phenomenal, and for this rea-
son, it has spawned a host of zero-margin imi-
2
tators. Onsale.com, the Internet auction com- M.D. Smith, J. Bailer, and Brynjolfsson, E., “Understanding Dig-
ital Markets: Review and Assessment,” forthcoming in Understand-
pany, recently launched an AtCost model built ing the Digital Economy (E. Brynjolfsson and B. Kahin, eds.), MIT
around a similar pricing strategy. Free-PC made Press.
59
that they will receive their goods in a timely ● extensive product reviews from experts and
fashion. Third, a significant percentage of buy- other customers;
ers may be purchasing goods online for the first ● product samples (e.g., music clips, books
time; this may lead to heightened concerns chapters)
about being “ripped off.” Assurances from ● product recommendation tools;
credit card companies about protection offered
● convenient check-out services.
to buyers may reduce some of these concerns.
However, for all of these reasons, online con-
All of these features contribute to the cre-
sumers may still be willing to pay a premium to
ation of a particular shopping environment that
purchase a product from a retailer they are
affects the likelihood that customers will enjoy
familiar with, rather than risk dealing with an
shopping at the site. Firms that successfully le-
unknown seller.
verage these features may be able to charge a
Conversations with managers from price
price premium.
comparison sites support this view. These man-
agers point out that many of the shoppers using
their sites to compare prices end up purchasing Lock-In
items from branded retailers such as Amazon. Lock-in refers to mechanisms that increase cus-
com, even when they are given information tomers’ switching costs. Sometimes lock-in oc-
about dozens of other retailers offering lower curs simply as a result of familiarity with a par-
prices.3 In fact, Amazon.com reportedly gets ticular Website. Rather than incur the switching
two-thirds of its business from returning shop- costs associated with learning how to navigate a
pers. And some online companies feel so new Website, customers may choose to pay a
strongly about the importance of building con- higher price to avoid this inconvenience. In
sumer confidence, they are refusing to compete other cases, firms explicitly attempt to increase
on price alone. For example, although NECX lock-in by creating additional incentives for re-
raised eyebrows when it began offering the peat customers. Frequent buyer programs, such
built-in price comparison tool that seemed to as that marketed by Netcentives, are a good
encourage its customers to shop elsewhere, it example of this. Other, less obvious, mecha-
argues that the feature reinforces consumer nisms include personalization features such as
trust. As proof, it claims a 30% increase in busi- individualized shopping lists, customized inter-
ness since launching the feature. faces, and “one-click” ordering accounts.
One company that has managed lock-in par-
ticularly well is Dell Online. While first-time
The Shopping Experience
visitors are greeted with Dell’s standard Web-
As in the brick-and-mortar world, online retail- site, for its most valuable corporate customers
ers offering similar products and prices may Dell has developed hundreds of customer-specific
differ significantly across a variety of other di- webpages. These Dell Premier Pages not only
mensions. Some Websites are simply easier to display specific computer configurations that
navigate than others, for example. The most have been pre-approved by the customer’s firm,
sophisticated shopping sites offer a number of but they display prices that reflect negotiated
features that contribute to the shopping expe- discounts. Detailed account purchasing reports
rience, such as: and inventory analyses are also customized for
these customers. As a result, Dell’s Premier
● superior product information; Pages have become management control tools
● sophisticated search tools; for its customers, who use the customized web-
pages as a means of enforcing product stan-
dards and increasing internal efficiencies. Dell’s
3
“Call your agent for online shopping,” Information Week, Decem- prices may not be the lowest in the industry, but
ber 7, 1998. the company has succeeded in creating ex-
60
tremely high switching costs for its most valu- menu costs increase the likelihood that re-
able customers. tailers will change prices more frequently.
Add to these factors the fact that technology
Dynamic Pricing has made it easier for online retailers to check
Figure 1 describes another set price mechanism the prices of their competitors, and the end
in which posted prices are continually updated result is that online prices tend to be more
(Type Ib). Of course, dynamic pricing is not dynamic than prices in conventional settings. As
new. Airlines, for example, often have dozens of one online computer merchant advertises:
different fares paid by passenger on a given
When you shop at eCOST.com, you don’t have
flight. These fares depend on a number of vari-
to wonder if you’re getting a great value on
ables, including how early customers booked what you need. . . To make sure we are offering
their flights, inventory of available seats at the you the best price at all times, we update our
time of booking, what restrictions they were prices at least once a day, and more often as
willing to accept, their travel history, etc. The needed. . . When you visit eCOST.com, you can
hotel and car rental industries have followed be sure you are getting the latest information
suit, adopting the airline industry’s yield man- available. – eCOST.com Website
agement principles. Grocery stores also employ
dynamic pricing using “smart” cash registers. Dynamic pricing can be implemented in a
These cash registers automatically offer custom- variety of ways. Firms can simply update prices
ers discounts (e.g., cents-off coupons) depend- frequently, as in the eCOST.com example.
ing on their purchases. Even soft drink compa- Firms can also engage in various forms of price
nies are experimenting with vending machines customization, where different customers are
that charge different prices depending on the charged different prices, as in the airline exam-
weather (the hotter the temperature, the ple.
higher the price).4 On the Internet, price customization can
On the Internet, the opportunities for dy- take many forms:
namic pricing are even greater, for at least two ● Some online retailers track the click-
reasons: streams of customers, instantaneously mak-
ing special offers based on their online
● Customer Information. While the Internet
activity.
has made it easier for customers to collect
● Other retailers rely on their extensive cus-
information about products and prices, it
has also made it easier for sellers to gather tomer databases to “micromarket” custom-
information about customers. This informa- ized offers to customers based on their past
tion can be used to more accurately deter- purchase behavior, often using personal-
mine how much individual customers are ized email.
willing to pay for certain goods. ● Dell’s Premier Pages allow for a relatively
● Lower Menu Costs. Menu costs refer to the novel price customization mechanism, in
costs associated with making price changes. that the company is essentially establishing
For example, every time a traditional cata- different “storefronts” that reflect variable
log retailer decides to change prices, it pricing schemes.
must incur the costs associated with re- ● Some online merchants are using price
printing its catalog. On the Internet, lower comparison technology to develop instan-
taneous “price-matching” systems. When a
customer visits the Website directly, the
4
posted prices are fixed. However, if the
R.G. Cross, Revenue Management (Broadway Books, 1997) dis-
cusses the broad applicability of yield management/dynamic pric- customer uses a third-party search tool to
ing techniques across industries. compare prices among a number of com-
61
petitors, the prices automatically drop. As a presentation of the product features and
result, customers that access the Website value;
via the price comparison tool get a lower (iii) for negotiation to be effective, the cus-
price than customers who access the Web- tomer contact person must have some
site directly. degree of pricing authority.
This movement to price customization is pur- The Internet provides an efficient mecha-
sued widely and when well implemented can nism for buyer/seller(s) interaction alleviating
offset the added customer information on each of these problems. For instance, to over-
prices. The ultimate form of price customiza- come disadvantage (iii), the seller can develop
tion is customization directly to the buyer’s will- an intelligent agent to simulate the process of
ingness-to-pay. That is pursued on the Internet person-to-person negotiation. Several general
via auctions which will be addressed fully later purpose and many special purpose negotiation
in this note. sites currently operate on the Internet.
NexTag.com is a site of market mechanism
Type II(a)—negotiation with a specified start-
TYPE II: THE BUYER/SELLER NEGOTIATED ing price. To illustrate the process, consider a
PRICE MECHANISM customer wishing to buy a Palm V. To start,
Negotiations, big and small, are commonplace NexTag produces the “seller price” from a num-
in the real world. Agents negotiate the price of ber of vendors. In this case, there were ten
star athletes’ services with teams. A buyer hag- potential sellers sorted by “seller price” ranging
gles over the $2.00 asking price for a set of six from $288.98 to $437.12. Entering a ship-to zip
chipped saucers at a Saturday morning yardsale. code adds the supplier’s shipping and tax to
Some buyers like the negotiation or bargaining yield a comparison of out-of-pocket or “Total
process, perceiving it as a route to a “good Price.” If the price from any seller is acceptable,
deal.” Others detest it. This latter segment has the customer can just purchase the item and we
grown large enough that it has prompted the have just reverted to a Type I mechanism. How-
institution of the option of “no haggle” pricing ever, if no price is acceptable, Step 2 is to “Enter
in some historically negotiation situations. For Your Own Total Price” and select the suppliers
example, General Motors institutionalized “no to whom this information or counteroffer is
haggling” for its Saturn model and many deal- conveyed. At this point, the buyer is under no
ers of other vehicles have adopted “Saturn pric- obligation; for example, the buyer could enter
ing” either on a full-time basis or for special $275.00 but is not obligated to buy the product
sales events. if a supplier accepts that price. The process
However, a supplier’s expressing a willing- then follows the real world negotiation process.
ness to negotiate can attract certain customer Sellers respond to the “total price” offered by
groups. It can also offer an additional way in the buyer. Some seller responses are auto-
which the seller can customize the price to the mated, viz., as the NexTag site puts it, “If a
individual buyer. seller’s systems has been fully integrated with
Historically, the negotiation mechanism has NexTag.com, you may see an immediate re-
had some disadvantages compared to Type I: sponse to your offer. . . .” Sellers can send a
Set Price. For example, in a negotiation situa- message along with their price counteroffer. As
tion: in the real world, the seller’s response can be
more complex than just a price offer; it could
(i) it typically takes longer to complete the be for a substitute item (e.g., a Palm III not a V)
transition; or include other goods (e.g., hold on price but
(ii) the price aspect of the transaction can throw in software). NexTag notes that “most
become highlighted dominating the buy- sellers respond within minutes.” NexTag pro-
er–seller interaction and squeezing out vides a “price history” of completed transactions
62
for the item to help the buyer in the negotia- for a particular issue of Mac World at its “rate
tion. This “price history” also serves to indicate card” price. The buyer then makes an offer
to the buyer what a reasonable offer might be, which the seller responds to with “accept, reject,
which helps keep the system from being or hold” (hold meaning the seller wants to wait
clogged with bargain hunting that will prove and see if other offers come in or not). If not
fruitless. accepted, the potential buyer is free to make
This transition of the negotiation process to another offer.
the Internet overcomes many of the disadvan-
tages of negotiations in the real world. From a
Buying-Power Based “Negotiations”
customer’s point of view, negotiation can be
done with multiple suppliers at once. Because A common negotiation tactic in the real world is
response is immediate in many cases, the trans- to stress the size of the order at issue or even
action can still close quickly even with multi- increase the quantity of goods to be purchased
supplier negotiation. The customer is always in as a mechanism to get the price down, for ex-
control and not subject to unwanted persuasion ample, “I’ll take both the white and blue set of
attempts such as many have encountered trying chipped dishes if you give them to me for $1.50
to end a real world negotiation about a car each.” Even this “buying power” tactic has an
purchase. The advantage to the seller is that the analog on the Internet. Sites such as Accom-
dialog about price provides information about pany and Mercata aggregate the demand from
the buyer which can be used to customize different customers who are unknown to one
prices. another to use in “negotiating” lower prices.
Other sites covering a range of products are Accompany calls itself the “Get It Together Net-
Make Us An Offer and Hagglezone. Make Us work.” Rather than truly negotiating lower
An Offer offers “Real-Time Online Haggling” prices as buyers come together, Accompany has
hosted by an animated “artificially intelligent pre-determined a set of quantity discount
sales agent” named Chester and positions itself schedules with its “Supplier Partners.” These
as a solution to the delayed respond time of discount schedules are provided to buyers at the
other sites such as the auction site eBay, as bid site. For example, for the Palm V on December
responses are delivered “within seconds.” Hag- 1, 1999 at 1:40 p.m., the price schedule off the
glezone “where everything is negotiable” fea- Manufacturer’s Suggested Retail Price of
tures six hagglers with “unique personalities, $399.00 was:
moods and tendencies.” A buyer can choose Number of Buyers Price
which haggler to deal with. Hagglezone empha-
sis the fun/entertainment aspects of buying. It 0–5 $304.95
has invested in a major television ad campaign 6–10 $297.95
humorously showing a women attempting to 11–20 $290.95
haggle in a traditionally set price format (a 21–50 $279.95
supermarket) as the customer behind her be- 51–126 $267.95
come upset given the time involved in complet-
ing the transaction. Hagglezone is presented as At that point in time, 74 buyers had already
the answer to her problems. Hagglezone is part signed up so that “tier 5,” the last price tier of
of the Netmarket Group which also runs the set $267.95, was already hit. Consequently, a new
price format netmarket site featuring over buyer arriving at the site could join the 74 al-
800,000 items. ready committed to the item knowing that
Special-purpose sites, such as Adoutlet.com, $267.95 would be the price paid. In contrast,
simulate face-to-face negotiations for a particu- when buyer #8 signed on, only “tier 2” had been
lar product category. Adoutlet brings together reached so he or she agreed to pay up to
media buyers and sellers. Adoutlet displays $297.95 but with the prospect of the price de-
available inventory, for example, a one-page ad clining as more users signed on for the deal.
63
This is precisely what happened, driving the sit unsold. In an auction the price moves to a
price for all buyers down to $267.95 per unit (in level where the item is sold. And in contrast to
contrast to a $299.99 price the same day at negotiated selling in which a seller bargains
egghead.com). with an individual buyer, classic auctions bring
It is not clear at this point in time how im- buyers together in competition with one another.
portant these negotiation sites will be in the They are basically demand aggregation models
long run. Clearly, the Internet creates situations that function to deliver the best price for the
in which this Type II mechanism is feasible. seller, given the market demand the seller has
Some buyers prefer the option to “haggle.” Sell- been able to assemble.
ers have the ability to automate the process on Classic auctions have existed for hundreds of
their side via intelligent agents, yielding more years, typically in situations where the value of
price customization opportunity. Thus, for at the product is (i) difficult to determine, (ii) a
least some segment of the market, this mecha- matter of private taste and opinion, or (iii)
nism will likely be operative as the market mech- highly variable depending on market condi-
anism itself provides value to buyers. tions. For example, the world-famous auction
houses of Sotheby’s and Christie’s both date
back to the 1700s and specialize in the sale of
TYPE III: AUCTIONS AND EXCHANGES antiques, artwork, and other fine collectibles—
Figure 1 displays three types of pricing mecha- products whose value is almost impossible to
nisms involving horizontal interactions between determine prior to the actual sale.
buyers and sellers. In Type II, negotiations, it Until a few years ago, classic auctions—while
was one-on-one vertical negotiation between en- the predominant mode in certain industries
tities at different levels of the marketing system (e.g., the famous Dutch Fresh Flower Auctions,
that drove prices. In these three cases, compe- the Thoroughbred Horse Auctions in Ken-
tition across buyers and/or sellers produces tucky)—tended to be a niche phenomenon.
prices that can be highly variable across trans- They also tended to be concentrated in highly
actions. In the case of the “classic auction” specialized agricultural and commodities mar-
model (Type IIIa), competition across buyers kets. The interactive nature of the Internet has
leads to a price. In the case of the “reverse changed all of that; indeed, auctions now con-
buying” model (Type IIIb), competition across stitute some of the most popular sites on the
sellers leads to a price. And in the case of “ex- Web. Their popularity has largely been driven
changes” (Type IIIc), multiple buyers and mul- by the fact that the Internet increases the eco-
tiple sellers interact to set prices. nomic efficiencies associated with auction mod-
els. More specifically, for suppliers the Internet
III(a): Classic Auctions has not only lowered the search costs associated
In the classic auction a vendor puts items up for with finding a critical mass of buyers in the
sale and would-be buyers are invited to bid in market, but it has also lowered the costs associ-
competition with each other. Bidding can take a ated with making inventory available to buyers
number of forms, for example, sealed bid or on an immediate basis. For buyers, the Internet
open. Most common is the ascending price for- has lowered the costs associated with accessing
mat wherein the highest bidder “wins” the item. hard-to-find items, and finding other buyers
As more potential buyers become involved, who share common interests.
there is upward pressure on prices.
Classic auctions differ from other pricing The Internet Lowers the Search Costs for Sell-
mechanisms in several fundamental ways. In ers Looking for Buyers. In traditional mar-
contrast to “take it or leave it” pricing, classic kets, sellers face significant hurdles associated
auctions involve a flexible pricing scheme in with “finding” a critical mass of buyers in a
which prices are tailor-made for each transaction. large, unorganized open market. In order to
Moreover, in a fixed price system, the item can access these potential buyers, they often have
64
no choice but to incur significant marketing plus goods via auction must accept the uncer-
costs. In some cases, geographical dispersion tainty associated with dynamic pricing. How-
precludes the efficient organization of potential ever, for many sellers, this uncertainty is easily
buyers altogether. An auction can be risky be- worth the cost-savings associated with quick in-
cause it is not clear that at any one time the ventory turnover: online auctions generally
market of potential buyers can be brought to- move goods much more quickly than direct
gether. sales, catalogs, or off-line auctions. In addition,
The Internet, however, has produced a num- firms that use auction mechanisms to liquidate
ber of “market-makers” that have been able to surplus goods are able to bypass liquidation
pool together significant numbers of potential brokers who tend to pay fire sale prices. As a
buyers without having to deal with physical result, auctions—particularly business-to-con-
search and travel costs. These market makers set sumer auctions—are becoming an increasingly
up the infrastructure which individual sellers common mechanism by which firms adjust in-
can plug into. ventory levels.
Indeed, in the Web universe, several factors
make it easy to transform “niche” market seg-
ments into “mainstream” market segments. For Buyers, the Internet Lowers the Costs Asso-
First, the global reach of the network provides a ciated with Accessing Hard-to-Find Items. In
much greater pool of potential buyers to draw the past, buyers searching for hard-to-find items
from. Second, reduced search costs make it eas- had very restricted choices, regardless of
ier to identify small pockets of people with whether those items consisted of collectibles
highly specialized needs. Finally, reduced com-
and memorabilia, or closeout computer hard-
munication costs make it easier to establish and
ware. In the former case, hobbyists were left to
sustain relationships with these segments.
either scan local classified listings or make the
The end result is a situation in which firms
rounds among a few, scattered dealers who spe-
are discovering that there is significant value
cialized in such merchandise. In the latter case,
associated with simply aggregating demand
bargain-hunters typically had to choose from
among these market segments. Some of the
the limited supply of surplus goods carried by
busiest sites on the Web are those fulfilling this
market-making function, in three settings: the their local computer retailer. In both cases,
consumer-to-consumer, business-to-consumer, even when buyers were able to find what they
or business-to-business context. were looking for, prices tended to be non-nego-
tiable.
The Internet Lowers the Costs Associated with Internet auctions have significantly increased
Making Inventory Available to Buyers Immedi- the options available to buyers in the market for
ately. When it comes to excess merchandise— hard-to-find items. Indeed, the online classic
such as surplus, refurbished, or closeout com- auction houses not only aggregate demand for
puter merchandise—the need to liquidate sellers, they aggregate supply for buyers. In this
inventory has traditionally been a problem for sense, they have become convenient “one-stop
suppliers. Internet auctions, however, allow sup- shopping” sources for buyers in this market. A
pliers to make this inventory available to buyers collector looking for a rare Beanie Baby now
on an immediate, and continually updated, ba- has a myriad of online auction choices; simi-
sis. When sellers make errors forecasting de- larly, a home-office worker looking for a deal on
mand for perishable inventory, instantaneous a 17⬙ computer monitor can now bid on dozens
auctions mitigate the costs associated with such of such monitors online. Moreover, buyer
errors. For this reason, the sale of excess com- choices are not limited to the big auction firms.
puter products comprises the bulk of the online Niche auction companies have sprung up all
business-to-consumer market. over the Web, covering every product category
Of course, sellers who choose to auction sur- imaginable.
65
The Interactive Nature of the Internet Facili- conduct auctions in which both the sellers and
tates the Creation of Buying Communities. the buyers are businesses.
While the economic efficiencies afforded by In-
ternet auctions have no doubt played a large Consumer-to-Consumer Auctions. The total
role in their popularity, it is impossible to over- consumer-to-consumer auction market on the
look another factor that has contributed to Internet is currently estimated to be about $2.3
their success: Auctions are “fun.” Indeed, online billion (sales) in 1999, and is expected to grow
auctions owe at least some of their popularity to to $6.4 billion by 2003.6 And while most firms in
the fact that they have become choice destina- this category specialize in collectibles, antiques,
tions for bargain-hunters who derive significant memorabilia, and second-hand goods, the
pleasure from the “thrill of the hunt.” In this amount of variety among the products being
regard, it is important to reiterate that classic offered is growing daily.
auctions do not necessarily lead to bargain pric- Typically, firms in this category do not own
es; on the contrary, the competitive dynamic the goods up for auction; rather, they simply
tends to push prices upward (the “winner,” after conduct auctions on behalf of a large group of
all, is typically the individual willing to pay the sellers. For this reason, they do not have to deal
highest price). with the logistics associated with shipping actual
Classic auctions on the Internet also have a products. They simply act as electronic interme-
distinctly social component that most successful diaries, connecting sellers with a pool of buyers.
auction sites not only recognize, but promote. For these firms, the bulk of their revenues
They provide an online forum where buyers tends to come from seller fees, although they
and sellers can become acquainted, discuss top- occasionally collect additional revenues from
ics of common interest, and exchange informa- advertisements and buyer fees. eBay is the run-
tion about one another. A typical example: away leader in this category. It has over 7 mil-
Members of the eBay community who met while lion registered users who at any given time can
trading in the Elvis category have forged such find up to 3 million items at auction, ranging
strong relationships that they now gather to from placemats to cars to homes. eBay collects a
make annual pilgrimages to Graceland to- modest fee from sellers in exchange for listing
gether. As Meg Whitman, eBay’s CEO explains, an item, ranging from $0.25 to $2. It also col-
this community-building dynamic is impossible lects a seller’s fee, that is, a percentage of the
to replicate off-line: sale ranging from 1.25% to 5%. From the seller
perspective, the fees are a bargain compared to
Whereas so many of the Internet companies in the $50 it would typically cost them to post a
existence had borrowed something that existed traditional classified ad for a week. And from
off-line and translated it into an online version,
the company perspective, the commissions may
[eBay] is actually the creation of something
that could not be done in the real world.5
seem tiny, but they add up: eBay had net reve-
nues of over $150 million through three quar-
Types of Classic Auctions ters of 1999, and net income of almost $6 mil-
lion over the same period, making it one of the
Classic auction firms on the Internet can be few profitable sites on the Web.
roughly categorized into three groups: consum- One of the biggest challenges facing consum-
er-to-consumer sites that conduct auctions in er-to-consumer auction businesses is dealing
which both the sellers and the buyers are con- with fraud. Because these firms only serve as
sumers; business-to-consumer sites that conduct intermediaries, they exert little direct control
auctions for businesses wishing to sell products over the sellers posting items. The most com-
to consumers; and business-to-business sites that mon complaint comes from buyers who pay for
5 6
From eBay, Inc., HBS case #N9-700-007. Source: Forrester Research.
66
merchandise, only to have the seller disappear In some cases, firms in this category do not
without delivering the goods. eBay, however, own the goods up for auction; rather, they con-
has implemented some elegant (albeit imper- duct auctions on behalf of vendors in exchange
fect) ways to address some of these potential for a seller’s fee. In other cases, they take title to
hazards. On its site, regular sellers establish a the goods and handle shipment to customers.
“reputation” for reliable delivery and quality Onsale (recently merged with Egghead.com)
through a ratings system based on comments was the first business-to-consumer auction site
from previous buyers who have transacted with on the Internet and is still one of the largest.
the seller. Bidders can not only browse through Other sites that fall into this category include
these comments and ratings, but they can also uBid, BidOnline, and WebAuction. Niche sites
add their own feedback, based on their experi- are also becoming increasingly popular. Mil-
ence. Extensive chatboards also let eBay-ers lionaire.com—founded by Robb Report
share tips and gossip. In effect, the company founder Robert White—targets the high-end
relies on the users themselves to establish trust market by connecting buyers of luxury items
between buyers and sellers. Its fraud rate is such as antiques, fine art, yachts, watches, wine
subsequently very low: 25 out of every million and jewelry with dealers and galleries. The
transactions. Note that this reputation-building Sharper Image holds auctions at its website that
system not only promotes “community,” but it include a range of yuppie gizmos.
increases the switching costs for both buyers Even investment banks are getting into the
and sellers. auction business. Many initial public offerings
eBay currently faces competition from a display classic signs that shares are being sold
number of competitors, including Yahoo! auc- too cheaply and to the wrong people (i.e., not
tions and Auction Universe. And, recognizing to those who value them the most highly). As a
an opportunity to leverage its already existing result, there is often a sharp rise in price on the
customer base, Amazon.com jumped into the first day’s trading, and a huge volume of shares
auction business in the spring of 1999. Tradi- changes hands. W. R. Hambrecht, an online
tional, off-line auction houses are also entering investment bank, is now using auctions to sell
the fray. Butterfield’s, a high-end auction firm, initial public offerings of shares more effi-
was recently purchased by eBay, while Sotheby’s ciently. Investors submit secret bids; the price is
recently forged an alliance with Amazon. There set at the highest level at which all available
are also literally hundreds of niche auction sites shares can be sold, and they are allocated at that
on the Web, including Mobilia (a place to bid price to everybody who bid that amount or
on specialty automotive products), PlanetBike, more.
Hasbro Collectors, Vintage Surfboard, etc.
Business-to-Business Auctions. Business-to-busi-
Business-to-Consumer Auctions. The total ness auctions are expected to eventually make
business-to-consumer auction market on the In- up most of the volume of the online auction
ternet is estimated to be about $0.4 billion market. In fact, many auction firms that started
(sales) in 1999, but is expected to grow to $12.6 out as business-to-consumer firms (e.g., Onsale,
billion by 2003, overtaking the consumer-to- uBid) are finding that an increasing percentage
consumer category.7 While many firms in this of their revenues is now being generated by
category began by specializing in computer business customers.
hardware and other technology-related items, a In general, business-to-business auctions in-
number have since expanded to offer every- volve fundamentally different dynamics than
thing from travel packages to sporting goods consumer auctions. They typically involve larger
items. amounts of money, firms are not seeking enter-
tainment, and firms tend to be wary of jeopar-
dizing long-term strategic relationships.
7
Source: Forrester Research. AdAuction.com is an example of an business-
67
to-business auction site. The company provides company currently has a combined reach of 50
a venue for companies to buy and sell advertis- million users (compare this to eBay’s audience
ing space for all sorts of media: online, broad- of 7 million).
cast, and print. Sellers must fulfill certain crite-
ria to qualify for participation in the auctions, III(b) Reverse Buying
which gives them the opportunity to sell excess The term “reverse” buying refers to the fact that
ad inventory to over 6,000 registered media buy- in these mechanisms there is a flip in the usual
ers. Another example is TradeOut, a business- role of buyer and seller. Usually, the seller indi-
to-business liquidator auction with products cates what is for sale and buyers search around
ranging from a lot of 2,000 Duncan Yo-Yo’s to for what they want. In reverse buying, the buyer
70 tons of Borosilicate Glass Tubing. Its devel- is more proactive—specifying what it is that will
oper was inspired in his design by reading be purchased; then, suppliers’ bids indicate the
eBay’s prospectus. eBay invested in TradeOut in price of fulfilling the specified demand. In
November 1999. some situations, this happens in a true reverse
auction process, as sellers perceive themselves
Entering the Classic Auction Market. In all of in active competition with one another. In
the classic auction categories, barriers to entry other cases, a service will identify potential sell-
are relatively low, and competitors can launch ers and their posted prices for buyers, but with-
new sites at a relatively low cost using commer- out anything approximating a bidding process
cially available software. However, the biggest among sellers.
hurdles involve building a potential bidder and
seller base. Success literally breeds success; the Reverse Auctions. In a reverse auction, a
large bidder base draws the suppliers which buyer communicates a need to a set of potential
enhance the site’s appeal to bidders. For suppliers and suppliers bid on fulfilling that
smaller players seeking to enter the market, demand. The reverse auction has been staple of
breaking this self–reinforcing cycle can pose purchasing in business-to-business situations for
quite a problem. many years, often under the name of competi-
But several firms are now offering these tive bidding.8 The process entails the buyer
smaller players an alternative. These firms focus drafting a Request-for-Proposal (RFP) or Re-
on helping other firms get into the auction quest for Quotation (RFQ) specifying what is to
business by using network synergies to quickly be purchased. This request is transmitted to
build a large bidder and seller base. FairMarket, qualified sellers. In some cases, drafting the
a leader in this category, has created an auction RFP/RFQ and then identifying and communi-
network that connects a number of smaller auc- cating to potential suppliers is easy. For exam-
tion sites hosted by some of the leading portals ple, when the Tennessee Valley Authority
and vendors on the Web, including Microsoft needed electrical generation equipment in the
(MSN), Excite, Lycos, AltaVista, Dell, Com- 1950s, it knew only three suppliers, Allis-Chalm-
pUSA, Cyberian Outpost, MicroWarehouse, ers, Westinghouse and General Electric were
and Boston.com. Each individual site is con- qualified to supply its needs. The products to be
nected to a single massive database of merchan- bought were well-known commodities, easy to
dise. A computer listed from Dell at www.del- specify. Similarly, in current times, a U.S. gov-
lauction.com, for example, will automatically ernment agency making a bulk buy of PCs
appear on all the auction sites in the FairMarket would need only contact a few firms and these
network. Besides developing the network, Fair- firms would be well known to them. In other
Market provides a number of other services to
its members: It hosts the servers, and creates the
software and user interface for member auction 8
See, e.g., Chapter 9, “Competitive Bidding,” in B.C. Ames and
sites. It also provides customer service, includ- J.D. Hlavacek, Managerial Marketing for Industrial Firms, Random
ing fraud protection and security features. The House, 1984.
68
situations, the “making of the market” by bring- proach is to provide the total package of ser-
ing in a more complete set of potential suppli- vices necessary for an effective reverse auction
ers is a major task. process. It has recognized that, in many situa-
Supplier bidding can be of two general types: tions, preparation of the RFQ is a non-trivial
task. As stated on the company’s Website,
(i) sealed bidding, in which each qualified “. . .products are often technically complex and
supplier submits one secret bid and the custom-made. That’s why we work with several
buyer chooses on the basis of bids sub- members of each clients organization to specify
mitted in that round their needs in detail and communicate them to
(ii) open bidding, in which sellers interact in buyers.” FreeMarkets’ staff works to have auc-
real time just as buyers do in a classic tion bidders (suppliers) “present and prepared”
auction, except the bidding goes down at the bidding event. At the bidding event,
over time and the lowest supplier price FreeMarkets’ BidWare proprietary software is
wins used by suppliers from many geographic loca-
tions to submit real time bids. FreeMarket on-
The Internet’s interactive communication ca- line auctions covered over $1.5 billion in pur-
pability broadens the feasibility of economically chase orders from January 1998 to June 199.
efficient reverse auctions. The Web expands the Major clients included General Motors, Quaker
scope of sellers participating. This creates an Oats, and AlliedSignal. A November 1999 Wall
overall downward pressure on prices. Online Street Journal ad of FreeMarkets described its
analogs of business-to-business competitive bid- work for United Technologies Corporation
ding situations are gaining acceptance on the (UTC) in its acquisition of specialty metals. In
Web. Need2Buy, for example, is a special pur- one bidding day, 14 bidders submitted 318 bids
pose site at which a buyer can engage in a covering about $20 million in UTC require-
ready-made reverse auction for electronic comments, saving UTC 22% in the process. In gen-
ponents. These components are tightly speci- eral, the company estimated that its process
fied by industry standards so the buyer needs saves individual buyers between 2 and 25%.
are easily expressed, for example, part number The Internet makes possible the more effi-
74L5240AN means the same thing to everyone cient organization of reverse auctions— bring-
in the industry. The buyer submits the RFQ to ing in the maximum number of qualified sup-
the system and indicates his choice of the pliers, well-informed on the requirements. The
Sealed Bid or Open Bidding format. The real-time bidding process also helps the buyers.
Need2Buy expert system searches the database Overall, the net result is downward pressure on
to find vendors carrying the requested product. prices.
The buyer may delete vendors unacceptable to
it. Accepted vendors then receive an email in- Emerging Business-to-Consumer Reverse Buy-
viting bids on the RFQ. In an open-bid system, ing Models. Business-to-consumer reverse buy-
vendors are informed of the lowest bid and ing services are less well developed at this point
invited to rebid if not the lowest. The buyer and less truly auctions, but several types of
reviews the final bids, which could include mechanisms are in operation. For example, as
quantity available and delivery date in addition described on its website, imandi is the place
to price, and decides how to proceed, following “Where Customers Rule”—“Connecting You
up with sellers via e-mail, fax, or telephone as with Thousands of Merchants Competing to
desired. Serve You.” imandi trademarked the phrase
FreeMarkets is a firm directed to creating “we’re turning shopping on its head.” As the site
effective Competitive Bidding Events for indus- puts it, “our aim is to put an end to fixed pricing
trial buyers. In contrast to some vendors selling on the Web.” Originally set up for the acquisi-
just reverse auction software enabling buyers to tion of services from a fragmented supplier base
construct their own auctions, FreeMarkets’ ap- of painters, carpenters, etc., the scope has ex-
69
panded to include collectibles. An individual Restrictions include the following:

buyer effectively enters an RFQ, that is, what it
wishes to purchase. imandi searches its database ● The buyer cannot specify a preferred car-
of 168,000 merchants (as of December 1999) to rier, nor even exclude an undesirable car-
provide a list of local and national merchants rier to them;
believed capable of supplying the desired prod- ● The buyer cannot specify times of travel
uct. The buyer eliminates any undesired suppli- and must take anything the system finds
ers. imandi transmits the RFQ to the remainder between 6 a.m. and 10 p.m.;
who submit price quotes. imandi had 40,000 ● When the buyer names an “offer” price, he
registered users in December 1999 compared to or she is obligated to pay that price if the
7 million for eBay. departure/return days are met.
Similar services are offered by MyGeek and
Respond. Basically, these are buying services Note that the database of vendors’ minimum
which broadcast a buyer’s RFP to potential sup- revenue requirement for fulfilling the demand
pliers who respond via email. The customer can could show numbers significantly lower than
then choose the seller to transact with or not the willingness-to-pay expressed by the buyer.
buy at all. An advantage of Respond is that it is (To induce consumers to express high willing-
able to accommodate a situation in which the ness-to-pay, requests can be made only once a
buyer is only able to describe the item sought in day.) The buyer is charged the expressed will-
generic terms, for example, “an inexpensive ingness-to-pay price generating margin for
two-bedroom condominium rental on a beach.” Priceline.
Buyers remain anonymous to potential sellers As described by Priceline on its Website,
and can choose to follow up or not on e-mailed “. . .we collect consumer demand. . . By requir-
offers sent to Respond.com for their attention. ing customers to be flexible with respect to
brands, sellers and/or product features, we en-
The Priceline-Type Variant. A particularly able sellers to generate incremental revenue
high-profile variant in the reverse buying genre without disrupting their existing distribution
is Priceline. Priceline’s marketing proposition channels or retail pricing structures.”
(as noted on the Website and in advertising) is Priceline has extended the service to addi-
“Name Your Own Price and Save!” It is hyped as tional product categories: hotel rooms in 1100
the ultimate in consumer-driven commerce.9 In cities, home financing, and new cars. In Decem-
some respects, however, the service represents ber 1999, a grocery service was in-test in metro
the sacrifice of customer power in favor of solv- New York and Priceline announced plans to
ing a vendor’s problem of selling off excess expand to long-distance telephone calls. For the
inventory. first six months of 1999, Priceline received 1.5
Priceline’s initial product category was airline million “guaranteed offers” from consumers
seats. The process has a buyer naming a price representing $486MM in revenue. It fulfilled
he or she is willing to pay for a roundtrip flight just over one-third of these offers, generating
between points A and B. The customer specifies $135MM in revenue. Total revenue for the nine
only the day of departure and day of return. months ending September 30, 1999 was
Then, supplier databases are searched to see $313MM, 88.4% of which was paid to suppliers.
the minimum revenue an airline cooperating With other expenses at 55% of revenues, like
with Priceline is willing to take to fly someone many other Internet companies, Priceline was
from A to B and back on those days. running at a substantial loss.
Microsoft offers a similar service at Expedia
for hotel rooms: “Hotel Price Matcher.” Expe-
9
dia describes the service as “It’s all about help-
This has been noted in the popular press, e.g., see Peter Elkind,
“The hype is big, really big at Priceline,” Fortune, September 6, ing you get the price you want—YOURS! If
1999. Hotel Matcher finds a hotel that meets your
70
criteria and price, we’ll automatically select that on factors influencing industry supply and
hotel on your behalf and charge a pre-paid, demand.
nonrefundable reservation to your credit card.” Fast Parts:
an exchange, patterned after the NASDAQ,
Rationale for Reverse Buying Models. As an to serve the electronics manufacturing and
Internet-based analog to familiar real world assembly industries. The site has also added
competitive bidding, reverse auctions on the an auction facility.
Internet have the potential to reduce acquisi-
tion costs significantly in many situations. For ESteel:
complex products, an integrated approach as for the steel industry, facilitates negotiations
proposed by FreeMarkets is necessary. Their between buyers and sellers rather than an
work with very sophisticated purchasing organi- auction model.
zations has already proven the value of develop- ChemConnect:
ing the worldwide seller pool and providing the Internet’s largest chemical and plastics ex-
tools for real-time bidding which promotes change. The exchange evolved out of an on-
competition. For commodity products, simple line suppliers directory.
systems can be effective in expanding the seller
base to promote lower prices for buyers. The general process at an exchange is con-
The economic rationale for reverse buying of ceptually that for each item, a dynamically up-
the Priceline and Expedia variety is less clear. dated list of “offers to buy” and “offers to sell” is
These systems seem less a reverse buying mech- maintained. These buys/sells are matched up
anism with great customer power (as these com- through a process. The process on Chem-
panies have touted) than a way to create a new Connect’s World Chemical Exchange is exem-
product—the unbranded, unknown airline seat plary. A buyer arriving at the site with a need to
or hotel room. In this age of increased buyer procure something would typically begin by
information, here the seller works with mark- querying the system to see currently posted
edly less information and cannot withdraw from Product Offerings. The system shows available
the deal when the actual product definition is offers to sell including price, quantity available,
known. It offers “guaranteed demand” to sup- and expiration time of the offers. (Product of-
pliers and lots of flexibility in exactly how to fering submitters may post an expiration time of
meet it. It degrades the quality of the product between 15 minutes and 7 days when the offer is
supplied to the consumer and presents down- posted.) The buyer also sees any bids already
ward pressure on price as compared to a regular made for a given Product Offering.
transaction. The buyer then selects among the Product
Offerings posted and submits a bid. The ex-
III(c): Exchanges change member who posted the Product Offer
Exchanges are electronic marketplaces where a may then negotiate with the buyer on his bid via
group of buyers and a group of sellers interact an e-mail process. An offering firm can accept
to trade and set prices for transactions. The bids on any terms it wishes and the buyer may
familiar exchanges would be the stock ex- modify the bid at any time to reflect current
changes and currency exchanges around the market conditions.
world. The electronic product exchanges of the If the current list of Product Offerings does
Internet have typically been are organized not include the item the buyer is seeking or if
around a particular industry. For example: the offers are in any way undesirable, he can
post a Product Request. The system first shows
Metal Site: other buyers’ Product Requests posted for the
has 18 sellers of metals interacting with many same item (if any) and any offers made against
buyers. It also is designed to be a comprehen- those Product Requests. The prospective buy-
sive industry resource providing information er’s Product Request typically includes an indi-
71
cation of the price the buyer is willing to pay, the sake of clarity in exposition, discussed each
quantity desired and any other important terms- separately. However, some sites already in effect
and-conditions of sale. Sellers submit offers offer a combination of these market mecha-
against the Product Request which can then be nisms, from which the buyer can choose. For
accepted, rejected or negotiated by the buyer. example:
At ChemConnect, all negotiations must be
anonymous, i.e., neither buyer nor seller can Set Price and Negotiation Combination:
reveal their identity in the negotiation process. As noted in the NexTag discussion (under
The outcome of the negotiation is to be a prod- the Negotiation heading above) the process
uct of the forces of market supply and demand. begins by searching sites and bringing back
A seller coming to the exchange behaves in a the set prices of alternative suppliers. If any of
mirror-image fashion to buyers—typically first these set prices is acceptable, the buyer can
checking Product Requests posted by potential select one and conduct the transaction in
buyers then perhaps posting Product Offers, that way without invoking the negotiation ca-
interacting with buyers as described above. No pability of NexTag.
access fees are charged to either buyers or sell- Set Price and Auction Combination:
ers. Both the buyer and seller pay a fee for
completed transactions. Each pays either 0.1% Some sites offer a capability wherein a seller
or 1% of the final transaction price depending conducting an auction can specify a “Quick
on the product category transacted. Buy” price. Any buyer willing to pay the
A major advantage of these organized ex- “Quick Buy” price in order to save time can
changes is that they bring together buyers and click on it, effectively buying under a set price
sellers on a global scale. The impact of this on mechanism.
average price paid is not clear. A buyer benefits Negotiation and Exchange Combination:
by having access to all sellers on the exchange— While some exchanges, such as ChemConnect
not just those with whom he is familiar or in discussed above, require anonymous ex-
geographic proximity. For an individual trans- changes between buyers and sellers, others
action conducted at a given point in time, this such as e-Steel allow the buyer to restrict the
expanding of the potential supplier pool should set of sellers to whom requirements are made
drive the price paid down. On the other hand, known. By restricting the seller set to one or
the exchange also opens up a host of new po- two potential vendors, the market mecha-
tential buyers to sellers. A seller needing to sell nism becomes more negotiation than open
quickly will sell at a less distressed price than if market exchange.
his potential set were restricted to local, known
buyers. A real benefit to both buyers and sellers To summarize the impact of the Internet on
is a reduction in the variability of prices across pricing by saying that increased price informa-
transactions. Prices on the exchanges are the tion availability to buyers will drive prices down
product of marketwide economic forces impact- is like saying “the effect of global warming is
ing all buyers and sellers—not specific, highly that it’s hotter at the beach in July.” As usual,
variable and relatively unpredictable local con- the answer to seemingly simple question “will
ditions. prices go up or down?” is the not so simple “it
depends.” Markets will be more efficient and
different forms of market mechanisms will op-
SUMMARY erate. As noted above different price effects will
As the description above shows, the Internet has be found.
already changed the way many markets are or- A great deal depends on the nature of the
ganized and consequently the mechanisms via product. Certainly, commodity products will ex-
which prices are set. Figure 1 set out three perience increased price pressure due to more
distinct market making mechanisms and, for buyer information about prices. As discussed at
72
the outset of this note, the information of the supporting the premium $499.00 price; the Gap
Internet cuts into the “ignorance premium.” site includes current television commercials and
However, even for commodities, the Internet communicates the benefits of Gap’s integration
can increase some realized prices. In an ineffi- of online and real world presence for consum-
cient information market, some commodities ers; and the BMW site lets a buyer build a
bring a price of zero— unsold advertising time custom car. More customized information can
is used for a public service announcement, be delivered in response to either consumers’
empty seats fly into the air, and a truck deliver- explicit requests or their observed behavior.
ing an order in Boston from New York returns In short, the Internet offers expanded oppor-
to New York empty. While the Internet will not tunities for avoiding the commodity trap. More
increase airline industry load factors to 100% or consumer information can mean more informa-
put an end to truckers returning to home base tion about how sellers are the same and in-
empty, it can create a market for the commod- crease the emphasis on price. Alternatively, it
ities which would have gone unsold even can mean more appreciation of how sellers and
though buyers were willing to pay more than products are different, decreasing the emphasis
sellers required as a price. National Transporta-
on price.
tion Exchange (NTE) has created such a service
The Internet is a disaster for those with a
for shippers and in several years individual driv-
commodity selling mentality. For them, the
ers will respond to buyer RFPs in real time from
story of increasing consumer power over sellers
the road via wireless Internet access devices.10
resulting in price pressure and margin erosion
In contrast to the general price pressure be-
will come true. The more sophisticated will see
falling commodity products, the Internet can be
a boon price realization for those with a differ- the possibility of new market mechanisms for
entiated product. While the Internet can convey transacting with customers and take advantage
to consumers a more full understanding of of the opportunity to differentiate themselves
competitive products and prices, it can also pro- not only by giving consumers products they
vide another communication vehicle via which want to buy but also by giving them choices
to create the perception of value in the consum- about how they can buy them. For these mar-
er’s mind. For example, the Bose site provides keters, the Internet will not be a story of buyer
detailed information on the Bose Wave Ra- triumph over sellers through information but
dio/CD including “The Technology Inside” in rather a mutually beneficial success story built
on taking advantage of more efficient commu-
nication and the opportunity for a more inti-
10
“The Rise of the Infomediary,” The Economist, June 26, 1999. mate, personalized relationship.
73

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PRICING AND MARKET MAKING ON

PROFESSOR ROBERT J. DOLAN Robert J. Dolan

Copyright © 1999 by the President

Published by John Wiley & Sons, Inc. and

JOURNAL OF INTERACTIVE MARKETING

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

panded to include collectibles. An individual Restrictions include the following:

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

JOURNAL OF INTERACTIVE MARKETING ● VOLUME 14 / NUMBER 2 / SPRING 2000

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