Internet Price Competition

Amazon.com was one of the brightest stars of the tech boom, yet its stock market success baffled many economists. The Internet multiplies competition, and nearly anyone can sell books on-line, so Amazon was destined to compete for consumers based on price alone. While a firm fighting with prices can survive, it shouldn’t prosper.

Imagine two neighboring bookstores in a mall. If a customer found a book in one store that he liked, it would be easy for him to check whether it was being sold for a lower price in the other store. If one of these stores had consistently higher prices than the other, therefore, it would generate little business. Each store would face enormous pressure to charge lower prices than its neighbor. Now imagine instead that these two bookstores are in opposite sides of a large mall. It would be much more challenging for customers to compare prices. A store now could afford to maintain higher prices because its customers (1) might not realize its prices were higher and (2) might not be willing to walk to the other store just to save a few cents. The closer the stores, the more likely the stores are to compete on price because price will have a greater influence on sales.

On the Internet all stores are next to each other. It’s easy to compare prices at different Internet retailers. This is especially true if you use intelligent searching agents to seek out low-cost providers. Consequently, web consumers are especially price-sensitive and Internet retailers have large incentives to undercut rivals because the firm that charges the lowest price is likely to get most of the business. Of course, if everyone tries to charge the lowest price, then prices plunge and profits disappear.

Not only do Internet retailers compete mostly on price, but they also face more competition than their brick-and-mortar cousins do. If there were, say, 10,000 brick-and-mortar widget retailers spread across the United States, but only 20 on-line sellers of widgets, then Internet retailers might actually face more competition. Two stores in the real world compete only if a customer is willing to shop at either of them. Consequently, in the real world two bookstores should consider themselves rivals only if they are within, say, 15 miles of each other. Any connected person can visit any virtual retail store, regardless of where the store is really located. The actual number of competitors an Internet retailer faces will thus usually be much higher than the number faced by real-world stores. Since more rivals means more price competition, Internet retailers will never achieve sustained high profitability unless, perhaps, they use complex pricing.