Analysis of Pricing and Efficiency Control Strategy between Internet Retailer and Conventional Retailer

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1 Recen Advances in Business Managemen and Markeing Analysis of Pricing and Efficiency Conrol Sraegy beween Inerne Reailer and Convenional Reailer HYUG RAE CHO 1, SUG MOO BAE and JOG HU PARK 3 Deparmen of Indusrial Sysems Engineering, Engineering Research Insiue Gyeongsang aional Universiy JinjuDaero 501, Jinju KOREA 1, Deparmen of Business Adminisraion Caholic Universiy of Daegu Geumnak-ri, Hayang-eup, Gyeongsan-si, Gyeongsangbuk-do KOREA 3 Absrac : This sudy deals wih compeiion beween wo channels he Inerne reailer and he convenional reailer. Based on he circular spaial marke model, we derive he ash and Sackelberg equilibria as a funcion of he efficiency of he Inerne reailer. By analyzing he equilibria i is shown ha (1) he Sackelberg equilibria is always superior o he ash equilibrium for boh channels () if he efficiency of he Inerne reailer is higher han a cerain poin, he convenional reailer is willing o ac as a price-leader, while he Inerne reailer as a price-follower (3) on he conrary, if he efficiency of he Inerne reailer is higher han he cerain poin, boh he convenional and Inerne reailers prefer o play as a price-follower (4) in cerain cases, couner inuiively, he Inerne reailer has he incenive o decrease is efficiency o gain more profi. Keywords: Inerne reailer; convenional reailer; circular spaial marke model; ash equilibrium; Sackelberg equilibrium 1. Inroducion According o he classificaion of elecronic commerce research [4], elecronic commerce lieraure can be classified ino four caegories: applicaions, echnological issues, suppor and implemenaion, and ohers. Alhough a grea deal of research had been made abou elecronic commerce wih respec o hese caegories, sudies invesigaing compeiion beween he convenional reailer and he Inerne reailer from he markeing sraegy perspecive are rare, suggesing a need for furher research ha addresses his issue. This sudy seeks o fill such need. Markeing on he Inerne, a very acive area of elecronic commerce [][4], is emerging as a powerful communicaion and disribuion medium. Alhough markeers all over he world agree ha he Inerne will have a major impac on he way modern companies operae managemen and markeing aciviies [3], he convenional reailer will sill remain as an enduring realiy [1]. Even wih he presence of Inerne reailer capable of providing elecronic service for consumers o choose a desired produc wih jus a simple mouse click, he opion of purchasing from nearby convenional reailers such as an oule or a sore will coninue o be available o consumers [1]. In his regard, compeiion beween he Inerne reailer and he convenional reailer will become inense as elecronic commerce progresses. This sudy addressed he opimal pricing and efficiency conrol sraegy beween he convenional reailer and he Inerne reailer. We firs provide a heoreical framework o concepualize he compeiion beween Inerne reailer and ISB:

2 Recen Advances in Business Managemen and Markeing convenional reailer, and hen derive several markeing implicaions from he framework s applicaion o specific price compeiion beween boh channels. The derived markeing implicaions can be summarized as follows : (1) he Sackelberg equilibria is always superior o he ash equilibrium for boh channels () if he efficiency of he Inerne reailer is higher han a cerain poin, he convenional reailer is willing o ac as a priceleader, while he Inerne reailer as a price-follower (3) on he conrary, if he efficiency of he Inerne reailer is higher han he cerain poin, boh he convenional and Inerne reailers prefer o play as a price-follower (4) in cerain cases, couner inuiively, he Inerne reailer has he incenive o decrease is efficiency o gain more profi.. Basic Compeiion Model The circular spaial marke model [1][6] was used as a basic medium for analyzing compeiion. In he circular spaial marke model (ig. 1), consumers are disribued uniformly on a circle of uni circumference, and in he marke each consumer is purchasing a sandardized produc in each period. Consumer demand is assumed o be inelasic. In igure 1, we have convenional reailers denoed R, which are locaed a equal disances from each oher on he circumference. When visiing a convenional reailer, consumers incur ravel coss a a linear rae per uni disance. The ravel coss include he opporuniy cos of ime, he real cos of ravel, and he implici cos of inconvenience [1]. ig. 1. Circular spaial marke model for boh convenional reailer and Inerne reailer Since he web can always be elecronically accessible from anywhere, he exac locaion of Inerne reailers does no have o be defined. However, for he sake of convenience, he Inerne reailer (denoed D) is assumed o be locaed a he cener of he circle in igure 1. Consumers of he Inerne reailer do no incur any ravel coss o buy he produc. Bu addiional cos is sill incurred when buying on he Inerne because consumers are no able o ouch and feel he produc o check is qualiy. Aside from his, a cerain amoun of delivery ime is necessary before he produc can be used, a cerain level of compuer lieracy is needed on he par of he consumers, and here is securiy anxiey abou he Inerne reailers and he Inerne iself. Based on he above model we can derive he marke share and profis of he convenional reailer and he Inerne reailer as follows[1]. A consumer locaed a a disance x from a reailer is indifferen beween purchasing from he reailer and D when r d p x p. Thus he marke share of each convenional reailer is confined o: r p p S x. (1) The convenional reailer ries o maximize he profi: r r p p ( p c). () Because here are convenional reailers in he marke, he marke share of he Inerne reailer becomes: d ( p p ) S 1. (3) The Inerne reailer ries o maximize he profi: d r 1 p p ( p c). (4) In equaions () and (4), c represens cos of goods sold(cogs) per uni produc. or he convenional reailers, invenory cos as well as sore managemen cos are incurred. The Inerne reailers are exemped from hese coss bu insead have o pay he delivery coss. The COGS of he convenional reailer may differ from ha of he Inerne reailer. In his paper, for convenience, we assume COGSs of he wo channels are he same. In his paper we consider wo ypes of game, namely, ash and Sackelberg games. In ash game, each ISB:

3 Recen Advances in Business Managemen and Markeing player coninuously reacs (i.e., changes is price) o is compeior s couner price. If his chain of reacion leads o sable prices for he players, he resuling prices are called a ash equilibrium. The ash equilibrium can be derived by solving he reacion funcions of he game players simulaneously, where he reacion funcion of a player can be derived from differeniaing is profi funcion by is price. In his sense, he ash game is someimes called as simulaneous price seing. Meanwhile, in he Sackelberg game, a price-leader (firs mover) firs deermines is price by using he counerpar s (pricefollower s) reacion funcion, hen he price-follower ses his price based on he price-leader s price. In his sense, he Sackelberg game is someimes called as sequenial price seing. Calculaion of he ash and Sackelberg equilibria is no so complex, hus we show only he resuls in Table 1,,3. Table 1. ash Equilibrium Price Marke Share Profi Inerne reailer p c 3 3 S Convenional reailer * * p r c 3 6 S r ( 9 ) 1 ( 18 r * ) Table. Sackelberg Equilibrium (Case: Convenional reailer as price-leader) Price Marke Share Profi Inerne reailer p 3 c 4 8 Convenional reailer p r * c 4 S S r * (3 ) 3 ( ) 16 r * This secion elaboraes on he Inerne reailer's markeing sraegy by performing sensiiviy analyses of equilibrium soluions. The convenional reailer becomes efficien (or inefficien) as becomes small (or large). Meanwhile, he Inerne reailer becomes efficien (or inefficien) as becomes small (or large), because denoes addiional cos incurred in shopping on he Inerne. I should be noed ha and are semiconrollable because reailers can adjus hem according o he qualiy of services ha hey provide o cusomers. or insance, he convenional reailer can lower by providing shule or delivery services. ikewise, he Inerne reailer can reduce by inroducing he policy of cerified produc qualiy assurance, uncondiional refund and goods reurn, onime delivery, and paymen securiy. Considering he inrinsic characerisics of and, i is easy o idenify ha is more conrollable in comparison wih. Henceforh, under he assumpion ha he convenional reailer's channel efficiency is fixed a, we invesigae he sensiiviy of profis of he convenional reailer and he Inerne reailer according o. ig. shows he sensiiviy of profis of he convenional reailer and he Inerne reailer wih respec o changes in. or he sake of convenience, we assume ha c 0, where c represens COGS per uni produc. Table 3. Sackelberg Equilibrium (Case: Inerne reailer as price-leader) Price Marke Share Profi Inerne reailer p c S 1 Convenional reailer p r * 1 c S r 4 4 * ( ) 4 ( ) 8 r * 3. Opimal Pricing Sraegy (a) Inerne reailer's profi sensiiviy o ISB:

4 Recen Advances in Business Managemen and Markeing of a price-follower under he same channel cos condiion ( / ), is profi is greaer han ash equilibrium. Therefore, if wo players know his fac beforehand, hey would compromise halfway a some poin insead of compeing for he pricefollower posiion a he risk of ending up wih a ash equilibrium. 4. Channel Efficiency Conrol Sraegy (b) Convenional reailer's profi sensiiviy o ig.. Profi sensiiviy o The implicaions direcly derived from ig. can be summarized as follows. irs, he Inerne reailer can no make any profi (i.e. can no survive in he marke) if he Inerne reailer becomes exremely inefficien (ig. (a)). Meanwhile, he convenional reailer can mark a cerain level of profi (i.e. can survive in he marke) even if he Inerne reailer accomplishes an ideal level of channel efficiency (i.e., 0 ) (ig. (b)). Second, when he efficiency of he Inerne reailer is relaively low ( / ), he Sackelberg profi by a price-leader is greaes for he convenional reailer (ig. (b)), while he Sackelberg profi by a price-follower is greaes for he Inerne reailer(ig. (a)). This makes he convenional reailer be willing o ac as a price-leader, while he Inerne reailer as a price-follower. Thus, when /, he Sackelberg equilibrium (he convenional reailer as he price-leader and he Inerne reailer as he pricefollower) becomes he opimal sraegy for boh he convenional and he Inerne reailer. Third, when he efficiency of he Inerne reailer is relaively high ( / ), boh he Inerne and convenional reailer prefer o play as a pricefollower. However, if boh reailers compee severely o secure ha posiion, i will lead o ash equilibrium soluions afer all [5]. Bu he problem is ha he profi from ash equilibrium is always lower han from Sackelberg equilibrium (ig. ). In oher words, even if a player aced as a price-leader insead ig. 3 depics he maximum profi which he Inerne reailer can obain as changes. As menioned previously, he profi by ash equilibrium becomes opimal in inerval I and II, while he profi by Sackelberg equilibrium, where he Inerne reailer plays a price-follower, becomes opimal in inerval III. In ig. 3, we see he following implicaion wih regard o he Inerne reailer s cannel efficiency conrol sraegy. irs of all, suppose ha in ig. 3, "d" is denoing a profi compued from d ( / ) and a is ( defined as saisfying a) ( / ). Suppose ha he Inerne reailer's channel efficiency is represened by any value b falling in a /. In his case, he Inerne reailer may have wo ways for improving profi by conrolling is channel cos. The firs is by having a lower like he convenional reailer as menioned before. However, lowering also causes addiional cos for he Inerne reailer. I is generally acceped ha marginal cos increases as decreases. Therefore, before making a final decision o adop his way of increasing profi, i would be beer for he Inerne reailer o compare profi incremen wih cos incremen. The second way of increasing profi is more complicaed o increase (or decrease channel efficiency level) conrary o common sense. By referring o ig. 3, c is defined as saisfying ( c) ( b). Then he second way simply means increasing from b o any value denoed by an inerval / c, which is a region on ISB:

5 Recen Advances in Business Managemen and Markeing axis of ig. 3 wih a crossed line. By increasing like his, he Inerne reailer does no only save cos incurred by mainaining inenionally wihin a specified low level, bu also increases profi because is pricing sraegy is changed from ash equilibrium o a price-follower sraegy of Sackelberg equilibrium guaraneeing more profi. In addiion, he Inerne reailer can expec more profi by mainaining very close o. The bold line in igure 5 represens a maximum profi which he Inerne reailer can obain by he lowering channel cos o in case is channel cos belongs o a /. rom he previous discussions so far, i can be concluded ha he Inerne reailer may mark more profi and expec cos savings by increasing (or sacrificing channel efficiency) in a specific inerval. In oher words, for he Inerne reailer, lowering (or improving channel efficiency) does no always lead o profi increase, which is sharply differen from he convenional reailer. homogeneous produc in he marke, and he Inerne reailer is compeing for price wih he convenional reailer. The opimum pricing sraegy for boh channels is deermined as he Inerne reailer's channel efficiency changes. Two ypical ypes of pricing game models such as ash and Sackelberg equilibrium were used, anesuls were analyzed. The implicaions derived from he analysis are as follows. Pricing by Sackelberg equilibrium was found o always ouperform pricing by ash equilibrium. An ineresing phenomenon discovered in his sudy is ha when he Inerne reailer's channel efficiency is greaer han a cerain level (or is lower han a cerain poin), boh channels prefer price-follower posiion. On he conrary, when he Inerne reailer's channel efficiency becomes degraded under a cerain level (or is rising above a cerain level), he convenional reailer prefers o ake a price-leader posiion while he Inerne reailer, a price-follower posiion. This phenomenon conradics convenional wisdom such ha he firs mover (or price-leader) usually benefis more in he price compeiion. Even if he Inerne reailer's channel efficiency improves exremely (or decreases very much), i is sill possible for he convenional reailer o ge a marke share greaer han a cerain level and se a price covering COGS. Therefore, here always exiss a marke lef available for he convenional reailer, indicaing ha he Inerne reailer's marke share canno reach 100% under any marke circumsances. Anoher ineresing noe from his sudy is ha he Inerne reailer can benefi more in erms of profi by lowering is efficiency when is channel efficiency is mainained wihin a cerain inerval. Meanwhile, he convenional reailer should always upgrade is channel efficiency o increase profi when addiional cos incurred by providing service o increase channel efficiency is negligible. ig. 3. Inerne reailer's maximum profi according o 5. Concluding Remarks Under he condiion ha boh he Inerne reailer and he convenional reailer are selling a single and The sudy is hoped o pave he way for providing useful guidelines for decision-making abou how o deermine opimum pricing sraegy as well as opimum channel efficiency conrol sraegy where he Inerne reailer and he convenional reailer are compeing wih each oher in erms of price for a single produc in he marke. ISB:

6 Recen Advances in Business Managemen and Markeing References: [1] Balasubramanian, S. (1998), Mail versus Mail: a Sraegic Analysis of compeiion beween Direc Markeers and Convenional Reailers, Markeing Science, Vol.17, o.3, pp [] Brynjolfsson, E. and Smih, M. D. (000), ricionless Commerce? A Comparison of Inerne and Convenional Reailers, Managemen Science, Vol.46, o.4, pp [3] al, R. and Sarvary, M. (1999), When and How Is he Inerne ikely o Decrease Price Compeiion?, Markeing Science, Vol.18, o. 4, pp [4] gai, E.W.T. and Wa,.K.T. (00), A ieraure Review and Classificaion of Elecronic Commerce Research, Informaion and Managemen, Vol.39, pp [5] Rasmusen, E. (1989), Games and Informaion: An Inroducion o Game Theory, Basil Blackwell, Inc. [6] Salop, S. (1979), Monopolisic Compeiion wih Ouside Goods, Bell Journal of Economics, Vol.10, pp ISB:

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