Is the Internet Making Retail Transactions More Efficient? : Comparison of Online and Offline CD Retail Markets

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1 Is the Internet Making Retail Transactions More Efficient? : Comparison of Online and Offline CD Retail Markets Ho Geun Lee, Hae Young Kim, and Ran Hui Lee Department of Business Administration College of Business and Economics Yonsei University Shinchon-Dong 134, Seodaemun-Ku, Seoul , Korea [email protected] Abstract If a perfect market in economic theory ever comes true in the digital world, sellers will not be able to gain profits above the marginal costs, and the resource allocation will become much more efficient. This paper attempts to investigate whether this prediction is true in the electronic marketplace. We have observed 2,000 prices listed by online and offline retailers. By comparing price levels, price adjustment, and price dispersion among CD (Compact Disk) retailers, we empirically test whether online retail channels are more efficient than conventional retailers. We have found that prices on the Internet are lower than those in conventional outlets. It is also found that Internet retailers adjust theirs price by much smaller increments than offline counterparts, in order to flexibly respond to demand and supply conditions. Finally, the price dispersion among Internet retailers is lower than the dispersion among traditional retail stores. Our findings suggest that Internet improves efficiency of markets by lowering costs to obtain and to disseminate information on products and prices. Keywords: perfect market, electronic market, price, Internet, efficiency of market 1. Introduction The conventional wisdom regarding B2C e-commerce is that the unique characteristics of the Internet will bring about a more efficient market. Compared to traditional brick-and-mortar retail markets, online shoppers can obtain information on products and services instantaneously and thus can compare the offerings of sellers more easily. The result is the increased competition among sellers, making online markets more efficient than traditional markets.

2 This paper investigates whether Internet brings about more efficient retail markets than traditional retail markets. For this purpose we compare online stores with conventional brick-and-mortal retail stores. Market efficiency is measured using three dimensions; (1) price level, (2) price adjustment, and (3) price dispersion. CDs (Compact Disks) are chosen to study the market efficiency of online stores and traditional retailers because these products are homogeneous and online CD markets have already matured enough to be examined in comparison to offline markets. 2. Literature Review Perfect Market with Efficiency The perfect market is feasible if the following conditions are satisfied (Bertrand, 1823). First, the products exchanged must be homogeneous. Second, firms are price-makers, thus selling firms determine transaction prices based on market demands. Finally, there should be no information asymmetry among consumers. Consumers should be fully informed of products and prices in the market. Transaction Costs, Search Costs and Market Efficiency According to Malone et al. (1987), information technologies reduce the level of asset specificity and complexity of product representation, increasing the use of markets rather than hierarchies. Bakos (1991, 1997) found that high search costs create inefficient allocation of resources, and allow suppliers to take monopolistic profits. With lower search costs, for example, sellers would offer continuously lowered price and at last the prices are likely to converge into a single price. With lowered price and searching costs, the market efficiency would be increased, and marginal revenue of suppliers would be reduced. Previous Research on Online Market Efficiency Lee (1998) found that prices for used cars were higher in online market than in traditional market. The quality difference of traded cars in online and offline markets is the major reason for price difference between the two markets. Clemons et al. (1998) compared the price level of airline tickets sold by online travel agents. It turned out the price dispersion of airline tickets on the Internet was significantly high. Bailey (1998) conducted a study on prices of books and CDs and discovered that the Internet retailers have higher price levels than traditional retailers. The price dispersion among online channels was also wider than offline retailers. This result, opposite to the prediction that online market would be more efficient, may be due to the immaturity of Internet market. There were only few Internet retailers and their offerings were limited at that time. Brynjolffson and Smith (1999) extended this previous work by Bailey. They investigated the price of books and CDs in the US, and found that prices in online market are lower than conventional outlets. However they noted that the

3 price on the Internet is more widely dispersed. Several works published in this area thus provides conflicting views on the efficiency of Internet markets. Some authors provoke that Internet improves market efficiency, while others report no evidence or support of Internet market efficiency. Our research extends these early works with more rigorous methodology. 3. Research Hypotheses In order to test the market efficiency, we look into the extent suppliers are competing with one another. Our research model investigates the price level, price adjustment and price dispersion in online and offline CD markets as depicted in Figure 1. Retail Channels Online Retailers Offline Retailers Market Efficiency Price Level Price Adjustment Price Dispersion Product Popularity Bestsellers Regular Items Release Time New Release Old Release Retailer Size (online) Mega Stores Specialty Stores Medium Stores Retailer Size (offline) Large Medium <Figure 1> Research Model Our first hypothesis compares the price level between online and offline retailers. From an economic perspective, price levels are a particularly useful measure of efficiency. Lower search costs will drive Internet prices for homogeneous goods toward the Bertrand marginal cost pricing result. Hypothesis 1 (Price Level) Online retailers offer lower-price products than offline retailers do The second and the third hypotheses are associated with the level of price adjustment to market demand and supply changes. As menu costs should be much lower on the Internet, and therefore Internet stores can more easily change product prices than traditional retailers.

4 As a result, the price changes can occur more frequently in online stores than in offline outlets. Furthermore, the amount range of price changes is expected smaller in online stores than in offline stores. Due to the low menu costs, online retailers react promptly to changes of market conditions by adjusting product prices more frequently with smaller ranges of change magnitudes. Hypothesis 2 (Price Adjustment: Frequency) Online retailers change their product prices more frequently than offline retailers do Hypothesis 3 (Price Adjustment: Amount) Online retailers change their product prices by smaller amount than offline retailers do Considering lower search costs, we expect to see only a small degree of price dispersion on the Internet. Price dispersion arises from differences in search costs. Since the online consumers are more likely to be well-informed of price(salop and Stiglitz,1977, 1982), the price dispersion in online channels would be smaller than in offline channels. Hypothesis 4 (Price Dispersion) The price difference among online stores is smaller than that of offline retailers 4. Data Analysis for Hypothesis Testing For five weeks, we collected price data on twenty CD titles from twenty retailers (12 online retailers and 8 conventional offline outlets). The price data was collected once a week, with the total number of observations being 2,000. Out of these 2,000 observations, 1,200 pricing data came from online retailers and the remaining 800 data from traditional brick-and-mortal stores. Price Level The empirical test on the price level supports our first hypothesis. compares the mean value of prices were \10,921 on online and \12,041 on offline channels. The mean difference of the price level between online and offline CD retailers is statistically significant (significance level of 1% in t-test). Price Adjustment (Frequency & Amount of Change) The number of pricing changes observed during the data collection period was 24 for online(2.5%) and 19 for offline retailers (3%). Unlike our expectation, the frequency of price

5 change was not significantly different between online and offline channels. Therefore, our second hypothesis for the price change (frequency) is not supported. As expected, the amount of price changes is more widely spread in conventional channels than online channels. The average amount of price change was \654 in online channels and \1,405 for offline channels. This difference is significant at the 99% confidence level. Thus, our third hypothesis is strongly supported. Price Dispersion We observed prices for the identical CDs vary depending on retailers both in online and offline channels. Both F-test and t-test reveal that the price dispersion in offline stores is much higher than that of online stores, thus supporting our hypothesis on the price dispersion. Our findings suggest that the prices in online market are converging into a single price, which is near to the equilibrium price. 5. Conclusion It has been widely speculated that Internet will make retail transactions more efficient by lowering search costs that buyers must incur to obtain information on products and prices. We examine this hypothesis empirically using the prices charged by Internet and conventional retailers for homogeneous products (CDs). Our analysis indicates that Internet retailers charge lower prices than conventional retailers. In contrast to Bailey s study (1998) which is done in early Internet era, Internet technology is getting improved day by day attracting buyers and suppliers both into the Internet retail market. We postulate that developed Internet technology reduced costs to obtain and to disseminate information in Internet and they contribute to the lower price offering. Thus, an implication of our findings is that conventional retailers will find it increasingly difficult to compete on price so long as the substantial differences between channels persist. In this paper, we have investigated whether online channels are more efficient than traditional retail channels by looking into three dimensions of the market efficiency: price level, price adjustment and price dispersion. We examine this hypothesis empirically using the prices charged by Internet and conventional retailers for homogeneous products (CDs). Our results suggest that electronic markets are more efficient than conventional retail markets within the scope of a single product category and data from a single country. Thus, generalization of our research findings may be limited and leave opportunity for later discussion on heterogeneous products as well as other homogeneous products. This result may provide a fruitful starting point for future research into sources of price advantage on the Internet.

6 References Bailey, Joseph P. Intermediation and Electronic Markets:Aggregation and Pricing in Internet Commerce. Ph.D Thesis, Technology, Management and Policy, Massachusetts Institute of Technology, Cambridge, MA, jbailey/pub Bakos, J. Yannis, A Strategic analysis of electronic marketplaces, MIS Quarterly, Vol.15, No.3, September 1991, pp Bakos, J. Yannis, "Reducing Buyer Search Costs: Implications for Electronic Marketplaces", Management Science. Vol. 43, No. 12, December pp Bertrand, J. Theorie Mathematique de la Richess Sociale, Journal des Savant, 1823, pp Brynjolfsson, E. and Smith, M. "Frictinless Commerce? A Comparison of Internet and Conventional Retailers," Management Science, Vol. 46, No. 4, April 2000, pp Clemons, E. K., Hann, I..H., and Hitt, L. M. "The Nature of Competition in Electronic Markets: An Empirical Investigation of Online Travel Agent Offerings", Working Paper, The Wharton School of the University of Pennsylvania, Lee, H. G., Westland, J. C., Hong, S. "The Impact of Electronic Marketplaces on Product Prices: An Empirical Study of AUCNET" International Journal of Electronic Commerce, Vol.4, No.2, Winter pp Malone, T. W., Benjamin, R. I. and Yates, J. "Electronic Markets and Electronic Hierarchies: Effects of Information Technology on Market Structure and Corporate Strategies" Communications of the ACM, Vol. 30, No.6, pp Salop, S and Stiglitz, J. E. Bargains and Ripoffs: A Model of Monopolistically Competitive Price Dispersion, Review of Economic Studies(44), October 1977, pp Salop, S and Stiglitz, J. E. The Theory of Sales: A Simple Model of Equilibrium Price Dispersion with Identical Agents, American Economic Review, December 1982, pp Smith, M., Bailey, J., and Brynjolffson, E. "Understanding Digital Markets" E. Brynjolffson, B. Kahin, eds. Understanding the Digital Economy. MIT Press, Cambridge, MA /ude.pdf