Price Comparison for Music CDs in Electronic and Brick-and-mortar Markets: Implications for Emergent Electronic Commerce

Price Comparison for Music CDs in Electronic and Brick-and-mortar Markets: Implications for Emergent Electronic Commerce Zoonky Lee Department of Management University of Nebraska-Lincoln zlee@unlnotes.unl.edu Sanjay Gosain Decision & Information Technologies Robert H. Smith School of Business University of Maryland sgosain@rhsmith.umd.edu Abstract The Internet has great potential as a medium to reach consumers. We need to examine the efficiency of this medium in producing efficient allocations in market transactions and increasing buyer welfare. Using the case of Internet-based shops selling music CDs, we compared prices on the Internet and in brick-and-mortar shops, and investigated how the general market efficiency hypothesis is borne out in practice. We collected price information for 21 current-hits and 23 old-hits albums. Also, prices for the same albums were collected from top five nationally-known brick-andmortar CD shops. Overall, 428 data points, 296 from the Internet and 132 from brick-and-mortar retail shops were collected. The results showed that a) the Internet market still shows price differences despite the apparently near zero searching cost, b) CD prices for the current-hit albums were lower in the brick-and-mortar market, but the old hits prices were nearly similar or slightly lower in the Internet shops, and c) the two largest Internet sellers seem to have a matching pricing strategy. Through this effort we derive a better understanding as to the shape of the fully-edged electronic commerce system that is taking shape now. We argue that a fundamental difference in the structure of the Internet market leads sellers to employ new strategies to extract the consumer surplus. We, especially, propose that differences in consumer base, sellers inventory cost and buyers purchasing cost can explain the higher-than-expected Internet prices and price dispersion for the two different types of products. Introduction The growing population of Internet users provides a large consumer base for businesses to target. Businesses have responded by increasing their visibility on this medium, and some have tried to move parts of their value chains on to the Internet. It has been proposed that the Internet will ultimately play host to full-scale electronic commerce -leading to more choices and lower prices for consumers, redistribution of profits in the favor of consumers increasing their surplus, and elimination of intermediaries in the distribution channel that have a failing value proposition. Clearly, the Internet has a great potential as a medium to reach consumers. However, our understanding about the Internet as a market is still in infancy. We need to examine the efficiency of this medium in producing efficient allocations in market transactions and increasing buyer welfare. We are also interested in how the pricing strategy in the Internet has been set up in a way that is different from the brick-and-mortar market when the fundamentals of the market change due to the adoption of the Internet. Using the case of web-based music compact disk (CD) shops we investigated how the general market efficiency hypothesis is borne out in practice. CDs are one of the simplest products which can be very well-specified and differ mostly in price given a certain album or single choice. We compare CD prices on the Internet and in brick-and-mortar shops and find that, despite reduced search costs, there is still considerable price dispersion in the electronic market. We provide some conjectures on the possible underlying causes for this observation and derive implications for 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 1

the future of electronic commerce. Through this effort we hope to acquire a better understanding of the emergent shape of the fully-edged electronic commerce system. Electronic Markets and Their Impact on Buyer Welfare One theme consistently discussed in the electronic market literature is that, with the advent of electronic markets, the buyer will be better off in extracting a share of sellers profit [6]. In predicting the shape of emerging electronic markets with the development of information technology (IT), Malone et al. [13] pointed out that the advantage of electronic markets will be manifested in the reduction of transaction costs using IT. Transaction costs can be classified into search costs, exchange costs and monitoring/negotiation costs [17]. The focus of this study is on consumer search costs as it is expected that the reduction of search costs through IT will dominate the impact on exchange, monitoring and negotiation costs. Search models have been proposed in the economics literature to deal with incomplete buyer information [15]. The central implication of costly information-gathering is that the equilibrium will not occur at the perfectly competitive price. Price dispersion arises due to the lack of price information for buyers. In competitive market conditions the classical economic model suggests that market price will be close to marginal cost of sellers (i.e. Bertrand model). Price dispersion theory based on search costs also predicts that if the searching cost is close to zero, we approach the perfectly competitive market. When we compare the electronic marketplace with traditional shopping, the former offers a huge search space coupled with low search and transaction cost [5]. Since, in the electronic market, the searching cost is typically smaller than the brick-and-mortar market, we expect the price in the Internet to be lower than the price in the brick-and-mortar market. Hence, it is predicted that electronic markets reduce the cost buyers must incur to acquire information (search cost), and this reduction will lead to efficiency of markets to the benefit of consumer [2, 3]. Previous Empirical Studies Theories have usually predicted the shift to electronic markets and the development of efficient markets with the advancement of electronic economy. Anecdotal evidence supporting them has been abundant while empirical investigations are still scant [4]. The impact of electronic markets in driving down profits for producers is reflected in the case of airline travel reservation systems (e.g. APOLLO and SABRE). These systems led to profits for the market makers at the expense of the airlines. Also, the dissemination of information by Reuters, Quotron and Telerate results in the reduction of profit for bond dealers. Recent developments in the Internet-based bookstore business, with the emergence of Barnes & Noble in response to the leading on-line book retailing shop, Amazon, suggests a competitive convergence in prices. When it comes to empirical studies, however, the emergence of a complete efficient market has not been reported. Hess and Kemerer [11] studied computerized loan origination in the home mortgage industry. They observed that the emergence of electronic markets may have a long gestation, and may be impacted by other factors such as complexity of the transaction, frequency of transactions and current market structure. But Hess and Kemerer found little evidence of the emergence of electronic markets over hierarchies despite the availability of technology and favorable characteristics of the product. Lee [12] compared the prices between the brick-and-mortar and electronic used car auction in the Japanese auto-auction market. He found that prices in the electronic auction are higher contrary to expectations. He attributed the higher contract prices to three reasons - the higher quality of cars in the electronic auction, increase in the market power of sellers when they are free from carrying costs for cars and increase in the number of bidders due to the elimination of a need for physical presence. Studies of online travel agent offerings (OTA) also found that ticket prices vary by as much as 20% across travel agents [8]. A more extensive price comparison between electronic and brick-and-mortar market can be found in a study by Bailey and Brynjolfsson [1]. They compared prices of books, music CDs and software, but did not find much evidence that prices on the Internet were lower than prices in traditional retail shops. They explained the unexpected phenomenon as resulting from the following reasons: incomplete searching mechanisms on the Internet, different demographics of typical Internet users, an experimenting stage of many on-line retail shops, and on-line shops differentiation strategies based on other services such as delivery options and customized recommendations. Despite these findings, we still are short of rich empirical results that could increase our understanding about this new phenomenon of electronic market. Understanding and resolving issues should begin from the basics. For this reason, we have investigated a massproduced commodity-like product in this study. 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 2

The Market for Music Compact Disks (CD) The choice of music compact disks as a product in our study is driven by their commodity-like nature and their popularity in the electronic marketspace. It is argued that for the class of products that are characterized by low asset specificity and ease of description, electronic markets are more efficient forms of coordination [17]. Music CDs have lower asset specificity, are easy to describe, and are therefore, suited for electronic markets. Besides, a number of music CD stores has been set up in the Internet. The proliferation of this product could be due to the following reasons. Suited to Internet demographics (Well-off, educated consumers) Ability to make use of the medium (audio files) for consumer sampling Low product cost limits the consumer and seller risks, also stimulates impulse buying Competitive market with large number of buyers and sellers It has been reported that it costs a major label approximately one dollar to manufacture and package a CD, one dollar for distribution, between one and two dollars for royalties to the artist and songwriter, and five dollars for the retailer [7]. Hence, there are major incentives for the large labels to knock-off the retailers from the value chain. The industry is highly concentrated with about 90% of the gross sales of recorded music worldwide coming from albums, singles and music videos owned or distributed by one of six multinational corporations: Time Warner, Sony, Philips, Bertelsmann, Thorn-EMI and Matsushita. The traditional distribution channels for pre-recorded music are retail shops, record clubs, rack jobbers, and "one-stops" [14]. Retail shops consisting of large store chains and independent record shops account for a major part of the industry revenue. Another interesting feature of the CD market is the availability of prices for comparison. Bakos [3] showed that even a small searching cost leads to different price structures among sellers. As surfing different sites for the price comparison is considered an incurring of the searching cost, price-comparison agents could significantly reduce the search cost and lead to more competitive pricing. Price comparison in two markets We, first, listed music shops that have the largest collection of CDs on the Internet by using Internet search engines. Shops that carry special types of CDs (e.g. Latin Music, Foreign Music, etc.) were excluded, and only shops that provided product and price information through a searching mechanism were selected. As a result, we identified nine on-line shops. Brick-andmortar shops were also selected based on size. Limiting our-selves to a single market area, one city in Southern California was selected, and five nationally-recognized CD shops in the area identified (see Appendix A for the list of shops included in this study). A total of 428 available CD prices, 296 from Internet and 132 from brick-and-mortar shops for 43 different albums were collected. Since we expect that the pricing strategy for mainstream high volume products could be different for specialized niche products, we collected prices for two kinds of albums - current-hits and old-hits. Prices were collected for one week s (current-hits) Billboard chart and for the same period ten years ago (old-hits) of the Billboard chart. Results First, we investigated the price dispersion in brickand-mortar and electronic markets. Price dispersion was studied by using two measures: variance in prices and the percentage of price difference between the highest-priced and lowest-priced shops for the same album. Overall, the price dispersion on the Internet was not smaller than that in the brick-and-mortar market (See Graph 1). Among the twenty-one current-hit albums, the average percentage of price difference was 18%, which was very similar to 19% for the brick-and-mortar markets. For the old-hit albums, the price dispersion among Internet shops was even higher than among brick-and-mortar shops. For twenty-two old-hit albums, the average percentage of price difference was 31% in the electronic market, while it was only 11% in the brick-and-mortar market. The result was corroborated with the price variance. Among twenty-one current-hit albums, 12 albums have higher standard deviation in the brick-and-mortar market, but the rest of nine albums have the higher variations in the electronic market. Overall, the price dispersion on the Internet was wide enough to nullify the efficient market proposition. The prices vary by as much as 7% to 32% across different on-line retail shops for the current-hit albums. The difference was much higher for the old-hit albums, ranging from 8% to 51% among Internet shops (See Appendix B for the Price dispersion for each album). 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 3

% Difference 35 30 25 20 15 10 5 0 Average Price Dispersion Current Hits Old Hits Brick-and- Mortar Electronic Frequency of Price Difference (%): (Internet - Brick-and-Mortar) All Shops (Current Hit) Two Leading Shops from the Internet (Current Hit) Old-Hit Frequency 10 9 8 7 6 5 4 3 2 1 0 Cheaper in Brick-and-Mortar Shops Cheaper in the Internet Shops Over -15% -15% to -10% -10% to -5% -5% to 0% 0% to 5% 5% to 10% 10% to 15% Over 15% Graph 1: The Average Price Dispersion in the Brickand-Mortar and Internet Shops One interesting result is the difference in price levels between the two markets (See Graph 2). When we take a shipping and handling cost for the Internet markets ($2.95 to $4.95 for a single CD or usually $2.99+$0.96 per item) and a tax rate of 8% for the brick-and-mortar, Internet prices are generally higher than the brick-andmortar market for current-hit albums (paired t-test: t=2.08 with df=20, significant at the 95% level), but slightly lower or almost the same for old-hit albums (paired t-test: t= -1.83 with df=18, significant at the 90% level). Brick-and-mortar retail shops are cheaper on average price for 14 albums out of 21 albums for the current-hit albums. (See Appendix B for the Prices Differences). However there also was a sign that two leading online shops are engaged in head-to-head price competition. Among the twenty CDs they were carrying, they have exactly matching prices 13 times (65%), and their average price difference was less than 5%. Since these two leading on-line shops account for more than 80% of CD sales on the Internet, the price dispersion based on market shares will be much smaller on the Internet market. The price difference between these two Internet shops and brick-and-mortar shops for current-hit albums is not statistically significant (paired t-test: t=- 1.08 with df = 19). Comparison of the price for old-hit albums is not possible since these two shops carry only four albums at the same time among twenty-two old-hit albums. Graph 2: Frequency of Price Difference Discussion Consistent with previous studies, our study confirms that price variance is not lower for the Internet. Our study, especially, shows that the variances still exist even for the simplest commodity-type products. While other services are not very different, there are consistent 15% to 20% price differences for the current-hit and 25% to 35% differences for the old hits. The evidence on direct price comparisons also shows that the hypothesis of increase in consumer welfare through reduction in searching cost is not borne out. The adjusted price comparison suggests that CDs are generally cheaper in the brick-and-mortar shops for the popular products, and in the Internet shops for the niche products. Although there were some variances in shipping and handling, and in the promised delivery time across on-line shops, the difference was not significant enough to change the price competition. Nor is there any distinctive feature such as noticeable shorter delivery time guarantee, an easier searching mechanism or a refund guarantee that will provide evidence of a differentiation strategy as these functions are pretty uniform. The existence of some variance in prices on the Internet leads us to believe that there may be a case for either improved search and comparison mechanisms on this medium or there still remains search costs that customers perceive cost in terms of time spent in search for example. A recent survey by Mckinsey & Company indicated that more than 80% of on-line shoppers do not search for making price comparisons before buying [16]. Other explanations such as an experimental stage of Internet retailers can also contribute to resolve these seemingly unexpected results 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 4

[1]. Although these explanations might be valid, we might provide alternate explanations when we rethink of the electronic market as a totally new market in which new customer basis is formed, and therefore different marketing and pricing strategies are required. A recent study by Grover and Ramanlal [1] indicates that while we usually possess a congenital view that IT will benefit the buyer, the supplier also will exert alternative strategies to extract consumer surplus. Therefore, it is not that IT will move the industry into one direction (e.g. electronic market hypothesis), but competing forces are influenced from the seller side, making the trend more interacting and complex. While more empirical results should be accumulated, consistent empirical findings that electronic market has not resulted in enhanced consumer surplus at the cots of the sellers should not be merely attributed to the infancy of Internet as a market. We provide three propositions that provide alternate explanations for the general market efficiency hypothesis not being borne out in practice: differences in characteristics of consumer base, in sellers inventory cost and in buyers purchasing cost of two markets P1: The electronic market has a different consumer base from the brick-and-mortar market: Internet shoppers have a higher reserve price than do shoppers in the brickand-mortar market. This explanation follows from the observation of higher-than-expected prices for CDs on the Internet. We postulate that this could be due to the electronic market catering to a special niche of customers with different demand characteristics compared to the brick-and-mortar markets. On-line retailers have refused to serve the Internet as a medium to disseminate price information through search agents (such as Andersen Consulting s bargain finder - refer to http://www.ac.com/services/cstar/cstar_child/ecagents_c n.html). While the most popular purchasing way in the Internet is searching, it is browsing in the brick-andmortar market. All these facts indicate that customers in the electronic market tend to be more specific about products they will purchase than those in the brick-andmortar market. With the different customer base, we would expect to see an independent price structure in the brick-and-mortar and electronic markets. We propose that the higher reserve price of the Internet shopping customers contribute to higher-than-expected price in the electronic market. P2: Price volatility over time could be greater for brickand-mortar markets than for electronic markets. Differences in cost structure such as inventory cost and selling cost result in different pricing strategy. Eppen and Liebermann [9] show that sellers with higher inventory costs will offer periodic price deals as a mechanism for minimizing inventory holding costs. In general, the inventory costs of brick-and-mortar retail shops are higher than those of Internet shops. It is expected, then, that sellers tend to "sale" their prices in brick-and-mortar markets (in response to seasonal and other factors) more often and to a greater extent than electronic markets. Our results show that the brick-andmortar markets have more price deals on the popular CDs. A longitudinal study of prices needs to be undertaken to confirm this hypothesis. P3: Pricing strategies adopted in brick-and-mortar and electronic markets are different due to buyers' cost of transacting: the higher buying cost in the brick-andmortar market contribute to sellers adapting more of "inducing strategies". One way in which price breaks for popular products work is that sellers induce customers with notable products and induce them to purchase other products. The assumption here is that customers commit the resources to purchase a product (i.e. going to the shop) and that by purchasing other products they will save on the average purchasing cost. Then, "inducing customers" by lowering the prices for the most popular may be more effective in the brick-and-mortar shops than in the electronic market. Of course, "traffic" is very important for on-line retailers, and many on-line shops offer price discounts to attract customers. The range of target products for price discounts in this case may be very extensive, and the strategy is feasible only if it is part of an overall cost structure or when used temporarily for customer acquisition it may not be a long-term strategy [16]. In the electronic markets where going into the market does requires less resources, "inducing customers" can be a less effective long-term pricing strategy, and therefore, might not result in as much of price deals as in the case of brick-and-mortar retailers. Again, the relatively lower price of popular products than that of old-hits in the brick-and-mortar market supports our proposition. Conclusions The music CD market on the Internet offers an insight into the dynamics of a nascent electronic market. Economic factors predict the emergence of unbiased or personalized electronic markets with intermediaries giving way to electronic mediation or market makers. Also, one would expect the law of one price to prevail for a well-specified commodity product. However, the lack of emergence of these conditions can be attributed 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 5

to factors hypothesized in the preceding section. We propose that price dispersion is likely to continue to be observed in Internet marketspace even as it matures because of likely segmentation of the market. The nascent stages of electronic commerce on the Internet show that the medium has not fulfilled its potential in reducing price variance through lower search costs for consumers. While various search engines provide for information sharing across disaggregated markets, there remains the issue of search time and ease of comparison of prices particularly when there may be different conditions attached to the quoted price. The emergence of a market maker has been opposed by the retail channels as it would threaten their profits. Appendix A: List of Shops Included in This Study Internet Shops AbbyRoad: www.abbyroad.com All Direct: st5.yahoo.com/cgi-bin/addback?acct=adirect Amazon: www.amazon.com Borders: www.borders.com CD Connection: www.cdconnection.com CDNow: www.cdnow.com CD world: www.cdworld.com Current developments in the electronic market have begun to indicate that the fundamental market structure is different from conventional markets in terms of consumer base, purchasing methods, settlement method, buy-seller-intermediary role relationships, etc. We, then, need to understand new marketing and pricing strategy that suit this new market structure. Coupled with conventional explanations such as incomplete searching mechanisms and the "still experimenting" stage of the Internet marketspace, we need to try to find alternative ways to examine this phenomenon. Empirically investigating pricing in brick-andmortar and Internet markets, and comparing price differences for two different types of products, we show that the structural difference between two markets might contribute to the higher-thanexpected price dispersion and average prices for Internet retail shops. Above all, we showed that the pricing structures of two different types of products are different; cheaper CD prices in the brick-andmortar shops for the popular albums and in the Internet shops for the niche products. These differences suggest differences in customer base, sellers selling cost and buyers purchasing cost that lead to different pricing strategies for sellers. Spree: www.spree.com Tower Records: www.towerrecords.com Brick-and-mortar Shops Barns & Noble Borders Sam & Goody Tower Records Virgin 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 6

Appendix B: Price Comparison of Internet and Brick-and-mortar Retail Shops Current-hit Albums: Old-hit Albums: References [1] Bailey, J. and Brynjolfsson, E. "In Search of Friction-free Markets: An Exploratory Analysis of Prices for Books, CDs and Software Sold on the Internet," In Proceedings of the 25 th Telecommunications Policy Research Conference, Alexander, VA, September 1997. [2] Bakos, Y. "A strategic Analysis of Electronic Marketplaces," MIS Quarterly, 15, 3, September 1991, pp. 295-310. [3] Bakos, Y. "Reducing Buyer Search Costs: Implications for Electronic Marketplaces," Management Science, 43, 12, December 1997, pp. 1676-1692. [4] Bakos, Y. "The Emerging Role of Electronic Marketplaces on the Internet," Communications of ACM, August 1998, 41, 8, pp. 35-42. [5] Baty, II, J. and Lee, R. M. "InterShop: Enhancing the Vendor/ Customer Dialectic in Electronic Shopping," Journal of Management Information Systems, 11, 4, Spring 1995, pp. 9-31. [6] Benjamin, R. and Wigand, R. "Electronic Markets and Virtual Value Chains on the Information Superhighway," Sloan Management Review, Winter 1995, pp. 62-72. [7] Burnett, Robert. The Global Jukebox- The international music industry. Routledge, New York. 1996. [8] Clemons, E., Hann, I. And Hitt, L. "The Nature of Competition in Electronic Markets: An Empirical Investigation of Online Travel Agent Offerings," Department of Operations and Information Management Working Paper, The Wharton School, June 1998. [9] Eppen, G.D. and Liebermann, Y. "Why do retailers deal? An inventory explanation," Journal of Business, 57, October 1984, pp. 519-530. [10] Grover, V. and Ramanlal, P. "Six Myths of Information and Markets: Information Technology Networks, Electronic Commerce, and the Battle for Consumer Surplus," MIS Quarterly, Forthcoming 1999. [11] Hess, C. M. and Kemerer, C. "Computerized Loan Origination Systems: An Industry Case Study of the Electronic Markets Hypothesis," MIS Quarterly, September 1994, pp. 251-265. [12] Lee, H. "Do Electronic Markeplaces Lower the Price of Goods?" Communications of the ACM, January 1998, 4, 1, pp. 73-80. 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 7

[13] Malone, T.W., Yates, J. and Benjamin, R.I. "Electronic Markets and Electronic Hierarchies," Communications of The ACM, 30, 6, June 1987. [14] Peralta, Ken and Rayport, J. Geffen Records. Harvard Business School Publishing, Boston, 1995. [15] Salop, S. and Stiglitz, J.E. "The Theory of Sales: A Simple Model of Equilibrium Price Dispersion with Identical Agents," The American Economic Review. December 1982, pp. 1121:1130. [16] Tedeschi, B. "Using Discounts to Build a Client Base," E- commerce report, The New York Times on the Web, http://www.nytimes.com/library/tech/99/05/cyber/commerce/31 commerce.html, May 1999. [17] Williamson, O. Markets and Hierarchies, Free Press, New York, 1985. 0-7695-0493-0/00 $10.00 (c) 2000 IEEE 8