E-Commerce, Mass Customisation and Price Discrimination

E-commerce brings firms new personalisation technologies enabling them to exploit information about individual consumers in order to tailor both products and prices to individual requirements. Thus firms can engage in two new competitive strategies – first degree price discrimination and mass customisation. In this paper we develop a simple framework within which to understand firms’ incentives to adopt each of these strategies in a competitive environment. In particular we examine the interaction between the two decisions. We show: (i) the greater the degree of customisation adopted by firms the stronger will be their incentives to adopt first degree price discrimination; (ii) if firms use first degree price discrimination then mass customisation is a dominant strategy; (iii) but firms are in a prisoners dilemma since they would be better off if they neither customised nor engaged in first-degree price discrimination. Acknowledgements Both authors thank the financial support of the ESRC grant no. R000222642. Introduction As e-commerce develops there are growing opportunities for firms to employ personalisation technologies that allow them to use information collected about the customer to offer individually tailored goods and services at individually tailored prices. There are two separate and independent phenomena at work here. (i) The first is first degree price discrimination offering the same good at different prices to different customers. (ii) The second is mass customisation. We define this as a situation in which firms can offer a whole range of finely differentiated products at the same constant marginal costs without having to incur additional fixed costs on every differentiated brand they offer. Thus firms can reap the benefits of customisation without foregoing the benefits of scale economies. Notice that mass customisation offers firms the possibility of what we will call second degree price discrimination where different brands of the same product are sold at different prices. Of course there have always been limited opportunities for some firms to engage in first-degree price discrimination. However, by operating in a computer mediated environment which allows firms to recognise individual consumers as soon as they contact them, e-commerce is bringing the possibility of first-degree price discrimination to a far wider range of goods and services than before. Thus, as Shapiro and Varian (1999) note the on-line data provider Lexis-Nexis “sells to virtually every user at a different price”. For some goods and services, the possibility of mass customisation is also closely related to developments in computer technology. For example information goods can be customised and sold over the Internet at virtually zero marginal cost. Thus on-line news providers, like Reuters, can offer any bundle of news and can sell different bundles at different prices. For other goods, such as cars, it is other technological developments that have brought the possibility of mass customisation. However ecommerce still enhances mass customisation since it provides a useful means by which consumers can view the range of alternatives and prices on offer and communicate their choice. Now the fact that there are these different technologies available does not necessarily mean that firms will choose to use them. Thus, in a companion piece, Ulph and Vulkan (2000) we analysed a model in which firms were unable to mass customise – 1 This information can be collected by the firm itself or, more likely, be provided by independent data companies. Thus the data agency Experian provides a software package that enables websites to recognise customers instantly and sends the customer’s profile to the retailer. 2 This is illustrated by recent campaigns by Internet Service Providers (ISPs) like British telecom who promise commercial users the opportunity to “treat all your customers as individuals”. 3 First degree price discrimination arises when each unit of a good can be sold at a different price. In our models each consumer buys just 1 unit of the good, so by being able to distinguish between consumers firms can effectively first-degree price discriminate. and so produced just a single good – but could still choose whether or not to engage in first degree price discrimination. We showed that price discrimination has two separate effects: it allows firms to extract more surplus, but it also intensifies price competition. In a wide class of cases the second effect dominates and firms would choose not to first-degree price discriminate. In this paper we extend the analysis to the case where firms also have the possibility of introducing mass customisation. Because there are two independent processes at work here, firms have a considerable degree of choice over their combined differentiation/customisation and pricing strategies. Thus a firm could choose not to customise and so produce just a single product, but could still choose whether or not to employ first-degree price discrimination. On the other hand if it chooses to customise, it has three pricing strategies. (i) It can engage in no price discrimination and so sell all products at the same price irrespective of brand or consumer. (ii) It could second degree price discriminate and so sell different brands at different prices – though different consumers buying the same brand will pay the same price. (iii) It could engage in first degree price discrimination and so sell at prices that are in principle differentiated both by consumer and by brand. It is easy to see, however, that in this case the firm will discriminate solely by consumer. For the firm wants to extract the maximum surplus from each consumer, and to do this it wants the consumer to choose the brand that comes closest to its taste. It does this by having prices independent of the brand. The goal of this paper is to provide a framework in which we can understand what choices firms will make along each of these two dimensions, and, in particular, the interaction between these decisions. The emphasis will be on the case where firms are making these decisions in a competitive environment like the internet. There are three sets of issues we wish to explore. (a) How does the degree of mass customisation chosen by firms affect their choice of price discrimination strategy? (b) How does their price discrimination strategy affect their choice of customisation? (c) What combination of the two strategies will firms choose? To address these issues we use an extension of the Hotelling (1929) framework to model price competition in differentiated goods between two firms. Consumers are located along a line of length 1 representing the degree of product differentiation. The two firms are located at either end of the line. The firms have the same technology with marginal costs independent of output. Firms can choose either (i) not to mass customise – in which case they just produce the single product at their end of the line; or 4 It turns out, however, that if firms mass customise, they will always use second-degree price discrimination in preference to no discrimination. Also if firms do not mass customise, second-degree price discrimination is formally identical to no price discrimination. So in all circumstances the choice is effectively between first-degree and second –degree discrimination. (ii) to mass customise – in which case they can produce at the same constant marginal costs all products over an interval of length 1 2 m < from their end of the line. Firms also choose what price discrimination technology (i.e. first or second) to use. We prove the following results. 1. The profits of the firm that uses first degree price discrimination technology are independent of the pricing strategy used by its competitors. This generalises the result proved in Ulph and Vulkan (2000) where firms were not capable of mass customisation. 2. The greater the degree of mass customisation chosen by firms the more likely they are to choose to first-degree price discriminate. More precisely, profits under both first and second-degree price discrimination fall as the degree of customisation increases. However they fall faster under second-degree discrimination. 3. A firm which uses first-degree price discrimination technology is strictly better off if it also mass customises (i.e. this is true whatever the behaviour of its competitor). By mass customising it is able to extract more surplus from its most loyal customers by producing for each of them exactly the good which it wants to buy. 4. If firms do not use first-degree price discrimination technology then they are better off if they mass customise, everything else fixed, because they are better able to segment the market and extract surplus from their most loyal customers. 5. However it follows from the above results that firms are locked-in a prisoners’ dilemma situation, where they would be better off not adopting any of the two technologies. But because mass customisation dominates a single price setting, then firms will mass customise. And once mass customisation is adopted the incentives increase to use also first degree price discrimination, firms will end up adopting both technologies and making lower profits. The relationship of our work to the existing literature is as follows. Most of the literature on price discrimination has focused on the case of monopoly. A small number of papers have, however, analysed how price competition operates in a competitive environment Katz (1984), Borenstein (1985), Holmes (1989), Corts (1998), Armstrong and Vickers (1999), Thisse and Vives (1988), and Ulph and Vulkan (2000). The paper by Armstrong and Vickers (1999), provide an elegant framework that incorporates much of the earlier work. However this analysis concentrates on the case of third-degree price discrimination in a competitive environment. They show that the analysis of third-degree price disc