A Model of Competition Between Online and Traditional Firms

This paper attempts to model the strategic interaction between firms in online and traditional markets. It analyzes how each market affects the competitive characteristics of the other. Existing research on electronic markets has focused largely on their welfareenhancing features. However, electronic markets coexist with traditional markets with each strongly influencing the other. Results show that the profits of firms in competing channels increase as they differentiate themselves as much as possible from each other, and by differentiating themselves based on the characteristics over which consumers have the maximum variety in relative valuations. The choice of the factors of differentiation, however, is crucial, as are the relative sizes of the online and offline markets. The results also indicate that neglecting the impact of traditional markets on online firms risks oversimplification, and might lead to incorrect prescriptions to both offline and online firms. 1. Motivation and Research Questions “As demand for eSchwab’s $29.95 online trades was booming beyond expectations, customers with Charles Schwab’s traditional brokerage still had to pay an average of $65 per trade. The two-tiered pricing was awkward. Soon Schwab decided to price all trades at $29.95, thus adopting the same pricing strategy both online and off. ” “Internet Defense StrategyCannibalize Yourself”, Fortune, Sep., 1999. Online retailing has been growing rapidly, and is soon predicted to account for a significant portion of the overall retail revenues. Given the explosive growth of online markets, there have been claims that Internet retailing would displace traditional firms and markets in several sectors. As a retailing channel, the Web differs significantly from traditional channels in several ways. It offers convenient access, wider variety, and ease of search/comparison. Consumers who value such features prefer shopping online. However, a large number of consumers prefer shopping via traditional channels. Overall, therefore, a more realistic scenario is one where both online and traditional firms co-exist, competing either for an overlapping set of consumers, or serving orthogonal segments. With more and more traditional firms beginning to realize the potential of online retailing, there has been a surge in the number of hybrid firms operating in both domains. According to recent surveys by Media Metrix and Nielsen, the lists of 50 top online retailing sites read like a Who's Who of land-based retailing. Gap.com, eSchwab, JCPenney.com, WalMart.com and Barnesandnoble.com were among the hybrid firms that made the grade. One of the serious challenges faced by traditional firms moving online is the issue of integrating their online strategies with their traditional operations. Since online markets are characterized by severe price competition, traditional firms that move online are forced to match their competitors’ prices, and this can conflict with their pricing strategies offline. As illustrated by the quote above, Charles Schwab was forced to adopt the same pricing strategy both online and off. Wal-Mart, Home Depot, Electronics Boutique and Circuit City are examples of some other firms that have streamlined their traditional operations to be in sync with their online operations. With more and more traditional firms moving online, Web-based markets and traditional markets are no longer isolated but strongly influence one another. The fact that online markets coexist with and compete with firms in traditional markets has been largely overlooked in the research literature. Most of the existing research on electronic commerce (for instance, see Bakos,1997, Brynjolfsson and Smith,1999; Bakos et al.,1999) that has focused on studying the efficiency of electronic markets, has neglected this strategic interaction between firms operating in the two domains. This research seeks to address this issue by analyzing the impact of Internet retailing on traditional brick-andmortar firms. More specifically, it seeks to examine how the strategic interaction between online, traditional as well as hybrid firms which have a presence in both markets, impact competitive outcomes in both markets. The differences between online and traditional channels, makes this issue more interesting. A spatial differentiation model (Hotelling 1929, Salop 1979) is constructed to examine the impact of the interactions between these two markets. The features of the equilibrium configurations and its sensitivity to various parameters are also analyzed. Finally, the welfare implications of this model are compared with the benchmark case where the online markets are independent of traditional markets. 2. A Model of Competition between Online and Offline Firms In this model the online and traditional markets are each represented by a unit circle. There are three types of firms – pure online firms located wholly online,