Economic Perspectives on the Internet

by

Alan E. Wiseman

BUREAU OF ECONOMICS

FEDERAL TRADE COMMISSION

July 2000
ECONOMIC ISSUES

Economic Perspectives on the Internet

by

Alan E. Wiseman

Bureau of Economics

Federal Trade Commission

July 2000
ii

FEDERAL TRADE COMMISSION

ROBERT PITOFSKY Chairman

SHEILA F. ANTHONY Commissioner

MOZELLE W. THOMPSON Commissioner

ORSON SWINDLE Commissioner

THOMAS LEARY Commissioner

BUREAU OF ECONOMICS

JEREMY I. BULOW Director

PAUL A. PAUTLER Deputy Director for Consumer 

Protection and Research

GREGORY S. VISTNES Deputy Director for Antitrust

PAULINE M. IPPOLITO Associate Director for Special 

Projects

DENIS A. BREEN Assistant Director for Economic 

Policy Analysis

ROBERT D. BROGAN Assistant Director for Antitrust

GERARD R. BUTTERS Assistant Director for Consumer 

Protection

DANIEL P. O’BRIEN Assistant Director for Antitrust

LOUIS SILVIA Assistant Director for Antitrust

The author served as an economic research analyst with the Bureau of Economics, 

Federal Trade Commission in 1999, and is currently a doctoral candidate in political economics, 

Stanford University, Graduate School of Business. The views expressed in the report are those of 

the author and do not necessarily reflect the views of the Commission or any individual 

Commissioner. Furthermore, the views expressed herein do not necessarily reflect the views of 

the Commission or its staff regarding any pending matter.

I would like to acknowledge the support of the Bureau of Economics and the Federal 

Trade Commission, and thank them for providing me with the opportunity to study this 

interesting topic. In addition, I would thank David Balto, Denis Breen, Jeremy Bulow, Gerard 
iii

Butters, Dan Caprio, Robert Cannon, Patrick DeGraba, Susan DeSanti, Sara Harkavy, Michael 

Kende, Robert Litan, David McAdams, Thomas Pahl, Paul Pautler, Robert Pepper, Simon Steel, 

Michael Vita, and Dean Williamson for helpful comments and suggestions on this project. 

Thanks also goes to Sara Harkavy (again), Morgan Long, and Melissa Oshfelt for excellent 

research assistance. 
iv

Table of Contents

Executive Summary . . . . . . . . . iv

Introduction . . . . . . . . . . 1

Section 1: What is the Internet? . . . . . . . 3

1.1 History and Origins . . . . . . 4

1.2 Basic Technology and Infrastructure . . . . 5

1.3 Governance Structure . . . . . . 7

Section 2: Pricing of Access to the Internet . . . . . . 9

2.1 Flat Pricing . . . . . . . 10

2.2 Auction Approach . . . . . . 12

2.3 Static Priority Pricing . . . . . . 15

2.4 Dynamic Priority Pricing . . . . . 17

2.5 PMP Approach . . . . . . 19

2.6 Summary and Implications . . . . . 21

Section 3: Pricing of Goods and Services on the Internet . . . . 25

3.1 Effects of Search Costs on Pricing Policies . . . 25

3.2 Packaging and Pricing of Information Goods. . 33

3.3 Prospects for Price Discrimination . . . . 38

3.4 Future of Sales Assistance . . . . . 43

3.5 Summary and Implications . . . . . 46

Section 4: Network Effects and the Internet . . . . . . 52

4.1 Network Effects and Technology Adoption . . . 54

4.2 Applications to the Internet . . . . . 59

4.3 Summary and Implications . . . . . 64

Section 5: Internet Taxation . . . . . . . . 67

5.1 Legal and Legislative History . . . . 67

5.2 Current Research on Internet Taxation . . . 71

5.3 Summary and Implications . . . . . 77

Section 6: Conclusion . . . . . . . . . 80

References . . . . . . . . . . 83
v

Executive Summary

The information technology sector of the United States economy, spurred on by the 

expansion of the Internet, has undergone explosive growth. According to one estimate, in 1998 

Internet-related industries led to the creation of over 1.2 million jobs and generated more than 

$300 billion in revenue. At the same time the Internet has expanded immensely. As of 

December 1999, it was estimated that more than 4.9 million commercial websites had emerged, 

and in the closing months of the year, that number was increasing at a rate of almost 500,000 per 

month. The rapid growth of the “Information Economy” has drastically changed the manner in 

which commercial transactions are conducted, as anything from material goods (such as books) 

to information goods (such as databases) can be procured with the ease of a mouse click. This 

report investigates the underlying economics of certain facets of the Internet. By examining 

recent literature addressing economic aspects of the Internet and electronic commerce, as well as 

more traditional literature on pricing practices and market structure, this report will serve as a 

roadmap of the current terrain in Internet-related economic matters, as well as a framework for 

future analysis.

The report covers five primary areas of inquiry. The first section provides a brief 

technical overview of the Internet and discusses the transmission technologies employed. What 

is currently known as the “Internet” is a descendent of federally-funded research that began in 

the Department of Defense in the early 1960's and was maintained by the National Science 

Foundation until the mid 1990's. Unlike telephone networks where conducting a call requires a 

dedicated circuit for the duration of the transmission, information is sent across the Internet via 

packet-switching technology that breaks the transmission down into data “packets” of 

approximately 200 bytes and sends them from origin to destination. While traveling from end to 

end, the packets may traverse several different computer networks, and the Transmission Control 

Protocol/Internet Protocol (TCP/IP) helps facilitate the arrival and reassembly of all packets at 

their destination. High levels of user activity can lead to congestion on the network, which might 

slow down, or prevent, packet transmission. No centralized authority governs the Internet, but 

several industry consortiums and volunteer nonprofit groups help devise standards for 

interoperability. For the matter of domain name assignment (assigning the proper names for 

webpages), Network Solutions Incorporated (NSI) currently maintains control over the domain 

name registry.

The second section of the report discusses different methods employed and theoretical 

models proposed for pricing user access to the Internet. The most commonly used method is 

known as flat pricing, where users pay a flat fee to have unlimited access for a fixed period of 

time (e.g., per month). While flat pricing is very convenient in that it simplifies accounting 

issues, certain economic properties may make it less than optimal. First, the flat price does not 

induce users to take into account the congestion costs (an externality) that they impose on other 

users during peak periods, which can lead to further network congestion. Second, the flat price 

cannot discriminate between “high” and “low” priority applications, leading to cases in which 

those who value services the most are not receiving them. To address these problems, several 

alternative models of access pricing are being studied. The auction approach would require users 
vi

to attach bids to each packet they submit to the network, and any bid above the market clearing 

price (as defined by the network’s congestion constraints) would be transmitted. Static and 

dynamic priority pricing models present users with a menu of applications, which vary in price 

as a function of the priority level the user attaches to the application in question, which will 

designate its place in line should network congestion occur. Finally, the Paris Metro Pricing 

model partitions the network into subsections and charges different prices for access to each 

subsection; users will sort themselves into divisions depending on their willingness to pay, 

leading to an efficient allocation of network resources. With the impending growth of Internet 

usage, in the absence of some sort of technological change and/or pricing policy change, it is 

possible that the quality of service associated with a flat-pricing regime will deteriorate. Among 

the technological alternatives being considered is capacity expansion, “caching”, and new 

protocols to facilitate differentiated service levels. The pricing models proposed might succeed 

in alleviating congestion, but as of yet, none have been widely implemented in a real-world 

setting. Future research might aim at testing these various models against each other, either 

through simulations or in experimental settings, to determine which options perform the best in 

managing congestion.

The third section of the report examines economic issues surrounding pricing of goods 

and services on the Internet. Theory might imply that a reduction in the costs of transactions will 

lead to lower prices, less price dispersion, and frequent price adjustments by online firms in 

comparison to their offline counterparts. Early empirical analysis offers mixed support of these 

hypotheses; in the markets for books and compact discs, prices seem to follow these trends, but 

these findings do not hold across all markets. Because the Internet environment facilitates easy 

(and costless) reproduction of information goods, theory might lead us to believe that one should 

expect to see many products and services being packaged together and sold as bundles. While 

there are efficiencies to be gained from such ventures, there are also possibilities that such 

activities might stifle innovation and deter entry of potential competitors into the market. The 

utilization of technologies that allow firms to monitor surfers’ travels across the Internet present 

numerous opportunities for price discrimination and product customization. The use of 

electronic agents known as “shopbots” may lead to lower prices which benefits consumers, but 

may also have the effects of adding to Internet congestion and facilitating industry collusion. 

Theory and preliminary empirical analysis suggests that regardless of the reduction in 

transactions costs, there will still be a need for institutions that can provide product expertise and 

vouch for firm reputations on the Internet. Future research might study the robustness of price 

differences between online and offline firms across additional markets, the prospects for 

collusion in electronic markets, and the manner in which the Internet serves as a clearinghouse 

for second-hand durable goods.

The fourth section of the report examines the role of network externalities in the 

development of the Internet, and how such effects might affect firms’ activities. A good is 

commonly referred to as possessing network externalities if the value of the good to an 

individual user increases as more individuals use it. Given that the Internet, by design, is a 

“network of networks”, one would suspect that conventional economic principles should apply to 

much of its underlying mechanics. Theory implies that in network industries, a consumer’s 

choice of a given technology depends directly on their perceptions about the likelihood of that 
vii

product’s dominance. Once a technology has attracted enough users, it is said to achieve 

“critical mass,” after which it can survive as a viable product, and possibly be the dominant 

standard. In trying to achieve critical mass, firms might employ various strategies, such as low 

introductory prices, aggressive advertising, etc., in the hopes of attracting consumers as quickly 

as possible. On the Internet, network externalities arise in considering network interconnection 

agreements between Internet service providers, as well as in considering standards adoption by 

emerging technologies such as digitized media. The ownership of an (arguably) essential 

facility, such as an Internet backbone, may allow large Internet service providers to squeeze rents 

from those firms that require interconnection to conduct business. In establishing new standards, 

there is the potential for excluding competitors from the standard, who may then be harmed 

because of their incompatiblity with the existing network. Furthermore, in trying to achieve 

critical mass, some of the strategies employed by firms may be viewed as anticompetitive. At 

the same time, standards can obviously benefit consumers in that they expand the size of the 

network. Future research might aim at uncovering the differences between market power that 

arises from normal competition versus market power that arises from anticompetitive 

exploitation of network externalities. 

The final section of this report considers the issue of taxation of Internet commerce. 

There is a debate ensuing between the proponents and opponents of online taxation. Those in 

favor of effective collection of existing sales taxes on the web cite economic research arguing 

that such taxes are necessary to ensure that the sales tax system is not distortionary, as well as 

ensuring that state and local governments will not lose sizable revenues as more consumers 

migrate to the Internet. Those opposed to Internet taxes claim that mandating such taxes will 

place a large burden on retailers who would likely be required to collect and remit the taxes, as 

well as stifling the growth of electronic commerce. The existing empirical research has focused 

on estimating the likely effects of instituting Internet taxes with respect to consumer activity, 

state revenues, and the level of compliance costs. With respect to consumer purchasing patterns, 

early analysis has shown that those who live in areas with high sales taxes purchase more often 

online (and actually buy more) than those who do not; hence, implementing current sales taxes 

online would likely decrease online purchases. It does not appear currently that governments are 

losing a sizable portion of their revenues to the web. Finally, there is empirical evidence to 

suggest that smaller businesses would bear the burden of collecting and remitting sales taxes 

more so than larger businesses. While the empirical evidence might offer a modicum of support 

to those who oppose taxation, the Internet as a transactions medium is immature, and further 

research, studying sales, rates of Internet diffusion, and revenue streams of local governments 

and bricks-and-mortar stores, is necessary to determine if these findings are representative of a 

long-run stable outcome.
1

Economic Perspectives on the Internet

Alan E. Wiseman

Introduction

The information technology sector of the United States economy, spurred on by the 

expansion of the Internet, has undergone explosive growth. According to a recent study by the 

University of Texas at Austin and Cisco Systems, the “Internet Economy” has led to the creation 

of over 1.2 million jobs, and generated over $300 billion in revenue (Barua, et al. 1999). In 

terms of user base, recent estimates project that by the end of 2000, 72 million Americans will 

have access to the web--up from 14.3 million in 1995 (Atkinson and Court 1998). The Internet, 

by all accounts, has drastically changed the manner in which business is done. Anything from 

material goods, such as groceries and compact discs, to information goods, such as database 

access and newspaper text, can be acquired with the ease of a mouse click or key stroke. 

The ease with which goods and services are purchased has corresponded to a dramatic 

expansion of web-based businesses, known generally as electronic commerce. One source has 

estimated that there were over 4.9 million commercial websites, as of December 1999, and that 

the number of commercial websites was growing in the last months of the year at a rate of almost 

500,000 per month.1 This proliferation of commercial websites, as well as the potential 

profitability associated with such ventures, has motivated entrepreneurs to attempt to carve out 

niches in this new marketplace. Their activities have, in turn, also drawn attention from the 

legislative, executive, and regulatory arms of the government as they seek to understand this new 

medium, and its potential for both growth and misuse. 

 

1

 The term “commercial” website refers specifically to those websites that have a “.com” 

suffix. If one includes those commercial sites that use a “.org”, “.net”, or other suffix, then the 

number would be substantially larger. Estimates from: http://www.netcraft.com/survy/Reports.
2

A common question being voiced is: “What is the ‘Information Economy’?” While it is 

easy for media commenators to claim the Internet has spawned a revolution that will redefine 

virtually all economic and societal relationships, as an economist, one might critically wonder 

what this “digital revolution” will mean for government enforcement policy.2 Does this new 

technology require economic practitioners to actually consider new theories in order to 

understand the internal workings of the digital market? Or is it the case, as Shapiro and Varian 

(1999) have argued, that “a few basic economic concepts go a long way toward explaining how 

today’s industries are evolving.”

 

This essay will discuss some of the recent literature dealing with the economics of the 

Internet, focusing on the subjects of pricing of access to the Internet, pricing of goods sold via 

the Internet, network externalities, and Internet taxation. It attempts to present a succinct picture 

of the relevant literature, and offer some thoughts about the future development of the Internet, 

with respect to competition and consumer welfare. While none of the topics is covered in 

complete detail, this paper will hopefully provide the reader with enough information to serve as 

a roadmap of the current terrain in Internet-related economic matters, as well as a framework for 

future research endeavors.3

 

2 A recent report by the International Competition Policy Advisory Committee 

(International Competition Policy Advisory Committee 2000) noted several possible threats to 

competition, such as cartels and price signaling, that might follow from the expansion of Ecommerce. While not offering any specific policy recommendations, the committee urged 

governments to be very attentive to the ongoing development of the e-marketplace, and to be 

ready to respond with appropriate antitrust enforcement measures.

3

 The topics covered in this essay were selected for investigation primarily because of 

the sizable body of existing (and relevant) economic research. A non-exhaustive list of 

additional Internet-related topics might include commercial fraud, electronic payment systems, 

security and privacy of Internet transactions, copyright protection, and advertising strategies. 

For a treatment of several of these subjects, the interested reader is referred to Choi, Stahl and 

Whinston (1997). 
3

Section 1 will present a brief, relatively non-technical analysis of the current state of the 

Internet to help readers familiarize themselves with the technologies being discussed in 

subsequent sections. Section 2 will discuss current pricing practices for providing Internet 

access, as well as theoretical possibilities that have yet to be implemented. Section 3 will 

consider how the environment of the Internet, especially with respect to relatively low search 

costs and a variety of easy-access information, will shape the pricing of goods and services sold 

online. Section 4 will consider the network externalities literature and note how these theoretical 

models of network creation might apply to the current state of the Internet. Section 5 will move 

beyond theoretical and empirical studies and address a topic that has generated significant 

attention in the public as of late: taxation of online commerce. Finally, Section 6 will conclude 

with some general comments and a discussion of possible future areas of study.

Section 1: What is the Internet?

This section will present a very brief historical sketch of the technological development 

of the Internet.4 Particular attention will be drawn to the relevant transmission technologies 

(packet switching versus circuit switching), as these factors will be especially relevant to the 

sections on pricing of access and network externalities.

 

4 The term “Internet”, as used in this paper, refers to an open network. More specifically, 

the Federal Networking Council (FNC) has defined the Internet as follows: “the global 

information system that— (i) is logically linked together by a globally unique address space 

based on the Internet Protocol (IP) or its subsequent extensions/follow-ons; (ii) is able to support 

communications using the Transmission Control Protocol/Internet Protocol (TCP/IP) suite or its 

subsequent extensions/follow-ons, and/or other IP-compatible protocols; and (iii) provides, uses 

or makes accessible, either publicly of privately, high level services layered on the 

communications and related infrastructure described herein.” (FNC Resolutions: Definition of 

“Internet”, 10/24/95, http://www.fnc.gov/Internet_res.html). In contrast, the web is an 

application that runs on that network.
4

1.1 History and Origins

The technology that is currently referred to as the “Internet” can trace its origins back to 

the early 1960's when a division of the Department of Defense, ARPA (Advanced Research 

Projects Administration), developed the predecessor to the Internet, ARPAnet, to link together 

universities and high-tech defense contractors.5 In October 1969, a message was successfully 

transmitted between research centers at UCLA and the Stanford Research Institute in Northern 

California, and the Internet was effectively born. Government involvement in the evolution of 

the Internet continued into the 1980's when the National Science Foundation (NSF) created 

NSFNET to serve as a “backbone” that would connect the NSF-funded supercomputer centers. 

The NSFNET evolved to serve as a backbone network to which several smaller regional 

networks, and their supported local area networks (LAN) connected themselves. Around the 

same time, several private Internet backbones began to emerge, providing access to private 

networks in a manner analogous to NSFNET. In 1994, there were three privately funded 

backbones in the United States besides NSFNET: Alternet, PSInet, and SprintLink. With the 

success of these privately funded ventures, the federal government withdrew from backbone 

provision in 1995 when NSF funding for NSFNET expired. Although federal funding of 

NSFNET expired, the NSF helped coordinate the development of interconnection points between 

backbones, known as Network Access Points (NAPS), which are currently being administrated 

by private entities.6

 

5

 One of the original motivations for ARPAnet was to devise a communications network 

to link together the branches of government that would be highly resistant to the destructive 

effects of war. Given that information is transmitted via packets, rather than closed circuits, on 

the Internet, even if certain telephone networks were destroyed, communications would most 

likely still be possible, as packets would find whatever pathways were still available upon which 

to travel (Tapscott 1996, pp. 17-19). 

6

 For more detailed information on the history of Internet development, as well as further 

technical details, see Esbin (1998), Krol and Klopfenstein (1996) MacKie-Mason and Varian 

(1997), and Oxman (1999). Galla (1998) provides a relatively non-technical introduction and 

explanation of recent Internet technologies, and Greenstein (1999) provides a history of the 

Internet Service Provider market. Interested readers might also consult the Internet Society’s 
5

1.2 Basic Technology and Infrastructure

Given that there is no central authority, and it is composed of several components 

connected by an open communications standard, the Internet has commonly been referred to as a 

“network of networks”.

7

 While such a characterization might imply a lack of organization, the 

infrastructure is still organized in a relatively straightforward hierarchical manner consisting of 

backbone providers, regional networks, and Local Area Networks (LAN).8 At the highest level 

of the infrastructure are the backbone providers. Using the analogy of a road system, a backbone 

can be thought of as an interstate highway, stretching from one side of the nation to the other; 

and to which smaller intrastate highways are connected. These smaller intrastate highways are 

analogous to regional networks, connecting individual city roads to the interstate highway. 

Finally, at the lower level, the LANs, such as those utilized on a university campus, are 

analogous to the city/country roads, where a given traveler might begin his journey from pointto-point.

The road system analogy is especially appropriate for characterizing the Internet if one 

considers how information is transmitted. Unlike conventional telephone networks, which 

employ circuit-switching technology, the Internet operates by utilizing a packet-switching 

technology. The term “circuit-switching”, implies that for two customers to make a phone call, a 

circuit must be established between them, and remain open, for the entire duration of the call--

even in periods of dead silence. In highway terms, circuit switching would be analogous to 

closing off an entire lane of the interstate for a person who wanted to send a dozen roses between 

 

webpage on “Internet Histories” that includes hyperlinks to several other historical accounts of 

the development of the Internet: http://www.isoc.org/internet/history/index.shtml. 

7 This is not to say that no organizations exist that oversee Internet development. As will 

be discussed below, numerous voluntary groups have emerged to assume various roles.

8

 This three-tier characterization is discussed in greater detail in MacKie-Mason and 

Varian (1997).
6

San Francisco and Washington D.C., and not opening the lane until the flowers were delivered.9 

The Internet, by contrast, allows communications to occur by transmitting data between users in 

small “packets”, usually consisting of approximately 200 bytes. Sending these packets does not 

require a dedicated circuit, and packets from other users can be sent on the same pathway 

contemporaneously. Employing the highway analogy again, packet switching is analogous to 

breaking up the dozen roses into individual flowers, carried by twelve cars, and sending them on 

the interstate to get to their end destination as quickly as possible, where they are reassembled 

into one complete package. The time of delivery, of course, would depend upon the quality of 

the road, and on the amount of traffic caused by other cars in transit.

In trying to send information across the Internet, two questions might seem pressing: how 

is the information broken down into packets, and how are the packets reassembled? The 

technology that allows such data transmission to occur is known as the TCP/IP protocol. When a 

user at a given terminal sends data off on the Internet “highway”, (e.g., email message, web 

page, etc.), the first thing that occurs is that the message is broken down into packets by the 

Transmission Control Protocol (TCP). In creating a packet, the TCP attaches a “header” to the 

packet that specifies how the packets will be recombined upon arrival at their destination. Once 

the packets are created, the Internet Protocol (IP) specifies address information for each packet 

that determines where it will go next on its journey between points. An IP address is a series of 

four numbers, each ranging from zero to two-hundred-fifty-five, separated by periods (dots), 

which represents the “mailing address” of the computer to which the content is being sent.10 

Between origin and terminal destination, the packets might traverse several computer networks, 

 

9

 For the sake of illustration, the author requests that readers disregard the option of 

teleflorist services.

10 All email addresses and web pages have a corresponding unique IP address. 

Conventional email addresses and web page names (e.g., awiseman@ftc.gov,

http://www.ftc.gov) are only used as convenience for memory. Upon sending email, or 

requesting a web page, a name server translates the email address/web page name into its 

corresponding IP address to determine where precisely, the message is going on the web. For 

example, the home page of Stanford University, http://www.stanford.edu has the IP address of: 

171.64.14.237.
7

analogous to interstate (backbone) and intrastate (regional network) highways. At each junction 

between networks, a “router” will examine the packet and its IP address, and then determine 

where to send the packet next in order to manage traffic most efficiently. Finally, the packets 

will reach their terminal destination and the TCP will reassemble them into the original content.

While the above process might seem simple, user activity can easily complicate matters, 

as congestion on the network can severely inhibit delivery time and performance. Most 

networks do not currently employ any method to determine priority classes with respect to 

packets. This is not a problem in low-traffic periods where congestion is negligible and packets 

are sent practically instantaneously. In periods of high traffic however, packets enter a queue 

and are usually sent in a first-in-first-out manner (FIFO), possibly leading to some packets being 

substantially delayed or discarded altogether. In the case of dropped packets, further delay can 

ensue as the TCP, in an attempt to relieve congestion, may reduce the rate at which packets are 

sent.11

1.3 Governance Structure

As noted above, at this time no centralized authority governs the Internet. While the 

infrastructure is continuously being developed through a combination of public and private 

investment, different portions of the network are run essentially independent of one another. 

Industry consortiums and volunteer nonprofit groups such as the World Wide Web Consortium 

(W3C), the Internet Engineering Task Force (IETF), and the Internet Corporation for Assigned 

Names and Numbers (ICANN) have emerged in recent years to help devise universal standards 

for interoperability, but none of these bodies possess any sort of de facto lawmaking power that 

 

11 New technological developments have helped to ameliorate congestion problems even 

absent any sort of market rationing of access. Introduction of “broadband” Internet services 

through either cable, satellite, or conventional copper telephone lines (DSL), have enabled 

consumers to surf the web at much higher speeds. Of course, as the Internet becomes 

increasingly popular, these technologies, too, may eventually experience congestion problems 

absent any sort of rationing mechanism. Kopel (1999) provides a detailed overview of current 

broadband technologies.
8

can create general rules for web “etiquette”. A matter that is being dealt with by one of these 

consortiums, and has recently attracted significant attention, is domain names registration. A 

domain name is the term given to the proper name assigned to the IP address of a webpage (e.g., 

www.washingtonpost.com). Network Solutions Incorporated (NSI) of Herndon Virginia, 

currently maintains the domain name registry.

NSI held a virtual monopoly over registering websites ending in several suffixes 

including .com, .edu, and .net as the result of a contract awarded to it by the United States 

Department of Commerce in 1992. Anticipating the expiration of NSI’s monopoly in 1998, the 

Clinton Administration charged (ICANN) with trying to assess the most efficient manner to 

manage the domain name registration process once NSI’s contract was terminated. Following a 

year of negotiations, an agreement was hammered out between the Department of Commerce 

and NSI in September 1999 that paved the way for open competition in domain name 

registration. Under the agreement, NSI would make a one-time grant of $1.25 million to ICANN 

to help cover their administrative fees, and formally recognize that ICANN had administrative 

authority over domain name registration, while NSI would retain control over the domain name 

database until 2003 (at which point a successor registry, possibly NSI, would be designated).

12

 

In aiding competition, the agreement opened up the way for other firms to handle domain name

registration, providing that they paid a six-dollar-per-name fee to NSI to have the new name 

entered in NSI’s database.13

 

12 The agreement did not specify the process by which ICANN would designate the new 

registrar, but the agreement did provide NSI with financial incentives to withdraw from the 

registration business (Kaplan and Schriver 1999). If the registry was sold to another company in 

the first eighteen months after the agreement was ratified (which occurred in November 1999), 

the purchaser of the registry would have administrative authority over domain names for an 

additional four years after 2003, (thereby increasing the sale price, other things being equal). For 

more information on the agreement, see http://www.icann.org/nsi/nsi-registry-agreement.htm.

13 NSI also registers domain names themselves, charging anywhere between $35 and 

$169, depending upon the registration options desired (e.g., length of registration, listing in a 

directory, etc.). In a response to a Request for Comment (RFC) by the National 

Telecommunications and Information Administration, Vita and Horne (1998) provide a technical 

overview of domain name assignment as well as the competitive implications of the breakup of 

NSI’s monopoly over assignment power. For more information on the development of Internet 
9

The explosive growth of the web combined with lack of central authority has raised some 

serious questions about the appropriate role of government (federal or otherwise) in managing 

the web. Industry leaders have argued that the Internet, in both electronic commerce matters and 

otherwise, should be managed by various methods of self-regulation on the part of the private 

sector.14 Various advocacy groups, however, have pressed for government involvement in 

managing the web on issues ranging from privacy to access provision, to sales tax. Regardless of 

what role the federal government adopts in the future, the topics addressed below are most likely 

to be among some of the more relevant issues that will be brought to the forefront of the policy 

debate.

Section 2: Pricing of Access to the Internet

The Internet is an interesting environment with respect to user activity, in that for a given 

user, his preference regarding the number of network users is somewhat mixed. As more 

consumers and businesses begin using the Internet, the value of the network to any given user 

increases. This positive trend is not constant however, as it only continues until the point where 

the congestion caused by additional users on the system leads to a degradation in service, either 

because of excessive delay, or loss of services altogether.15 The explosive growth in the number 

of web-users, combined with the increased use of data-intensive applications (e.g., streaming 

audio, video, etc.), has raised questions about how best to manage Internet traffic in order to 

ensure high levels of service quality. Several technological innovations have been suggested to

address potential congestion problems. In addition to technological changes, much scholarly 

 

governance and domain name assignment, see Gillet and Kapor (1997), Shaw (1997), Gigante 

(1997), and Oppendahl (1997). 

14 In a recent study, Oxman (1999) has examined how the private marketplace and 

minimal government intervention has allowed the Internet to thrive in various ways.

15 Economists would argue that such preferences are indicative of the concavity of a 

user’s utility function over network activity.
10

attention has been directed towards devising some sort of distribution system, relying primarily 

on pricing mechanisms, which can provide an efficient utilization of network resources. In the 

following section several theoretical pricing options will be discussed.

Taken together, these pricing models represent an interesting combination of traditional 

microeconomic theory and more recent computer science, and they range from very simple 

methods, such as flat pricing for access, to significantly more complicated approaches, such as 

conducting auctions over individual packets. In this section, several of these approaches will be 

discussed in detail.16 After investigating the models, we will consider other, supply-side, 

alternatives to pricing models that might facilitate efficient Internet traffic, and conclude with a 

brief discussion of other public policy aspects of access provision.

2.1 Flat Pricing

The most common method currently used for access to the Internet is flat pricing. Under 

this scheme, users pay a flat fee, usually monthly, which allows them to have unlimited access to 

the Internet at a particular service level. For example, one might pay $19.95 a month to be 

connected to an Internet Service Provider (ISP), which allows the customer unlimited use at 

whatever speed the modem pool of the ISP supports. Flat pricing essentially offers “best effort” 

service for all users. When the network is uncongested, there is negligible waiting time and all 

information is transmitted instantaneously. When there is a high level of usage, however, flat 

pricing cannot discriminate between users, and all customers are subject to the same level of 

delays and loss in service quality.17 In some applications, delay in transmission might have little 

 

16 The approaches discussed here are not meant to be an exhaustive list off all methods 

being considered, but rather a sample of the relevant microeconomic research that is 

investigating the issue of alleviating Internet congestion. For additional examples and 

references, see McKnight and Bailey (1997).

17 This does not imply that other pricing systems would fail to provide “best effort” in 

terms of the transmission path chosen and guarantee of delivery. Rather, it means that other

pricing mechanisms, in differentiating between packets, could possibly provide those users who 

pay higher prices with a higher quality of service than that which they receive when all packets 
11

effect (e.g., email); but, applications such as real-time video or audio streams can suffer greatly 

due to delayed or dropped packets.18

Proponents of flat pricing argue that such a mechanism is more convenient for both 

consumers and providers in that it simplifies accounting issues, as well as encouraging usage. 

Furthermore, flat pricing provides a guaranteed revenue stream with which ISP’s can recover the 

high sunk costs associated with developing the infrastructure of the network (Clark 1997, Anania 

and Solomon 1997).19 Unfortunately, the conveniences that come with flat pricing also 

correspond to several elements that can cause inefficiencies. First, and most obvious, the flat 

price does not induce users to take into account the congestion costs (an externality) that they 

impose on other users during peak periods. Given that users are charged the same price to send 

data regardless of when the data is sent (essentially nothing, given that they have paid for access 

already), each user is faced with the classic prisoner’s dilemma problem: individuals would be 

happier if others stayed off the network during periods of congestion, but each user would prefer 

to send their transmission and wait a bit, rather than get off the network altogether. As a result, 

as one would expect, users continue to log onto the network, even in periods of high congestion, 

causing degradation in service quality.20

 

are treated equally (which is commonly the case under a flat-pricing regime).

18 Werbach (1997) provides an excellent discussion of the numerous potential congestion 

points on the Internet, including backbone congestion, and switch congestion at various points on 

the Local Exchange Carrier (LEC) networks being employed for transmission.

19 Because it is essentially costless to provide access to a user once the infrastructure is 

developed, charging the marginal cost of production of access (which is conventionally 

associated with the “efficient” competitive outcome) would lead to a price necessarily equal to 

zero. Unfortunately, such a scheme makes it impossible to ever recover the costs expended by 

developing the network.

20 Odlyzko (1997) points to American Online’s (AOL) 1996 experience with pricing 

mechanisms as evidence of this real world tragedy-of-the-commons. When AOL switched from 

usage-sensitive pricing to flat-pricing, users flooded the system, at times leaving their 

connections on unattended; leading to excessive delays and, at times, complete system 

breakdown.
12

Another problem, closely related to the first, is that the flat price does not discriminate 

between “high” and “low” value applications. As a result, a teenager sending a video stream of 

his summer vacation can plausibly take precedence over a video conference-call of a Fortune 500 

company. Even if the Fortune 500 company would be willing to pay a premium for higherquality service, most current flat-pricing packages do not provide such an option. The lack of 

discrimination, combined with the deterioration in quality of “high” priority applications that 

comes with increased traffic on the network has led to the examination of more usage-sensitive 

and priority-sensitive pricing mechanisms that could, in theory, lead to a more efficient 

allocation of resources than could be accomplished by the flat-pricing scheme.

2.2 Auction Approach

One pricing scheme that has been posed to avoid some of the inefficiencies inherent with 

the flat-pricing schedule has been discussed by MacKie-Mason and Varian (1993, 1995, 1997). 

The authors first note that most of the costs associated with backbone networks are the fixed 

costs incurred with creating the infrastructure. In times when the network is not saturated, the 

cost (i.e., delay time) of sending a message is zero and packets travel seamlessly from sender to 

receiver. In times of high congestion however, packets are delayed, leading to them being 

dropped from the queue, and re-sent from their origin. The authors propose a per-packet pricing 

mechanism that varies according to the congestion level on the network.

More specifically, the authors envision a mechanism that has the following 

characteristics: first, the incremental costs of sending a packet should be zero when the network 

is uncongested (to accurately reflect the social costs of the transaction at that time). Second, the 

social costs of delaying others’ packets should be internalized by a given user and be positive. 

Third, funding for the infrastructure should be covered by some sort of fixed connection fee that 

should vary between consumers as a function of their relative willingness to pay. In trying to 

accomplish the above goals, the authors present a “smart market” in which each user pays a flat 

fee for connection to the network and then submits a “bid” with each packet for the amount that 
13

they are willing to pay to have that packet transmitted. The “bid” is submitted by attaching it to 

the header of the packet21 and is only a bid for the relative priority of service, in the sense that 

higher bid packets enter the queue before lower bid packets, but it is impossible to guarantee 

priority in delivery due to network issues at the other end of the transaction.

Given this specification, the price paid at each router by a given bidder is the market 

clearing price; which is defined as the bid submitted by the first person whose packet is not sent 

due to the capacity constraints of the network and the range of bids submitted. Applying this 

mechanism to the Internet, for example, if a router could only forward 5 packets, and 10 packets 

were submitted for consideration with bids attached, then the first five highest-valued packets 

would be accepted and sent on, and the users whose packets were sent would pay the bid 

attached to the sixth-highest valued packet.22 The authors argue that the use of an auction in this 

setting has several desirable efficiency properties. First, it should be evident that the smart 

market proposed by the authors succeeds in inducing customers to pay non-zero positive prices 

when the social costs of their packet transmissions are positive, while paying prices equal to zero 

when the network is uncongested. Second, the authors claim that this mechanism is analogous to 

a well-established mechanism known as the Vickrey auction, in which a bidder’s dominant 

strategy is to bid their true valuation of the item being sold (in this case, packets).23 Hence, the 

 

21 The authors note that IP addresses currently contain fields for “priority” and/or “type 

of service” (TOS) specifications. Hence, using a subsection of the IP address as a bid field 

seems technologically feasible.

22 It should be evident that the sixth-highest bid is the marginal bid, because anyone who 

submitted a bid less than the sixth highest would strictly prefer to keep their money rather than 

pay the sixth-highest price for service. Conversely, anyone who submitted a bid greater than the 

sixth highest bid would strictly prefer to pay the sixth highest bid over their own bid for packet 

transmission. Finally, the individual who submitted the sixth highest bid, if that was their true 

valuation for service, should be indifferent between paying for their service and keeping their 

money without transmission. 

23 In a Vickrey auction bidding one’s valuation is a dominant strategy because the value 

of a user’s bid only affects the price that user pays when he is the marginal bidder. In such a 

situation, if a user were to overbid his true valuation, the only time it would change the outcome 

would be cases in which he received service but paid a price higher than his valuation. 

Conversely, if a user underbid his true valuation, the only time it would change the outcome 
14

authors claim, from an efficiency standpoint, their smart market ensures that bidders will not 

misrepresent their valuations, leading to their paying more, or less, than the true valuation of 

their transmissions.24 Third, in further results, the authors show that the revenues generated from 

such a mechanism will equal the optimal level of investment in infrastructure capacity.

Despite these favorable qualities, the authors address several concerns pertaining to their 

proposed smart market. Among other issues, they concede that many individuals might not find 

the notion of fluctuating access prices attractive. To counter this criticism they note that first, 

fluctuation of the network prices will occur less often as prices and availability become more 

predictable through the use of the market. Second, the smart market should lead to only 

downward fluctuations in price with respect to a bidder’s expectations.25 Finally, institutions, 

such as intermediate sellers, can emerge in this market to sell to end users who are hesitant to 

enter the market directly. Another point addressed is the skepticism over whether or not a smart 

market can accommodate the inherent “burstiness” (i.e., quick fluctuations in traffic over short 

periods of time) that is present with many packet transfers. To ameliorate concerns over this 

issue, the authors argue that the technology currently exists to handle the complications that 

accompany such burstiness, as well as arguing that the implementation of the smart market 

should lead to an overall decline in the market burstiness.

 

would be cases in which he was denied service despite having a higher actual value for the 

service than the posted price. Hence, a user can do no better than simply bidding his true 

valuation for the product in question.

24 MacKie-Mason and Varian’s claims about truth-telling being a dominant strategy in 

their smart market are somewhat questionable due to the fact that their auction is more 

representative of a uniform-price auction than a multi-unit Vickrey auction. Ausubel and 

Cramton (1998) discuss how a uniform price auction does not possess the efficiency properties, 

particularly with respect to truth-telling, of the multi-unit Vickrey auction.

25 Because a bidder is only paying the marginal price of service, any large “fluctuations” 

in price should manifest themselves as large downward shifts from the expected price paid, if the 

marginal user has a far lower valuation for the service than a given bidder.
15

2.3 Static Priority Pricing

A simple model of access pricing, that differs from MacKie-Mason and Varian’s smart 

market, is presented by Cocchi, et al. (1993).26 The authors first note that the development of 

applications such as real-time audio or video streams place high demands on the network that 

render current pricing schemes (mostly flat-pricing at the time the paper was written) unable to 

efficiently manage congestion. Furthermore, they point out that users are likely to place different 

weights on the value of quick access to the network, depending upon what sort of application is 

being used. For example, it is reasonable to believe that most users would be willing to tolerate 

delay in email packet delivery, but less willing to tolerate delay in real-time audio or video 

transmission. Recognizing this difference in delay valuation, the authors propose to create 

different priority classes for the network (as a function of expected delay) and have the users 

self-select which priority class they would prefer for the packets they send. The authors do not 

propose actually partitioning the network into different priority classes, but rather assigning 

“priorities” to packets when they are sent, which represents where they will be placed in the 

queue should the network become congested (at which point, they will be handled according to 

FIFO).

It should be obvious that any sort of priority class system must attach some sort of pricing 

scheme to the different priority classes in order to induce efficient self-selection into the 

classes.27 In the Cocchi, et al. model, users’ utilities are defined over the value (negative) that 

they place on the delay time for a given packet and the amount of money that they pay for 

transmission. The sequence of events consists of users simply placing an order for service at a 

particular priority level, paying the fee associated with that priority level, and having their 

 

26 Variants of this model are discussed in Braden, et al. (1994), Clark, et al. (1992), 

Shenker (1995), and Shenker, et al. (1993).

27 Without monetary considerations, all users would have an incentive to specify the 

highest priority level for all of their applications, leading to the network being just as congested 

as if there were no priority classes.
16

packets sent. Using a very general framework, the authors derive results showing that prices can 

be constructed for different priority classes which maximize aggregate welfare for all users in the 

network. The prices for priority classes are not updated every period in response to the level of 

network traffic; rather, prior to making their service request, users are faced with an unchanging 

(i.e., static) menu of priority levels from which to choose. Considering different users who are 

selecting service levels for four different applications (email, ftp, telnet, video) the authors 

demonstrate, through simulations, how a static two-priority (“high” and “low”) pricing system 

can generate the socially desirable congestion level for a wide array of network configurations 

and load usage.

While the static priority pricing system seems to have some very attractive 

implementation properties, especially from an accounting standpoint28, there are certain issues 

that might concern a network designer. First, because the prices are unchanging with respect to 

network load, as a matter of efficiency, there may be cases in which users are paying 

inappropriate amounts for the level of service they request. For example, when the network is 

completely uncongested, high-priority users will effectively be overpaying to have service 

identical to low-priority users (essentially, no delay), and conversely, when there is excessive 

congestion, high-priority users may be underpaying, leading to further congestion. While it is 

true that these effects might “even out” in expectation, on a point-by-point basis, it seems that a 

more dynamic approach to network pricing may be more desirable. Concerns might also be 

raised (Gupta, et al. 1997a) over the feasibility of implementing such a system on a large 

network where a central planner might have limited information over users’ priority preferences, 

that could serve to inhibit the derivation of efficient priority prices. Regardless of how valid this 

latter point is, Cocchi, et al. succeed in showing that implementing some sort of differential 

 

28 There is no need to worry about what path a given packet takes in trying to assess 

charges. Users are assessed a simple entry fee per application for a given priority level, and then 

the system does the best it can in providing service.
17

pricing scheme between priority levels, even in a static setting, can succeed in enhancing social 

welfare.29

2.4 Dynamic Priority Pricing

Addressing some of the concerns associated with Cocchi, et al.’s model, a more 

complicated model of priority pricing has been developed in a series of papers by Gupta, Stahl 

and Whinston (Gupta, Stahl and Whinston 1995, 1996, 1997b, 1997c). Similar to MacKieMason and Varian, the authors argue that flat-pricing methods are inappropriate for Internet 

communications, and some sort of congestion-pricing mechanism should be adopted to enhance 

efficiency of the network. While admitting that the auction presented by MacKie-Mason and 

Varian is attractive, Gupta, et al.(1997a) argue that the efficiency properties associated with the 

auction are contingent on two conditions being satisfied: all potential packets must be present at 

the auction, and the value of a packet is independent of the conditional passage of other packets. 

Both of these conditions, they claim, are obviously violated in the Internet environment where 

there will almost always be a time delay at congestion points between packet arrival and bids, 

and the value of packets are obviously affected by the drop rates in the network.

 Rather than attempt to refine MacKie-Mason and Varian’s proposal to account for these 

problems, Gupta, Stahl and Whinston begin anew by claiming that any sort of congestion pricing 

scheme should satisfy the following conditions. First, it should be constructed from some sort of 

theoretical basis (e.g., microeconomic theory). Next, it should be operational and adjust prices in 

real time. The overhead costs associated with implementing such a system should be 

manageable, and it should be adequately tested before being deployed onto a network. In trying 

to satisfy these conditions, the authors develop a priority-pricing mechanism that, in theory, 

could be implemented in a completely decentralized environment; and through simulation, can 

be shown to be more efficient than a flat pricing model for network access.

 

29 Citing the postal system’s mailing policies, (e.g., overnight, priority mail, standard 

first class, etc.), Einhorn (1995) also speaks of the virtues of static-priority pricing schemes as a 

technologically feasible and welfare enhancing pricing mechanism. 
18

Grounding their model in a general equilibrium framework that generically incorporates 

the preferences of all relevant users and service providers, the authors consider a scenario where 

users are faced with a variety of access options (varying in estimated delay times, price, and 

quality of service) and choose the expected optimal access option.30 The result of such a process 

leads to the realization of a “stochastic equilibrium” that has the following properties: “(i) 

average flow rates of service are optimal for each user given the prices and anticipated delay, and 

(ii) the anticipated delays are correct ex-ante expected delays given the average flow rates”

31

(Gupta, et al. 1995). A third property of the stochastic equilibrium prices is that their adoption 

maximizes social welfare.

Delving into the specifics of the model, the dynamic that they propose operates in 

countable periods (discrete time), and in each period a user is presented with a menu of options 

listing the relative prices for different priority classes as a function of delay time or other 

qualities. After considering each option, a user (or perhaps an electronic agent which has been 

programed with the user’s preferences) selects the option that he prefers (which might include 

not using any service at all, as would manifest itself in best-effort service). After selecting their 

option, a user’s request is sent to the least cost available server where it is immediately processed 

if the queue is empty. In the event that the queue currently has jobs in it, users’ requests are 

processed in a first-in-first-out (FIFO) method as a function of priority class. The estimates for 

prices in the user’s initial menu are updated every T units of time, and the authors assume that 

the actual prices in period (t+1) are a function of the prices in period (t) and expected prices in 

period (t+1) (where prices are positively correlated with delay times in the previous period, 

which increases with the number of users on the system).32

 

30 Economists would refer to this choice as choosing to maximize one’s “ex ante utility”.

31 This latter condition intuitively means that conditional on the average level of user 

traffic being known, users’ expectations about plausible delay times will be realized.

32 The authors offer three arguments for updating every T periods rather than in response 

to when service requests are made. First, estimating delays and prices over longer periods of 

time produces more stable results. Second, small perturbations in prices will not warrant 
19

Having developed the model of priority-pricing, the authors simulate user service 

requests to compare aggregate welfare under systems of free access to the network, flat pricing, 

and priority pricing. In addition, the authors also consider how the system operates in the cases 

where there is perfect and imperfect information with respect to the delay times for a given job. 

In all cases, simulation reveals that a dynamic priority pricing system does better than both free 

access and flat pricing. While it is unsurprising that their model performs better in cases of 

perfect information with respect to delay times, even in cases where the prices are a function of 

expected delay, the priority-pricing model generates higher social welfare than the other two 

options because the imposition of prices for different service levels effectively constrains 

congestion. From these results, the authors conclude that, contingent on the availability of 

supporting technologies, their model is a practical and desirable alternative to current flat-pricing 

practices.33

2.5 PMP Approach

A proposal that has attracted less attention than preceding options but also involves users 

sorting themselves as a function of their respective budget constraints has been put forth by 

Odlyzko (1997, 1999a, 1999b). Dubbing his model the “Paris Metro Pricing” (PMP) approach, 

Odlyzko proposes to actually partition the network into different, independent routes, and assign 

different prices for access to each route. The model’s name comes from a characterization of the 

 

frequent updates once a stochastic equilibrium is realized. And finally (and most compelling 

given that this model is meant to be practical), the computational effort associated with updating 

following each service request is likely to be prohibitively high.

33 Similar to Cocchi, et al.’s proposal, an especially attractive feature of the stochastic 

equilibrium model is that it reduces accounting issues significantly. All entities in the 

transmission chain are only presented with one bill, which represents the cost of sending a packet 

to the next node in the network. Of course, in equilibrium, subsequent transmission costs 

between links are accounted for in the bill presented to the prior link. The one critique of their 

approach is that despite criticizing the theoretical underpinnings of MacKie-Mason and Varian’s 

approach, they do not offer side-by-side simulation comparisons to determine which model 

might perform better under particular assumptions about user demands for timeliness, price, etc.
20

Paris train system where, until the 1980's, first and second class seats were completely identical 

in number and quality, with the exception of the price assigned to each (first class seats were 

priced higher). This difference in price led to a de facto difference in quality between the first 

and second class cars, given that more people would purchase second class tickets, increasing 

congestion on second class cars, while first class cars remained less occupied, and hence more 

comfortable.

Applying this intuition to the Internet, Odlyzko proposes a system where, unlike the static 

priority-pricing model proposed by Chocchi, et al., the different prices assigned to the routes will 

not reflect differences in precedence levels across routes, and not even different quality-ofservice guarantees. Odlyzko posits that similar to the Paris Metro system, these differences in 

transmission costs will lead to expected differences in quality-of-service on the part of users. 

These expected differences in service quality will be realized as users sort themselves depending 

on willingness-to-pay, leading to lower congestion levels (i.e., better service) on the higherpriced channels. The attractive properties of the PMP system Odlyzko contends, are (1) after 

being developed, it is relatively inexpensive to administer, and (2) from a technical standpoint it 

should be easy to implement given that current Internet Protocol standards could be altered in 

such a way as to designate the portions of the network onto which a given packet should travel.34

While PMP seems simple in principle to deploy, Odlyzko sees two main practical 

problems with the system with respect to efficiency. First, for applications to run well, there 

must be sufficiently low traffic on the system, which raises questions as to how to theoretically 

partition the network to ensure that portions of it are not being under/over-utilized. Closely 

related to this issue is a second problem; from a technical standpoint, current technologies (as of 

1999) make it extremely difficult to actually measure the traffic on the Internet, making 

development of efficient partitions difficult to conceive. These technical concerns aside, the 

 

34 As of 1997, when the theory was developed, IPv4 packets had a 3-bit priority field that 

was unused (Odlyzko 1997, p. 9). In theory, it would be simple to assign a network class to this 

priority field that would designate which portion of the network the packet would use for 

transmission.
21

PMP system seems attractive in the sense that while possibly unable to achieve “optimal” 

efficiency, it would likely alter the current Internet in such a manner as to ensure that “high” 

priority applications were not subjected to the current delays that they experience under a flatpricing mechanism. 

2.6 Summary and Implications

In considering the body of work being developed on the pricing of Internet access, one 

might wonder how relevant such research is to the future evolution of the Internet. In answering 

this question, one should consider the following points: between 1998 and 2003, the number of 

U.S. households that are connected to the Internet is expected to increase from 33 to almost 60 

million (Carmel, et al. 1999).35 At the same time, it is expected that there will be a proliferation 

of data intensive real-time applications such as Internet telephony and video conferencing. 

These two trends will likely lead to a substantial increase in both demands for access more 

generally, and demands for high-speed access, such as that provided by broadband technologies 

(e.g., DSL, cable modem), in particular. Combined with the increased traffic that will likely 

follow as currently underexposed populations in other continents such as Europe and Asia gain 

access, it is reasonable to assert that absent any sort of change, either through pricing policies or 

technological innovation, the quality of standard service that accompanies a flat pricing regime 

may deteriorate.

 

On the supply side, recent technological developments have emerged that might serve to 

ameliorate congestion, absent changes in pricing. Werbach (1997) discusses how the simple 

increase in backbone capacity can help to solve congestion-related problems.36 Another 

 

35 If one is focusing on the number of adults connected to the Internet at the end of the 

century, the estimates range from 72 million (Carmel, et al. 1999) to 110 million (http://www.c-ia.com/199911iu.htm). Moving into the new millennium, one estimate has placed the number of 

web users in 2001 at 175 million (Thompson 2000).

36 Questions exist over whether simple capacity expansion can effectively reduce 

congestion. Huberman (1997) has argued that capacity expansion would actually increase 

congestion because users, believing that expanded capacity should facilitate data-intensive 
22

alternative is to implement “caching” technologies, which effectively reduces Internet traffic by

aggregating and maintaining content (e.g, an electronic newspaper’s webpage) in a location that 

is easily accessible to a pool of users, rather than requiring these users to individually seek the 

content at its original source (Thompson 1999, 2000).37 Finally, Werbach (1997) and Mace 

(2000) argue that the adoption of various technological protocols by network designers can help 

facilitate differentiated levels of service, which, when combined with an appropriate pricing 

scheme, can help to alleviate congestion.

Moving beyond supply-side alternative, experiences in Berkeley, CA (Edell, et al. 1994) 

and New Zealand (Brownlee 1996) have shown that implementing various usage-sensitive 

pricing mechanisms can significantly alter consumers’ Internet usage patterns. Winston and 

Shirley (1998), in studying a seemingly analogous problem of automobile traffic congestion, 

have also argued in favor of congestion pricing mechanisms as an efficient way to manage road 

(network) resources. While the options proposed in the previous section might serve to alleviate 

congestion under certain conditions, and may even provide an “efficient” allocation of Internet 

resources, there are technological and distributive concerns that follow from these options that 

make them less than ideal. From a technological standpoint, it is questionable whether adequate 

accounting mechanisms can be devised to make some of these options useful and feasible 

alternatives to a flat-pricing regime. When one considers the global implications of network 

interconnectivity, it is easy to envision the difficulties that might arise in trying to establish and 

coordinate an international accounting system that facilitates a particular pricing policy. 

 

applications and higher levels of service, will engage in higher/more intense levels of web-usage 

than they ever would in the absence of expansion. This increase in usage, he claims, would 

likely overcome the efficiency gains that might normally be made by any capacity expansion.

37 Concerns have been raised over whether caching can cause other difficulties, in the 

sense that the content being stored on the local server can easily become out-of-date/obsolete 

between the time that it is originally downloaded and when it is finally viewed by a user. 

Proponents of caching argue that such problems will eventually be solved through technological 

innovations (Thompson 1999).
23

Furthermore, even if a given system can be technically implemented, the models 

proposed are only being compared against the conservative benchmark of a flat-pricing regime, 

and none are being tested against each other in order to see which might prove “most efficient”. 

Hence, there is little evidence from which to argue that a particular mechanism might produce 

the best outcome. Future research might attempt to fill this void by testing these proposed 

models against each other, either through simulations or in experimental settings, to determine 

which mechanisms perform best under certain circumstances.38

Considering distributional issues, arguments can also be raised against any sort of usagesensitive mechanism that discriminates according to consumers’ willingness-to-pay. While such 

mechanisms may achieve an outcome that is appealing on efficiency grounds, more normative 

policy concerns (e.g., concerns over the “digital divide”) may favor opening up the Internet to 

those who otherwise would not have access due to the costs imposed by providers.39 Finding an 

appropriate middle ground between these conflicting goals is likely to be one of the most 

challenging issues pertaining to access provision in the coming years.

Anticipating that the availability of quality Internet access might become a scarce 

resource, the question turns to where might one expect to see potential problems for competition. 

Any projections of this sort are uncertain at this stage, in the sense that any claims made might 

be proven technically trivial or generally unfounded within months of this writing. That being 

said, it would be worthwhile to note particular phenomena that might appear to raise concerns. 

As attention is turned to the development of broadband access, it is important to consider the 

 

38 In addition, given that ISPs and backbones are private enterprises, it seems reasonable 

that a congestion pricing mechanism could only be implemented if there were sufficient demand 

for it on the part of consumers. Contrary to theoretical arguments in favor of congestion pricing, 

empirical findings by Calfee and Winston (1998), demonstrating that even the wealthiest 

automobile commuters are hesitant to pay for lower travel times, beg the question as to whether 

“sufficient” demand for a congestion-sensitive pricing system will ever be realized.

39 An alternative, less distorting, option might be to give income supplements to those 

that were disadvantaged, and let them decide how/if to purchase access as a function of pricing 

and services offered.
24

possibilities of market power on the part of both the backbone providers and providers of 

broadband services. While the issue of backbone access will be discussed further in Section 4, 

the issue of broadband provision will be discussed here. The introduction of broadband 

technologies will provide service that is far superior to that of conventionally used 

“narrowband” technologies, such as standard (i.e., non-DSL) copper telephone wire. Realizing 

that they might be locked out of the broadband market, ISP’s began lobbying government 

officials in 1999, arguing for mandated access.40 ISP’s claimed that such measures were 

necessary to ensure that Internet access monopolization by broadband providers could not occur. 

Conversely, cable providers pointed to the huge capital investments that they had made in their 

networks (as much as $100 billion), and argued that they had the right to earn a substantial rate 

of return on their investments (Warren and White 1999).

This recent debate has raised new questions as to whether competition in access provision 

would be better served by letting industry hammer out the access issues themselves (Kopel 

1999), or by government intervention (Einhorn 1995, Sarkar 1997). Sarkar (1997) in particular, 

has argued for government regulation of access, claiming that the implementation of any sort of 

dynamic pricing model must be overseen by some sort of regulatory body to ensure that 

manipulation and other anticompetitive practices are not possible.

41 On the issue of broadband 

provision, MacKie-Mason (1999) has demonstrated that under a variety of assumptions about 

market structure, mandating access to broadband facilities could enhance both consumer and 

broadband-provider welfare. These issues will be discussed in greater detail in Section 4 of this 

essay. 

 

40 AOL and other ISPs, for example, formed a lobbying group named openNET, which 

pressed government regulators to compel broadband providers such as AT&T and Time-Warner 

to sell them access to their networks (Warren and White 1999).

41 Sarkar identifies the smart market proposed by MacKie-Mason and Varian, in 

particular, as a mechanism that is ripe with potential for abuse. In theory, those who control the 

system bottlenecks might be able to artificially inflate the level of network congestion in order to 

raise revenue. Furthermore, Sarkar argues that a smart market would require a high degree of 

coordination in order to function, which could not be achieved absent government intervention.
25

Section 3: Pricing of Goods and Services on the Internet

One of the topics that has received the most attention in the popular media is how the 

Internet is affecting traditional markets. Specifically, changes in search costs, ease of 

information acquisition, and reductions in the need for conventional shelf space in the “emarketplace” have led scholars and journalists to speculate how the Internet will contribute to 

such disparate effects as the proliferation of personalized products and the death of the bricksand-mortar retail outlet. Bakos (1998) claims that the three main purposes of a market are a) to 

match buyers and sellers, b) to facilitate the exchange of information, goods and services, and 

payments, and c) to provide some sort of institutional infrastructure. Having established these 

principles as “functions of the market”, he then argues that the rise of the electronic marketplace 

will fundamentally change all of these functions. Similarly, a 1998 article in Business Week

(Kuttner 1998) claimed that the Internet is a “nearly perfect market” and the costs and 

availability of information will lead to “fierce price competition, dwindling product 

differentiation, and vanishing brand loyalty.”

With these issues in mind, this section will address the current literature that deals with 

the pricing and production of goods and services that are sold over the Internet. Among the 

issues that will be addressed are: How can changes in consumer search costs affect pricing 

policies of online merchants? By what methods can information goods be packaged and sold in 

this new environment? How does information acquisition on the part of firms affect prices 

offered to consumers? In many cases, it will be seen that the answers to these questions follow 

from conventional microeconomic theory, but unlike conventional retail outlets, the Internet 

provides a scholar with a unique environment in which assumptions that were previously 

considered unrealistic (e.g., perfect information at negligible costs), are no longer so implausible. 

3.1 Effects of Search Costs on Pricing Policies

Many conventional economic models implicitly assume that search costs on the part of 

the consumer are either negligible or altogether nonexistent. In a market of undifferentiated 
26

goods, conditional on negligible search costs and the usual technical assumptions being satisfied, 

the traditional Bertrand model of price competition would predict that goods will be priced at the 

marginal cost of production, and all firms will earn zero profits. While such a result is obviously 

desirable to consumers, the failing of the traditional assumptions might lead to something other 

than the predicted Bertrand competition equilibrium price. In considering the presence of 

positive search costs, several studies have derived theoretical results predicting above-marginalcost pricing.

One of the seminal works in this field is Diamond (1971) who considers a model of price 

determination with positive search costs. Diamond’s model of a market consists of several 

identical firms and consumers who operate in discrete time. In each period a firm sets a price for 

their good and a consumer enters only one firm Upon entering, a consumer either makes a 

purchase, or decides that the good is priced too high and visits another firm in the subsequent 

period. In every period, a consumer updates his “cutoff” price, (i.e., the price such that they 

purchase a good in a given period rather than continue to search), as a function of his underlying 

demand and expectations about finding a better deal. While the specific dynamic is not 

analyzed, Diamond assumes that consumers raise their cutoff prices between each period to 

correspond with a positive search cost they accrue between periods. The main insight of this 

model is that because of positive consumer search costs, firms will set an identical price that 

maximizes joint profits, and is greater than the competitive equilibrium. Conditional on certain 

assumptions being satisfied, this price will be the monopoly price.

Using Diamond’s work as a starting point, several other studies have investigated the 

theoretical effects of search costs on pricing dynamics. Robert and Stahl (1993) consider pricing 

practices by firms who are able to effectively lower/eliminate search costs through the provision 

of informative advertising. Envisioning a market of a finite number of firms selling a 

homogenous good and consumers who are initially uninformed about prices, but can learn prices 

through either searching or advertisements, the authors investigate what kinds of advertising and 

pricing decisions firms will make, depending on consumer demands, search costs, and market 

structure. Conditional on certain assumptions holding, a unique equilibrium exists in which 
27

firms either charge a high price and do not advertise, or two prices, high and low, where they 

advertise the low price aggressively.42 The presence of advertising will produce heterogenously 

informed consumers, and the authors find that as adverting costs decrease, the equilibrium price 

converges to the marginal costs of production (i.e., the traditional Bertrand equilibrium). 

Placing their findings in the context of the Internet, one might predict that prices posted 

on the Web tend to be lower than in the physical world because advertising costs, per capita, are 

far lower. While this prediction seems sensible, Robert and Stahl provide another result that 

might conflict with this assertion: holding advertising costs constant, as search costs decrease (as 

one would suspect they do on the Internet), prices may still remain above marginal costs. Such a 

phenomenon occurs because these lower search costs reduce the incentive to advertise; and in 

doing so, place the burden of information transmission on the consumer. Hence, with (even 

slightly) positive search costs, Robert and Stahl’s model is similar to Diamond’s in that 

merchants will try to raise prices as much as possible to maximize profits. Unlike Diamond’s 

model, however, the ability of any one merchant to raise prices is constrained by the ability of 

other firms to advertise (if some firms raise their prices too much, than other firms might find it 

profitable to advertise, drawing all consumers to them). Given that it is likely that a) merchants 

on the Internet face differential advertising costs, and b) consumer search costs are non-zero, the 

implications of Robert and Stahl’s model for prices on the Internet are ambiguous. 

A more recent paper by Stahl (1996) ignores advertising concerns and focuses solely on 

price determination in a world where consumers have varying search costs associated with 

shopping.43 In Stahl’s model, a finite number of stores sell identical goods; and similar to 

Diamond, consumers must visit a particular store to learn a price. Also similar to Diamond, 

Stahl’s shoppers have a reservation price that determines whether they stop their search process 

 

42 The equilibrium concept adopted by Robert and Stahl is Perfect Bayesian.

43 The motivation for the differences in shoppers’ search costs stems from consumer 

differences in the disutility associated with shopping. In other words, those who like to shop are 

likely to have lower costs associated with search than those who hate to shop. 
28

and purchase, or continue to shop. Stahl shows that any price between marginal cost pricing to 

monopoly pricing can be supported in equilibrium, depending upon the underlying distribution 

of consumer search costs. In the event that no consumers enjoy shopping, the equilibrium 

(subgame perfect) is monopoly pricing by all firms, whereas as more shoppers’ search costs 

converge to zero44, the equilibrium price converges to marginal cost pricing. For any distribution 

in between these two extremes, however, no pure strategy equilibrium exists, and a wide range of 

pricing schemes might be observed.45

While these three papers are only a small sample of the work that has been done in this 

area, their findings are representative of some of the conclusions that have been drawn pertaining 

to the relationship between consumer search costs and firm pricing practices.46 Generally 

speaking, one should expect that as consumer search costs are driven down, firms will respond 

by lowering their prices closer to marginal costs, but many factors might constrain complete 

convergence. Hence, in the environment of the Internet, where search costs are relatively trivial 

compared to shopping in bricks-and-mortar outlets (mouse clicks versus car trips)47, one should 

 

44 More specifically, as the density of shoppers converges to a spike around zero search 

costs, marginal cost pricing is realized.

45 In considering how market structure might influence price, Stahl’s model also shows 

that under certain conditions (the density of shoppers being finite), the number of stores has no 

bearing on whether or not prices converge to marginal costs. Hence, even with a substantial 

expansion of stores, as is being observed on the Intenet, prices might not converge to the 

competitive equilibrium.

46 Other industrial organization papers that study the relationship between search costs 

and price dispersion are Axell (1977), Rob (1985), Salop (1977), Salop and Stiglitz (1982) and 

Stiglitz (1987). 

47 At the same time, the extent to which this generalization holds true might depend on a 

given consumer’s knowledge about the products being considered. For example, consider the 

book market. If a shopper knows the title and/or author of a book, search costs on the Internet 

are trivial. Conversely, if the consumer only knows the book’s subject, and/or what its cover 

looks like, searching for the title on the Internet might prove difficult. Further technological 

innovation may eventually solve problems such as this, but at the moment, it is difficult to 

conclude that Internet necessarily facilitates low search costs.
29

expect that electronic merchants should be lowering their prices accordingly. In response to this 

conjecture, a sizable body of work has recently been developed that aims at both theoretically 

and empirically investigating the relationship between reduced transactions costs and pricing in 

the electronic marketplace.

Bakos (1997), in focusing primarily on the effects of reduced search costs on electronic 

marketplaces, begins his inquiry by postulating that extreme reductions in search costs might 

lead to the destabilization of oligopolistic pricing, which in turn that can lead to price wars, that 

will eliminate excess profits in a given market. Building on Salop’s (1979) spatial competition 

model of differentiated products, Bakos considers a world in which sellers choose where to 

locate on the unit circle, and consumers learn the prices and locations of given sellers for a 

constant cost, c. Upon learning the location and product offerings for a given merchant, a 

consumer decides whether to purchase from a given seller, or to incur search costs to look for a 

seller whose products/prices are more to their tastes.48 Among the conclusions derived by Bakos 

are first, with a large number of firms and no search costs, the equilibrium is characterized by 

seller profits equal to zero. Conversely, in the presence of high search costs, significant 

allocational inefficiencies exist; and in cases of extremely high search costs, complete market 

failure can ensue. Given that extremely high search costs can lead to complete market 

breakdown, Bakos claims that “electronic marketplaces will enable ‘missing’ markets, thereby 

creating substantial social surplus.”

49

Besides showing how electronic marketplaces might yield benefits to buyers/consumers, 

Bakos also investigates the corresponding incentives of sellers to invest in the development of 

 

48 The equilibrium concept adopted by Bakos is Perfect Bayesian.

49 Bakos uses unemployment as an example in which a market (i.e., the labor market) 

has broken down due to the excessively high search costs associated with matching workers and 

employers. By lowering the search costs associated with this process, perhaps by creating a job 

clearinghouse on the Internet (e.g., Monster.com), unemployment can be significantly reduced, 

enhancing social welfare. No research has been conducted, as of yet, that examines the effects of 

the introduction of such clearinghouses on unemployment rates.
30

such marketplaces. As would be expected, sellers are apt to be opposed to the introduction of 

systems that lower buyers’ search costs because such systems, in turn, would lower sellers’ 

profits. Given that it is difficult to prevent the introduction of any sort of marketplace, however, 

Bakos suggests that sellers have three options that might aid them in their efforts to preserve 

profits. First, they might seek to take the initiative and try to influence the kind of system that is 

introduced--perhaps by requiring user fees for access to the market that would serve to 

compensate for lost profits. Second, citing the airline industry, Bakos notes that sellers might 

want to compensate for the low cost of price information by raising the costs associated with 

acquiring product information.50 Third, sellers might seek to increase the differentiation between 

their products, such that they are no longer competing with other firms over the price of identical 

products.51 Regardless of what approach firms take, Bakos argues that the development of such 

markets is inevitable, and their introduction will enhance economic efficiency of conventional 

transactions.

Addressing the issue from an empirical angle, Bailey (1998a) examines price differences 

between online merchants and bricks-and-mortar stores for items such as books, compact discs, 

and software.52 Noting predictions that emphasize the prospect for perfect competition on the 

Internet due to “frictionless” commerce following from lower transaction costs, Bailey seeks to 

establish whether Internet retailers differ from offline outlets in three specific ways with respect 

to pricing policies. First, an environment that encourages perfect competition (e.g., the Internet) 

should lead to products being sold at prices lower than their offline (presumably, less 

 

50 A reader need only consult the typical airline’s website to confirm Bakos’ assertion 

that electronic marketplaces have not necessarily facilitated the easy diffusion of information 

with respect to airline tickets. 

51 This latter possibility is very similar to results presented by Eaton and Grossman 

(1986) who show that when firms are able to first choose the level of differentiation before 

presenting product information, the unique equilibrium will involve firms choosing the 

maximum level of differentiation possible and full revelation of product information. By 

developing products that are completely different from each other, firms avoid a vicious price 

competition that would eventually end in competitive pricing and zero profits for all firms. 

52 This work is building on previous research in the author’s dissertation, Bailey (1998b).
31

competitive) counterparts. Second, Bailey argues that another symptom of heightened 

competition would be less price variance in online versus offline prices, given that online 

merchants should be driven to pricing close to an identical (presumably, perfectly competitive) 

price. Finally, one would expect that heightened competition, combined with lower menu costs 

should lead to prices being changed more often on the Internet than in bricks-and-mortar world, 

as online firms are easily able to tweak their prices in response to other firms’ adjustments.

Using data consisting of 24,000 price observations collected in February and March 1997 

from 52 different retailers, Bailey tests whether the prices of Internet and offline merchants for 

identical products differ with respect to absolute level, dispersion, and frequency of change. 

While one might suspect that the above hypotheses find support in the data, Bailey shows that 

with the exception of the third hypothesis pertaining to frequency of menu adjustment, none hold 

true across all three markets of books, compact discs, and software. Surprisingly, the data show 

that across all markets, Internet retailers price significantly higher than physical retailers, and in 

two of the three markets (books and compact discs), the Internet retailers exhibit a higher level of 

price variance.53 From these results, Bailey claims that the Internet does not currently 

approximate a world of “frictionless” commerce, and may not anytime in the near future. 

Furthermore, Bailey claims that the segmentation of the market into those who do, and do not, 

shop online will likely lead to some form of price discrimination for a variety of products that 

were, up until recently, priced uniformly. From a policy standpoint, Bailey emphasizes the need 

for strong consumer protection activities to ensure that buyers are not being exploited.54

 

53 Bailey attributes the lower price variance in software prices to the fact that when the 

data were collected (1997), search engines for software that could find the lowest price very 

easily were reasonably widespread, and more generally, that software tends to attract a 

“technically sophisticated and more demanding” consumer base.

54 From an efficiency perspective, it is questionable whether the sort of price 

discrimination that Bailey is referring to is necessarily welfare-reducing and would warrant 

government intervention.
32

While Bailey’s study is a solid first step towards uncovering whether the Internet might 

lead to the realization of perfect competition, his findings are weakened by possible flaws in his 

data collection method. In trying to collect data from offline retailers to compare with Internet 

seller prices, Bailey did not actually visit offline outlets, but rather collected most of his data 

from the bricks-and-mortar business’ websites. The problem with such data collection, as he 

admits, is that there is no way to confirm that the prices posted on the Internet are identical to the 

prices of goods in the offline outlet. In the event that prices on these websites were 

systematically lower than those in their bricks-and-mortar counterparts, false inferences can 

easily be drawn. Specifically, one might conclude that Internet prices were not lower than 

offline prices, even if bricks-and-mortar prices were, in fact, substantially higher (but were 

different than those posted on their websites). A similar argument can be made with respect to 

the findings dealing with price dispersion.

A study that addresses the hypotheses posed by Bailey, but provides a less objectionable 

approach to data collection is presented by Brynjolfsson and Smith (1999). Focusing only on the 

markets for books and compact discs, Brynjolfsson and Smith collect pricing data for twenty 

books and twenty compact disc titles from eight Internet and conventional retailers. The offline 

retailers were selected at random from across the country, and attempts were made to ensure that 

the stores selected were not subject to any sort of systematic bias. Prices from the conventional 

retailers were acquired by either visiting the bricks-and-mortar outlet, or visiting its 

corresponding webpage after confirming that the prices posted on the webpage were identical to 

the offline outlet. A total of 8,500 price observations were collected between February 1998 and 

May 1999, and the main findings of Brynjolfsson and Smith’s paper differ from Bailey’s results 

in several ways.

First, Brynjolfsson and Smith find that prices on the Internet are significantly lower 

(between 9-16% less) than prices for identical goods in conventional outlets. Even when 

accounting for shipping charges and other costs associated with purchasing either online or in 

stores (such as sales taxes), there is still a cost differential favoring Internet purchases. Second, 

depending on the measure used for price dispersion, it can be shown that the variance in prices is 
33

lower on the Internet than in conventional markets.55 Finally, and consistent with Bailey’s study, 

Brynjolfsson and Smith find that Internet stores are far more sensitive to pricing changes than 

conventional stores in that Internet sellers exhibit far less “price-stickiness”, changing their 

advertised prices by significantly smaller margins than offline outlets. From these results, the 

authors conclude that the Internet does, in fact, help to create a world of “frictionless” commerce, 

and that as more consumers find their way online, conventional retailers will find it increasingly 

difficult to compete with online counterparts offering identical products.

3.2 Packaging and Pricing of Information Goods

As noted by several scholars (Bakos and Brynjolfsson 1999a, 1999b, Odlyzko 1996, 

Shapiro and Varian 1999), the infrastructure of the Internet greatly reduces the costs associated 

with both reproducing and distributing information goods. Current technologies make it possible 

to reproduce copies of manuscripts, audio, or video recordings, that are identical in quality to the 

original document and distribute them to prospective consumers instantaneously over the 

Internet. Extremely large databases, which may have taken years to compile, can now be 

distributed to virtually anyone in seconds, ready for use upon arrival. The ease of replication, 

along with the ease of altering information goods in such a manner as to “customize” them to 

consumer tastes has raised several interesting questions about how these products can practically 

be packaged and priced for consumption. 

In considering the selling of access to information goods on the Internet, such as a 

databases or electronic newspapers, one sees that such a transaction is very similar to a classic 

durable goods monopoly problem (Bulow 1982). A seller of a given information good is able to 

make copies of his product that are identical in quality to the original, and the use of these copies 

 

55 The authors also discuss possible theoretical reasons for observed price dispersion. 

Noting that the most well-known and popular online firms tend to sell their products at some of 

the highest prices (e.g., Amazon.com), the authors claim that even on the Internet, when dealing 

with homogenous goods, reputation carries significant weight which might allow firms to charge 

above average prices.
34

(or the original) does not cause a decrease in the level of the quality of the good, opening up the 

possibility of a viable secondary market. An electronic copy of the New York Times is not 

going to depreciate in quality, regardless of how many times it is read (although it may decrease 

in value to a given consumer). In studying such transactions, the problem that faces producers is 

the classic “Coase conjecture” (Coase 1972)--unless they are able to commit to a specific (finite) 

level of production, despite their monopoly, they will be unable, in equilibrium, to price their 

good at anything above the marginal cost of production.56

While recent literature has not focused primarily on the implications of the Coase 

conjecture, several theoretical studies have emerged that analyze optimal pricing policies for 

producers of information goods given the unique environment of the Internet (e.g., the marginal 

costs of producing information goods is close to zero). Odlyzko (1996) has hypothesized that

despite declining transactions costs associated with production and sales, retailers will still be 

able to devise various mechanisms in order to extract consumer surplus. Chief among these 

mechanisms are different bundling schemes and various differential pricing strategies.

Bakos and Brynjolfsson (1999a, 1999b, 1999c) present several studies investigating how 

sellers might choose to package multiple information goods into one product bundle. The authors 

show (1999c) that under some very general conditions, bundling of multiple goods can have 

some very desirable efficiency properties. More specifically, conditional on the marginal cost of 

copying a good being zero, and certain technical assumptions about consumers’ demands 

 

56 Coase’s result follows from the fact that producers are facing a known market demand 

function, time between transactions is negligible, and consumers realize that upon selling a given 

unit of a good, the monopolist will produce an identical copy and sell it, trying to extract 

additional consumer surplus. Hence, “high” value consumers who would be willing to buy the 

good for a high price, will choose to wait until the price drops after the first transaction rather 

than buy the first unit at a high price. Because no one will purchase the good for the “high” 

price, the monopolist will have to lower the price to the value of the next-consumer, but then 

because all consumers feel this way, it will be impossible for the monopolist to sell the product 

for any price above the marginal cost of production. Consumers, placing relatively high, as well 

as low, values on the good are willing to wait until the price is driven to marginal cost (which it 

ultimately will be) rather than buy it for a price above marginal cost.
35

holding, 57 then selling a bundle will be “remarkably superior” with respect to both producer 

profits and general welfare considerations than selling the bundled goods individually. Such a 

result follows from the fact that the inclusion of more goods into a bundle effectively makes the 

collective bundle attractive to a wider audience, leading to more consumers purchasing it, 

allowing the producer to collect higher profits than if he were selling each good individually. 

The authors note that their results hinge on both a negligible cost of reproduction and the fact 

that goods that provide negative utility will not be included in the bundle; each of which seem 

easily satisfied when using the Internet as a sales channel.

From these results, the authors conclude that a multi-good monopolist will obviously tend 

to do better in terms of profits by bundling their goods rather than selling them individually; and 

in considering implications for market structure, they argue that single-good firms can benefit 

from selling their goods to a coordinating firm that will incorporate the good into their multiproduct bundle. Such findings provide a theoretical justification for why one might observe 

software providers acquiring smaller specialized software programs from potential competitors 

and incorporating them into omnibus software packages rather than letting them fend for 

themselves on the open market. 

Considering other aspects of market structure, Bakos and Brynjolffson (1999b) consider a 

model where firms compete with each other over both acquiring content for their bundle and 

selling it as a package to consumers. The authors first consider a two period game where in the 

first period, two firms submit bids for content, and in the second period, a good is acquired by 

one or both firms, depending on whether the bids were for exclusive or nonexclusive rights to the 

content. Their central result is that, in equilibrium, the firm that has the greater initial level of 

wealth will outbid the less wealthy firm for exclusive rights to the good. Hence, the wealthier 

bundler will always be willing to spend more money to acquire monopoly rights over new 

products for their bundle. In the case where goods are being bid on sequentially, the implication 

 

57 Specifically, Bakos and Brynjolfsson assume that consumer valuations for goods are 

bounded and well-behaved, and that consumers exhibit free disposal.
36

is that the larger (wealthier) bundler will keep growing and adding more goods to its bundle as 

the weaker firm fails to acquire any new content. 

Considering the downstream market for content, the authors present a two period game 

where in the first period, firms invest fixed costs into production (good acquisition), and in the 

second period, they decide whether to offer their content as a bundle or separate products. 

Results are derived that demonstrate the feasible ranges of costs wherein both firms will offer 

competing goods, and where such competition will be impossible. Conditional on certain 

assumptions being satisfied, the unique equilibrium will involve the firm with larger resources 

offering as many goods as possible in their bundle, and all consumers purchasing it over either 

the smaller bundle, or individual products. Furthermore, it can be shown that a bundler can 

always add profits to their bundle by adding goods, even if such goods are substitutes to existing 

content. 

Because the marginal costs of adding more goods to the bundle are essentially zero when 

dealing with information goods, the authors argue that a potential entrant will be deterred from 

coming into the market for a broader range of costs than what would typically follow from 

normal competition. Simply put, a potential entrant will either be easily outbid in the 

competition for content, or else they will lose in the downstream competition for consumers; 

hence, such entrants will choose to stay out the market altogether. The authors note that such 

entry deterrence is not the result of any threat or dynamic strategy on the part of the bundler, but 

simply a function of the economies of aggregation associated with the bundle.58 Given that 

bundlers will “always win” when facing either an entrant or an incumbent, Bakos and 

Brynjolffson argue that incentives for innovation are significantly reduced in markets where 

bundling is possible. If one believes that innovation is positively related to social welfare, then 

these results seem to contradict their earlier findings (1999c) about the positive welfare aspects 

of bundling.

 

58 The authors note that their results imply that a bundler could plausibly enter an 

incumbent’s market where their bundle includes the incumbent’s good and force the incumbent 

out, because all consumers will choose to purchase the bundle over the incumbent’s good.
37

Having discussed the characteristics of bundling, the question then turns to how, 

precisely, might these bundles be offered to consumers? More specifically, speculations about 

the potential of network-based applications have raised questions about the economic viability of 

pricing policies for information goods. Network-based applications will allow users to download 

from a remote server via the Internet only those programs that they require at a given point in 

time, rather than having to buy a software package that will remain dormant on their hard drive 

when it is not in use. In such a world where information goods are, in effect, being rented like 

video tapes in a store, one might wonder if the rise of network-based applications might increase 

or decrease retailers profits. In addressing the virtues of buying versus renting information 

goods, Varian (1999a) considers cases in which a producer is choosing to price his product for 

purchase, rental, or both, as a function of consumer valuations and various transaction costs. 

Conditional on the transaction costs of sharing the product being lower than the marginal costs of 

reproduction, Varian concludes that creating some sort of rental market can increase producer 

profits (and enhance social welfare by opening up the market to those who otherwise would not 

experience the good). Varian cites the institution of site licenses as an obvious market where this 

principle holds--it is likely far more costly to provide support for an additional piece of software 

than the transaction costs of sharing it between users on the same networks. The same principle 

seems to hold for the prospect of network-based applications.

Addressing similar questions to those of Varian, Fishburn, et al. (1997) present a model 

of two-firm price competition for information goods when one firm sells their product for a fixed 

fee/subscription rate, while the other firm charges a per-use price. Disregarding earlier questions 

about the effects of lowered transactions costs on pricing policies, the authors focus solely on 

how differences in pricing schemes might affect competitive equilibria. The authors first show 

that in the absence of competition, a monopolist might actually rather sell information goods 

through either fixed price or subscription channels, rather than per-use/rental agreements. The 

value of selling a product for a fixed price over a per-use fee will depend on the distribution of 

consumers’ demands and the costs of product distribution; and the authors claim that the 

“population distributions for which a flat fee is most profitable are more natural” than other 
38

possible population distributions. Such findings call into question the validity of conjectures 

about the future proliferation of per-use micropayment schemes for information good 

consumption. The authors also show that in the presence of competition between two firms, 

despite the difference in their pricing schemes, it will be difficult to avoid a price war that drives 

their prices down to marginal costs. Such a price war can only be avoided at the expense of one 

of the two firms, or in the presence of some sort of collusive arrangement.59 

3.3 Prospects for Price Discrimination

While much work on bundling has centered around recent technological applications, 

there has been a sizable body of more traditional economic research aimed at uncovering the 

relationship between product information, consumer tastes, and pricing by retailers. Some of this 

research has aimed at discussing the strategic quality of information provision by sellers as a tool 

for market segmentation and price discrimination. Lewis and Sappington (1994) for example, 

consider a model where sellers decide how much product information to provide as a function of 

consumers’ demands, and prior expectations about product characteristics and quality. The 

authors find that in equilibrium, firms will choose to a) either provide no information about their 

product and sell it for the average expected price, or b) provide extensive information and sell 

only to those “high demand” customers. The provision of product information in this game 

essentially leads to market segmentation between high and low valuation consumers, such that 

the sellers can post a high price that high demand consumers will find attractive given their 

knowledge about the products in question.

Moving beyond retailer’s incentives to provide product information, a topic that has 

garnered significant attention in the popular press is how information acquisition by firms about 

their consumer base affects their pricing policies. Philips (1983, p. 14), in his seminal work on 

price discrimination argues that for price discrimination to occur, “markets must be separated.” 

 

59 As a technical note, the authors demonstrate that competition can lead to above 

marginal-cost pricing for particular functional forms of the distributions of consumers’ demands. 

These issues are covered rigorously in Fishburn and Odlyzko (1999).
39

This sentiment is echoed by Varian (1989, p. 599) who notes that a necessary condition for price 

discrimination to occur is the ability of firms to “sort” customers. For several years, firms have 

been able to acquire detailed demographic information about potential (and actual) consumers 

from marketing research organizations, but for the first time in history, it is technologically 

possible to learn details about the particular tastes of consumers without them being aware of it, 

and independent of their purchase decisions. For example, by employing “cookies”, a firm may 

be able to monitor a surfer’s clickstream patterns through its website, and actually determine 

such factors as what products he was looking at, how long he was studying them, whether he 

compared prices with other items, etc.60 Such information can be extremely valuable in that, 

combined with demographic information, a firm might be able to impute a user’s demand 

function for their product and customize the prices for their products accordingly to maximize 

revenue. 

Bailey (1998c) discusses these issues by investigating different ways that firms attempt to 

acquire consumer information and implement some form of price discrimination. Noting the 

conventional arguments about how price discrimination can significantly increase producer 

surplus, Bailey argues that price discrimination is likely to occur in markets where products and 

services have high asset specificity. For example, it is reasonable to expect that “news clipping 

services, collaborative filtering, and other customized Internet markets” will foster the flexibility 

in prices that would make price discrimination possible. This is not to say that homogenous 

goods are free from potential cases of discrimination. As an interesting illustration, Bailey points 

to the case of Books.com, an Internet-based bookstore that until recently, engaged in a form of 

 

60 “Cookies” are small programs that are placed on a user’s hard drive when they visit a 

given site. The cookie might keep track of the user’s password for a particular site, where he 

surfs, what he purchases, etc. Upon returning to the site, the data stored in the cookie will be 

available to the website, and often the website will be customized in some way, in response to 

the cookie (e.g., password prompt will be waived). See Galla (1998, pp. 280-283) for more 

information.
40

third-degree price discrimination (i.e., providing different unit prices to different consumer 

groups).61

If a consumer were to visit Books.com’s website he could conduct a typical search for a 

title/author/subject of their choosing. Upon finding the title he was interested in, he would be 

presented with the Books.com price, and then see a hyperlink for “Price Compare”. Upon 

clicking on this hyperlink, Books.com would present the shopper with the prices for the title at 

Amazon.com, Barnes and Noble.com and Borders.com. In the event that the Books.com price 

was lower than these three, it would remain the official price; in the case where the Books.com 

was not the lowest however, the website would update their price to undercut the cheapest of the 

three, establishing the “new” Books.com price.62 It should be noted that this “new” Books.com 

price would not be shown to a consumer if they had not choosen to price compare--so, 

Books.com was price discriminating in favor of those consumers who were more patient/price 

conscious, as exhibited by their surfing patterns.63

 

61 Books.com ceased to exist on November 3, 1999 when it was acquired by 

BarnesandNoble.com.

62 For example, on October 1, 1999, this author looked up a title on social choice theory: 

“Positive Political Theory I: Collective Preferences and Political Analysis” by David AustenSmith and Jeffrey Banks. The initial Books.com price was $39.45. After clicking on the “Price 

Compare” hyperlink, Books.com showed that the prices of Amazon.com, Barnesandnoble.com 

and Borders.com to be $39.50, $39.50, and $27.50 respectively. The “new” Books.com price 

was $27.20--thirty cents less expensive than the closest competitor, and 31% off of the 

publisher’s list price ($39.50). 

63 This example is discussed further in a recent literature review on digital markets by 

Smith, Bailey and Brynjolfsson (1999). In illustrating how Books.com is effectively 

discriminating between consumers as a function of extreme price sensitivity and patience, the 

authors note that in a sample of twenty books, the average cost savings from clicking on “price 

compare” was fifteen cents. (Although they subsequently note (fn 10) “that academics seem 

prone to push this button independent of price-sensitivity considerations”). Following the 

acquisition of Books.com, Barnesandnoble.com encouraged former Books.com customers to 

shop at Barnesandnoble.com by offering a one-time redeemable ten-dollar coupon for a purchase 

larger than $25.00 at Barnesandnoble.com. Barnes and Noble did not adopt the price comparing 

features that made Books.com a competitive threat. 
41

Noting that price discrimination is a plausible practice for most firms on the Internet, 

Bailey discusses mechanisms to avoid price discrimination. First among these mechanisms is 

price competition, which should (in theory) either reduce, or eradicate altogether, attempts at 

discriminating between consumers. Another possibility is for consumers to take control of their 

information by prohibiting its collection or dissemination without appropriate compensation. 

Bailey also claims that firm reputation, generally speaking, might inhibit price discrimination. 

Finally, electronic market intermediaries, such as “shopbots” that can automatically search the 

web for low prices, might render price discrimination ineffective. 

Studying price discrimination from a different approach, and considering the issue in the 

context of lowered search costs, Kephart and Greenwald (1998) investigate the effects of the 

presence of shopbots on the electronic marketplace. As noted above, shopbots are electronic 

intermediaries that can search the web for the different products as a function of price or product 

qualities. Certain shopbots, such as the one used in the Books.com example, might only search 

for the prices of a limited number of firms, whereas the technology may be employed to learn the 

posted prices on hundreds of websites simultaneously.64 Scholars and commentators (Casey 

1999, Hagel and Singer 1999, Tapscott 1996, 1998) have argued that the widespread use of these 

programs will significantly enhance competition as retailers will be forced to constantly lower 

their prices to ensure that a particular shopbot recognizes them as the lowest price on the market 

for their relevant user. Considering a model where a portion of the consumers do not 

discriminate between sellers as a function of price, and another portion of consumers are 

“bargain hunters” who might employ shopbots to find the lowest price possible, Kephart and 

Greenwald analyze equilibrium pricing policies of firms.65

 

64 For a brief discussion of Internet agents, see Galla (1998), pp. 204-207.

65 The model developed by Kephart and Greenwald is similar in motivation to earlier 

models of consumer search such as Salop and Stiglitz (1977) and Varian (1980). In both of these 

models, certain consumers utilize search tools, such as a newspaper, to learn market prices while 

others do not. Equilibrium conditions derived in these studies are substantively similar to 

Kephart and Greenwald’s.
42

Contrary to popular speculation, the authors find that conditional on certain assumptions 

being satisfied, in equilibrium, only one firm will post their prices below the monopolistic price. 

Realizing that this result is contingent on certain informational assumptions being satisfied, the 

authors investigate its robustness by simulating an economy consisting of 1000 buyers and five 

sellers, where the sellers employ various adaptive learning mechanisms to determine their 

optimal prices.66 While the adaptive simulation results are not identical to the theoretical results 

for all learning algorithms, the results are consistent, in that stable marginal-cost pricing by all 

firms is never achieved so long as a fraction of the consumers do not employ shopbots. 

Furthermore, for certain cases, simulations lead one to believe that the presence of shopbots 

could lead to phenomena such as cyclical price wars and widespread monopoly pricing. Finally, 

the authors note a seemingly perverse implication of their findings: the presence of shopbots 

might lead to retailers engaging in a veritable “arms race” over who can lower their prices faster. 

Such prices can only be lowered in response to the speed with which firms can acquire pricing 

information about their competitors through the use of shopbots, and the widespread and 

constant use of such shopbots can only serve to congest the Internet in a way that inhibits 

electronic commerce. Hence, from at least one perspective, it seems questionable as to whether 

the presence of these emerging institutions provide obvious benefits to Internet consumers.67

 

66 More specifically, sellers determine prices by employing either a) a “game-theoretic 

strategy”, which is analogous to the theoretically derived results, b) a “myoptimal strategy”, in 

which firms adjust their prices in discrete time, conditional on static expectations about other 

firms’ behaviors, or c) a “derivative-following strategy” in which firms randomly experiment 

with prices, without knowledge of other firms’ behaviors and/or consumer demands, and adjust 

their prices in the direction which yields them greatest profits. 

67 Varian (1999b) speculates that the rise of price-matching devices such as shopbots will 

lead to firms differentiating their products on grounds other than price. Among the forms of 

differentiation that are likely are consumer-specific versions of a given product, as well as 

loyalty programs for shopping with a given merchant.
43

3.4 Future of Sales Assistance

Addressing Bakos’ (1998) claims about the functions of a market, it can be argued that 

one of its primary purposes is to facilitate “the exchange of information”. The information that 

is exchanged in transactions is of the nature discussed above: product quality and price 

information. Central to providing such information in traditional transactions are sales assistants, 

who have acquired expertise in their product areas so that they can offer useful information that 

helps potential customers with their choices. A question being posed recently is: how will the 

proliferation of the Internet affect the sales assistance sector of the economy? Given that the 

transaction costs associated with information acquisition by consumers are significantly reduced, 

will traditional assistants be able to maintain economic viability in the future?

In trying to answer this question, one might turn to recent studies investigating the 

presence and need for expertise and assistance in markets. Wernerfelt (1994) presents a model 

involving buyers and sellers who are engaging in a “matching game” over product qualities and 

prices. More specifically, the model is a sequential game where in the first period, a seller learns 

the types of products he has available for sale, in the second stage a buyer communicates his

preferences, in the third stage the seller identifies the proper match for the buyer and makes a 

take-it-or-leave it offer for the product, and finally, the buyer accepts or rejects the offer. 

Wernerfelt notes that there are numerous ways to communicate the relevant information for 

matching (e.g., printing brochures, salesperson monologue, dialogue, etc.), and each method has 

varying costs accompanying it. Conditional on certain assumptions being satisfied, Wernerfelt 

shows that dialogue between seller and buyer can lead to the most efficient outcome (with 

respect to both cost and product matching). Furthermore, with respect to active sales assistance 

more generally, Wernerfelt concludes that sales assistance is more likely to thrive as an 

institution where products are varied and possibly complicated, many buyers are uneducated 
44

(technically speaking), and the cost of a sales assistant’s time is lower than the buyers’.

68 If 

these latter conclusions hold true, then it is unlikely that one will see complete migration of all 

goods and services to Internet where they will be sold in an automated fashion. For certain 

products, even though information acquisition will be reasonably costless, a consumer might still 

require input from an expert/sales assistant to ensure that he is making appropriate purchase 

decisions.69

Investigating a slightly different question, Biglaiser (1993) studies how different markets 

for durable goods can encourage the institution of the “middleman”. By “middleman”, Biglaiser 

is referring to any intermediary who purchases a durable good from one individual and sells it to 

another buyer, without changing it in any identifiable manner or affecting its value in any de 

facto manner.70 Recognizing that in the absence of some sort of credible signal of quality for a 

given product, the market for durable goods will quickly collapse into the market for lemons 

(Akerloff 1970)71, Biglaiser shows that the presence of a qualified middleman in the market, who 

is known for his expertise, can serve to enhance aggregate welfare by providing a credible signal 

about the quality of particular goods (i.e., resolving the adverse selection problem) in certain 

 

68 Wernerfelt also argues that sales assistance is likely to thrive in industries where 

unpleasant buying experiences can significantly influence future purchase decisions, and in cases 

where institutions can be created to give strong long term incentives to sales representatives.

69 Moving beyond the need for sales assistance, concerns about the cost-effectiveness of 

Internet retailers might also prevent mass migration of all markets towards the web. While the 

popular press has argued that moving a business to the web significantly reduces inventory, and 

overall administration costs, such is not always the case. In studying the web-spinoff of 

Recreational Equipment Inc. (REI.com), journalist Leslie Kaufman (1999) notes that the 

requirement for skilled labor to maintain the website has led to consistent increases in operating 

expenses--even more so than the bricks-and-mortar outlets in some cases; leading one to suspect 

that not all web businesses may be significantly less expensive than conventional outlets. 

70 The typical example of such an individual would be a used coin salesman, who buys 

and sells coins from and to collectors, without actually altering the material value of the coin in 

any way.

71 That is, because buyers cannot differentiate between “high” and “low” quality goods, 

owners of high quality products, knowing that they will be unable to sell their good for its true 

value, will refuse to enter the market, leaving only goods of low quality (lemons) in the market.
45

markets. Specifically, he finds, in equilibrium, that if a middleman exists market segmentation 

will ensue, in that all high quality goods will pass through the middleman, whereas all low 

quality goods will be sold on the open market from owner to buyer. Furthermore, in such a 

regime the middleman will receive a high enough price for his services that he will not shirk by 

selling goods of low quality. Finally, these results will still hold even if the investment required 

by the middleman to establish his credibility as an “expert” is extremely high. As to where one 

might expect to see middlemen, Biglaiser’s conclusions are unsurprising: where there are many 

low-quality goods in the market, and there is a notable difference in quality between “high” and 

“low” quality goods, yet it is difficult to discern relative quality levels from casual inspection. 

Such conclusions seem to strengthen the argument that at least for certain types of goods, 

widespread person-to-person sales via the Internet, absent any sort of intermediation, is not very 

likely.72

Considering empirical studies dealing with this issue in the context of the Internet, Bailey 

and Bakos (1997) consider the market activities of thirteen firms that are engaging in electronic 

commerce in order to determine how the proliferation of electronic markets might affect the 

intermediate channels between producers and consumers.73 Examining a sample of both 

information goods and conventional goods retailers, the authors examine, specifically, whether 

electronic markets lead to “disintermediation”. In other words, does the reduction in transactions 

costs that accompany electronic markets effectively eliminate the need for intermediaries 

 

72 This conclusion is especially reasonable given that casual forms of inspection that are 

usually available during person-to-person sales are impossible on the Internet. How many 

people would feel comfortable buying rare coins or stamps from a personal collector having been 

unable to even look at them in person? An example of where intermediary institutions have 

emerged to solve this problem on the Internet is the market for collectible baseball cards; where 

before being posted for sale on the web, cards are inspected by independent grading agencies, 

graded appropriately, and then encased in plastic with a stamp indicating the grade and grading 

house.

73 The sample was constructed by members of an MBA class at the MIT Sloan School of 

Management entitled “Electronic Commerce and Marketing on the Internet” as one of their 

course requirements. Class members prepared detailed reports about sample companies 

consisting of surveys and, at times, interviews with management executives.
46

between producer and end-user? Looking solely at the sample considered, it appears that the 

need for certain intermediary roles such as product aggregation and certain infrastructure-related 

facilitation activities are significantly diminished in electronic market settings. While these 

functions seem to fall by the wayside however, it seems that there is still a great, if not greater, 

need for intermediaries to provide services to create consumer trust, and, in some cases, to 

facilitate matching between buyers and sellers. Because of the sampling size (and methodology), 

such analysis is obviously preliminary and should be interpreted with caution. That being said, 

these last two trends seem to support the theoretical results laid out by Biglaiser and Wernerfelt, 

arguing for the viability of intermediaries in electronic markets74. 

3.5 Summary and Implications

When considering the existing body of work that either directly or indirectly pertains to 

electronic commerce, it seems evident that the Internet will have a significant long-run effect on 

the way commercial transactions occur. That being said, the logical question that arises is: to 

what end? Once electronic markets have matured, will lowered search costs and price-matching 

policies lead to something approximating marginal-cost pricing? Does the ease of monitoring 

firms’ pricing policies necessarily facilitate vigorous competition? From a consumer standpoint, 

one might wonder if firms will be able to effectively engage in price discrimination by more 

sophisticated methods than those exhibited by Books.com as they become better educated about 

their consumer base. 

On the matter of how lowered search costs will affect consumer prices, theoretical results 

offer no conclusive implications. As shown above, information-based pricing models can justify 

pricing policies that range anywhere between marginal cost to monopoly levels. Because many 

 

74 A related topic that has recently attracted much attention in the popular press is the 

development of “infomediaries”. Generally speaking, infomediaries are electronic 

intermediaries that, equipped with specific information about a consumer’s tastes, income, etc., 

serve as computerized agents for the consumer in identifying and purchasing appropriate 

products and services. For a non-technical overview of the potential for such institutions, see 

Hagel and Singer (1999). 
47

models fail to distinguish between the various functions of information and advertising (e.g., 

price information, product information, information about firm reputation, etc.) one is unsure 

about how decreasing search costs will affect each of these elements (and their interactions), and 

their subsequent effects on prices. From an empirical perspective, the evidence is mixed as to 

whether marginal cost pricing will ever be achieved. While Brynjolfsson and Smith (1999) note 

the presence of lower prices, and less price dispersion on the Internet for certain markets, such 

findings do not seem to be a general phenomenon. First, Brynjolfsson and Smith note that their 

findings about price dispersion are not robust to various specifications, and evidence from other 

markets might add to skepticism. For example, in studying the market for airline tickets, 

Clemons, et al. (1999) have found prices offered by online ticket agents can differ by as much as 

18-28%, depending on how one controls for qualitative differences in the tickets.75 Second, in 

considering absolute price differences between the online and offline world, the evidence is also 

sketchy. Lee (1998) has shown that in the Japanese used car auction market, price levels are 

consistently higher in electronic markets than offline auction blocks.

Faced with the empirical realities of the persistence of high prices and price dispersion, 

the question again turns to, what might be generating these outcomes? A variety of explanations 

can be posited, but to observe such pricing patterns in markets for homogenous goods, it seems 

that there might be some truth in Smith, et al.’s (1999) claim that reputation is a likely cause.76 

To illustrate their point, the authors point out that several customers who regularly employ 

shopbots will persist in purchasing from retailers such as Amazon.com that post consistently 

higher prices than their shopbot findings. While Amazon.com might not have the lowest prices, 

it is well known for it’s prompt delivery practices, and general widespread acceptance as a 

legitimate business actor; and it is these qualities that might be driving transactions.

 

75 While the authors do not compare these prices with offline counterparts, Smith, et al. 

(1999) note that “the amount of dispersion they find is higher than one might expect.” 

76 Clemmons, et al. (1999) attribute the observed price dispersion to concerted efforts to 

engage in price discrimination, in conjunction with differing degrees of product differentiation, 

rather than any sort of reputation effect, per se. 
48

On the web, which is a transactions medium that is, by construction, relatively devoid of 

personal contact, it seems likely that intangible qualities such as brand recognition could define 

consumers’ demands more so than price. Hence, a firm that possesses a “high quality” brand 

name might have the luxury of consistently pricing above most of its competitors, because it 

realizes that consumers will still choose to shop with them over their lower priced competitors.77 

It seems reasonable, then, that new firms will seek to establish brand name and firm reputation 

by such means as aggressive advertising and free promotions, in efforts to expand market share 

and achieve a position where higher prices can be charged commensurate with the reputations 

gained. Closely related to the value of a brand name are the actual pecuniary benefits that a 

consumer accrues by continuing to shop with a particular retailer. As noted by Shapiro and 

Varian (1999) and Varian (1999a), various loyalty programs such as discounts for repeat 

shoppers, can serve to effectively “lock in” prospective consumers with particular retailers.78 

Once customers are locked into a loyalty program, retailers may have some (albeit possibly 

limited) latitude with which they can exercise market power.79 

 While firm reputation and loyalty programs might prevent widespread convergence in 

prices, price-matching policies can serve to stimulate the “race-to-the-bottom”. As to whether 

such policies might actually enhance consumer welfare is an open question. Disagreeing with 

conventional notions of how price-matching might harm consumers by facilitating collusion, 

Corts (1996) considers a model in which he shows that price matching policies can, in some 

cases, unambiguously enhance consumer welfare. While such findings might call into question 

 

77 The empirical implication of such a theory is that the more well-known online retailers 

will consistently price higher than less well-known retailers. At least in the market for books, 

Brynjolffson and Smith (1999) show that this trend holds true.

78 For example, while it existed, “Books.com” rewarded “bookmark points” to customers 

for every dollar spent at the website, which could be redeemed for discounts towards future 

purchases.

79 The validity of this statement necessarily rests on the requirement that the prices being 

charged by a given firm trying to exercise “market power” are still less than the costs to a 

consumer of switching and foregoing the benefits of the respective firm’s loyalty program.
49

those less optimistic findings that support the emergence of collusion (Salop 1986)80, certain 

features particular to the Internet might weaken the strength of this finding.

First, as noted by Kephart and Greenwald (1998), price matching, if conducted by 

shopbots, could lead to the unpleasant externality of Internet congestion. Therefore, if all firms 

are trying to match each other by using shopbots, the entire web might suffer at times, and hence, 

it is inappropriate to say that consumers will “benefit” from widespread adoption of price 

matching.81 Second, given that monitoring costs on the Internet are negligible, this could 

facilitate efforts to coordinate prices. If the field of Internet retailers of homogenous goods 

shrinks to relatively few in number, it seems plausible that price coordination might emerge, 

using shopbots as a monitoring device, to keep prices set just above the point that widespread 

migration to bricks-and-mortar outlets is prevented.82 

On a related issue of how prospects for price discrimination might affect consumer 

welfare, the verdict also seems mixed. On one hand, price discrimination, in certain situations, 

can be shown to enhance welfare by expanding the potential market for certain products. With 

respect to the provision of information goods in particular, it seems that the Internet can easily 

facilitate the practice of “versioning” (Shapiro and Varian 1999, Varian 1999a) products, or 

selling identical goods of varying quality (a.k.a. “damaged goods” ala Deneckere and McAfee 

1996) that can lead to a substantial expansion of the potential consumer base, enhancing 

aggregate welfare. On the other hand, Chiang and Spatt (1982) has shown that if firms 

implement price discrimination by tying lower prices to delay (e.g., longer search processes, 

 

80 Salop (1986) cites price-matching, and meeting competition clauses specifically, as a 

practice that can “facilitate oligopolistic co-ordination”.

81 Of course, the plausibility of the claim that shopbot proliferation will clog up the 

Internet is an empirical question that requires further study. Simulation exercises might help 

provide information as to whether this is a realistic possibility. 

82 One would expect that cyclical price wars would be associated with such coordination 

as firms that attempted to defect and lower prices, were quickly detected and then punished. 
50

hunting through numerous menus, etc.), then welfare effects are ambiguous; and for certain 

cases, the outcome is socially inferior to a competitive outcome.

Welfare effects aside, with additional prospects for price discrimination come prospective 

lawsuits alleging discrimination. Currently, business-to-business transactions on the Internet 

account for a substantial portion of electronic commerce. Estimates for total business-tobusiness transactions range from 40% (Goolsbee and Zittrain 1999) to 80% (Cline and Neubig 

1999b) of all commerce conducted on the web. While price discrimination from business to end 

consumers is not per se illegal, suppliers discriminating between retailers or secondary suppliers 

could be violating the Robinson-Patman Act. With the technological innovations discussed in 

the above sections, it seems likely that primary suppliers might be able to be better informed 

about their consumer base than ever before, and hence be able to extract differential rents from 

customers as a function of their willingness to pay. In the event that the customers are 

competitors in a secondary market, then the retailer could be subject to antitrust liability.

Other fields in which competitive concerns might arise include the issue of bundling of 

content and services. The studies discussed above provide theoretical efficiency justifications 

for such bundling, but such results may not compensate for anti-competitive concerns associated 

with such activities. As more firms seek to offer wider and better-integrated services to attract 

users, questions will arise as to whether the provision of such goods serves to weaken 

competition. Competition issues aside, as electronic commerce matures and more data become 

available, there are several possible directions for future research. First, and most obvious, it 

would be interesting to analyze whether the price differences (or lack thereof) between online 

and offline firms become a robust phenomenon across all markets. In the event that certain 

markets still exhibit higher online prices, one might seek to address what, specifically, about 

different markets might facilitate a price differential favoring bricks-and-mortar outlets. Along 

these lines, future research might focus on more large-ticket items such as automobiles and

consumer electronics, where repeat buying is less frequently observed (or where there is a 

lengthy period between purchases). For such items, loyalty programs, for example, should not 
51

affect consumer choice, so it would be interesting to analyze whether lower search costs do, in 

fact, lead to lower prices.

Closely related to these issues, it should be noted that prices on the Internet might not be 

accurately reflecting the welfare benefits that consumers receive from shopping online. When 

one takes into account the convenience associated with delivery and the appeal of customized 

orders, it is reasonable to argue that despite marginally higher prices, consumers are still better 

off purchasing products online. Future research might explore this perspective by developing 

welfare measures that accurately reflect consumers’ web experiences, and that do not solely rely 

on product price data.

 Another research possibility is to examine the extent to which the ability of firms to 

engage in price matching facilitates de facto collusion. By programming a shop bot to collect 

pricing data from several stores (either small or large items), one can easily compile a rich 

database with which to discern pricing patterns that might suggest price coordination and/or 

retaliation for deviations from a price agreement.

A fourth area of research is to examine the extent to which the Internet is effectively 

serving as a clearinghouse for relatively hard-to-move durable goods. Given the informationrich environment of the Internet, one might expect that certain goods should be transacted more 

often on the Web than in the real world, as more interested consumers are able to become better 

informed about the potential product offerings available on the Internet. Specifically, one might 

expect that the market for second-hand goods would flow more freely on the Internet than in the 

offline world, as consumers would no longer be effectively limited to product choices in local 

markets. Comparisons between online auction sales and sales through classified ads or secondhand specialty stores (disregarding the middleman problem for a moment), would help clarify 

whether the Internet truly helps facilitate the realization of “frictionless commerce”. 
52

Section 4: Network Effects and the Internet

Schmalensee (1995) defines a network as “a set of nodes connected, directly or 

indirectly, by a set of links”, and argues that a defining characteristic of a network “is the 

presence of ‘network externalities’”. In simple terms, a good is commonly referred to as 

possessing network externalities if the value of the good to an individual user increases as more 

individuals use it. In discussing the Internet, the concept of network externalities has been 

popularized in a statement known as “Metcalfe’s Law”, which roughly claims that the value of a 

given network is proportional to the square of the number of its users.83

The most straightforward example of a product that possesses network effects is a 

communications network such as a phone system or a fax machine: with only one user, it is 

basically worthless, but as more people come to own phones/faxes, the value of the system, and 

the consumer demand associated with it, increases significantly. Early research by Farrell and 

Saloner (1985) and Katz and Shapiro (1986) draw a distinction between direct and indirect 

network effects. In the case where the product in question is a communications network, the 

value associated with the growth of the network can be classified as direct: the more people that 

become part of the network, the more people one can communicate with, and hence, the more 

valuable the network is to a given user. An alternative possibility however, is that the positive 

network effect is indirect, as is usually the case with consumer electronics technology and 

computer systems. As more individuals purchase CD players or a given operating system, 

suppliers of technological compliments (e.g, CDs or software) recognize the increased value 

associated with the network and increase the production of these necessary components 

accordingly.84

 

83 “Metcalfe’s Law” is named after Bob Metcalfe, the inventor of the Ethernet (Shapiro 

and Varian 1999, p. 184). 

84 Shapiro and Varian (1999) present examples of success and failure stories about 

various products, such as betamax standard videotapes, and ATM’s, that possessed network 

effects, and whose markets expanded or contracted based on consumer expectations about the 
53

As noted in Varian (1999b), the value of a given communications network such as a 

phone system rests on the fact that all phones use a common communications standard such that 

any member of the network can communicate with another member. This argument would also 

apply to the Internet, as the communications protocol (TCP/IP) serves as a de facto open 

standard between completely disparate networks, allowing members from different networks to 

connect with each other without actually belonging to each others’ networks. In allowing such 

interconnection, the Internet truly serves as a “network of networks.” That being said, one should 

expect that the conventional economic principles that apply to networks should also apply to the 

Internet; whether one is considering interconnection agreements, technological innovation, or 

electronic commerce more generally.

Unlike the previous two sections, there has not been a substantial amount of recent 

literature written that specifically addresses the role of network effects in the context of the 

Internet. A sizable portion of the existing literature focuses on subjects such as network effects 

in technology adoption, strategic pricing policies by firms, and efficient network size. Recent 

scholarship has often incorporated these earlier findings to study network effects and emerging 

information technology more generally, with possible applications to the Internet. Because of 

this dearth of Internet-specific literature, this section will focus primarily on discussing the 

traditional literature on technology innovation, and then turn to more recent literature (where it 

exists) on Internet and technology-related matters.85

 

future size and scope of the network associated with the good. In contrast, Liebowitz and 

Margolis (1994) argue that the failure of many products, the betamax standard in particular, 

might have been due to poor management decisions rather than any sort of network effects.

85 The body of literature that can generically be classified as dealing with “network 

effects” is quite broad. Only a minute portion of the literature will be discussed in this essay. 

For a more extensive treatment of the subject, see Tirole (1988), particularly chapter 10, for a list 

of relevant references. Economides (1996), and Katz and Shapiro (1994) also provide detailed 

overviews on the literature pertaining to the economic issues surrounding networks and vertically 

related industries.
54

4.1 Network Effects and Technology Adoption

One of the first, and more influential studies of network effects in the context of 

technology adoption is Rohlfs (1974). Noting that for a generic “communications system”, the 

utility of a given subscriber increases as more users are added to the network, Rohlfs sets out to 

determine the equilibrium user set associated with such a network; and to analyze under what 

conditions such an equilibrium can be achieved.86 Employing a very general framework, Rohlfs 

finds that for any given price, there are multiple possible equilibria that may emerge; and the 

realization of a given equilibrium is determined, in part, by the size of the initial network. More 

specifically, the “viability” of a given equilibrium is a function of the initial network size. If the 

number of initial users is “large” enough (as defined by the theoretical results), then the system is 

said to possess “critical mass”, and is guaranteed to eventually converge to an equilibrium user 

set. Conversely, if the initial user set is below critical mass, the equilibrium will not be realized.

Having established a distinction between potential and realized equilibria, Rohlfs 

provides several possible strategies that firms (or other service providers) might employ to solve 

the “start-up problem” such that critical mass is achieved. Among the options discussed are 

giving the product away and/or providing it for a low introductory price to potential users.87 In 

addition, Rohlfs makes the interesting point that the presence of small communities or interest 

groups can help ameliorate the difficulties associated with achieving critical mass (assuming that 

the communities adopting the product en masse are large enough, in the aggregate, to achieve 

critical mass).

 

86 Rohlfs defines the equilibrium user set simply as “the set of users consistent with all 

individuals’ (users and nonusers) maximizing their utilities.” 

87 Rohlfs recognizes that inefficiencies are likely to follow the implementation of a 

single low introductory price, as low-valuation consumers are likely to drop out of the network 

as the price is raised following widespread adoption. In order to ensure that the equilibrium user 

set is realized, Rohlfs proposes price discrimination as a possible solution.
55

In considering the theoretical plausibility of the pricing strategies suggested by Rohlfs, 

Cabral et al. (1997) focus on what kind of pricing policies might be employed by a monopolist 

that is producing a good with network effects. More specifically, the authors seek to answer 

whether the Coase conjecture will always hold for durable goods. That being, whether it is true 

that the price posted to first-period consumers is necessarily higher than any price posted for 

subsequent-periods. Considering cases in which consumers are “small” and “large” with respect 

to their influence on the network, Cabral et al. finds that under certain cases, the presence of 

network externalities can facilitate penetration pricing in which prices for new products are 

lowest at their time of introduction: even in the absence of any sort of competition. This result 

confirms Rohlfs’ suspicions that such strategies may help firms develop a viable installed base. 

Consistent with this revelation, the authors note that their findings provide a theoretical 

explanation for the pricing trends that were observed with Compuserve and Prodigy: two Internet 

service providers that were priced lowest upon debut, and then consistently increased to a stable 

plateau as more members subscribed to their services.

Investigating similar issues as Rohlfs in a competitive setting, a series of papers by Katz 

and Shapiro (1985, 1986) and Farrell and Saloner (1985, 1986) study the issues of standard 

setting and technology adoption in various markets where network effects are present.88 Katz 

and Shapiro (1985) present a static model of oligopolistic competition where consumers’ utilities 

for a given product are explicitly defined as a function of its price, the consumers’ “types” and 

the number of consumers that use the product. In their model firms decide how much of their 

product to produce, as well as whether to make it technologically compatible with other 

products. The equilibrium concept employed is “Fulfilled expectations Cournot equilibrium” 

(FECE), which implies that a given firm chooses its output level conditional on the belief that a) 

consumers’ expectations about the network sizes are common knowledge, and b) competing 

firms’ outputs are fixed. Similar to Rohlfs, they find that multiple equilibria may be realized, 

conditional on consumers’ expectations about potential network size. Hence, the success of any 

 

88 See Besen and Farrell (1994) for a nontechnical discussion of various strategies that 

firms might employ in standard setting competitions.
56

given network becoming the dominant standard is very much a self-fulfilling prophecy 

depending on whether consumers believe that the standard’s dominance is plausible.

Besides focusing on existence, the authors also consider a firm’s strategic choice about 

whether to institute compatibility with other firms. As might be expected, those firms that are 

large, and have a strong consumer base, will tend to favor compatibility less than those firms 

with weaker consumer bases--regardless of social welfare considerations. The authors note that 

under certain conditions, widespread industry compatibility may be welfare-enhancing over 

incompatibility, and that institutions such as side-payments between firms and industry coalitions 

may serve as mechanisms to foster such compatibility. While such mechanisms may have 

adverse effects (e.g., competition-chilling cartels), the authors note that a policy argument can be 

made for antitrust exemptions in such cases where industry “cartels” are likely to yield welfareenhancing compatibility decisions for their products.

Similar in focus, Katz and Shapiro (1986) consider a two-period model where consumers 

are choosing between adopting one of two incompatible technologies, either of which may be 

sponsored. A technology is “sponsored” if a producer has some sort of proprietary rights over 

the technology, such as a patent, that might allow him to price the product at something other 

than competitive levels. In the absence of either technology being sponsored, the authors find 

that both technologies will be subject to marginal cost pricing, and (unsurprisingly) because of 

the existing network externalities, the competitive equilibrium will likely be inefficient from a 

social welfare standpoint. This outcome changes dramatically, however, when one or both 

technologies are sponsored. Similar to Rohlfs and Cabral, et al., the authors find that when one 

technology is sponsored, the sponsoring firm might be able to create a solid established base in 

the first period by engaging in below-cost penetration pricing that will lead to its technology 

being the dominant standard in the second period. While such standardization might prove 

optimal over the competitive outcome, the authors note that sponsorship could yield suboptimal 

outcomes, in that the “wrong” technology can be adopted from a social welfare standpoint.89 

 

89 This somewhat perverse result is possible because the sponsoring firm might price 

their technology so far below cost in the first period that all first-period consumers adopt it. 
57

Finally, the authors note that for the case where both technologies are sponsored, the rational 

expectations of consumers can lead to the normatively desirable outcome that the technology that 

would be superior in future periods is made the standard, despite a cost differential that favors an 

inferior technology in the current period.

A question that arises when considering the Internet is how feasible is it for new 

standards/technologies to emerge (e.g., the current question over different formats for digitized 

music) that can displace entrenched products. This question is addressed in a paper by Farrell 

and Saloner (1986) where they investigate whether a new technology can emerge as the 

dominant standard in the case where there currently exists an incompatible installed base. In 

trying to answer this question the authors present models in which users (either users of old 

technology, or those who are altogether new to the market) are choosing whether to adopt a new 

technology. In the case where new users are choosing what technology to adopt, the authors find 

that equilibria exist where the new technology both is, and is not, adopted as the dominant 

standard. In the simple framework of their model, their results imply that the primary factor that 

determines new technology adoption is the size of the installed base that favors the old 

technology, and the perceived benefits of the new network. Hence, while not a general property 

of products with network effects, one can find cases in which the installed base of the old 

technology can effectively be viewed as a barrier to entry.

Realizing how installed bases can dissuade entry, Farrell and Saloner note that firms, 

both incumbent and entrant, might take certain, arguably anticompetitive, steps to try to either 

bring a new technology to market, or keep a competitor off the market altogether. From the 

perspective of the incumbent producing the old technology, the authors note that various 

“predatory” pricing schemes might be an effective way to expand their installed base to prevent 

 

Conditional on the size of the first period network being sufficiently large, second period 

consumers will also adopt the sponsored technology even if it is priced higher than the 

unsponsored technology and less desirable. 
58

entry of the new technology.90 Alternatively, an entrant might attempt to stall the expansion of 

the incumbent’s installed base by preannouncing their technology prior to release. By 

conducting a product preannouncement, new users, realizing the potential benefits of such 

technology, might choose to wait for its release, rather than accept the current standard. Such a 

phenomenon can lead to cases in which new technologies are adopted where they otherwise 

might not have been, absent such an announcement.91

Disregarding the issues of market competition altogether, Farrell and Saloner (1985) 

focus solely on the question of when it is possible for network externalities to cause the 

“stranding” of industries in old standards that are inferior to new technologies. Considering a 

model of technology adoption where N firms make a discrete, sequential choice of whether or 

not to adopt a new technology, the authors find that the answer to their question hinges 

profoundly on the amount of information available to the firms at the time of their decision. For 

the complete and perfect information case, where firms are fully aware of the relative payoffs of 

all industry players from adopting a particular new technology, the authors show that in 

equilibrium, all firms in the industry will switch to a new superior technology, if such technology 

 

90 The authors point out that there are cases in which an entrant might be priced out of 

the market despite the fact that an incumbent is not engaging in predatory practices as defined by 

the conventional standards of Areeda and Turner (1975) and Ordover and Willig (1981). 

Suppose for example, that the incumbent firm is a monopolist, and upon witnessing an entrant 

trying to bring his technology to market, he cuts his price below the monopoly price, but still 

above marginal-cost pricing. Furthermore, assume that this price cut causes the incumbent’s 

installed base to expand substantially. Such expansion might prevent an entrant from ever 

penetrating the market, after which the incumbent could raise his prices again to the monopoly 

level. Such a situation is arguably anticompetitive, and cannot be accounted for by the 

conventional standards for predation because a) the incumbent is still pricing above average 

variable cost (Areeda and Turner), and b) reentry costs are irrelevant (Ordover and Willig). 

91 In addition, the authors can point to examples in which product adoption following 

from such a preannouncement might actually be a social welfare-reducing phenomenon; because 

the welfare loss to those consumers that are stranded with the old technology is far larger than 

the welfare gain that accrues to the new technology adopters.
59

is available; and hence, there will be no “excess inertia”.

92 Unsurprisingly, the authors find that 

for the incomplete information case, where firms are less certain about industry switching 

dynamics, equilibria can arise where the industry fails to adopt a new technology despite the fact 

that such adoption would be best for society (Pareto optimal). Finally, the authors note how the 

introduction of communication prior to an adoption decision can lead to a stable outcome 

wherein efficient industry adoption prevails.93 Given that many would argue that current market 

conditions are representative of an incomplete information environment, such results imply that 

there is a potential for stranding in the context of the Internet.94

4.2 Applications to the Internet

 Having discussed a small sample of the existing literature on network externalities, the 

question naturally turns to: what does this mean for the Internet? More specifically, given the 

network properties associated with the Internet, are there things particular to the Internet that 

might warrant special attention from antitrust agencies? Before answering this question, it is 

important to note that it is difficult to identify any sort of application that exhibits obvious 

network effects that is unique to the Internet. That is, many of the Internet-based applications 

that seem clear candidates for having network externalities (e.g., shared databases), have bricksand-mortar counterparts that exhibit many/all of the same properties. Having said that, the 

following discussion of implications for the Internet necessarily applies to conventional network 

industries as well.

One of the more likely venues for potential anticompetitive problems is the Internet 

 

92 By “excess inertia” the authors refer to the phenomenon where the entire industry 

would prefer to switch to a new technology, but fails to do so.

93 The equilibrium concept adopted in deriving this latter finding is Perfect Bayesian.

94 This point should not be overstated. As noted by Katz and Shapiro (1994), “there is no 

general result implying excess inertia in market equilibria.” Because of the existence of multiple 

equilibria, it is impossible to objectively determine the conditions under which a particular 

market/industry may become “stranded.”
60

infrastructure. Considering the issue of network architecture, White (1999) argues that “even if 

competition is present in most of the components of a network, monopoly in just a single 

component may be sufficient to capture all the potential rents from the transactions that use that 

component.” In the context of the Internet, a parallel can be drawn between these theoretical 

results and the current state of interconnection agreements between regional networks and 

backbone providers.

While most backbones currently do not charge for network interconnection between 

backbones, backbone to regional networks connections are usually established on a fee-perconnection basis, where the smaller network would appear to have limited bargaining power.95

 

Given that the backbone owners may arguably possess an essential facility in the conventional 

sense, there are several competitive concerns that might arise when considering the prospects for 

infrastructure development. First, as backbone owners begin to provide integrated services, such 

as acting as an ISP to end users, one might fear that competition will be lessened as backbone 

providers could raise interconnection fees so high that they effectively foreclose potential 

competitors for ISP services from the market. While such a scenario may have some 

plausibility, theoretical results from Economides and Woroch (1992), and Ordover and Willig 

(1981, 1999), imply that a more likely outcome is one in which backbone providers attempt to 

engage in some manner of price discrimination to “squeeze” as much value as possible from 

those firms that must rely on their technologies.96 Similar to the issues presented in Section 3, 

 

95 Concerns about network interconnection fees, and possible service degradation, 

surrounded the 1999 MCI-WorldCom merger, where the combined firm would have been a 

dominant backbone provider. Litigation was avoided by MCI divesting their Internet business to 

a third party, thereby preserving a “rough parity” among existing backbone providers (Melamed 

1999, Robinson 1999). There is a substantial body of work dealing with the economics and 

technical details surrounding settlements and interconnection agreements on the Internet that 

overlaps with the topics discussed in Section 2. For a treatment of such issues, see Bailey 

(1997), Herzog, et al. (1997), Lehr and Weiss (1996), and Srinagesh (1997).

96 Of course, any sort of “squeeze” may require some sort of price coordination on the 

part of the backbone providers.
61

these possibilities for price discrimination might require some sort of antitrust enforcement on 

the part of the relevant agencies.97

Besides the possibility of price discrimination at the bottlenecks, there are several other 

developments that might warrant the attention of antitrust authorities in future years. Lemley 

(1996) considers the issue of standardization and its implications for the Internet. Noting the 

inherent network externalities associated with the Internet, combined with the value of product 

interoperability and the presence of notable resource commitments on the part of investors and 

consumers, Lemley claims that standardization, at one level or another, is inevitable. 

Furthermore, he argues that this standardization will likely lead to the rise of natural monopolies 

providing one group of widely-adopted products “with market durability that may significantly 

outlast the competitive superiority of the products.” While he believes that the software industry 

is not a natural monopoly, per se, the natural tendencies towards standardization, combined with 

consumers’ expectations about market position may render competition somewhat inefficient.

Given that consumers might be harmed in a “winner-take-all” battle for standards, 

Lemley argues that it would be worthwhile to consumers and industry to ensure that competing 

standards are interoperable. Such interoperability might be achieved through existing intellectual 

property laws, government mandate, or industry-wide adoption of a universal standard.98 With 

respect to the basic communication protocol, the private sector has obviously been successful in 

navigating the standard-setting minefield. That being said, with the impending introduction of 

technologies such as network-based applications, it seems likely that questions will arise over 

which standards to implement vis-a-vis operating systems and the Internet to make such 

 

97 Unlike the matters covered in Section 3, however, any price discrimination that might 

occur vis-a-vis backbone providers and regional networks would not be subject to RobinsonPatman enforcement because Robinson-Patman only applies to markets for tangible goods, and 

is not relevant for service provision, such as backbone access.

98 Lemley notes the complications that exist with all of these options, ranging from 

government ignorance about the relevant technologies to the possibility of industry-group 

coercion on the part of a dominant firm.
62

applications function efficiently. In such a situation, Lemley would argue against 

“condemnation” of industry standard-setting coalitions that often raise red flags for regulators. 

While it is true that such organizations could potentially foster anticompetitive cartels, Lemley 

agrees with Katz and Shaprio (1985), when he notes that the benefits that could follow from 

information sharing and the industry consensus might ameliorate the usual anticompetitive 

concerns. 

Focusing on exclusivity provisions in networks, Balto (1999) argues that products and 

systems exhibiting network effects should be subject to heightened scrutiny from antitrust 

authorities because of the ease with which market power can be established relative to normal 

goods.99 In particular, Balto argues that exclusivity provisions could have the anticompetitive 

effects of foreclosing new entrants, in that they effectively raise another barrier to entry in a 

given industry.100 Such foreclosure, in turn, could potentially stifle innovation, as entrenched 

market leaders would not feel the competitive pressures to offer new products to maintain 

industry dominance. To prevent such harms, antitrust authorities need to address the issues of 

market definition and de facto market power, realizing that the presence of a relatively small 

installed base might make a given firm far more entrenched than they otherwise would be, absent 

the presence of network effects. 

 

99 In writing this article, David Balto was expressing his own views, and did not

necessarily reflect the views of either the Federal Trade Commission or any individual 

Commissioner.

100 An example of such a provision might be some sort of joint venture exclusivity 

whereby members of the joint venture agree not to compete with the network, either by 

themselves or as participants in alternate networks. Balto cites the formation of the Florist 

Telegraph Delivery Association (FTD) as an example of a network that employed such an 

exclusivity provision. Shapiro (1999) also discusses the effects that exclusivity provisions in 

network industries might have on the propensity for firms to enter a market. Similar to Balto, 

Shapiro argues that while exclusivity provisions can, in theory, be pro competitive, the presence 

of network externalities might lead to decreases in welfare that would overwhelm whatever 

procompetitive effects would normally follow.
63

In the context of the Internet, one might consider the recent debate that has arisen over 

developing uniform standards for digital music downloads. The effort is currently being 

coordinated by a recording industry consortium (Richtel 1999), and if members of this coalition 

were to agree to certain protocols and standards, but not make the applications available to all 

music producers, then such actions might likely yield anticompetitive effects that could warrant 

government attention.101 Another example of standard setting competitions is the debate that 

ensued between America Online (AOL) and Microsoft in the fall of 1999 over Instant Messenger 

networks. As reported in The Washington Post (Chandrasekaran 1999a), Microsoft attempted to 

provide its 4.5 million Microsoft Network (MSN) members with access to AOL’s Instant 

Messenger service so that MSN members could communicate with AOL’s members. According 

to the report, AOL, in trying to maintain exclusivity to its standard, began blocking MSN’s 

attempts at compatibility. After developing over two dozen versions of its Messenger software, 

each of which was successfully blocked, Microsoft gave up in November, 1999, citing concerns 

about security as the reason to end the battle. Despite the drawn out conflict between the two 

firms, both AOL and Microsoft publicly pledged to develop a compatible protocol for their two 

systems to ensure interoperability.

In addition to standard setting, government intervention might be relevant in the debate 

over universal access. As noted in the above models, a given technology, or system, can only 

become dominant in the case that there is a sufficient number of users such that “critical mass” is 

achieved. Given that virtually everyone sings the praises of the educational and economic 

benefits that come with Internet access, similar to earlier debates about telephony, a question has 

arisen over whether the government should become involved with subsidizing Internet access 

(e.g., the FCC’s universal service fund) to ensure that it achieves widespread use. Politicians, 

scholars, and various advocates find themselves on all sides of this issue. For example, the 

Progressive Policy Institute, an arm of the Democratic Leadership Council, has stated that it 

should be the goal of the government to “provide sufficient free access to the Internet” such that 

 

101 Similar developments are occurring in the market for digital books, where industry 

representatives have been attempting to develop uniform standards for digitizing text for Internet 

transmission (Macavinta 1999).
64

all individuals will have access to emerging technologies and realize the benefits of the 

developing network (Atkinson, et al. 1999, p. 40). On the other side of the issue, Shapiro and 

Varian (1997) are skeptical as to whether government should be involved in providing access, 

arguing that current rates of telephone penetration might have occurred even without government 

intervention. White (1999) argues more strongly against mandating universal access, claiming 

that such mandates are “almost always antithetical to efficient pricing and ultimately to 

competition.” 

On the separate question of whether or not it is appropriate to provide special treatment to 

firms, through either subsidization or monopoly protection, in order to help achieve critical mass, 

Shapiro and Varian (1997) argue that it may be very worthwhile for the government to sponsor 

“demonstration projects” to stimulate interest; however, “one should not underestimate the 

ingenuity of the private sector in dealing with network externalities”. In other words, the private 

sector, more often than not, should be able to overcome the coordination problems associated 

with introducing new systems of products and establishing a market presence. Their sentiments 

are similar to the theoretical findings of Economides and Himmelberg (1995) who, in studying 

the evolution of the fax machine market, inquire whether a monopoly, oligopoly, or competitive 

market will be more successful at achieving critical mass. Central to their findings is that the 

point at which a market obtains critical mass is independent of market structure. Hence, in the 

absence of any sort of external coordination by nonmarket forces, monopoly, oligopoly, or 

perfect competition can theoretically produce equally desirable outcomes with respect to 

technology diffusion.

4.3 Summary and Implications

In considering the previous sub-sections, certain points are evident. First, there is 

obviously a sizable body of active research discussing general economic phenomena that can be 

classified as “network effects.” Second, much of the research discussed may have implications 

for the development of electronic markets, and the Internet more generally. The previous subsection pointed to several examples of how the research covered could be relevant to Internet-
65

related matters, and while such examples seem thought provoking, it should again be noted that 

many of these applications (e.g., database access, communications systems, uniform standards) 

have easily visible bricks-and-mortar counterparts. Having said this, in viewing the rapid 

developments of new technology, a question that naturally arises is: to what extent do network 

effects actually exist? (Liebowitz and Margolis 1994). This leads to a related question: is there 

any empirical evidence that would lead one to treat certain markets differently from others in 

trying to analyze the relative competitive effects of different market structures? If future 

empirical work were to show that network effects are merely theoretical concepts, then 

government antitrust authorities should treat Internet-related markets like any other sort of 

product market or distribution channel in determining the presence (or lack) of viable 

competition.

This concern speaks to the broader question of what, precisely, constitutes a network 

effect? Taken at the most base definition, one can provide a rationalization for why virtually any

product/service/system can be said to possess network effects, but is such an expansive definition 

empirically accurate? For example, as noted by Liebowitz and Margolis (1994), the negative 

relationship between product price and network size is often cited as evidence of network 

effects,102 but such a relationship could be following from any of several factors besides the 

presence of network effects, including something as basic as economies of scale with respect to 

the cost of inputs. Unfortunately, solely observing such trends as price and production levels 

makes it impossible for one to distinguish between observationally equivalent phenomena, each 

of which would justify different methods of government intervention (Liebowitz and Margolis 

1994, p. 138)

There has been a sizable body of empirical work aimed at uncovering evidence of the 

presence of network effects in markets such as home computers (Goolsbee and Klenow 1999), 

 

102 For such a negative relationship to be observed, it would likely be the case that the 

“technological externalities” that follow from increased network size on the part of producers, 

are leading to cost savings that exceed the increases in value to individual consumers from 

network growth (the latter would usually produce an increase, not decrease, in price).
66

computer spreadsheet programs (Gandal 1994), and automated teller machines (Saloner and 

Shepard 1995). While these studies have been successful in showing that network effects may 

plausibly exist in certain markets, Liebowitz and Margolis’ original concern still resonates: it 

may be very difficult to determine whether a given change in the relationship between price and 

market structure is a result of network effects or some underlying economies of scale particular 

to the market in question.103

In the United States, the exercise of lawfully obtained market power is not illegal. In the 

event that a firm is exerting market power to obtain supra-competitive profits, the relevant 

question turns to how the firm in question obtained and maintains such market power. Of the 

many methods available to a given firm, most possibilities fall into one of the following 

categories: Either a firm achieved market power because of some underlying economies of scale 

(that might lead to a natural monopoly), the production of a superior product, the existence of 

legal sanction (e.g., patents or licenses), the presence of network effects (e.g., “tipping”), or some 

sort of anticompetitive practice (e.g., exclusion or predation). If such power was created through 

the last channel, then current antitrust policy can address the problem. 

Network effects, however, pose difficult problems for antitrust policy. First, as noted 

above, the difficulty associated with recognizing network effects as the source of market power 

might discourage enforcement for fear of taking inappropriate action. Second, even if a case can 

be made that market power follows from network effects, it may be difficult to identify how a 

firm’s market dominance followed from its conscious exploitation of existing network effects 

through some sort of “attempt at monopolization”.

104 Establishing this latter condition will likely 

raise a host of other, relatively messy, questions. For example, what constitutes predatory or 

exclusionary conduct, and how should entry barriers be evaluated in a market characterized by 

 

103 The analysis conducted in the above studies does not require the authors to control for 

economies of scale.

104 The Federal Trade Commission (Federal Trade Commission 1996, Ch. 9) explores 

these issues in the context of competition policy in high-tech and developing marketplaces.
67

network effects? These questions are not trivial, and they will likely confront antitrust 

authorities in the coming years as the Internet expands to touch more industries and channels of 

commerce. Future research might aim at theoretically (and empirically) distinguishing between 

market power that arises from normal competitive responses and market power that arises from 

anticompetitive exploitation of network effects. Such scholarship will be highly relevant to 

forthcoming developments of the Internet (and Internet-related industries) and can serve as a 

useful guide for government antitrust policy. 

Section 5: Internet Taxation

Whereas previous sections of this essay have focused on Internet-related research that 

addresses pricing and market structure, this section will change direction by considering a topic 

which is at the forefront of recent legislative debates: Internet taxation. A question being voiced 

currently is: should the government impose new taxes upon Internet commerce? If so, which 

level of government should have taxing authority? How should a given taxation system be 

implemented? These and other questions have been the focus of an intensifying debate that has 

started to rage between small businesses, local governments, online merchants, and a host of 

other interests. This section will present a brief review of the legal and legislative history 

surrounding the issue, and then discuss some of the academic work that has been done on this 

matter. As will be seen, the question over whether electronic commerce should be taxed seems 

neither clear-cut, nor subject to obvious resolution anytime in the near future.

5.1 Legal and Legislative History

The current debate over Internet taxation has many parallels to the previous controversy 

over taxing mail-order catalogue sales. In considering transaction formats alone, at least for the 

case of physical goods, the two channels of commerce are virtually identical. Neither the 

Internet nor catalogue sales require any sort of bricks-and-mortar outlet for commerce to 

proceed. In both cases, a consumer might, in theory, be ordering from a company that keeps its 

stock in a nondescript warehouse, for the sole purpose of processing mail/e-orders. Even more 
68

extreme is the possibility that a consumer might be ordering from a company that owns 

absolutely nothing with respect to capital or inventory, and simply supplies orders on demand 

from producers to consumers. Given that consumers may be purchasing goods across state lines, 

questions have arisen over which body possesses the authority to collect taxes from such sales.

The question over whether remote sellers have an obligation to collect sales taxes from 

out-of-state buyers was addressed in two seminal Supreme Court cases: National Bellas Hess v. 

Department of Revenue of the State of Illinois (386 U.S. 753, 1967) and Quill v. North Dakota 

(504 U.S. 298, 1992). Without getting into the details surrounding these cases, their decisions 

established the current environment in which remote sales (i.e., catalogue) take place. Currently, 

companies cannot be compelled to collect sales taxes on those transactions that occur in a state 

where they do not have a “physical nexus”; which is loosely defined as a geographical presence. 

The same standard has been conventionally adopted for electronic commerce as facilitated by the 

Internet

While companies cannot be compelled to collect taxes on Internet sales that occur outside 

of states in which they possess a nexus, in most states individual consumers are still considered 

responsible for paying taxes. Specifically, in most taxing jurisdictions, consumers are subject to 

paying “use” taxes for goods that are bought outside of the jurisdiction in question. The use tax 

rate is typically the same level as the given jurisdiction’s sales tax rate, and usually applied to the 

same sorts of goods as covered by the sales tax. While such an institution might allow local 

governments to retain the tax base that is theoretically being lost to mail-order or Internet 

transactions, it should be unsurprising that use taxes are somewhat ineffective. Most consumers 

are completely unaware that their purchases are subject to such taxes; and even if they are aware, 

the rate of compliance is very low. If local governments are to hold on to such tax revenue, 

therefore, it seems necessary that they be allowed to collect taxes on Internet sales in some 

capacity.

Beginning in 1997, state and local governments, concerned that consumer migration to 

the web would drastically reduce their available tax base, began considering and advocating 
69

Internet-tax legislation. Their cause was strengthened by the interests of small businesses who 

were beginning to feel the competitive pressure of online stores, that were able to offer lower 

prices, at least partly due to a tax-advantage. Some state legislatures pushed forward and

considered passing new legislation specifically for electronic commerce, which would allow 

them to tax remote sales.105

In response to this public interest and pressure, Rep. Christopher Cox (R-CA) and Sen. 

Ron Wyden (D-OR) introduced the Internet Tax Freedom Act (ITFA) in 1998. Passed as part of 

the Omnibus Appropriations Act of 1998, the ITFA placed a three-year moratorium on new 

Internet taxes and created the “Advisory Commission on Electronic Commerce” to study issues 

related to the taxation of the Internet. The Commission was to consist of nineteen members 

appointed by Congress representing business, the Federal Government, and State and local 

governments, whose term would expire in April 2000, at which point they were expected to 

present their recommendations to Congress about the appropriate course of action for future 

Internet tax policy.106

The Commission held its first meeting in June, 1999, in Williamsburg, VA, and among 

the attendees was Federal Trade Commissioner Orson Swindle, who, in his speech, pointed to 

the many complicated issues that the Advisory Commission would need to address.107 As 

 

105 Most state legislatures were not considering legislation that would make it legal to tax 

electronic commerce per se, but rather legislation that would require online merchants to collect 

existing use taxes owed by those customers who lived in a state in which the firm did not have a 

physical presence.

106 This entire situation seems like a case of history repeating itself. In 1961, Congress 

created a special commission to study the issues surrounding sales taxes and mail-order sales. 

The report, commonly known as the Willis Commission Report, was delivered to Congress in 

1965, and made several recommendations including the creation of a multi-state cooperative 

system that would help ease the compliance burdens of small businesses. Caldwell (1998) 

provides some history of the Willis Commission and discusses its relevance to the current 

debate. 

107 Commissioner Swindle was speaking for himself and did not necessarily reflect the 

views of either the Federal Trade Commission or any other individual Commissioner.
70

Commissioner Swindle noted, “with approximately 30, 000 taxing jurisdictions, compliance 

becomes a significant obstacle. The Internet is inherently susceptible to multiple and 

discriminatory taxation in a way that commerce conducted in more traditional ways is not” 

(Swindle 1999). These, and other concerns led the Commissioner to believe that coming up with 

a clear method of defining the Internet tax structure would be “very tricky.” 

In the months following the first meeting, the Advisory Commission considered various 

options ranging from no tax, to a flat tax for all electronic commerce. At the same time that the

Advisory Commission was considering the possible options, Representatives and Senators, as 

well as representatives from local governments, began pushing different legislative proposals for 

dealing with the taxation issue. Wyden and Cox, original co-sponsors of the ITFA introduced 

legislation that would ask the WTO to enact a permanent global moratorium on taxation of 

Internet commerce. Similarly, Sen. John McCain (R-AZ) introduced a bill that would 

permanently extend the ITFA moratorium after its expiration in 2001. On the other side, arguing 

that local governments stood to lose $11 billion a year, organizations such as the U.S. 

Conference of Mayors organized panels for lobbying Congress to secure taxation power.108 

Representing this school of thought, Sen. Ernest Hollings (D-SC) introduced a bill that would 

impose a uniform five percent tax on all remote sales, including Internet and conventional mailorder transactions. In early December, 1999, the Clinton Administration openly criticized a plan 

proposed by Governor James R. Gilmore III (R-VA) Chairman of the Commission on Electronic 

Commerce that would have made all online purchases exempt from sales taxes; arguing that such 

a policy would both disadvantage offline firms and deprive local governments of potential 

revenues (Chandrasekaran 1999b). Heading into January 2000, it was unclear in which direction 

the debate would go, and several economic arguments and justifications (discussed below) were 

being voiced to support the relevant camps.109

 

108 Cottman (1999)

109 For a succinct history of the legal and legislative issues surrounding Internet taxation, 

see Lukas (1999).
71

5.2 Current Research on Internet Taxation

The current debate has placed the onus on scholars to provide justifications for why 

electronic commerce should, or should not, be taxed. A small portion of work has emerged that 

addresses the equity issues associated with taxing electronic commerce. Much of this 

scholarship has been theoretical, employing general arguments from traditional public finance 

economics to support the respective positions. McClure (1999) provides a detailed description of 

the current debate, comparing it to the history of mail-order catalogues, and argues that 

electronic commerce should be taxed. Discarding the conventional “infant industry” arguments 

that might support a moratorium on Internet taxation until the electronic commerce channels are 

more “mature”, McClure argues that such policies inevitably lead to favored industries “never 

growing up”. Furthermore, McClure claims that there are substantial horizontal and vertical 

equity issues at stake, noting that not taxing the Internet is, in effect, providing an indirect 

transfer of wealth to the rich (who, by and large, engage in electronic commerce more so than the 

poor). 

These sentiments are echoed in earlier work by McLure (1998b), in which he argues that 

a regime in which the Internet is not subject to taxation will lead to “gross inequities and 

distortions of economic decisions” and that “local merchants would face unfair competition from 

out-of-state vendors who pay no sales tax”. The question over whether taxation of electronic 

commerce is necessary to facilitate a level playing field between the Internet and bricks-andmortar outlets has been addressed in several sources, including Lukas (1999) and McLure 

(1998a). In much of this literature, the conclusions have been mixed. Those who favor taxation 

argue that exemptions for electronic commerce, combined with the current taxation system, will 

lead to significant distortions that greatly disadvantage conventional retailers. On the other hand, 

others have argued that the tax differential will merely inspire conventional retailers to migrate to 

the Internet, and that if state governments are genuinely concerned about equity, they should 

consider “harmonizing tax rates downward for local retailers” (Lukas 1999, p. 16) rather than 

creating new taxes for the Internet to eliminate the tax differences.
72

Moving beyond the theoretical issues associated with taxing the Internet, scholars have 

begun to empirically examine the possible effects of instituting Internet taxes with respect to 

sales, and compliance costs. Goolsbee (forthcoming) attempts to determine the price elasticity of 

demand associated with Internet sales, in order to predict the likely effects on sales and 

consumption choices that would follow from instituting a tax on electronic commerce. Drawing 

upon data from a private survey conducted by Forrester Research in late 1997, Goolsbee 

analyzes the purchasing decisions of 25,000 users as a function of their demographic traits, as 

well as residential characteristics, including local sales taxation rate. The two questions 

Goolsbee seeks to answer are a) how does the local sales tax rate affect the choice to purchase 

something online, and b) how does the local sales tax rate affect the average amount of money 

spent online by the typical consumer. 

In answering the first question, Goolsbee analyzes what drives a shopper to commit to 

purchasing something online.110 Controlling for a variety of conventional demographic 

characteristics such as income, education, and age, Goolsbee finds that the probability of buying 

something online grows as the local sales tax rate increases. Furthermore, this finding is robust 

to a variety of specifications, controlling for such features as consumer technological saviness, 

and general computer access. To determine how offline sales taxes affect the levels of 

consumers’ online expenditures, Goolsbee analyzes individual spending patterns as a function of 

the local sales tax rate, as well as the usual demographic variables and others aimed at 

controlling for technological sophistication.111 In performing such analysis, Goolsbee finds that 

the coefficient on local tax rate is positive and significant, implying that the higher the local sales 

tax rate, the greater amount of dollars the average consumer spends online. In summarizing his 

 

110 Goolsbee conducts probit analysis where the dependent variable is “1" if a surfer 

purchased something online and “0" otherwise. Independent variables are items such as 

demographics, rate of computer usage, and local sales tax rate.

111 Goolsbee conducts tobit analysis where he regresses the total dollar expenditures of 

those surfers who bought something online onto their respective demographics, local sales tax 

rates, level of computer literacy, etc.
73

findings, Goolsbee argues that applying existing tax rates to the Internet will reduce the number 

of buyers online from 20-25% and reduce total online sales by 25-30%.

Considering his findings, Goolsbee argues against instituting a tax for electronic 

commerce in the short run for three main reasons. First, drawing on analysis pertaining to the 

elasticity of demand for conventional mail order sales, he notes that mail order and Internet sales 

seem equally responsive to taxation.

112 Hence, if taxes are raised on the Internet, it seems likely 

that consumers might migrate to conventional mail order sales and hence, no sizable revenues 

will be raised. Second, he notes the complications associated with enforcement; both in 

identifying what is actually taxable, and actual collection methods. Finally, he argues that there 

might be positive externalities associated with low/nonexistent tax rates, in that by not taxing 

electronic commerce now, more consumers will begin to experiment and gain confidence with 

the medium, which will yield a larger potential tax base should the government choose to 

institute some taxation scheme in the future.113

In light of Goolsbee’s findings, questions naturally arise over the robustness of the results 

given the growth of the web. Quite simply, Internet commerce has exploded since the point in 

time when the data were collected in 1997, and it is conceivable that Goolsbee’s study suffers 

from a very particular selection bias in that a majority of the consumers in the sample were both 

more technologically sophisticated and more tax sensitive than the typical offline consumer. In 

trying to address this question, Goolsbee (1999) revisits the 1997 database, in conjunction with a 

survey from the following year, also conducted by Forrester Research, and investigates whether 

these earlier results are robust in the event that the sample becomes more representative of the 

average consumer. Replicating the analysis from Goolsbee (forthcoming) on the entire sample 

 

112 Goolsbee analyzes the propensity of consumers to buy personal computers online, 

through direct mail, or in stores as a function of local tax rates.

113 Along these lines, the use of low taxation to facilitate Internet proliferation is 

somewhat analogous to Rohlfs (1974) and Cabral, et al.’s (1997) results pertaining to penetration 

pricing in the presence of network externalities. The veracity of this claim is obviously an 

empirical matter that should be studied further.
74

of users, Goolsbee finds that the coefficient on local tax rates is still significant and positive, but 

when one partitions the sample into two groups, experienced and new users, one sees that the tax 

sensitivities are not very large (or even significant) for new users.

114

 

Noting this difference in tax sensitivity between “generations”, Goolsbee seeks to 

determine whether the difference follows from user heterogeneity or education about the tax 

code. More specifically, one might wonder whether new users simply are not as sensitive to tax 

rates as old users, or if they simply are not aware of the relevant differences in tax policies 

between the Internet and bricks-and-mortar outlets, such that it appears that they are less 

sensitive than experienced surfers. The policy implication from such a distinction, as noted by 

Goolsbee, is obvious: if these new users flooding the web are relatively insensitive to sales taxes, 

then arguments against taxation because of high consumer elasticities are moot. If on, the other 

hand, these new users are simply ignorant about the tax system, and upon learning the system 

they become tax-sensitive, then the results from Goolsbee (forthcoming) might still be relevant, 

and hence, implementing taxes on electronic commerce will likely have large chilling effects on 

electronic commerce. By controlling for demographic similarities across generations, Goolsbee 

presents results that support the latter argument: consumers, as they become more experienced 

with the Internet, become more aware of the tax code, and hence more sensitive to local sales 

taxes in their purchase decisions. Hence, it appears that there is a pervasive, (and sizable), tax 

sensitivity on the part of consumers, that would negatively affect online commerce, were sales 

taxes to be instituted. 

Putting aside the question over whether taxes on electronic commerce would impede its 

growth, another question fueling the debate is how much revenue is currently at stake for states 

to lose? As noted above, the thrust of state governments’ arguments is that they stand to lose 

billions of dollars in tax revenue if appropriate taxation schemes are not implemented to address 

the Internet. One figure that has been recently cited by the National Governors’ Association 

 

114 Experienced users are defined as those who have been connected to the Internet for at 

least two years, while new users are those consumers that have been connected for less than two 

years.
75

(NGA) puts the potential revenue loss following from Internet and mail order sales at $20 billion 

a year by 2002 (Associated Press 1998). If such figures are accurate, then it is hardly surprising 

that local governments are pressing the case for taxation so aggressively--with such large 

quantities of funds at stake, local infrastructure might be impaired if appropriate legislation is not 

implemented. The important phrase in the above sentence, however, is “if”. Crucial to the 

argument of the states and local municipalities is that the Internet, is indeed, likely to take such a 

sizable portion of their revenues out of their grasp.

In trying to assert the validity of local governments’ claim, Goolsbee and Zittrain (1999) 

conduct an exercise in revenue deconstruction to determine where states’ revenues are currently 

coming from, and how the Internet is likely to affect them. Contrary to popular beliefs, the 

authors conclude that the Internet will not wreak financial havoc on local finances in the 

foreseeable future, and hence, argue that tax-imposing legislation is neither a necessary nor 

appropriate manner with which to deal with the concerns voiced by the government agencies. To 

give a brief summary of their findings, the authors begin by arguing that the figure cited by the 

NGA is inappropriate for three main reasons. First, it includes business-to-business commerce, 

which is currently exempt from sales tax, regardless of the method of transaction. Second, the 

estimate ignores the possibility of trade creation following from the Internet that might be 

generating much of the commerce observed. In other words, some of these potential revenues 

would not even exist in the first place if it was not for the Internet, and hence, it is inappropriate 

to view them as “lost” revenues. Finally, even if the NGA is focusing on valid taxable items, 

their treatment of such items artificially inflates the potential loss.115

After stripping away those categories of goods that are either already being taxed, or not 

subject to sales taxes, Goolsbee and Zittrain claim that only $2.5 billion of sales are subject to 

taxes which are not being collected--which totals to a tax revenue loss somewhere between $210-

 

115 For example, the NGA counts the online sale of home computers as revenue losers 

even though most online computer sellers collect/pay sales taxes in some capacity.
76

430 million in 1998.116 Contingent on a high rate of growth in electronic commerce, the authors 

note that projected tax losses in 2002 will come to somewhere around $2.5 billion, and $3.5 

billion in 2003, which is less than two percent of potential sales tax revenue--a far smaller figure 

than that being cited by the NGA. Contending that conventional arguments about the need for 

taxes to “level the playing field” or ameliorate distributional concerns are unfounded, the authors 

push for a moratorium on Internet taxes so that usage might proliferate across all demographic 

groups and the maximum benefits of the network might be realized.

Closely related to Goolsbee and Zittrain’s study, Cline and Neubig (1999b) perform a 

similar revenue decomposition exercise on sales data from 1998 to determine how much 

governments plausibly stand to lose to the Internet, absent new taxation legislation. After 

discarding those categories of goods that cannot be considered as revenue losers, Cline and 

Neubig determine that the total amount of untaxed sales in 1998 was somewhere near $2.6 

billion--a figure very close to that determined by Goolsbee and Zittrain. From this estimate, the 

authors argue that the actual revenue loss to the Internet came to only $170 million in 1998. 

Given that current tax losses only amount to about 0.1% of total revenues, the authors claim that 

the notion of a tax “crisis” is inappropriate and that state and federal governments have plenty of 

time with which to develop an efficient and useful taxation scheme (if any) that can be applied to 

electronic commerce. 

Besides the effects on consumers and the relevant revenue streams at stake, another 

concern that has been voiced is the possible compliance costs associated with instituting different 

tax policies. Sales taxes of various forms are currently imposed by 46 states and almost 7,500 

local governments in the United States. These taxes are not typically uniform across all goods, 

but rather applied to certain distinct commodities, depending upon the jurisdiction in question. 

Absent some sort of technological intervention, requiring online merchants to determine what is 

 

116 The authors note that this $2.5 billion figure can only be accepted if one makes the 

assumption that somehow taxes would be collected on all auction transactions as if they were 

sales made through classified ads. The estimated size of the total tax loss is subject to variations 

in predicted growth in electronic commerce by the end of 1998.
77

taxable and the appropriate rate for a given destination as well as ensuring collection, might 

place significant burdens on retailers. (This is implicitly the rationale behind the court decisions 

in the landmark mail-order cases). While it is difficult to offer a comprehensive picture of the 

relative compliance costs involved, a recent study by the Washington State Department of 

Revenue (1998) offers a vision of what kind of burden imposing current local taxes on all online 

sales might impose.

In fulfilling the statutory requirements of the 1998 Washington State supplemental 

budget law, the Washington State Department of Revenue distributed a survey to 3,400 retailers 

in Washington and Oregon to determine the costs incurred by retailers in complying with 

collecting and remitting state and local sales taxes. From a response rate of 51% for Washington 

retailers and 36% for Oregon retailers, the Department of Revenue’s study states that the total 

cost to retailers for collecting and remitting sales taxes are 4.23% of total state and local taxes 

collected. Furthermore, it is observed that the burdens associated with tax collection and 

processing are not uniform across all businesses. When considering variations in retailer size, 

the study finds that costs range from 0.97% for large retailers to 6.47% to small retailers. Hence, 

in order to collect and remit sales taxes in their own state, small retailers are spending about 

$6.50 of every $100 collected on determining the relevant tax rates and exemptions for the goods 

being sold. It seems reasonable that these costs would be higher if merchants were required to 

collect taxes from states in which they do not have a presence and intimate knowledge of the tax 

code.117 

5.3 Summary and Implications

In summary, on the question of Internet taxation, most scholars and public officials have 

embraced one of two lines of thought. Those in favor of mandating new sales taxes for the Web 

point to the lost revenues to state and local governments that will likely occur without such taxes. 

 

117 Cline and Neubig (1999a) provide a succinct discussion of the findings of the 

Washington State Department of Revenue study as well as a brief picture of the complexities that 

surround the sales tax code in various municipalities across the country.
78

Furthermore, there are arguments to be made about the desire to maintain an economically 

neutral sales tax system, which might dictate the adoption of Internet taxes. Those opposed to

Internet taxes claim that first, the relevant levels of revenue at stake are not particularly large, 

and that implementing taxes on the Web will only serve to chill online purchases, and electronic 

commerce more generally. Those opposed to taxes also point to the potentially large compliance 

costs for retailers that will follow from collecting and remitting such taxes. While this latter 

point may be solved though technological, or other means, no obvious solution is currently 

available. 

While the current body of work dealing with Internet taxation is not amazingly broad, it 

is impressive in that it makes effective use of what limited data are available. With the rate at 

which the Internet is growing, it is quite difficult to acquire useful data and perform analysis 

such that the conclusions will still have substantive bite by the time the article in question has 

weaved its way through the referee process. That being said, the work discussed above is 

admirable in that it successfully provides, at the very least, a first-order approximation of the 

relative effects associated with mandating taxes on Internet sales.

As electronic commerce continues to grow, there are several issues that will need to be 

investigated thoroughly in order to determine appropriate tax policy. Chief among these issues 

are those that have been discussed above: the magnitude of the revenues forgone by local 

governments absent Internet taxes, as well as the likely effects on purchases that will follow from 

introducing such taxes. Conventional public finance scholarship such as Mikesell (1970), and 

Walsh and Jones (1988), have shown that differential sales tax rates can lead to the migration of 

commercial transactions towards jurisdictions that most favor consumers. While the studies 

discussed above would seem to support this conclusion, further data analysis will serve to 

confirm whether the magnitudes associated with these findings are robust, or merely the 

symptoms of preliminary shocks to the system that are being exhibited by an “infant” industry.

Another issue that will need to be addressed is the actual harm to bricks-and-mortar 

businesses from competing with outlets whose goods are not subject to sales tax. As noted 
79

above, theory would argue that taxing identical goods at different rates would likely lead to 

consumers shifting their purchases towards the lower-taxing outlets. While such a shift can (de 

facto) be pro-competitive if the less-expensive outlets are able to provide lower prices due to 

economies of scale, if the price differential is solely a function of the lack of sales tax, then such 

consumption shifts are inefficient.118 As noted by Goolsbee and Zittrain (1999), one would 

ideally like to have access to panel data which details consumers’ retail buying habits in both 

bricks-and-mortar outlets and online over time to see if consumers are shifting their purchases as 

hypothesized. Unfortunately, as noted by the authors, no such data currently exist. Future 

research might aim at filling this obvious gap in the literature by conducting such a study, which 

will help determine whether the theoretical inefficiencies that follow from differential tax rates 

are being empirically realized on the Internet.119

A final issue, the matter of compliance costs, will likely be dealt with through either 

legislation or technology so that they are not excessively cumbersome. Besides the possibility of 

some sort of uniform tax on all Internet sales, there are currently several software companies that 

are devising programs that allow retailers to instantly calculate the relevant sales taxes for 

purchases made in remote locations. While the costs of these packages may be currently too 

high for widespread use among small retailers, (Lukas (1999) quotes a price of $20,000) it seems 

reasonable that the costs associated with such technology will become more manageable in 

 

118 In addressing the subject of tax evasion, Trandel (1992) argues that differential tax 

rates, while possibly welfare-reducing with respect to aggregate state revenues and consumer 

purchase decisions, might also enhance welfare, in that the tax evasion that follows might serve 

to drive product prices towards marginal costs. Hence, the overall efficiency effects of 

differential tax rates and potential evasion seem ambiguous. 

119 A closely related subject to this debate is the question about what strategies brickand-mortar firms might employ to retain customers and reduce the ability of online firms to freeride on them with respect to product display, showroom expertise, etc. Given that it is simple for 

customers to wander around a real-world store examining products, and then purchase them on 

the Web for a lower price (and to avoid taxes), one might wonder whether such a trend will lead 

to an inefficient reduction in offline stores; and what measures brick-and-mortar stores can take 

to avoid such migration to the Web. There is room for significant theoretical and empirical 

research in this area. 
80

response to the increased demand that would come with mandated taxes.120 Hence, one way or 

another, it seems that compliance costs are destined to fall to levels that might facilitate the 

implementation of taxation schemes to be implemented. Therefore, in predicting how electronic 

commerce is taxed (if at all), it seems the debate will turn on one of the first three issues: 

consumers’ price elasticities of demand with respect to Internet sales, the potential effects of 

“forgone revenues” on local communities, and the threats to “main-street businesses” and bricksand-mortar outlets posed by e-commerce. All three of these matters are very politically charged, 

and will likely lead to very interesting developments on Capitol Hill within the next few years.121

Section 6: Conclusion 

No one can deny that the Internet has had a noticeable effect on society in general, and 

popular perceptions of the economy in particular. While originally developed as a tool for 

academia and government, the Internet has expanded in scope to become accessible to (and 

incorporated into the daily lives of) representatives from virtually all demographic groups. 

Faced with the possibilities of quick wealth in electronic commerce, entrepreneurs have begun 

experimenting with wildly diverse business models, ranging from conventional sales transactions 

to unorthodox practices such as providing free content and products in the hopes of securing a 

sizable market share. While many might remain skeptical about the viability of certain business 

 

120 In the area of software provision, innovative and unconventional methods are 

currently being devised to deal with the burden of tax determination. One option derives from a 

recent invention by two accountants from New Jersey (Chartrand 1999); it would transfer taxes 

directly from consumer to governments, using the credit card companies as an intermediary. 

Taking the collection and remittance responsibilities out of retailers’ hands, would, in theory, 

greatly ease the complications associated with applying sales taxes to online commerce. As of 

early 2000, several companies had announced their intention to release sales-tax accounting 

software packages that could calculate sales taxes across 60,000 potential tax jurisdictions (Jones 

2000).

121 Some of these issues have been raised more immediately at the state level. In 

February 2000, two bills were introduced into the Virginia legislature aimed at abolishing 

Virginia’s 4.5% sales tax. Those in favor of the legislation felt that it was an appropriate way to 

level the playing field between traditional merchants and online firms; and argued that the lost 

revenues from sales tax would be more than recouped from the boom in the state’s income tax 

revenue (Timberg 2000).
81

practices, or uncertain about the likely evolution of the Internet, most can agree that substantial 

change is likely in the future.

This essay has examined economic perspectives on various issues pertaining to Internet 

development. Sections 1 and 2 discussed some of the technological aspects of the Internet and 

presented several theoretical models that have been conceived to address different ways to price 

Internet access. Section 3 focused on theoretical and empirical studies that relate to electronic 

commerce, on matters such as the possible effects of changes in consumer search costs on firms’ 

pricing policies, as well as methods that might be employed by firms to separate consumers and 

engage in price discrimination. Section 4 addressed the role that network externalities might 

have on Internet development and the strategies employed by firms engaging in electronic 

commerce, drawing on the theoretical results from traditional economic literature, as well as 

more recent work. Finally, Section 5 focused on the arguments for and against taxation of 

Internet commerce, addressing the relevant academic (and political) perspectives.

While this work is a solid first step towards investigating the economics surrounding this 

new transactions medium, there is still much work to be done. There are several important 

subjects that have not been addressed in this essay, such as the effects of the Internet with respect 

to intellectual property, and the economics of personal privacy and information sharing. In 

addition, there is significant room for large-sample empirical research to be conducted that might 

investigate whether the theoretical implications of the models discussed (with respect to market 

structure, pricing policies, network architecture, etc.), hold true in the context of the Internet.

To review some of the suggestions considered, on the question of access provision, 

scholars might seek to examine, through simulations or experimental settings, which of the 

proposed models of access pricing seem to perform better, from an efficiency standpoint, under 

different circumstances. On matters pertaining to electronic commerce, there are several 

interesting questions that will become possible to answer as the electronic marketplace matures 

and more data become available. Inquiries about the magnitude and significance of differences 

between online and offline prices, the potential for online collusion, and the effectiveness of the 
82

Internet and electronic markets as a clearinghouse for second-hand goods pose topics that can 

serve to increase our understanding about the potential for the Internet to facilitate a world of 

“frictionless commerce.” Scholars investigating network externalities might seek to refine 

earlier studies such that they can offer guidance for distinguishing between market power that 

arises from normal competitive responses and market power that arises from anticompetitive 

exploitation of network externalities. Finally, in studying Internet taxation, scholars might seek 

to investigate whether current findings pertaining to consumers’ online purchasing patterns as 

well as likely revenue streams for local governments are representative of a long-run stable 

outcome, or more reflective of a shock to the system associated with an “infant industry”. 

Regardless of what direction is taken, this essay will hopefully serve as a useful roadmap 

of relevant research pertaining to some economic aspects of the Internet and a solid starting point 

from which to begin future inquiry. As the Internet becomes relevant to more sectors of our 

economy, we should expect to witness numerous changes that can significantly enhance 

consumer welfare. Further scholarship can only serve to enhance our understanding of this new 

and exciting transactions medium, as well as (hopefully) establishing some well-accepted 

principles that might help to guide government antitrust authorities in the regulatory process, and 

to assist their efforts in maintaining viable competition.
83

References

Adar, Eytan, and Bernardo A. Huberman. 1999. “The Economics of Surfing.” Typescript, Xerox 

Palo Alto Research Center.

Akerloff, G. 1970. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” 

Quarterly Journal of Economics. 84: 488-500. 

Anania, Loretta, and Richard Jay Solomon. 1997. “Flat–The Minimalist Price.” In L. McKnight 

and J. Bailey (Eds.), Internet Economics. Cambridge, MA: MIT Press.

Areeda, Philip, and Donald F. Turner. 1975. “Predatory Pricing and Related Practices Under 

Section 2 of the Sherman Act.” Harvard Law Review. 88 (February): 697-733.

Associated Press. 1998. “Governors Fear Tax Loss From Internet; States’ Surpluses Treated 

Cautiously.” Boston Globe. December 31.

Atkinson, Robert D., and Ranolph H. Court. 1998. The New Economy Index: Understanding 

America’s Economic Transformation. Washington, DC: Progressive Policy Institute.

Atkinson, Robert D., Ranolph H. Court, and Joseph M. Ward. 1999. The State New Economy 

Index. Washington DC: Progressive Policy Institute.

Ausubel, Lawrence M., and Peter Cramton. 1998. “Demand Reduction and Inefficiency in MultiUnit Auctions.” Typescript, University of Maryland.

Axell, B. 1977. “Search Market Equilibrium.” Scandinavian Journal of Economics. 79: 20-40.

Bailey, Joseph P. 1997. “The Economics of Internet Interconnection Agreements.” In L. W. 

McKnight and J. P. Bailey (Eds.), Internet Economics. Cambridge, MA: MIT Press.

Bailey, Joseph P. 1998a. “Electronic Commerce: Prices and Consumer Issues for Three 

Products: Books, Compact Discs, and Software.” Organization for Economic Co-operation and 

Development. OCDE/GD(98)4.

Bailey, Joseph P. 1998b. Intermediation and Electronic Markets: Aggregation and Pricing in 

Internet Commerce. Ph.D. Thesis, Technology, Management and Policy, Massachusetts Institute 

of Technology, Cambridge, MA.

Bailey, Joseph P. 1998c. “Internet Price Discrimination: Self-Regulation, Public Policy, and 

Global Economic Commerce.” Paper submitted to the 26th Annual Telecommunications Policy 

Research Conference Student Paper Competition, May 1.
84

Bailey, Joseph P., and Yannis Bakos. 1997. “An Exploratory Study of the Emerging Role of 

Electronic Intermediaries.” International Journal of Electronic Commerce. 1 (3): 7-20.

Bakos, J. Yannis, 1997. “Reducing Buyer Search Costs: Implications for Electronic 

Marketplaces.” Management Science. 43(12): 1676-1692.

Bakos, J. Yannis, 1998. “The Emerging Role of Electronic Marketplaces on the Internet.” 

Communications of the A.C.M. August.

Bakos, Yannis, and Erik Brynjolfsson. 1999a. “Aggregation and Disaggregation of Information 

Goods: Implications for Bundling, Site Licensing, and Micropayment.” In D. Hurley, B. Kahin 

and H. Varian (Eds.), Internet Publishing and Beyond: The Economics of Digital Information 

and Intellectual Property. Cambridge, MA: MIT Press.

Bakos, Yannis, and Erik Brynjolfsson. 1999b. “Bundling and Competition on the Internet.” 

Typescript, MIT Sloan School of Management.

Bakos, Yannis, and Erik Brynjolfsson. 1999c. “Bundling Information Goods: Pricing, Profits and 

Efficiency.” Management Science (forthcoming).

Balto, David. 1999. “Network Exclusivity: Antitrust Analysis to Promote Network 

Competition,” George Mason Law Review, 7 (3): 523-76.

Barua, Anitesh, Jon Pinnell, Jay Shutter, and Andrew B. Whinston. 1999. “Measuring the 

Internet Economy: An Exploratory Study.” Typescript, Graduate School of Business, The 

University of Texas at Austin.

Besen, Stanley M., and Joseph Farrell. 1994. “Choosing How to Compete: Strategies and Tactics 

in Standardization.” Journal of Economic Perspectives. 8 (2): 117-31.

Biglaiser, Gary. 1993. “Middlemen as Experts.” RAND Journal of Economics. 24 (2): 212-223.

Braden, R. D. Clark, and S. Shenker. 1994. “Integrated Services in the Internet Architecture: an 

Overview.” Request for Comments 1663, Information Sciences Institute, University of Southern 

California, July.

Brownlee, Nevil.1996. “Internet Pricing in Practice.” In L. McKnight and J. Bailey (Eds.), 

Internet Economics. Cambridge, MA: MIT Press.

Brynjolfsson, Erik, and Michael D. Smith. 1999. “Frictionless Commerce? A Comparison of 

Internet and Conventional Retailers.” Typescript, MIT Sloan School of Management. 

Bulow, Jeremy. 1982. “Durable-Goods Monopolists.” Journal of Political Economy. 90 (2): 314-

32.
85

Cabral, Luis M. B., David J. Salant, and Glen A. Woroch. 1997. “Monopoly Pricing with 

Network Externalities.” Typescript, University of California-Berkeley.

Caldwell, Kaye. 1998. “Deja Vu All Over Again.” Research Note #98-12, Palo Alto, CA: 

CommerceNet.

Calfee, John, and Clifford Winston. 1998. “The Value of Automobile Traffic Time: Implications 

for Congestion Policy.” Journal of Public Economics. 69: 83-102.

Carmel, Erran, J. Eisenach, and T. Lenard. 1999. Digital Economy Fact Book. Washington, D.C.: 

Progress and Freedom Foundation.

Casey, Michael. 1999. “Power of the Internet Ensures Supply and Demand Will Never Be the 

Same.” Wall Street Journal. October 18, p. A-43C.

Chandrasekaran, Rajiv. 1999a. “Microsoft Ends Message War.” The Washington Post. 

November 19.

Chandrasekaran, Rajiv. 1999b. “E-Commerce Tax Plan Assailed.” The Washington Post. 

December 11.

Chartrand, Sabra. 1999. “Collecting Sales Tax From the Internet.” The Washington Post. 

October 4.

Chiang, Raymond, and Chester S. Spatt. 1982. “Imperfect Price Discrimination and Welfare.” 

Review of Economic Studies. 49: 153-181.

Choi, Soon-Young, Dale Stahl, and Andrew Whinston. 1997. The Economics of Electronic 

Commerce. Indianapolis, IN: Macmillan Technical Publishing.

Clark, David D. 1997. “Internet Cost Allocation and Pricing.” In L. McKnight and J. Baily 

(Eds.), Internet Economics. Cambridge, MA: MIT Press.

Clark, D., S. Shenker, and L. Zhang. 1992. “Supporting Real-Time Applications in an Integrated 

Services Packet Network: Architecture and Mechanism.” Proceedings of SIGCOMM 92. 14-16.

Clemons, Eric K., Il-Horn Hann, and Lorin M. Hitt. 1999. “The Nature of Competition in 

Electronic Markets: An Empirical Investigation of Online Travel Agent Offerings.” Typescript, 

The Wharton School, University of Pennsylvania.

Cline, Robert J., and Thomas S. Neubig. 1999a. “Masters of Complexity and Bearers of Great 

Burden: The Sales Tax System and Compliance Costs for Multistate Retailers.” Technical 

Report, Ernst and Young Economics Consulting and Quantitative Analysis.
86

Cline, Robert J., and Thomas S. Neubig. 1999b. “The Sky is Not Falling: Why State and Local 

Revenues Were Not Significantly Impacted by the Internet in 1998." Technical Report, Ernst and 

Young Economics Consulting and Quantitative Analysis. 

Coase, Ronald H. 1972. “Durability and Monopoly.” Journal of Law and Economics. 15 (April): 

143-49.

Cocchi, Ron, Scott Shenker, Deborah Estrin, and Lixia Zhang. 1993. “Pricing in Computer 

Neworks: Motivation, Formulation and Example.” IEE/ACM Transactions on Networking. 1 (6): 

614-627.

Corts, Kenneth S. 1996. “On the Competitive Effects of Price-Matching Policies.” International 

Journal of Industrial Organization. 15: 283-299.

Cottman, Michael H. 1999. “Williams to Head Internet Panel.” Washington Post. September 26.

Deneckere, Raymond J., and R. Preston McAfee. 1996. “Damaged Goods.” Journal of 

Economics and Management Strategy. 5 (2): 149-174.

Diamond, Peter A. 1971. “A Model of Price Adjustment.” Journal of Economic Theory. 3: 156-

168.

Eaton, Johnathan, and Gene M. Grossman. 1986. “The Provision of Information as Marketing 

Strategy.” Oxford Economic Papers. 38: 166-183.

Economides, Nicholas. 1996. “The Economics of Networks.” International Journal of Industrial 

Organization. 14 (2): 673-99.

Economides, Nicholas, and Charles Himmelberg. 1995. “Critical Mass and Network Evolution 

in Telecommunications.” In G. Brock (Ed.), Toward a Competitive Telecommunications 

Industry: Selected Papers from the 1994 Telecommunications Policy Research Conference. 

Mahwah, New Jersey: Lawrence Erlbaum Associates.

Economides, N., and G. A. Woroch. 1992. “Benefits and Pitfalls of Network Interconnection.” 

Discussion Paper no. EC-92-31, Stern School of Business, New York University.

Edell, R., N. McKeown, and P. Varaiya. 1994. “Billing Users and Pricing for the TCP.” 

Typescript, Department of Electrical Engineering and Computer Sciences, University of 

California, Berkeley. 

Einhorn, Michael A. 1995. “Pricing and Competition Policies for the Internet.” In B. Kahin and 

J.H. Keller, (Eds.), Public Access to the Internet. Cambridge, MA: MIT Press. 

Esbin, Barbara. 1998. “Internet Over Cable: Defining the Future in Terms of the Past.” Federal 

Communications Commission, Office of Plans and Policy. Working Paper # 30.
87

Farrell, Joseph, and Garth Saloner. 1985. “Standardization, Compatibility, and Innovation.” 

Rand Journal of Economics. 16 (1): 70-83.

Farrell, Joseph, and Garth Saloner. 1986. “Installed Base and Compatibility: Innovation, Product 

Preannouncements, and Predation.” American Economic Review. 76 (5): 940-55.

Federal Trade Commission Staff Report. 1996. Anticipating the 21st Century: Competition Policy 

in the New High-Tech, Global Marketplace, Volume I, May.

Fishburn, Peter C., and Andrew Odlyzko. 1999. “Competitive Pricing of Information Goods: 

Subscription Pricing Versus Pay-per-Use.” Economic Theory. 13: 447-470.

Fishburn, Peter C., A. Odlyzko, and R. Siders. 1997. “Fixed Fee versus Unit Pricing for 

Information Goods: Competition, Equilibria, and Price Wars.” In D. Hurley, B. Kahin, and H. 

Varian, (Eds.), Internet Publishing and Beyond: The Economics of Digital Information and 

Intellectual Property. Cambridge, MA: MIT Press.

France, Mike. 1999. “What’s in a Name.com? Plenty.” Business Week. September 6: 86-90.

Galla, Preston. 1998. How the Internet Works. Indianapolis, IN: Que.

Gandal, Neil. 1994. “Hedonic Price Indexes for Spreadsheets and an Empirical Test for Network 

Externalities.” RAND Journal of Economics. 25: 160-170.

Gigante, Alexander. 1997. “‘Domain-ia’: The Growing Tension between the Domain Name 

System and Trademark Law.” In B. Kahin and J.H. Keller, (Eds.), Coordinating the Internet. 

Cambridge, MA: MIT Press.

Gillet, Sharon E. and Mitchell Kapor. 1997. “Self-Governing the Internet: Coordination by 

Design.” In B. Kahin and J.H. Keller, (Eds.), Coordinating the Internet. Cambridge, MA: MIT 

Press.

Goolsbee, Austan. forthcoming. “In a World Without Borders: The Impact of Taxes on Internet 

Commerce.” Quarterly Journal of Economics.

Goolsbee, Austan. 1999. “Internet Commerce, Tax Sensitivity, and the Generation Gap.” In J. 

Poterba (Ed.), Tax Policy and the Economy. Volume 14, Cambridge, MA: MIT Press.

Goolsbee, Austan, and Peter Klenow. 1999. "Evidence on Learning and Network Externalities in 

the Diffusion of Home Computers." National Bureau of Economic Research Working Paper 

#7329.

Goolsbee, Austan, and Johnathan Zittrain. 1999. “Evaluating the Costs and Benefits of Taxing 

Internet Commerce.” National Tax Journal. 52 (3): 413-28.
88

Greenstein, Shane. 1999. “Framing Empirical Research on the Evolving Structure of 

Commercial Internet Markets.” Paper presented at “Understanding the Digital Economy: Data, 

Tools and Research,” Washington DC, May 25-26.

Gupta, Alok, Dale O. Stahl, and Andrew B. Whinston. 1995. “A Priority Pricing Approach to 

Manage Multi-Service Class Networks in Real-Time.” Paper presented at the MIT workshop on 

Internet economics, March 1995.

Gupta, Alok, Dale O. Stahl, and Andrew B. Whinston. 1996. “An Economic Approach to 

Network Computing with Priority Classes.” Journal of Organizational Computing and 

Electronic Commerce. 6(1): 71-95.

Gupta, Alok, Dale O. Stahl, and Andrew B. Whinston. 1997a. “Economic Issues in Electronic 

Commerce.” In A. Gupta, D.O. Stahl and A Whinston (Eds), Readings in Electronic Commerce. 

Reading, Mass: Addison-Wesley Longman, Inc.

Gupta, Alok, Dale O. Stahl, and Andrew B. Whinston. 1997b. “Priority Pricing of Integrated 

Services Networks.” In L. McKnight and J. Bailey (Eds.), Internet Economics. Cambridge, MA: 

MIT Press. 

Gupta, Alok, Dale O. Stahl, and Andrew B. Whinston. 1997c. “Pricing of Services on the 

Internet.” In W.W. Cooper, and F. Phillips (Eds.), IMPACT: How ICC Research Affects Public 

Policy and Business Markets, a Volume in Honor of G. Kezmentsky. Wesport, CT: Quorum 

Books. 

Hagel, John, and Marc Singer. 1999. Net Worth. Boston, MA: Harvard Business School Press.

Herzog, Shai, Scott Shenker, and Deborah Estrin. 1997. “Sharing Multicast Costs.” In L.W. 

McKnight and J. P. Bailey (Eds.), Internet Economics. Cambridge, MA: MIT Press.

Huberman, Bernardo. 1997. “Storm Brewing on the Internet Horizon.” Interview in PC Week. 

October 10.

International Competition Policy Advisory Committee. 2000. Final Report to the Attorney 

General and Assistant Attorney General for Antitrust.

Jones, Jennifer. 2000. “Internet Tax Software Systems Being Readied.” Info World. January 10.

Kaplan, Karen, and J. Shriver, Jr. 1999. “U.S. May Soon End Its Reign of Domain Names.” The 

Los Angeles Times. September 29.

Katz, Michael L., and Carl Shapiro. 1985. “Network Externalities, Competition, and 

Compatibility.” American Economic Review. 75 (3): 424-40.
89

Katz, Michael L., and Carl Shapiro. 1986. “Technology Adoption in the Presence of Network 

Externalities.” Journal of Political Economy. 94 (4): 822-841.

Katz, Michael L., and Carl Shapiro. 1994. “Systems Competition and Network Effects.” Journal 

of Economic Perspectives. 8 (2): 93-115.

Kaufman, Leslie. 1999. “Selling Backpacks on the Web is Much Harder Than it Looks.” New 

York Times. May 24.

Kephart, Jeffrey O., and Amy Greenwald. 1998. “Shopbot Economics.” Typescript, IBM 

Institute for Advanced Commerce.

Kopel, David B. 1999. “Access to the Internet: Regulation or Markets?” Heartland Policy Study. 

No 92: September 24.

Krol, E., and Klopfenstein, B. C. 1996. The Whole Internet, Academic Edition: User’s Guide and 

Catalog. Sebastopol, CA: O’Reilly and Associates.

Kuttner, Robert. 1998. “The Net: A Market Too Perfect for Profits.” Business Week, May 11: 20.

Lee, H. G. 1998. “Do Electronic Marketplaces Lower the Price of Goods?” Communications of 

the ACM. 41 (1): 73-80.

Lehr, William, and Martin B. H. Weiss. 1996. “The Political Economy of Congestion Charges 

and Settlements in Packet Networks.” In G. W. Brock, and G. L. Roston, (Eds.), The Internet 

and Telecommunication Policy: Selected Papers from the 1995 Telecommunications Policy 

Research Conference. Mahwah, New Jersey: Lawrence Erlbaum Associates.

Lemley, Mark A. 1996. “Antitrust and the Internet Standardization Problem.” Connecticut Law 

Review. 28: 1041-1094.

Lewis, Tracy R., and David E. M. Sappington. 1994. “Supplying Information to Facilitate Price 

Discrimination.” International Economic Review. 35(2): 309-327.

Liebowitz, S. J., and Stephen E. Margolis. 1994. “Network Externality: An Uncommon 

Tragedy.” Journal of Economic Perspectives. 8 (2): 133-50.

Lukas, Aaron. 1999. “Tax Bytes: A Primer on the Taxation of Electronic Commerce.” Cato 

Institute. Trade Policy Analysis No. 9.

Macavinta, Courtney. 1999. “Simon and Shuster to Test Appeal of Online Books.” New York 

Times. December 6.

Mace, Scott. 2000. “Enter Ipv6: New Protocol, Not a Root Canal or Forklift Upgrade.” 

Boardwatch. February.
90

MacKie-Mason, Jeffrey K. 1999. “Investment in Cable Broadband Infrastructure: Open Access 

is not an Obstacle.” Typescript, University of Michigan, Ann Arbor.

MacKie-Mason, J. K., and Varian, H. R. 1993. “Some Economics of the Internet.” Technical 

Report, University of Michigan.

MacKie-Mason, J. K., and Varian, H. R. 1995. “Pricing the Internet.” In B. Kahin and J.H. 

Keller, (Eds.), Public Access to the Internet. Cambridge, MA: MIT Press.

MacKie-Mason, J. K., and Varian, H. R. 1997. “Economic FAQs about the Internet.” In L. W. 

McKnight and J. P. Bailey, (Eds.), Internet Economics. Cambridge, MA: MIT Press.

McKnight, Lee W., and Joseph P. Bailey (Editors). 1997. Internet Economics. Cambridge, MA: 

MIT Press.

McLure, Charles E., Jr. 1998a. “Achieving a Level Playing Field for Electronic Commerce: 

Policy Considerations.” State Tax Notes. June 1.

McLure, Charles E., Jr. 1998b. “Electronic Commerce and the Tax Assignment Problem: 

Preserving State Sovereignty in a Digital World.” Paper presented to the Institute of 

Professionals in Taxation/National Tax Association Joint Sales Tax Seminar, “Transactions 

Taxation: Telecommunications and Electronic Commerce,” La Jolla, California, February 2-3.

McLure, Charles E., Jr. 1999. “Electronic Commerce and the State Retail Sales Tax: A 

Challenge to American Federalism.” International Tax and Public Finance. 6 (2): 193-224.

Melamed, A. Douglas. 1999. “Network Industries and Antitrust.” Address Before the Federalist 

Society. The Eighteenth Annual Symposium on Law and Public Policy: Competition Free 

Markets and the Law. Chicago, IL. April 10.

Mikesell, John L. 1970. “Central Cities and Sales Tax Rate Differentials: The Border City 

Problem.” National Tax Journal. 23(2): 206-213.

Odlyzko, Andrew. 1996. “The Bumpy Road of Electronic Commerce.” In H. Maurer (Ed.), 

WebNet 96 - World Conf. Web Soc. Proc., AACE: 378-389.

Odlyzko, Andrew. 1997. “A Modest Proposal for Preventing Internet Congestion.” Typescript, 

AT&T Labs–Research.

Odlyzko, Andrew. 1999a. “Paris Metro Pricing: The Minimalist Differentiated Services 

Solution.” Proc. 1999 Seventh International Workshop on Quality of Service (IWQoS '99), IEEE: 

159-161.
91

Odlyzko, Andrew. 1999b. “Paris Metro Pricing for the Internet.” Proc. ACM Conference on 

Electronic Commerce (EC-99), ACM.

Oppendahl, Carl. 1997. “Trademark Disputes in the Assignment of Domain Names.” In B. Kahin 

and J.H. Keller, (Eds.), Coordinating the Internet. Cambridge, MA: MIT Press.

Ordover, Janusz A., and Robert D. Willig. 1981. “An Economic Definition of Predation: Pricing 

and Product Innovation.” Yale Law Journal. 91(1) (November): 8-53.

Ordover, Janusz A., and Robert D. Willig. 1999. “Access and Bundling in High-Technology 

Markets.” In J. Eisenach and T. Lenard (Eds.), Competition, Innovation and the Microsoft 

Monopoly: Antitrust in the Digital Marketplace. Norwell, MA: Kluwer Academic Publishers.

Oxman, Jason. 1999. “The FCC and the Unregulation of the Internet.” Federal Communications 

Commission, Office of Plans and Policy. Working Paper # 31.

Philips, Louis. 1983. The Economics of Price Discrimination. Cambridge, England: Cambridge 

University Press. 

Pollack, Andrew. 1999. “What’s in a Cyber Name? $7.5 Million for the Right Address.” New 

York Times. December 1.

Richtel, Matt. 1999. “Music Industry Fails to Meet Target for Start of Online Sales.” The 

Washington Post. November 22.

Rob, R. 1985. “Equilibrium Price Distributions.” Review of Economic Studies. 52: 487-504.

Robert, Jacques, and Dale O. Stahl. 1993. “Informative Price Advertising in a Sequential Search 

Model.” Econometrica. 61 (3): 657-686.

Robinson, Constance K. 1999. “Network Effects in Telecommunications Mergers: MCI 

WorldCom Merger: Protecting the Future of the Internet.” Address before the Practicing Law 

Institute, San Francisco, CA. August 23.

Rohlfs, Jeffrey. 1974. “A Theory of Interdependent Demand for a Communications Service.” 

Bell Journal of Economics. 5 (1): 16-37.

Saloner, Garth, and Andrea Shepard. 1995. “Adoption of Technologies with Network Effects: 

An Empirical Examination of the Adoption of Automated Teller Machines.” RAND Journal of 

Economics. 26: 479-501.

Salop, S. 1977. “The Noisy Monopolist: Imperfect Information, Price Dispersion, and Price 

Discrimination.” Review of Economic Studies. 44: 393-406.
92

Salop, S. 1979. “Monopolistic Competition with Outside Goods.” Bell Journal of Economics. 10: 

141-156.

Salop, S. 1986. “Practices that (Credibly) Facilitate Oligopoly Co-ordination.” In J. Stiglitz and 

G. F. Mathewson, (Eds.), New Developments in the Analysis of Market Structure. Cambridge, 

MA: MIT Press.

Salop, S., and J. Stiglitz. 1977. “Bargains and Ripoffs: A Model of Monopolistically Competitive 

Price Dispersion.” Review of Economic Studies. 44 (October): 493-510.

Salop, S., and J. Stiglitz. 1982. “A Theory of Sales: A Simple Model of Equilibrium Price 

Dispersion with Identical Agents.” American Economic Review. 71: 1121-1130.

Sarkar, Mitrabarun. 1997. “Internet Pricing: A Regulatory Imperative.” In L. McKnight and J. 

Bailey (Eds.), Internet Economics. Cambridge, MA: MIT Press.

Schmalensee, Richard. 1995. “On Antitrust Issues Related to Networks.” Testimony before the 

Federal Trade Commission, Hearings on Global Competition/High-Tech Innovation, December 

1.

Shapiro, Carl. 1999. “Exclusivity in Network Industries.” George Mason Law Review, 7 (3): 

673-83.

Shapiro, Carl, and Hal. R. Varian. 1997. “U.S. Government Information Policy,” Paper presented 

at the Highlands Forum, Department of Defense, Washington D.C. June 8.

Shapiro, Carl, and Hal R. Varian. 1999. Information Rules : A Strategic Guide to the Network 

Economy. Boston: Harvard Business School Press.

Shaw, Robert. 1997. “Internet Domain Names: Whose Domain is This?” In B. Kahin and J.H. 

Keller, (Eds.), Coordinating the Internet. Cambridge, MA: MIT Press.

Shenker, Scott. 1995. “Service Models and Pricing Policies” In B. Kahin and J.H. Keller, (Eds.), 

Public Access to the Internet. Cambridge, MA: MIT Press.

Shenker, S., D. Clark and L. Zhang. 1993. “A Scheduling Service Model and a Scheduling 

Architecture for an Integrated Services Packet Network.” Typescript, Xeorox PARC technical 

report.

Smith, Michael D., Joseph Bailey, and Erik Brynjolfsson. 1999. “Understanding Digital Markets: 

Review and Assessment.” In E. Brynjolfsson and B. Kahin, (Eds.), Understanding the Digital 

Economy. Cambridge, MA: MIT Press.

Srinagesh, Padmanabhan. 1997. “Internet Cost Structures and Interconnection Agreements.” In 

L. W. McKnight and J. P. Bailey (Eds.), Internet Economics. Cambridge, MA: MIT Press.
93

Stahl, Dale O. 1996. “Oligopolistic Pricing with Heterogeneous Consumer Search.” 

International Journal of Industrial Organization. 14: 243-268.

Stiglitz, J. 1987. “Competition and the Number of Firms in a Market: Are Duopolies More 

Competitive than Atomistic Markets?” Journal of Political Economy. 95: 1041-1061.

Swindle, Orson. 1999. Address to the Advisory Commission on Electronic Commerce. 

Williamsburg, VA. June 22. 

Tapscott, Donald. 1996. The Digital Economy: Promise and Peril in the Age of Networked 

Intelligence. New York, NY: McGraw-Hill.

Tapscott, Donald. 1998. Growing up Digital: The Rise of the Net Generation. New York, NY: 

McGraw-Hill.

Thompson, Jim. 1999. “Web Caching— Savior or Fad?” Boardwatch. December.

Thompson, Jim. 2000. “Caching Technology--Something For Everyone.” Boardwatch. February. 

Timberg, Craig. 2000. “Va. Assembly to Tackle the Future of Sales Tax.” The Washington Post. 

February 5.

Tirole, Jean. 1988. The Theory of Industrial Organization. Cambridge, MA: MIT Press.

Trandel, Gregory A. 1992. “Evading the Use Tax on Cross-Border Sales: Pricing and Welfare 

Effects.” Journal of Public Economics. 49: 313-31.

Varian, Hal R. 1980. “A Model of Sales.” American Economic Review. 70 (4): 651-9.

Varian, Hal R. 1989. “Price Discrimination.” In R. Schmalensee and R. D. Willig (Eds.), 

Handbook of Industrial Organization, Volume I. New York (New York): Elsevier Science 

Publishers B. V.

Varian, Hal R. 1999a. “Buying, Sharing and Renting Information Goods.” Typescript, University 

of California at Berkeley.

Varian, Hal R. 1999b. “Market Structure in the Network Age.” Typescript, University of 

California at Berkeley.

Vickrey, W. 1961. “Counterspeculation, Auctions, and Competitive Sealed Tenders.” Journal of 

Finance. 16: 8-37. 

Vita, Michael, and Frederick Horne. 1998. “Comment of the Staffs of the Bureaus of Economics 

and Competition of the Federal Trade Commission in the Matter of Improvement of Technical 
94

Management of Internet Names and Addresses.” Submitted to the National Telecommunications 

and Information Administration, U.S. Department of commerce, May 23.

Walsh, Michael J., and Jonathan D. Jones. 1998. “More Evidence on the ‘Border Tax’ Effect: 

The Case of West Virginia, 1979-1984." National Tax Journal. 41 (2): 261-65.

Warren, Michael, and Michael White. 1999. “Web War Pits AT&T vs. AOL.” Washington 

Times. July 28.

Washington State Department of Revenue. 1998. Retailers’ Cost of Collecting and Remitting 

Sales Tax.

Werbach, Kevin. 1997. “Digital Tornado: The Internet and Telecommunications Policy.” Federal 

Communications Commission, Office of Plans and Policy. Working Paper # 29.

Wernerfelt, Birger. 1994. “On the Function of Sales Assistance.” Marketing Science. 13 (1): 68-

82.

White, Lawrence J. 1999. U.S. Public Policy toward Network Industries. Washington, DC: AEIBrookings Joint Center for Regulatory Studies.

Winston, Clifford, and Chad Shirley. 1998. Alternate Route: Toward Efficient Urban 

Transportation. Washington, DC: Brookings Institution Press.