Price, quality, and service on the Internet: Sense and nonsense

Richard J. Cebula (*) Faster frictionless, cheaper, better: these are said to be the hallmarks of economic activity on the Internet. Search theory suggests use of the Net could reduce the prices consumers pay, but product branding, price discrimination based on data mining, and auctions may raise prices. The Net has lowered most prices, but raised others, even when shop bots are used. Price dispersion is greater on the Net, and Net sellers change their prices more often. The role of intermediaries has not been reduced. The quality of service is idiosyncratic and highly variable. The Net is a new and distinctive avenue of commerce, but those who argue it has invalidated conventional economic principles are well off base. (JEL D40, L10) I. INTRODUCTION Faster, frictionless, cheaper, better: these are said to be the hallmarks of economic activity on the Internet. An estimated $525 billion will be spent on e-commerce in 2001, with consumers accounting for about 10% of that amount (Lake, 2001). What do economic theory and empirical evidence tell us about the prices paid on the "Net," the quality of the goods purchased, and the nature of service received? To answer these questions, we focus initially on search theory and its implications for the Internet-based commerce. Next, we examine the complications generated by product differentiation and branding, data mining on the Net, the distinctive nature of digitized information markets, and Net auctions. This leads to a survey of the empirical evidence available on various aspects of pricing and finally to a discussion of the extent to which all of this adds up to a "new economy" guided by different economic principles. II. THE EFFECTS OF INFORMATION ON THE PRICES OF GOODS AND SERVICES A. The Economic Theory of Search Costs and Prices Ceteris paribus, the more accurate the information that consumers have concerning homogeneous goods and services, the lower the prices they will pay and the greater the consumers' surplus they will earn. However, this simple dictum may not say as much as it first seems. When goods and services are differentiated and consumers exhibit brand loyalty, they may pay higher prices. Further, asymmetric information is likely to generate price dispersion (some consumers paying higher prices than others), and the mean price paid by all combined could be higher (Brynjolfsson and Smith, 1999, 2000). Forty years ago, Stigler (1961) noted that the representative, optimizing consumer with imperfect information will search for additional price information and will move to the point where falling marginal search benefits equal rising marginal search costs. Stigler noted that advertising has the potential to reduce consumer search costs. Consumers expend greater resources on search, the greater the expenditure they intend to make and hence can be expected to do a more extensive search relating to an automobile purchase than a candy bar purchase. Some items are more searchable than others because they are standardized and more easily compared (such as Corel WordPerfect 9 software). It is more difficult to search for and compare products that involve distinctive service and atmosphere, or to search for products that are "touch, feel, and smell" goods (hair styling, for example). Such "experience" goods often cause consumers to focus on the seller's reputation because they do not know whether they will like the good or service until they have consumed it. Also, some goods are so highly differentiated and heavily branded that no significant duplicates exist (certain antiques or paintings), and this discourages search. Some items may be subject to extensive search because the marginal cost of an additional unit of search is relatively low. (1) In a Stiglerian world, marginal search benefits fall monotonically. The probability of a consumer finding a lower price, or more attractive terms, declines as the number of sites searched increases. …