The Great Experiment

Pricing on the Internet

Published in Handbook of Electronic Commerce in Business and Soceity,
Lowry, Cherrington, and Watson, eds.
CRC Press, New York, 2001, pp. 139-152

Karen Clay

Ramayya Krishnan

Michael Smith

H. John Heinz III School of Public Policy and Management
4800 Forbes Avenue
Pittsburgh, PA 15213

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The rise of business-to-consumer electronic commerce represents one of the greatest economics experiments in history. In its initial conception, anyone could start a business-to-consumer firm. By shipping goods directly from wholesalers, firms would run extremely efficient operations. They would spend only on the website and earn money from sales, possibly from advertising, and from interest earned because goods were sold before suppliers had to be paid. Customers would use comparison-shopping engines to choose the lowest cost suppliers for relatively standardized goods. Thus prices for these goods would fall to cost and price dispersion would fall to zero, because no firm could charge a price above market.

The reality as of 2001 is that business-to-consumer electronic commerce firms look a lot like physical retailers and many operate in both channels. Most customers do not use comparison-shopping engines, although usage is slowly increasing. Those who comparison-shop often do not choose the lowest price vendor. Thus, price has not fallen and almost certainly never will fall to cost. Further, price dispersion is significant, online as well as offline. The fact that the evolution of business-to-consumer electronic commerce did not conform to the initial rather far-fetched plan should not obscure the fact that the rise of business-to-consumer electronic commerce still represents one of the greatest economics experiments in history.

Despite the importance of the experiment, we know remarkably little about how the rise of electronic commerce has affected retail prices both online and offline. In this paper, we survey the academic empirical literature as of mid 2001 on the impact of the Internet on retail prices. The survey examines three issues: market efficiency, retailer behavior, and consumer behavior. The market efficiency section examines four aggregate measures that are related to efficiency: price, elasticity of demand, price dispersion, and menu costs (the costs of changing prices). The next two sections examine more disaggregate measures of pricing on the Internet: how firms set prices and how consumers respond to prices. Each of the three sections ends with suggestions for future research.