Study challenges claim that the Internet promotes price competition

Researchers have developed an analytical model that explains why the internet may actually be bad for consumers in some cases.

Many experts had argued that the internet will be a boon to consumers, forcing businesses to compete more aggressively on prices as customers effortlessly compare prices on the web.

There’s just one problem: actual empirical studies have shown mixed results, with prices on the web sometimes no better than brick-and-mortar competitors. “We’re challenging the conventional wisdom and showing that making it easier for consumers to compare prices on the web may actually result in higher prices and reduced consumer welfare,” said Waleed Muhanna, co-author of the study and associate professor of management information systems at Ohio State University’s Fisher College of Business.

He conducted the study with Colin Campbell of Rutgers University and Gautam Ray of the University of Texas at Austin. Their results appear in the March 2005 issue of the journal Management Science.

While the researchers used a complex game-theoretic analysis to reach their conclusions, the reasoning behind why the internet may hurt consumers is relatively simple, Muhanna said. The same web technology that allows consumers to compare prices on a product from several different businesses also allow these businesses to check easily on their competitors.

That means businesses cannot reduce their prices without competitors finding out quickly and possibly matching or beating those prices. The result is that businesses selling on the web have no incentive to undercut their rivals, he said. “If I know you can nearly instantly detect my attempt to undercut your prices, and that you will match or beat the new price almost immediately, there is a lot to lose,” Muhanna said. “It could trigger a price war that would hurt us both. “The incentives are such that businesses keep prices higher than they would otherwise be if they weren’t able to easily monitor each other’s actions.”

Contrast this situation with how businesses made pricing decisions in the pre-internet days.

If sales of a product went down, a business couldn’t easily determine if it was because competitors were beating their price, or there was some other reason for a decline in demand. In this situation, a business may decide the best choice would be to cut prices to boost demand for their product. A business could be reasonably sure that its competitors would not easily find the new price, allowing it a window of opportunity in which the company could have an advantage in the marketplace.

Now, however, the prices of competitors are “essentially one click away” on the internet, Muhanna said, reducing the potential gains from undercutting rivals.

In effect, competitors are involved in a “tacit collusion” to keep prices stable, he said. That means they don’t coordinate with each other or even agree with each other to prop up prices – but the effect is the same as if they did.

“It is as if they had gotten together to coordinate prices, but each is acting independently in their own self interest. They are agreeing to maintain a cartel-like pricing arrangement without explicitly coordinating.”

This presents major difficulties for federal and state authorities who enforce anti-trust laws, because it would be nearly impossible to prove collusion in cases like this, Muhanna said. Furthermore, even if there was some way to prove collusion, it’s not clear what steps government officials could take to remedy the situation, short of keeping businesses from posting their prices on the internet.

The end result is that consumers may not get the price benefits from internet shopping that many experts expected, Muhanna said.
While consumers may benefit from buying some goods online, Muhanna said the results suggest that overall, people shouldn’t expect huge savings from buying on the web, and in some cases consumer welfare may actually suffer.

Now that their model shows how internet shopping may hurt consumers, Muhanna said he and his colleagues are collecting data to see if they can find evidence consistent with their findings in the real world. They are trying to determine if prices on the web are trending higher over time, and if there is evidence that businesses are actively monitoring their competitors’ prices on the web.

Why have so many experts predicted the web will benefit consumers?

One reason is because they used a standard “static” economic model in which companies compete over a set period of time. But this is not how things happen in the real world, he said.

Muhanna and his colleagues used a dynamic model, more faithful to the real economy, in which companies compete over an unlimited period of time. When companies know they are going to be competing tomorrow and next year, their decisions are different than if you assume – like a static model does – that the competition will end at some set time.

“We think the model we used is more realistic and will deliver results that are more faithful to reality,” he said.