PRICING OPPORTUNITIES IN THE DIGITAL AGE
HERMANN SIMON
Simon-Kucher & Partners
HANS SCHUMANN
Simon-Kucher & Partners
The study of pricing actually consists of four distinct processes: the creation of value-to-customer; the "price-setting" process that determines the split in value created between seller and buyer; the interactive jockeying for position between sellers; and the sellers' internal price implementation process (see Figure 14.1).
The Internet is affecting all four areas. It is enabling the information flow and information-gathering process that fuels the competitive interaction. According to J.D. Power and Associates (2000), more than half of all new-vehicle purchasers in 1999 consulted the Internet for product information during the purchasing process. Brokerage houses are improving their products by providing online account information, stock news, and free "real-time" quotation services. Firms are keeping track of who visits their Web sites, when, and for what purpose.
Although these trends are not Internet specific, the Internet is the highest profile example of the information explosion of the digital age. Other non-Internet sources of information explosion can be found. Even in the traditional retail environment, many merchants are actively gathering customer purchase histories and intelligence. Supermarkets use checkout systems, combined with customer identification techniques such as check-cashing cards or discount cards, to track purchase behavior. Department stores track purchase history with credit card numbers and "reverse appending" name and address allowing for the aggregation of all the purchases by that person and household (as customers often use more than one type of credit card) along with the household-level demographic information commercially available.
Implementation is a neglected area in the pricing literature. But for the practitioner, it is of the highest relevance. The Internet will dramatically reduce the costs of changing prices. It will make printed price lists obsolete and increase the precision and clarity of price quotations and invoices. In some ways, it will also allow for easier price differentiation. In other areas, the higher price transparency in the Internet will increase the difficulty in building fences between price segments.
In this chapter we examine how the Internet information flows affect each of these pricing subprocesses. The results are summarized in seven management lessons at the end.
PRICING ASPECT 1: THE "VALUE-TO-CUSTOMER" CREATION PROCESS
The fundamental driver behind commerce of any kind is the creation of value. That is, the creation of a product or service that, in its final form, has more value to offer to customers than it costs to manufacture and deliver. Therefore, pricing must start before research and development (R&D).
Customers purchase products for the benefits they anticipate by using the products. Hence, before even beginning the process of pricing, it is important to understand what the most valuable product attributes are from the perspective of the consumers. By conducting the market research and listening to their customers, firms can better understand , what product attributes contribute to value and to what quantitative extent each attribute is important. This knowledge will assist the firm in successfully creating products that outperform those products of their competitors.
Value of Information
One of the most useful tools for businesses to assess their strategic (and hence pricing) position is the matrix of competitive advantages. To build this matrix, customers are asked to identify and rate the importance of all the major product attributes, and then rate the performance of each potential supplier. The results are then summarized in the matrix of competitive advantages (Figure 14.2), which graphically plots the relative performance of the firms' products versus the perceived importance of that attribute. The relative performance is defined as the firm's own performance relative to the performance of the competitor strongest in this attribute. Firms that have the resulting points aligned along the diagonal have succeeded in focusing product development and R&D resources on those product attributes that matter most. Further information regarding the use of this tool can be found in Simon's Hidden Champions (1996) or Dolan and Simon's Power Pricing (1996).
We often find a great divide between the customers' preferences for product attributes and those presupposed by the producers. Similarly, the consumers' perceived relative performance of vendors often differs from that perceived by the firms. When management and consumers do not see eye to eye, it is the consumer's opinion that counts. By improving the communication and information flow between customers and suppliers, better (more appropriate) product strategy and pricing will result.
Only when the end consumer manufactures his or her own homemade product is the information transfer ever perfect. In all other cases, imperfect information will undoubtedly lead to the production of products that are either over- or underengineered. It is in the interest of both the customer and supplier to improve this communication process.
Even when product development is focusing on the correct product attributes, communication between the producer and the consumer is critical. This is because as any attribute is improved, the costs for additional incremental improvements tend to increase; at the same time, additional consumer benefits from these incremental improvements tend to decline. The optimal point that maximizes total economic value is where the incremental Cost-to-Make = incremental Value-to-Customer (see Figure 14.3). However, neither the producer nor consumer can know this point without adequate communications. Furthermore, the differences between customer groups are often large. By not segmenting the market properly, producers make the wrong products or offer these products to inappropriate target groups. By bridging this gap through Internet-based market research techniques, the Internet can help to produce, and market, better and more targeted products. All of that can now be done in a timelier manner.
In the "value-to-customer" creation phase of pricing, the consumer and producer are in a win-win environment. With every bit or byte of information, a "Pareto superior" solution can result. That is, with every shared bit of data, one (or both) parties' value can be improved without negatively impacting anyone.
Impact of Internet
The Internet can significantly enhance value-to-customer creation in the following three ways:
1. Increased sharing of information between buyers and sellers.
2. Increased opportunities for market segmentation and mass customization.
3. Significantly reduced transaction costs, ease of doing business, and actual product improvements that come from being able to use the Internet for ordering and product fulfillment.
In each of these three ways, additional value-to-customer can be created.
Increased Sharing of Information. Practically every commercial home page is designed to communicate to the end user, whether a residential consumer or an end user in a business-to-business setting. Typically these sites will explain the firm, its current product line, and its capabilities. Communication between the buyers and producers needs to be in both directions. Just as suppliers should increase their awareness of the customer's needs, consumers need to be better informed regarding the full range of products, services, and producer capabilities at their disposal.
The Mazda Motors site (Figure 14.4) leads the customer through a series of questions designed to help match the customer's needs with the most appropriate Mazda model and equipment packages. By educating the customer, Mazda makes it more likely that the customer sees the most appropriate models and hence is more likely to purchase a Mazda product. The Mazda site helps increase the total value-to-customer through the two-way sharing of information. When the value-to-customer increases, higher prices can also be charged. Moreover, the information gathered in this process can be used within Mazda as a basis for future product introductions, which again increase Mazda’s pricing flexibility.
Increased Opportunities for Market Segmentation and Mass Customization. Often, through the interactive discussion, not only can existing products be recommended, but also unique products can be created. Gateway Computer (Figure 14.5), having grown its business on building computers to specification, is now using its Web site to allow customers to create the specific system of their choice. McGraw-Hill (wwwmhhe.com.) is using the Internet to custom design college textbooks, allowing professors to include the chapters of their choice and in the order the professor plans to cover them in class.
Some of the information sharing can be quite sophisticated. Korn Ferry, in its joint venture with the Wall Street journal, sends each potential job -applicant through a battery of psychological tests as well as through a conjoint study (Figure 14.6) to help identify the type of position and organization that would make a beneficial match. (Green & Savitz, 1994, provide more background on the applications of conjoint measurement.)
By being able to segment the market with target offers to specific customers, the Internet can increase the total value-to-customer. Without the ability to successfully target, products need to be developed for the average customer. This solution will undercut the total value-to-customer, which then limits the firm's pricing options. Based on a valid segmentation, a more effective price differentiation can be developed and implemented.
In none of these examples is the Internet the only way to accomplish these goals. However, information flows with greater speed, ease, and accuracy on the Internet than through most traditional media.
Significantly Reduced Transaction Costs, Ease of Doing Business. The ease of doing business is a product attribute in its own right. The product procurement and delivery process is itself a benefit that matters to customers. The Internet is open 24 hours per day, has the ability to be interactive, and is independent of geography; and orders can be sent with little chance of transcription error. The Internet does all of this at remarkably low costs. As the world has become an "information economy," some "products" themselves can often be instantaneously downloaded.
Cisco Systems, the world market leader in Internet routers, has deployed an interactive program through its Web site that helps its customers configure the complex router systems in a practically error-free way. The program makes automatic compatibility checks and quotes the correct system price. Through this e-commerce software, Cisco has not only become one of the largest sellers on the Internet, but has eliminated the need for hundreds of sales engineers while dramatically reducing order and pricing error rates and product delivery times. The added value (and improved customer service) of these improved ordering systems has been heralded as great competitive advantages by Cisco's customers. In 1999, 90 percent of Cisco's orders were transacted over the Internet! Intel also utilizes the Internet in a similar manner.
By lowering transaction costs, additional total value is created which can then be split between the buyer and seller through the price determination process. For more on the value of the Internet to customers, see Keeney (1999).
PRICING ASPECT 2: THE PRICE DETERMINATION PROCESS
In the previous section, creation of economic value was the goal and information sharing was advantageous to all parties. Once the optimal products are designed or produced, the created value needs to be split between the buyer and seller. In this process, there is no possibility of a win-win situation. It is at best zero-sum, or even lose-lose, if the buyer and seller cannot agree on price and no exchange is made.
Several different price determination processes exist in the economy. Before we can talk about how the Internet can affect these processes, it is important to understand how these processes function and under what circumstances they are typically seen:
· Seller-led retail.
· Buyer-led price offer/customer-driven pricing.
· Interactive bargaining.
· Seller-organized auctions.
· Buyer-organized auctions.
· Bid/ask markets.
Seller-Led Retail
This is the traditional price determination mode that we are familiar with.
Here, it is the seller of the good who sets a product price with a firm commitment to deliver the product if that price is agreed to. In this type of price determination, it is the consumer who decides between buying, walking away, or waiting to see if more attractive prices may be offered by the firm in the future.
Typically, this can be found in industries where there are significantly' more customers than suppliers, such as typical retail environments. It is the seller who tends to have the most information in this situation (e.g., costs to make, historical customer demand curves). Ultimately, the customers have a take-it-or-leave-it scenario. In this process, sellers are reluctant to let the buyers make counteroffers (see Interactive Bargaining) as any agreed-on price may soon need to be offered to everyone or is not feasible due to the large number of individual customers.
Buyer-Led Price Offer/Customer-Driven Pricing
When there are stronger purchasers than-producers, it is not uncommon to have the buyer take the pricing lead, and offer the potential supplier a firm price ultimatum. In this mode, the buyers make a firm commitment to buy if, and only if, the announced price is accepted. The tactics of some of the larger automobile manufacturers such as Volkswagen and GM in this regard are legendary.
This type of pricing is usually found when buyers are few in relation to potential suppliers, and where the buyer is well informed in regard not only to his own willingness to pay, but also to the cost structure and financial situation of the seller.
There are two advantages to the seller in this process. The first is that this is a one-to-one customization of price, since each customer with a significantly different reservation price is likely to make a significantly different price demand. The second advantage is the total intransparency of prices. Since the seller doesn't publicly post a price, only he and the individual customer know the transaction price. Thus, this may be an ideal way for a company to sell off excess capacity without jeopardizing the firm’s normal price level.
Interactive Bargaining
The best example of this type of pricing process is found where the products are differentiated, such as in the bargaining for the purchase of a home. In these cases, the bargaining process usually starts with the vendor whose product appears to offer the largest economic surplus. The seller and/or buyer initiates a firm price offer, which is then either accepted or a firm counteroffer is presented. In these markets, the buyers usually have determined the ideal suppliers, but whether an agreed-on price can be reached has yet to be seen. The interactive bargaining process is essentially a battle of wits. This is unlike the value creation part of the pricing process where information sharing is in both parties' interest. In this process, sharing your true product valuation may reduce your bargaining position.
This type of interactive bargaining is frequently found in differentiated industries (such as management consulting) and for relatively large-ticket items. Both parties in these processes try to have at least a "ball park" estimate of the other party's probable reservation prices for this product and potential second-place alternatives.
Seller-Organized Auctions
A seller-organized auction is usually found when there are relatively few goods in relation to potential purchasers, and the overall expected values to different customers are unknown. Seller-organized auctions are also common in special situations where a sale needs to be closed in a short period (foreclosure sales) or where it is politically important to appear to be fair or when it is socially important that the trade be consummated with the buyer who has the greatest desire for the product.
Buyer-Organized Auctions
Buyer-organized auctions are similar. They can be found when the buyer does not fully understand the seller's cost structure, or when fairness is a major issue such as a government bid. The traditional "Request-for-Proposal" process at major firms is an example of a buyer-organized auction.
Bid/Ask Markets
The stock market is the prime example of a bid/asked market. Here, instead of bargaining with a known seller, both the buyer and seller post firm "buy" and "sell" prices in some kind of market or forum. Whenever there is an overlap between these two, a trade takes place. This usually requires an intermediary that will fairly organize and run this exchange. A closely related process is when an intermediary will choose to offer both the bid/ask functions themselves. A classic example of such an intermediary would be the stereotypical antiques dealer who will both buy and sell goods. Here, it is often the intermediary who has the best information regarding the reservation values of both the buyers and sellers. His profit depends on that knowledge base.
As one can see, which pricing process is likely to prevail depends on the relative power and information available to each party. In many instances, information is power! As the Internet causes a new distribution of information, relative bargaining power usually shifts thereby increasing or decreasing bargaining ability and thus price levels. If the distribution of new information available to buyers and sellers is significantly greater for one group as opposed to the other, the entire pricing paradigm for that industry can shift.
The following pricing paradigm shifts have already been seen on the Internet.
New Internet Retail
The automobile industry has traditionally been an interactive bargaining type purchase. With the increased communications available on the Internet, it is now possible to purchase or lease a car from a dealer/agent far away. The new sites are now no longer marketing to consumers on a one-to-one basis at the car dealership, but are now marketing to a much wider audience. The result is that these sites now offer the single haggle-free "take-it-or-leave-it" price typical of other retail channels (e.g., see www.carmax.com).
New Internet Buyer-Led Price Process
A phenomenon of the Internet is the ability of consumers to communicate among themselves. One of the outgrowths of this communication is the banding together of consumers into purchasing groups or co-ops. Once a critical mass of consumers is in place, the customer "co-op" is then in a position to demand specific prices. Mobshop.com, for example, aggregates individual customer orders for computer products into single orders that then can take advantage of quantity discounts offered by wholesalers and manufacturers.
New Internet Bargaining
Almost all major newspapers are now online. The first feature automated on the Net was the classifieds. In addition to newspaper ads, many other sites such as Yahoo.com have classified sections. While some of the prices may indeed be firm, the reality is that once a buyer and a seller have identified themselves to each other, traditional bargaining is not far behind. Although some of the sales would also have been sold this way through the traditional media, the ability to advertise for free on some of these sites makes this option more appealing to some.
New Internet Seller-Led Auctions
The biggest example of an Internet seller-led auction site must be www.ebay.com. Without the Internet providing the unprecedented communication vehicle, we would venture to claim that 99 percent of the goods would not have been auctioned off on the business-to-business front, drug wholesaler Bergen Brunswig Corp. in December 1999 announced that it would set up a site on which drugs (many with limited shelf life remaining) would be auctioned off. This is clearly the case of the firm using a new media to deal with an unknown customer valuation that may be placed on these short-shelf-life products.
New Internet Buyer-Led Auctions
Various industrial buyers such as the state of Pennsylvania and Eaton Corporation, have experimented with creating a buyer-led Internet auction where prequalified potential suppliers bid against each other via the Internet. The firm FreeMarkets has held these auctions (www.freemarkets.com). Although some suppliers have indicated that during their initial participation, they bid lower than they otherwise would have, this is not likely to continue to happen as firms get more experience. More threatening to this process, however, is that all of the vendors can see each other's bids (although the actual name is withheld). Long term, this information is beneficial to the sellers as they now can better monitor the actions of their competitors. The alternative paper-based "request-for-proposal" process kept this information confidential to the buyer. A minilesson therefore is that just because a process is now possible on the Internet, does not necessarily make it a wise move.
New Internet Bid/Asked Markets
With the communications available via the Internet, Chicago-based www.nte.net has begun to allow truckers with partial trailer loads to identify other shippers on their intended route. NTE does not want involvement in the actual negotiation, but simply facilitates the trade through a traditional market structure. A famous example of a new intermediary who will take an active role in matching buyer and seller is Priceline.com. Here, Priceline gathers real information regarding both a consumer's willingness to pay (bid price) and the airlines' price (ask price). Unlike NTE, Priceline does take an active role in the management of the bid/ask prices. Its profit stream is dependent on keeping any overlap between the bid and ask prices. Busch (1999) and Hapgood (1999) review in more detail the various types of Internet auctions and how they can be of use to business.
OVERALL IMPACT OF THE INTERNETVALUE OF INFORMATION TO BUYERS
There are several pieces of information that buyers typically can utilize prior to determining what particular price they should accept or negotiate for. This information includes alternative sources or suppliers, their prices, and miscellaneous information regarding the financial and general health of the selling firm. The useful company-specific information includes an assessment of the selling firm's "personality," past behavior during pricing negotiations, and the firm-specific financial situation (including knowing about any unusual inventory levels, project sales slowdowns, and/or other news).
As illustrated, the Internet has already changed not only the overall price level, but also the structure of the pricing process. New available information can make each of these pricing paradigms disappear just as quickly as they arrived. The Internet aids in the creation of educated consumers. In this section, we identify and evaluate some of the data that is now readily available.
Financial and industry information is readily available throughout the Internet from Wall Street sites as well as from government sources such as the Securities and Exchange Commission (www.sec.gov/cgi-bin /srch-edgar). Although many of these documents have always been public, finding them in the government files or in a particular industry's trade press was not always practical. Now they can often be downloaded instantaneously. The Internet also provides other sources of information that have not always been easily obtainable. The Internet, with its many chat rooms, gives consumers access to others who have had experience with a particular vendor worldwide. Last but not least, the Internet has allowed for the creation of shopping robots that systematically check prices and/or availability from multiple potential retailers.
These pricing robots take a consumer's desired product description and try to shop with multiple sources. The result is a listing of alternatives from a multitude of vendors. A partial list of industries where such robots can already be found include air transportation, books (Figure 14.7), computers, insurance, and home mortgage loans. These robots can literally shop the entire world, doing currency conversions, and adding the appropriate shipping costs and times. With these prices in hand, a consumer knows what alternatives he has, the competitiveness of the industry, and by inference some information about cost structures.
Robots have some limitations. Many do not conduct a completely thorough evaluation, may require sellers to pay to be on the list, or even be owned by one of the merchants. The results that they obtain can contain errors and omissions. One book robot for instance returned substantially different results depending on which co-author was used in the search. Another robot included a few entries from bookstores that sold used copies, although the "used" status was not clear from the robot output. Also, most robots will find only the list prices, not taking into account any customer-specific discount you may be entitled to (such as corporate or AAA discount at selected hotels or car rental agencies). Despite these shortcomings, the robots provide a great benefit to buyers. In many cases, they can provide additional non-price information such as the inventory availability, which delivery firms each site utilizes, and the average time until delivery.
The ability of customers to so quickly get this level of information places extreme pressure on firms to be price competitive, if not the price leader. They also enable a relatively small or start-up seller to very quickly gain market exposure if it becomes the price leader.
OVERALL IMPACT OF THE INTERNETVALUE OF INFORMATION TO SELLERS
Since each customer is different, merchants are in a constant battle to develop segmentation schemes that allow them to treat each customer differently. Each customer group is likely to have differing propensities to purchase, willingness to pay and, hence, different optimal prices.
Firms rightly spend a great deal of energy in market research, customer tracking, and price elasticity estimation. To the extent that sellers have fully analyzed customers' needs, alternatives, and financial means, they are best able to optimize their prices.
The classic example of a seller who utilizes all the available information, is the stereotypical merchant at any bazaar. He will try to learn as much as possible about the customer before proposing or offering any price. His information comes from clues regarding the customer's wealth and willingness to spend money (car, clothes, camera brand, education, etc.), the other products and/or stalls he has spent time in, and information contained in direct questions and chit-chat. After obtaining and interpreting all that information, the bazaar merchant comes up with a price "especially for you"!
Sophisticated modern retailers are attempting to do the very same thing by building very large databases that catalog any known information regarding customers, their shopping patterns, credit card usage, and demographic profile. Based on the results, special promotions are often sent via direct mail.
One of the key uses of customer data is to determine the differing price sensitivities and elasticities across customers. To take advantage of these factors, sellers must find other differences in customer behavior or attitude in order to build "fences" allowing each group to be charged different prices. For example, airlines have identified that business travelers seldom wish to spend a Saturday night away from home, and leisure travelers usually are willing to spend this night on their trip. The result is that most airlines' low-fare offerings have a Saturday night stay requirement to prevent business travelers from obtaining the lower price. This fence is very effective in separating these two customer types. The better the firms' customer information, the better fences they can establish.
The availability of customer-specific offers on the Internet has the extra advantage of discrediting any robot that would have only returned the firm’s higher "list" price. In future purchases, these customers may go directly to the firm's Web site, or at the very least look at the site in addition to using the "robot”.
The Internet will have a great impact on a firm’s ability to collect and utilize data in the price determination process. The Internet will both assist in the data-collection process and improve the capability of firms to segment the market.
Different Web sites can be set up catering to different clienteles Egghead Software, for example, after-having closed its physical retail chain, has opened three separate Internet sites. One is aimed at the highend consumers willing to purchase premium products, one features off-price products and one utilizes a "bid" format on selected merchandise. A similar brick-and-mortar segmentation plan is likely not possible due to the market size and geographic distribution of like classes. Amazon.com has a German language sister site, (www.amazon.de), aimed at the German audience. Interestingly, the book prices on each site are not the same. Buy the book, Power Pricing, off the German site, and it will cost you 30 percent more!
Although, much information regarding a product's demand and price elasticity can come from market research functions (some of which is currently being done over the Internet), it can be advantageous to do some direct market testing to measure the price elasticity. The Internet can assist in this process. However, it is not likely to completely replace geographically distributed test marketing. A major advantage of doing test marketing on the Internet is the resulting national (international) distribution of customers in both the "test" and "control" cells.
During an Internet session, a substantial amount of data can be collected that could theoretically lead to a merchant concluding that a particular price may be in order for that particular individual. Since Internet merchants can identify the IP address of the customer, at the very least, they can install programs that automatically assign prenegotiated company discounts. This is, however, only the tip of the consumer information iceberg. If the customer is not originating behind a firewall, a substantial amount of information regarding the customer is at the merchant's disposal. Specifically, it is possible to see not just what other sites this particular customer has visited but also to tag the customer and observe his trail after he leaves the merchant's shop. This latter technique can be utilized to develop behavioral segmentation schemes. By identifying consumer behavior, the firm will be able to better assess the price level that is likely to optimize sales at the next Web site visit.
Priceline.com can be used for market research since each customer names his reservation price. The values are known not only for those customers who purchase, but also for those who do not. Indeed, the ability to provide this data was important in getting at least one of Priceline's initial airline providers to participate. Although this data is not currently being routinely harnessed, it soon will be. Many of the firms that have been collecting historic sales data are now able to statistically analyze this wealth of newfound data. Soon, the time of day you enter a site, your IP address, and your "cookie" history will all be part of the information that will be taken into account before your specific retail price is quoted. The CEO of Priceline, Jay Walker, discusses his view of the impact of the information revolution in Carr (1999).
As the pendulum of power switches back and forth, between the customer and seller, the competitive and pricing structures of e-commerce will be in constant flux. As e-commerce is still a relatively small part of the entire distribution system, manufacturers have to be conservative to ensure that the traditional distribution channels are not overly offended by the growth of their electronic business.
Indeed the interaction between the digital marketplace and the traditional retail channels will be an important area to watch. In some instances, customers will "shop" for a product via the brick-and-mortar channels, but will make their actual purchase via the e-commerce channel. Gateway Computers has recently added physical shopping locations in support of their e-commerce strategy. Lal and Sarvary (1998) point out that some product attributes are easily communicated via electronic media, whereas others, such as fabric texture, cannot be. The result is that in some cases customers will actually do less shopping in a digital environment and the value of brand increases. Customers tend to know and trust the features of the branded product and may be less than willing to try a competitor. They show that in this situation, competition is actually less intense in the digital environment than it was earlier.
PRICING ASPECT 3: COMPETITIVE POSTURING BETWEEN FIRMS
The information that is available to consumers is also available to competitors. The result is that few competitive advantages can go unnoticed anymore. If your competitor is undercutting you with fist prices, you know it instantaneously. As it becomes increasingly effective to undercut your competitor on price, the length of time that your competitor can allow you to maintain any such advantage goes down tremendously. Hence we have the following paradox:
Price is an increasingly powerful weapon,
yet....
price is becoming an increasingly useless weapon.
As any price reduction becomes immediately verifiable and effective, one would normally expect prices to be driven down to the economic "pure competition" zero profit level. This frictionless competitive nirvana for consumers requires any merchants who want to be a long-term success to do two things: invest heavily in differentiating themselves in non-price issues and build a reputation of having "very good" (although not necessarily the "best") prices. Bookseller Amazon.com (www.amazon.com) has included value-added features such as book reviews and book recommendations to its site. In the electronic brokerage business, E-Group (www.e-trade.com) is attempting to build a stock trading site with improved research tools and extra features such as free real-time stock quotations and after-hours trading.
As the barriers to entry into e-commerce are remarkably low, many competitors of widely varying size, quality, and competence are entering each business. As surfers are not likely to search out each firm, many firms are now actively spending money to make themselves visible on the Web. They are using advertising in several channels including radio, TV, the Yellow Pages, and even direct mailings of printed catalogs. The battle for visibility has led to high demand for advertising on other Web sites, especially sites that are visited frequently. Hence, the current "portal war" being waged between Yahoo!, Excite, and the other Home Page providers. Many firms even use dot-com as part of their official name (e.g., Amazon.com).
The effectiveness of price as a weapon is limited if no additional resources are invested to make the Web site attractive or otherwise visible or easy to get to. Price can only be effective to the measure that it is actually perceived by potential buyers. The combination of prices being both immediately effective and verifiable is the ingredient that is necessary to support another behavior pattern-collusion. On the Internet, price is such a strong competitive weapon that merchants can easily slip into using this weapon not just to get additional sales, but also to "punish” a competitor. Even without an explicit price-fixing discussion, the natural tendency of firm managers is such that bad behavior elicits punishment while more supportive behavior does not. A tit-for-tat strategy can easily develop among competitors. That tit-for-tat strategy in a repeated game environment can lead to an industry that behaves more like a cartel than the hypercompetitive industry we would expect the Internet to foster.
To see how this can happen, one needs only to look at the airline industry. In many respects, the widescale automation of the travel agencies through the introduction of Apollo and SABRE computerized reservation systems parallels the dynamics now found in the Internet. These distribution systems allow for instantaneous fare comparisons, with changes that are immediately available and visible to all.
A former airline pricer describes the result in an article for PlaneBusiness; (www.planebusiness.com):
The discussions don't take place on the phone anymore, they take place in the GDS (Reservation System). They are like little electronic smoke signals. Just read between the lines . . . "hey Northwest, you wanna take a little bump on these excursion fares?" "Nah. . . . I'm worried about my advance bookings with the Pilot's strike ...
While not every firm competing in the Internet will become a price fixer, the data availability does influence the outcome of competitive skirmishes. And these outcomes can vary greatly. Some industries will see increased hypercompetition, while others may even see relative competitive peace. The Internet will lead to both lower prices in some industries and higher prices in others.
Before leaving this topic, remember the key to any cartel being stable is the ability to verify when cheating is taking place. The Internet will initially provide this verifiability, but as firms begin to utilize all of the segmentation tools at their disposal, prices win begin to become customized and seen only by the individual customer. At that point, cheating will again become possible and the collusive behavior may quickly collapse.
In almost all instances, the sellers are continually competing against one another. Hence, we ideally would want to find the steady-state equilibrium. Unfortunately, most industries find themselves not only needing to understand the theoretical implications of playing a repeat game with incomplete information, they now need to consider that they are playing a repeat game in an industry where the information content is constantly changing.
In this context, customer-driven pricing (Priceline.com) is again unique. Due to the total intransparency of the actual transaction prices and the internal price limits, it offers a competitive scenario that makes a rational reaction difficult. In a game-theoretical scene, this situation is similar to a prisoner's dilemma with total secrecy.
PRICING ASPECT 4: PRICE STRATEGY IMPLEMENTATION
In our consulting practice, we assist firms in optimizing their pricing strategies. The end result of this analysis is frequently a computerized decision support model that allows product managers to optimize product pricing and positioning. This model attempts to capture all the relevant factors that the product manager would need to consider in price optimization. A typical decision support model is built utilizing inputs such as those found in Figure 14.8.
In such a model, we can easily include Internet-related features such as:
· Online tracking (e.g., for package delivery service).
· Current stock prices (e.g., for day traders).
· Internet bookings and reservation changes (e.g., for hotels, airlines, restaurants).
By changing the price and features of a product in the model, product managers can then identify the impact that these changes have on their product's demand, the demand for their firm's other products as well as the effect on their competitors. Figure 14.9a shows the effect of the introduction of Internet booking on the market share of Airline C on an Asian route assuming that competitors A, B, and D do not introduce Internet booking for the time being. The increased "value-to-customer" can be used to increase market share and/or to increase price. Figure 14.9b shows the impact of a 10 percent price increase after the introduction of Internet booking. Its value-to-customer is obviously not sufficient to support this price increase. Airline C would actually lose about 1 percent market share with Internet booking and a 10 percent higher price.
Armed with such a model and tools such as commercially available inventory management and yield management models, tomorrow's managers will be able to develop an optimal strategy for each market segment. Only one problem exists.... In the digital era, these models are needed not only to support a manager when he launches a product, they will need to be coupled with an artificial intelligence function so that they can be run and adjusted continuously. More than just the technical capability, a mental mind-set shift is important.
An example of such a future model comes from Coca-Cola, which is developing an online soda machine that continuously alters the price based on the outside temperature. Power pricers in the future will not have the luxury of letting a product manager be the end user of this type of tool. As information is gathered in real time, firms will need to be able to do this type of analysis and offer the optimal price instantaneously. This can be done utilizing an artificial intelligence program in conjunction with such a decision support tool.
Just as the trader at the bazaar analyzes all relevant information instantaneously before determining a price strategy, so must a firm in the digital age. For those firms that currently rely on quantitative price models, the transition may just require the development of an interface between the two systems. For other firms whose pricing is done primarily through the product manager's experience or instinct, significantly more work will be necessary to transfer this experience to the digital environment.
The Internet eases the task of implementing pricing strategies. Today, costs, time commitments, and sales force information requirements seriously impair the pricing process. Price changes can be costly since new price lists (sometimes these are voluminous "books") have to be printed and mailed to customers. Traditional mail-order companies have two catalogs per year and cannot change prices until a new catalog appears.
The Internet radically changes the situation. Price changes can be made at virtually no cost and at any time. It becomes possible to vary the prices in the course of a day. Prices can be computationally linked to any kind of variable (e.g., previous prices, costs, competitive prices, and even as in the Coca-Cola example, the weather). Errors from wrong price quotations, incompatible product configurations, and complaints about erroneous invoices can be dramatically reduced with accurate information transferred via the Internet. Cisco reports this as being one of the major advantages of e-commerce.
With this improved ability to accurately manage day-to-day price maintenance, the Internet will allow for significantly enhanced and more complex pricing strategies. Multidimensional price structures will be easily administered where the "price" has several components. Examples of industries that already routinely utilize these more complex schemes range from telecommunications to taxicabs. In telecommunications, customers' total costs customarily include a one-time installation cost, a fixed monthly charge, a minimum per call or "set-up" charge, and a price per minute. Taxicab drivers will often have an initial fee, extra passenger or baggage charges, a nighttime surcharge, mileage-based rates, and a per minute rate for waiting time or slow traffic. The driver is able to keep track of these charges only through the help of the cab's meter. The Internet can provide the infrastructure to be the "meter" for many more industries.
Overall, implementing a given price strategy will be radically eased by the Internet. But the new opportunities also require higher skills and more sophisticated price competencies.
CONCLUSION
Management Lessons
We summarize the main insights of this chapter in seven lessons.
Lesson 1. Good pricing starts with better knowledge of your customers. Utilize the Internet to increase communications regarding customers' wants, needs, and desires. Encourage feedback from your customers by creating a direct line of communication to your research and development group. Good pricing begins before R&D. Remember that it is in the best interest of both your firm and the customer to develop and produce optimal products. A good example of a firm developing that knowledge through sophisticated research tools is Futurestep.com.
Lesson 2. Use the Internet to add value by simplifying and controlling the product distribution and ordering channel. Thus, you create value that can be translated into higher prices.
The ability to communicate directly with the producer is often an attribute that has direct value to the end customer. The ability to know that the order was delivered without errors being introduced by middlemen has value as do the status reports including accurate shipping dates. A builder, for example, who ordered special order siding, would like to schedule installation crews. For him, order status information has real economic value. Again, Cisco systems is a good firm to emulate.
Lesson 3. Use the Internet to increase your segmentation ability and differentiate prices accordingly.
The Internet allows for multiple Internet sites specifically targeted toward the needs of individual market subgroups. To the extent different market segments have different price elasticities, price can and should vary from site to site. Additionally, the Internet with its interactive communications structure is an ideal platform on which to offer "mass customization." As customers provide you with additional information, update your estimate of the best price for that individual or group. Both Gateway and Dell are able to build a product to specifications. Customer-driven pricing lets each individual customer set his or her own price. In addition to providing high value-to-customer, it almost eliminates the risk of outdated inventory needing to be discarded.
Lesson 4. Unless you can guarantee that you will always be the low-cost provider, be wary of competing only on price.
Price is easily copied, and if you are successful and hurting your competitors, they will not allow you to continue your price leadership. Once they match or undercut you, the robots that likely would have given you the business, immediately take the same business away. Customer loyalty drops to zero. Successful companies will be those that offer additional reasons for utilizing their site at a fair price.
Successful retailers like Amazon.com have learned this lesson. Firms should do their research and find out what non-price features (including brand) are important to include in their offering. Although some of the lowest price discount stock brokerages have fees as low as $7 per trade, the clear winners are those firms who offer more value for money, not the lowest price.
Lesson 5. Don't expect a stable pricing environment (or even competitive structure).
The availability and ability to manage information is growing exponentially. As this is happening on both the buyer and the supplier sides, the degree of market power will shift back and forth. As it shifts, the appropriate pricing and industry structure will too. The successful firms will be those who are constantly adapting to the ever-changing environment, and those who are able to utilize or develop the best decision support models. The opportunities and complexities of Internet pricing escape intuition and gut feeling.
Lesson 6. Expect to see paradoxes, as the forces that control each short-term game may be significantly different when viewed in a repeated games context.
The paradoxes include:
· Price becoming less of an effective weapon as it becomes a more effective weapon.
· Brand reputation becoming stronger as small unknown merchants are given the same prominence in the Web.
· Collusive behavior that may become supportable due to the hypercompetitiveness of e-commerce.
Lesson 7. Firms must develop the tools and continually monitor and process all the information available. The Internet can significantly improve a firm’s ability to implement much more flexible or complex pricing strategies. The goal is to use the digital era to digest and process all available data instantaneously, and offer the optimal price to each individual, just like the trader at the bazaar.
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