Download The Economics of e-Commerce and the Internet

The Economics of e-Commerce and the Internet
Edward J. Deak, Ph.D.
Ch. 10 – Answers for Discussion and Review Questions
1. Identify the economic rule for achieving profit maximization. How does the
implementation of this rule set up a tension between the value –of-service and
cost-of-service pricing strategies?
The rule for profit maximization is to produce up to the output level where for the
last unit produced, the extra or marginal cost of product just equals the extra or
marginal revenue obtained from the sale of the last unit. The approach includes a
consideration of both the cost and technology of production as well as the
intensity of consumer demand for the product. Value-of-service pricing looks
only at the intensity or elasticity of consumer demand in establishing the sale
price. Conversely, the cost-of-service approach looks primarily at the fixed and
variable costs along with the profit markup in determining the suggested retail
price.
2. What kinds of firms are usually forced to resort to use standard cost pricing?
Why is the manufacturer’s suggested retail price so sensitive to the choice of a
standard sales volume?
Typically firms that must produce a tangible product prior to customer order are
forced into using standard cost pricing because they must attaché a suggested
retail price to the item before potential customers show up to buy the item. The
standard volume is important for two reasons. First, it is the denominator of the
calculation and determines the extent to which the fixed charges are spread over
the standard number of units. Second, it is the number that determines the size of
the variable cost per unit if variable costs fall with the number of units produced.
3. What is the price elasticity of demand and how does this information influence the
cost-of-service pricing strategy? Does the price elasticity of demand also play a
role in the value-of-service strategy? How?
The price elasticity of demand measures the sensitivity of consumers to a change
in the price of an item. Firms that employ a cost-of-service strategy would like to
see the consumers demand for the product be elastic if the pricing strategy lowers
the price and inelastic or minimally elastic if the strategy leads to a price increase.
The price elasticity of demand plays a larger role in the value-of-service pricing
strategy because it helps to determine the worth of the product to the consumer. If
the consumer regards the product as being essential, with few substitutes and a
relatively small portion of the overall budget then a high price based upon the
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value-of-service would not discourage a large number of potential customers from
acquiring the item.
4. Are profits more or less sensitive to changes in sales when the firm relies upon
standard cost pricing? Why?
Profits are very sensitive to changes in the number of units sold away from the
standard volume. If sales fall short of the standard volume each unit must carry a
proportionately higher share of fixed costs and profit per unit falls rapidly.
Conversely, if sales exceed the standard volume, all of the overhead or fixed
charges have been covered by the standard volume and profit per unit jumps up
sharply.
5. What kinds of problems do the unique technology and economic aspects of Web econtent create for e-commerce firms, such as Salon.com, as they try to set an
access price based upon cost-of-service pricing?
E-content firms face an uncertain elasticity of demand as they set a price based
upon cost-of-service. Information, such as weather, breaking news, sports scores
and stock quotes are close to being a homogeneous product. The setting of a
positive access price for content by one e-commerce firm may well shift a
substantial number of previous customers over to free or cheaper rival sites. This
will disrupt the pricing model based upon an assumed level of customer demand.
Only if the customers perceive the content to be unique and possessing value
added will they consider paying the price. The Wall Street Journal has a viable econtent subscription service because customers see the site as providing valuable
information that may not be available at other sites.
6. Show graphically and explain the concept of consumer surplus. How does the
presence of consumer surplus encourage firms to adopt a value-of-service pricing
strategy?
Consumer surplus is the uncompensated value received by some consumers who
attach a worth to the product that is greater than the market price. The area below
the demand curve and above the price line represents the amount of consumer
surplus. A value-of-service pricing model tries to get at some of this consumer
surplus and transform it into tangible revenue for the firm. One way to achieve
this conversion is by introducing different versions of the product with higher
value added versions carrying a higher price. Seats at a baseball game or boxing
match that are close to the action carry a higher price than those located a farther
distance away.
7. What is versioning and how does it help firms turn a portion of the buyer’s
consumer surplus into revenue for the firm? How does versioning lead buyers to
reveal the otherwise hidden true value that they place on an item?
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Versioning involves creating different variations of the same product, each with
slightly different characteristics that convey a different level of value added to the
customer. Multiple versions divide what might otherwise be a standard product
into different levels of product where those with the highest demand for the added
features may be willing to pay a higher price. If so, they reveal their own
preferences for the item and help to convert some of the previously
uncompensated consumer surplus into added revenue for the firm.
8. What is a two-part tariff? How might Internet firms employ this value-of-service
strategy to extract a greater flow of revenue from the customer?
A two-part tariff is a pricing scheme that requires the payment of a fixed charge to
gain overall access to a product or service and then also charges a use fee every
time the product or service is accessed. For example, some colleges require
outside supporters to make an annual fixed donation to the college in exchange
for the right to purchase tickets to the games of a nationally competitive
intercollegiate sports program such as football or basketball. To the extent that an
Internet site offers a high value added service or product, the two-part tariff can
generate a greater revenue flow for the firm.
9. Describe the distinguishing characteristics of a traditional English auction. In
what sense is it a transparent auction process? How does an English auction
help to capture some of the bidder’s consumer surplus?
An English auction is of the type that is usually found at a traditional auction
house. It is a first-price auction, where the winning bid determines both the
identity of the winner and amount to be paid. An English auction is a transparent
auction process where the participants know both the bidders and the bid prices.
Typically, the winner pays the sellers reserve price plus some portion of the
consumer surplus above the reserve price.
10. Describe how eBay’s bidding process differs from a traditional English auction.
Why does a bidder participation problem result from the eBay process, and how
do they solve this problem with a system of left bids?
With eBay, the seller places the item up for bid for a specific period until a final
date and time. Bidders come and go electronically, with few being available and
consciously participating in the bidding process at the time of closure. This
creates a bidder participation problem. The problem of bidder participation is
solved by a system of left bids where each bidder offers a maximum price at the
time of initial bid. Ebay’s electronic bidding process will automatically advance
the bid of bidder A up to the maximum of the left bid each time a second bidder B
tops the existing bid of A. If the bid of B tops the highest left bid of A, then A
drops out of the bidding process unless he or she enters a new higher left bid.
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11. How are prices determined in a market involving haggling? How can haggling
be made to work in favor of the buyer if the exchange is an all-or-nothing trade
involving multiple items?
Haggling involves a direct negotiation between buyer and seller where they dicker
with each other over the price that they are both willing to accept. As long as the
maximum price that the buyer is willing to pay is above the minimum price that
the seller is willing to accept, there is the potential for the deal to be consummated
at some price in between, depending upon the relative bargaining strengths and
skills of the participants. Sellers in a haggle market can extract some consumer
surplus from the buy if they offer to discount the sale price of all the items if some
minimum total is reached for all the items. This entices buyers to spend more
than they might otherwise spend, thereby giving up some of their consumer
surplus, in order to access the minimum overall total and qualify for the discount.
Conversely, the seller may sacrifice some producer surplus in the form of the
discount in order to secure a higher volume and dollar value of sales.
12. Distinguish between a seller-posted pricing model and the reverse auction pricing
model. Why does Priceline.com make so much of the reverse auction travel
information opaque? How and why does Priceline.com keep their reverse auction
from deteriorating into a haggling model of price setting?
In a seller-posted pricing model, the seller lists the price that the item will sell for
and the buyers determines whether or not they wish to purchase the item at the list
price. This is the normal way that the vast majority of items are sold, for example
in a super market. A reverse auction model has the buyer stating the price that
they are willing to pay for the item and the sellers determining whether or not
they wish to accept the offer price. The opaque nature of much of the travel
information on Priceline.com is so the sellers, who are discounting from their
normal full price, are protected and not subject to adverse customer reactions and
low ball bids in their normal sales venues. Priceline.com keeps the reverse
auction bidding process from deteriorating into a haggling model by limiting the
bidders to one bid per trip per day. If it is rejected, then they must wait 24 hours
before submitting a higher bid on the same trip.
13. Was the reverse auction model successful when it was applied to grocery items
and gasoline? Why? What are the economic and psychological limits to the
reverse auction model?
On one level the reverse auction bidding process was successful in that some
people were devoted to the activity. However, grocery items and gasoline are low
value products as opposed to high value airline tickets. The bidding process was
cumbersome and time consuming. Therefore, it failed for lack of sufficient
volume of activity to make the process profitable. The bidding has to be worth
the reward and the entire process can lead to a perception of unfairness as full fare
travelers are seated next to half-price travelers on the same airplane trip.
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14. Explain Amazon.com’s penetration pricing strategy. In what sense is it an
adaptation of the cont-of-service pricing scheme? Is the Amazon Strategy
threatened by the existence of shopping bots? Why?
The Internet retailing system involves a high fixed cost of site construction, along
with warehousing and shipping. The Amazon strategy involved pricing the
product low enough to penetrate the retail market and get sufficient volume to
lower the average fixed cost per order. This would allow the firm to eventually
make a profit with a price just slightly above the variable cost of the item. The
extra cost of an additional order placed, packed and shipped is small to zero given
the minimum fixed capacity needed to carry on any business at all. Therefore, the
penetration model is an adaptation of the cost-of-service scheme with Amazon
trying to hit a hit volume of orders. Shopping bots continually search the Web
looking for the lowest price for each item. This makes it difficult for any e-seller
to compete on price alone. Fortunately for Amazon, they also try to compete on
the nature of the shopping experience and the reliability of the service.
Purchasing for the site with the lowest e-price is of little value of the item is never
delivered or if it is delivered well past the promised date.
15. How does the Web influence the tension inherent between the forces working to
drive prices lower and those that work to drive prices higher? If price
competition on the Web is to be successful for an individual firm, what implicit
assumption must hold? Does the Web work to reinforce or undermine this
assumption? Why?
The Web lowers the search costs for both consumers and rivals. As such, it works
to drive prices lower in the absence of the ability of rivals to coordinate their
behavior. Conversely, if coordination is possible and the disciplining of cheaters
is easy, then the ready ability to see the prices being charged by your rivals makes
it more likely that rivals might come together and fix prices raising them above
the competitive level. If price competition is to convey a competitive edge then
consumers must learn about and react to price concessions before rivals can react.
The ready availability of price information on the Web to rivals and potential
customers alike undermines this assumption, and works to possibly limit price
cuts as an aggressive tool of competitive behavior.
16. Salon.com has chosen to impose a fixed annual fee as its pricing strategy. How
does this fee set up a reader conflict with the value-of-service pricing scheme? In
what ways might Salon resolve this tension?
The fixed fee is aimed at attracting sufficient subscriber revenue from an
anticipated customer base to raise enough money to cover the cost of providing
the editorial content. It does not take advantage of those readers who really love
the site and would be willing to sacrifice some of their consumer surplus and pay
even a higher price for the service. Salon might introduce a two-part tariff
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charging a modest fixed price to gain access to the list of specialized content
articles, which are then charged on a per unit basis if the subscriber wishes to read
the article.
17. What is a contribution margin? How has Salon.com used this concept to help it
potentially generate a sustaining level of normal profits?
A contribution margin is revenue above variable cost that contributes to the
coverage of fixed costs and a normal profit. The selling of Weblog or blog space
for a subscription fee is an example of an activity where Salon is earning a
contribution margin. With enough of these subscription services tied to the image
of Salon and the Salon community, the firm might be able to earn sufficient
revenues above variable costs to place its financial house in order.
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