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CHAPTER 4
Business
Strategies and
Conduct in the
Electronic
Marketplace
FUNDAMENTAL ISSUES
After you have read this chapter you should be able to
1. Define price discrimination.
2. Explain why firms typically practice imperfect price discrimination.
3. Describe how firms can use tie-in sales and bundling to engage in price discrimination.
4. Evaluate aspects of the electronic marketplace that simplify efforts to practice price
discrimination.
5. Identify factors that influence whether a company will vertically integrate to include online
selling within its scope of operations.
6. Discuss rationales for the use of vertical restraints by Internet sellers.
CHAPTER OUTLINE
I. Price DiscriminationSome Basics
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This chapter examines economic rationales underlying alternative business strategies in the
electronic marketplace. It explains how e-commerce firms can gain from price
discrimination and discusses strategic pricing issues in the electronic marketplace, vertical
integration in e-commerce, and alternative perspectives on the use of vertical restraints by
Internet sellers.
A. Perfect Price Discrimination
Internet sellers engage in price discrimination when they charge different consumers
different prices for identical goods or by charging the same consumer different prices for
the same good depending on how many units the consumer purchased. From the firm’s
perspective, the idea behind price discrimination is to try to capture as much consumer
surplus as possible, by charging prices that are equal to, or at least close to, the prices that
individual customers are willing to pay. To effectively engage in any form of price
discrimination, an Internet seller must be able to prevent its customers from reselling its
product. Otherwise, a consumer who was willing to pay a relatively low price could buy
the product and then offer to sell it to another consumer. If a firm is able to engage in
perfect price discrimination, it able to charge the maximum price that each and every
consumer is willing to pay for each unit of the product that it sells, thereby capturing all
consumer surplus in the form of higher profits. One way a firm can try to implement
price discrimination is via a two-part tariff, in which it imposes a lump-sum fee together
with a per-unit charge based on the quantity consumed, whether the product is sold in
volume or via periodic unit sales.
B. Imperfect Price Discrimination
1. Differential Pricing for Different Groups of Consumers
In many situations, Web-based firms cannot readily determine exactly how much each
customer is willing to pay to consume any given quantity of the firm’s product, so
perfect price discrimination normally is infeasible. Then a firm may still be able to
improve its profitability by practicing imperfect price discrimination, which entails
charging different prices to different groups of consumers.
2. Imperfect Price Discrimination with Two-Part Tariffs and Consumer Self-Selection
Under imperfect price discrimination, the firm varies the price it charges to a
consumer depending on whether the consumer is part of a group with relatively elastic
or inelastic demand for the firm’s product. Implementing a two-part tariff is one way
that a firm might be able to induce consumers to self select into such groupings. Then
it can boost its profits by charging a lower fixed fee to consumers with relatively
elastic demand and a higher per-unit price to consumers with relatively inelastic
demand.
II. Other Methods of Price Discrimination
A. Tie-In Sales
One way to practice price discrimination is to pursue tie-in sales, or agreements under
which a firm permits a customer to buy one good or service if the customer purchases
another good or service as well. There are many reasons firms may use tie-in sales that
CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
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have nothing to do with efforts to engage in price discrimination, such as efficiency gains
and quality assurance associated with selling highly complementary items together. In
addition, a firm within a cartel might use tie-in sales to grant secret price discounts to its
customers by selling the cartel’s product at the price established by the cartel but selling a
related product at a discounted price, to attract customers from other cartel members.
Nevertheless, tie-in sales also can be sued to engage in price discrimination via higher
charges to high-volume users of a product that is complementary to another item it sells,
or to develop implement two-part tariffs with separate prices for the two goods sold
within a tie-in arrangement.
B. Product Bundling
Another related method of price discrimination is bundling, or the joint sale of two or
more products. A firm that bundles sells a unit of one product to a consumer only if the
consumer simultaneously buys a unit of another of the firm’s products. This can allow
the firm to boost its revenues by selling products jointly to consumers with a different
willingness to pay for the separate products but the same willingness to pay for the bundle
of products.
III. Strategic Pricing in E-Commerce
A. Versioning
1. Versioning as a Method of Price Discrimination
Specific characteristics of the goods and services produced by some Internet sellers
makes them readily amenable to price discrimination. Versioning, or selling products
in slightly different forms to different groups, is one way that Web-based firms can try
to price discriminate.
2. Versioning in the Electronic Marketplace
Information-intensive products, for which a crucial factor of production used to
manufacture a good or provide a service is a rapidly evolving base of knowledge, are
particularly amenable to versioning, because the companies that sell them can control
the pace of product updates or upgrades.
3. A Problem of Interpretation: Different Versions, or Different Products?
A company that engages in versioning does not necessarily practice price
discrimination. Firms may initially engage in versioning in an effort to price
discriminate but can create separate markets for product versions sufficiently distinct
that consumers begin to regard them as different goods or services. Over time,
different versions of the same product can evolve into different products exchanged in
separate, competitive markets.
B. Is Perfect Price Discrimination Feasible in the Electronic Marketplace?
1. Direct Interactions and “Personalized Information”
In addition, the nature of interactions between e-commerce firms and their customers
and the use of information technologies by Internet sellers potentially simplifies the
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CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
strategic use of pricing to enhance profitability. To determine the prices to quote, the
Internet seller possesses considerable data to analyze to infer the shopping and buying
habits of its customers. This does not necessarily imply that e-commerce firms are
able to practice perfect price discrimination. Nevertheless, the customer-contact and
information-gathering advantages inherent in Internet selling can enhance the ability
of Web-based sellers, as compared with traditionally brick-and-mortar firms, to
capture a larger portion of consumer surplus.
2. A Fundamental Limitation on Price Discrimination: Competition
There is an important constraint on the ability of any firm to price discriminate, which
is that charging relatively high prices to any group of consumers give those consumers
an incentive to search for alternative products. Furthermore, if the companies’ pricediscrimination strategies generate significant economic profits, there is an incentive
for other firms to enter the marketplace. Firms that have the capability to price their
products strategically typically must balance short-term profit gains against longerterm erosions in their ability to engage in price discrimination in the face of the entry
of new rivals.
IV. Vertical Integration and Vertical Restraints On and Off the Web
A. Vertical Integration Offline and Online
Vertically integrated companies handle two or more successive stages of production and
distribution of their products.
1. Vertical Integration to Reduce Costs and Improve Efficiency
Firms may vertically integrate to reduce operating costs by combining stages of
production within one firm.
2. Will the Internet Bring About the Demise of the Industrial-Age Corporation?
Vertical integration via e-commerce may reduce transaction costs entailed in
exchanging products, assets, and information or associated with negotiating contracts
and monitoring adherence to contracts.
3. Vertical Integration in Search of a Market Niche
Companies may decide to integrate online product distribution into their operations in
an effort to enhance the potential sales of products that otherwise might be
overlooked in the marketplace. They may also vertically integrate to try to capture
actual or potential economic profits available to current firms in the electronic
marketplace.
4. Vertical Integration to Enhance Pricing Power
A firm that has pricing power over a product may vertically integrate in an effort to
extend or enhance its ability to engage in strategic pricing.
B. Vertical restraints in E-Commerce
Vertical restraints are binding contractual limitations that a nonintegrated firm places on
the behavior of another firm from which it buys or to which it sells.
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1. Vertical restraints as Anticompetitive Tools
Companies may try to protect competitive positions by establishing vertical restraints
limiting the distribution of their products. Existing firms might also be able to use
vertical restraints to perpetuate cartels by engaging in resale price maintenance by
using open pricing on Web sites to simplify to policing cartel agreements.
2. Alternative Rationales for Vertical restraints
Firms may impose vertical restraints to avoid the free-rider problem, or a situation in
which one agent benefits from the provision of a good or service by another agent
without having to contribute to the provision of that good or service, as can arise in
advertising or distribution relationships. They may also establish vertical restraints to
ensure joint coordination of joint sales efforts with advertisers or distributors.
KEY TERMS AND CONCEPTS
Bundling
Free-rider problem
Imperfect price discrimination
Information-intensive product
Marginal factor cost
Marginal revenue product
Monopsony
Perfect price discrimination
Price discrimination
Resale price maintenance
Self selection
Tie-in sales
Transaction costs
Two-part tariff
Versioning
Vertical integration
Vertical restraint
TRUE-FALSE QUESTIONS
Click on T if the statement is true; click on F if it is false. Explain to yourself why a statement is
either true or false.
T F 1. Under perfect price discrimination, an e-commerce firm’s economic profits equal the
entire area under the product demand curve up to the quantity sold minus the firm’s
total cost of producing that quantity.
T F 2. A firm in a perfectly competitive market can practice price discrimination.
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CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
T F 3. When an Internet seller uses a two-part tariff to price discriminate, it allows
consumers to buy one product only if they also purchase another one simultaneously.
T F 4. The only explanation for tie-in sales is a desire to engage in price discrimination.
T F 5. Incomplete information about consumers’ willingness to pay makes it impossible for
an Internet seller to practice perfect price discrimination.
T F 6. Selling two or more products to consumers simultaneously could be either a situation
of tie-in sales or a situation of bundling.
T F 7. Among the hardest products to sell at different prices to different consumers are
information-intensive products.
T F 8. Some firms vertically integrate so that they can enter markets where they perceive
economic profits are being earned by existing firms.
T F 9. The manufacturer of a product practices resale price maintenance when it establishes a
minimum price that Web retailers are permitted to charge for its product.
T F 10. Free riding refers to a Web surfer’s choice to navigate a site exactly as an Internet firm
has designed it, rather than to search for specific pages within the site.
MULTIPLE CHOICE QUESTIONS
Click the option corresponding to the single best answer.
1.
Which of the following statements is true of an Internet seller that practices perfect price
discrimination?
I. It charges each consumer’s willingness to pay for each item purchased.
II. It has incomplete information about each consumer’s product demand.
III. Its profits include what would have been consumer surplus under perfect competition.
A. both I and II only
B. both I and III only
C. both II and III only
D. I, II and III
2.
To engage in price discrimination, an e-commerce firm must be able to prevent resale of its
product by consumers, because
A. U.S. legal statutes prohibit price discrimination otherwise.
B. otherwise the firm’s total revenues will be less than its total variable costs.
C. otherwise some consumers could buy its product at a low price and sell it to other
consumers at a price below higher prices the firm tries to charge those consumers.
CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
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D. if resale is possible any consumer could buy its product at a price lower than the firm’s
marginal cost, thereby preventing the firm from maximizing its economic profits.
3.
Which of the following is an example of a two-part tariff that a producer might use to
engage in price discrimination for software that consumers must regularly upgrade via
downloadable file transfers?
A. Selling two versions of its software at different prices.
B. Selling two software products together as a single package.
C. Letting consumers choose either (1) to pay a high price to buy one unit of its software or
(2) to pay a lower price for each unit if consumers instead purchase two units of the
firm’s software.
D. Letting consumers choose either (1) to pay a high price to access upgrade downloads at
its Web site and a low price for each download or (2) to pay a low price to access
upgrade downloads at its Web site and a high price for each download.
4.
An e-commerce firm is able to induce consumers to self select into two groups, group A and
group B. Group A has a relatively higher price elasticity of demand as compared with group
B. To maximize its economic profits, the firm should produce to the point where marginal
revenue equals marginal cost, and as long as price charged each group exceeds the minimum
feasible average variable cost,
A.
B.
C.
D.
5.
charge a higher price to consumers in group A.
charge a lower price to consumers in group A.
sell its product only to group B.
sell its product only to group A.
A profit-maximizing Internet seller is currently selling sizable amounts of its product to two
groups of consumers, group X and group Y. It charges a lower price to group X than it does
to group Y. Which of the following is most likely to be true of these groups of consumers?
A. Consumers in group X can purchase unlimited quantities of the firm’s product from
consumers in group Y.
B. Consumers in group X can resell unlimited amounts of the firm’s product from
consumers in group Y.
C. The demand curve for group X is more inelastic as compared with the demand curve of
group Y.
D. The demand curve of group X is more elastic as compared with the demand curve of
group Y.
6.
An e-commerce firm sells produces a good and provides a related service. Even though the
good and service could be marketed as separate items, the firm only sell the two as a
package. This is an example of
A. bundling.
B. versioning.
C. a vertical restraint.
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D. vertical integration.
7.
An Internet advertising firm provides two types of Web ads. The table below reports the
annual willingness to pay for its two main customers.
Web Ad Product X
Web Ad Product Y
Customer 1 Willingness to Pay
$80,000
$70,000
Customer 2 Willingness to Pay
$50,000
$100,000
Suppose that the firm always prices its products to maximize its total revenues, given its
choice of how to market its Web ads. Which of the following statements is correct?
I. If the firm sells each product individually, its total revenues equal $180,000.
II. If the firm sells the products only as a package, its total revenues equal $300,000.
III. If the firm initially sells its products separately but then bundles them together as a
single package, its revenues rise by $120,000.
A. both I and II only
B. both I and III only
C. both II and III only
D. I, II, and III
8.
To engage in bundling to boost its revenues, an e-commerce firm must
I. be a multiproduct firm.
II. be a vertically integrated firm.
III. be a perfectly competitive firm.
A. I only
B. III only
C. both I and II
D. both II and III
9.
A rapidly expanding base of knowledge is a fundamental characteristic of
A.
B.
C.
D.
a bundled product.
a vertically restricted product.
a vertically integrated product.
an information-intensive product.
10. Which of the following is not helpful to a Web-based firm in gauging consumers’ price
elasticity of demand?
A. information about customers’ navigation paths through the firm’s Web site
B. information about the frequency of customers’ visits specific Web pages
CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
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C. data on the firm’s total expenses on its hardware and software inputs
D. data on past purchasing patterns tabulated by the firm’s Web server
11. An Internet seller has been able to maintain high economic profits by engaging in price
discrimination. Recently, however, its profits rose even though it did not change the prices
posted at its Web site. Which of the following could help to explain this observation?
I. increased consumer willingness to pay for the firm’s product
II. the exit of rival firms from the electronic marketplace
III. decline in consumer demands for the firm’s product
A. I only
B. III only
C. both I and II
D. both II and III
12. When the stages of production, marketing, and distribution are combined within a single
firm, then the firm
A.
B.
C.
D.
engages in price discrimination.
imposes vertical restraints.
is vertically integrated.
practices versioning.
13. Combining stages of production, marketing, and distribution typically harms consumers
when the firm’s
A. operating costs are reduced.
B. ability to set prices is enhanced.
C. costs associated with contractual agreements decline.
D. costs of monitoring production, marketing, and distribution processes fall.
14. Which of the following is an example of vertical integration?
A. An Internet bank acquires a rival Web-based banking firm.
B. A bricks-and-mortar banking firm acquires an Internet bank.
C. An Internet retailer insists on the exclusive right to offer a software manufacturer’s
downloadable product.
D. The manufacturer of a downloadable software product requires an Internet retailer to sell
only its software brand.
15. Which of the following is an example of a vertical restraint?
A. An Internet retailer requires a Web advertising firm not to do business with any of any of
its rivals in the electronic marketplace.
B. A Web broker buys a network of automated teller machines for customers to use for
account deposits and withdrawals.
C. An e-commerce toy distribution company purchases a rival Web-based toy distributor.
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D. A bricks-and mortar toy retailer purchases an e-commerce toy distribution company.
CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
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ANSWERS TO CHAPTER 4
TRUE AND FALSE QUESTIONS
1.
T Under perfect price discrimination, the firm is able to charge all consumers the price
they are willing to pay for all units produced, so its total revenues equal the area under
the demand curve up to the quantity consumed. So its economic profits equal this area
minus the total cost of producing the quantity the firm sells to consumers.
.
2. F Only an imperfectly competitive firm that has the ability to set the price of its own
product can engage in price discrimination.
3.
F When a firm charges a two-part tariff, it charges a lump-sum fee to consume a product
and a per-unit charge based on the quantity consumed.
4. F There are other reasons for tie-in-sales, including efforts by firms to operate more
efficiently, to assure quality by selling highly complementary items together, or to grant
secret price discounts in an effort to undercut cartel arrangements.
5. T
Perfect price discrimination entails charging every consumer a price equal to the
consumer’s willingness to pay, which requires complete knowledge of each consumer’s
demand for a product.
6. T Many economists classify bundling as a particular form of tie-in sales.
7. F In fact, information-intensive products are particularly amenable to versioning.
8. T This is one possible rationale for vertical integration.
9. T This is an example of resale price maintenance.
10. F Free riding occurs when someone who benefits from the provision of a product fails
contribute to the product’s provision.
MULTIPLE CHOICE QUESTIONS
1.
B A firm that is able to engage in perfect price discrimination is able to charge each
consumer the price he or she is willing to pay for each unit the consumer buys, and as a
result the firm captures all consumer surplus for itself. To do this, the firm must know
about each consumer’s willingness to pay, so the firm must have full information about
consumer’s demands for its product.
.
2. C To be able to price discriminate and charge consumers prices that reflect their differing
levels of willingness to pay, a firm must be able to prevent consumers with relatively
low willingness to pay from buying its product at low prices it charges them so that they
can profit from reselling the product to consumers with a higher willingness to pay.
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3.
CHAPTER 4: BUSINESS STRATEGIES AND CONDUCT IN THE ELECTRONIC MARKETPLACE
D Selling two versions of its software at different prices is versioning, and selling two
software products together as a single package is bundling. Charging lower prices for
larger quantities consumed would simply take into account the law of demand faced by
an imperfectly competitive firm. Offering consumers the opportunity to self select into
groups by offering different combinations of access and download prices is the only
example listed that corresponds to a two-part tariff.
4. B As long as the price the firm charges each group exceeds the minimum feasible average
variable cost, the firm should sell to both groups, and to maximize its economic profits
it should charge a lower price to the group with the higher price elasticity of demand,
which is group A.
5. D If a firm is selling large quantities to two groups of consumers at different prices, then it
must be able to hinder or perhaps prevent resale of its product, and to maximize its
profits it charges a lower price to the group with the higher price elasticity of demand,
which is group X.
6. A When a firm sells two or more goods together as a package, its bundles its products.
7. D To maximize its sales from selling the products individually, it would price Web ad
product X at $80,000 per year to maximize its revenues by inducing a purchase by
customer 1, and it would price Web ad product Y at $100,000, thereby obtaining
$180,000 in total revenues. To maximize revenues from bundling, it would charge an
annual price for both products together equal to $150,000 to induce both consumers to
buy the Web ad product package, thereby earning $300,000 in total revenues, or
$120,000 more revenues than before.
8. A Either firms that are or are not vertically integrated can engage in bundling as long as
they are multiproduct firms selling at least two products. But they can practice price
discrimination only if they have the ability to set the prices of their products, which is
not available to perfectly competitive firms.
9. D By definition, a rapidly expanding base of knowledge is a key input for an informationintensive product.
10. C Information about navigation paths, frequency of visits to Web pages, and past
purchasing habits are all potentially useful in gauging customers’ demand elasticities,
but cost information does nothing to help the firm in this endeavor.
11. C All options relate to factors affecting demand, and it could be that consumers demand a
larger quantity of this firm’s product at each posted price. This means that the demand
for the firm’s product has increased. Either an increased willingness to pay or the exit
of rival firms could bring this about.
12. C By definition combining production, marketing, and distribution within one company
produces a vertically integrated firm.
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13. B Consumers are harmed by vertical integration only when combining production,
marketing, and distribution processes enhances the firm’s pricing power. The other
options all refer to rationales for vertical integration that tend to reduce costs, which in
turn tends to push down prices and benefit consumers.
14. B Acquisition of a firm that provides another means of distribution, such as a traditional
bank’s purchase of an Internet bank, is an example of vertical integration. The
acquisition of a rival firm is not. Neither are contractual restrictions between
manufacturers and distributors, which are vertical restraints.
15. A A restriction on the ability of a Web advertiser to have accounts with rival firms is an
example of a vertical restraint. The other options relate to vertical integration and a
merger between rivals, which are not the same as this concept.
GLOSSARY TO CHAPTER 4
Bundling: Offering two or more products for sale as a set.
Free-rider problem: Failure of an agent that benefits from the provision of a product to
contribute to the provision of the product.
Imperfect price discrimination: Charging different prices to distinct groups of consumers or
charging a different price to a consumer depending on whether the consumer classified within
a group that buys relatively small or large quantities.
Information-intensive product: A good or service for which a fundamental productive input is
a swiftly developing foundation of knowledge.
Marginal factor cost: The additional cost that a firm incurs from employing an additional unit
of a factor of production.
Marginal revenue product: Marginal revenue times marginal physical product of a factor of
production, which is the contribution to a firm’s total revenue of an additional unit of that
input.
Monopsony: As single buyer in a market.
Perfect price discrimination: Charging each consumer the maximum price that the consumer is
willing to pay for each unit consumed, thereby capturing the entire amount of consumer
surplus; also known as first-degree price discrimination.
Price discrimination: Charging different consumers different prices for the same product or
charging the same consumer different prices for different quantities of the same product.
Resale price maintenance: Setting a minimum price that retailers are permitted to charge for a
product.
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Self selection: Consumers voluntarily sort into identifiable groups by choosing among
alternative pricing schemes offered by a firm.
Tie-in sales: Purchases of a particular product that are permitted only if a consumer buys a
different good or service from the same firm.
Transaction costs All the costs associated with economic exchanges, including the costs of
acquiring and disseminating information, plus the costs of negotiating and enforcing
contracts.
Two-part tariff: Charging a lump-sum fee to consume a product and a per-unit charge based on
the quantity consumed.
Versioning: Selling essentially the same product in slightly different forms to different groups
of consumers.
Vertical integration: Incorporating two or more successive stages of production and
distribution of a product within the same firm.
Vertical restraint: A legally binding limitation that a nonintegrated firm places on another firm
from which it buys or to which it sells.