Monday, November 21, 2011

Internet commerce will foster price competition

The critics of economists often accuse them of trying to change the world to make it more like their textbooks. But now the mountain is coming to Muhammad. The internet, and the electronic commerce it promotes, is making real-life markets work more the way economists assume they do.

As the retailers - particularly the department stores - have sought to explain the weak growth in their sales, their gaze has fallen on the internet. The high dollar has made it more attractive for people to buy stuff on the net from overseas sites. And people who buy from foreign sites don't have to pay goods and services tax on purchases of less than $1000.

As an explanation for their weak sales, it's not persuasive. The share of consumer spending accounted for by internet purchases is still quite small. The more likely explanation is simply a shift in consumer preferences from goods to services.

But internet purchases will become a significant competitive challenge to retailers as people get more experienced at and relaxed about internet shopping. (And as Australia Post gets better at delivering parcels to households without a stay-at-home spouse.)

It's a mistake, however, to imagine it's primarily the high dollar that will drive this trend (or that the presence or absence of a 10 per cent GST makes much difference). No, the primary source of internet bargains is the existence of what economists call ''price discrimination'': the longstanding practice of international suppliers charging higher prices in some markets than others.

Global firms selling books, music, DVDs, software, sneakers and much else know the punters' ''willingness to pay'' varies greatly between countries. Why? Because, for instance, Aussies are simply used to paying higher prices than Americans are.

Such price discrimination is a great way to maximise profits - provided you can keep the various markets separate and stop people in high-price markets switching their purchases to low-price markets.

Various global industries have long used legislated restrictions on ''parallel imports'' to protect their price discrimination arrangements - against which economic rationalists have long fought mainly losing battles. But all that legal protection is being swept away as the internet provides us with direct and easy access to cheaper American goods. This will put a lot of pressure on Australian retailers (and their foreign suppliers and landlords) to lower their prices.

Cyberspace breaks down the natural protection provided by oceans and geographic distance (although, of course, this becomes less true as the bulkiness of the goods in question increases, making transportation over long distances uneconomic).

So it breaks down barriers between certain geographic markets and also breaks down barriers to firms entering a particular market. If you're a big, established player in a physical market, it's very hard for me to start up in competition with you and get myself noticed. In cyberspace, however, a web browser that finds your huge site will list my bedroom operation beside it. It takes the punter only a few clicks to check me out after he's checked you out. Since I don't have the brand recognition you have, my price may well be 5 or 10 per cent lower. I can't charge a premium for my established reputation for quality and reliability.

In its basic form, the economists' model assumes there's no cost in money or time to gather all the information you need to be a fully informed buyer or seller in a market. In reality, there's often a lot of cost involved.

So much so that the possession of information is often ''asymmetric'' - the seller knows a lot more about what's what than the buyer does. This asymmetry tends to favour (professional) business over (amateur) punters (except in the labour market, where a worker knows far more about their personal strengths and weaknesses than a potential employer does).

Clearly, the internet greatly reduces the cost of gathering information so as to make better-informed decisions. This should reduce the asymmetry of information, thus shifting reality closer to the model.

The economists' model focuses on price - the price of the item in question relative to other prices - as the key to how markets work. It assumes relative prices (''incentives'') are the only motivator and that all competition is price competition.

In reality, oligopolies much prefer non-price competition via advertising, marketing (such as the nature of the packaging) and merchandising (where and how you display items in your store).

On the internet, many of these non-price devices are a lot less ''salient'' (prominent), thus making prices more salient. And the internet is a lot better at gathering and comparing price information than information about qualitative considerations.

According to a psychology experiment, when people face a choice between an interesting job paying $80,000 a year and a boring job paying $90,000, most choose the boring one. That's not because they're money-hungry, but because of the limits to our neural processing power: we focus on the numerical comparison because it's a lot easier than the qualitative comparison.

Information technology makes it a lot easier and less costly for firms to adjust their prices (while allowing them to collect better information about the right direction and size of those adjustments).

So it's likely the more commerce we do on the net, the more importance will be attached to price - just as the economists have always assumed.