Sunday, January 6, 2008

The One-Price Myth, Part One

In my first days in business school, my microeconomics professor (and an excellent professor he was) presented what I call the One-Price Myth - one of economics' favorite theories, one that is as flawed as it is compelling. The basic idea is that in a world with perfect information and no artificial barriers to competition (e.g. patents), every product is a commodity and will sell at the lowest price possible.

The argument is compelling - when you sell the same product as someone else, customers will only buy from the person who sells the product the cheapest, forcing everyone to price at the lowest price they can charge. The higher-priced sellers (who may just suffer from having a worse cost structure) will go out of business, leaving the remaining vendors with one low price. (This is a bit of an over-simplification since it ignores the effects of local cost structures and the fact that it costs a customer time and money to travel long distances to buy a product ... but for a given area, this should be true - shouldn't it?)

One could argue that most retail is just the business of selling products that anybody else can sell, and that the advent of the internet, price comparison websites and online stores selling just about everything makes for an environment of perfect competition. So the same product should cost the same amount everywhere, right?

The Nash Equilibrium website offers some fascinating insight. The website is named after one of the fundamental tenets of Game Theory, postulated by John Nash of A Beautiful Mind fame, which states that in any multi-person game, an equilibrium only exists when no player can benefit by unilaterally changing their strategy. The website tracks internet price competitiveness, i.e. the level of price competition seen on the internet, as measured by the price variation on various pricing sites. Here's the price gap data on the website - a graph that summarizes the difference in price between the two lowest prices for every product that they track.

Price Gap data on

What's interesting about this graph is that the price gap appears to have slowly moved towards a non-zero "equilibrium" - i.e. the price difference fluctuates in a narrow band around 2%. What gives?

The obvious answer is that a product is never just a product. This is more true in brick-and-mortar stores than with online retailers, but it does hold true online too. The reputation of a website and the customer experience it provides are also determining factors that create the potential for charging different prices. For example, has built a reputation for charging low prices (close to the lowest prices offered by any reputable vendor), offers many of its customers free expedited shipping on most products it sells (through the Amazon Prime program) and has an easy and clear return policy. People are usually willing to pay more for a trusted website that offers these perks. All these factors make it less likely that customers will shop elsewhere for, say, a 2% price difference.

Sure, reputation makes a difference, but what about a well-known big-ticket item sold by different well-known retailers? Shouldn't that cost pretty much the same anywhere? After all, people are more likely to be price sensitive for big ticket items, especially when reputation is less of a factor, right?

Glad you asked.

Here's the price range on a 46" flat-panel Sony TV (KDL-46XBR4), on some popular internet retailers: $2719.96 $2969.99 $2699.99
( $3099.99)


And here's the price range on a Canon EOS40D kit (with 28-135mm lens) $1399.99 $1499.99 $1399.99

That's wacky, isn't it? What gives?

At least two things.

First, the strategy of randomization comes into play. All things being equal, it acutally pays to randomize your price from time to time within a certain price range. Why?

  • You can attract price sensitive customers when you're the cheapest game in town.
  • At the same time, you can charge many customers who are less price sensitive and have built a relationship with you a slightly better price, depending on when they make their purchase. Further, by offering a price guarantee, many retailers ensure that loyal but price sensitive customers don't feel screwed - if they see a lower price on the same website within 30 days, customers can ask for and get a refund of the difference. Most won't.
    Just because information exists doesn't mean people use it. You'd think most people would comparison shop for big ticket items, but there's a surprising number who don't. Once a vendor acquires a reputation for pricing reasonably, many people will just assume their price is pretty close to the best price they can get and buy from them repeatedly. Of course, the vendor has to make charging a low price part of their strategy for this to work. One or two bad experiences will drive "trust" shoppers away in droves.
  • It makes it less likely that you and your competition will get into a price war and drive the prices down to a level where nobody's making much money.
In other words, price randomization within a certain range is a Nash Equilibrium - nobody can do better by unilaterally changing their strategy because they'll either make near-zero profits on every deal (by always charging the lowest possible price), or they'll bleed customers, and eventually money (by consistently pricing higher).

Second, the customer experience and additional benefits offered still create opportunities for pricing differently. Despite being well-known brands, Amazon has a very different customer experience than Best Buy or Circuit City (with Circuit City, IMHO, being the worst of the three, and Amazon up-and-away the best). Creating a superior customer experience costs money. Customers understand this, and the people who value the experience are willing to pay for it. A product is never just a product. This is the same reason why outlet shopping and traditional retail can coexist at significantly different price points - for some people, the outlet shopping experience makes the lower prices unattractive.

But what really surprised me is that Best Buy had higher prices for both the products I chose above, and the prices were significantly higher. One possible explanation is that the brand association with electronics is strong enough and carries over from the brick-and-mortar stores to the web so that lots of people who want to shop for big box items online automatically shop at, and the difference in margin more than makes up for those who don't . Another possible explanation is that Best Buy doesn't yet get this online thing. :)

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