Internet Shopping Agents: Virtual Co-location and Competition

Abstract

Recently, we have experienced an emergence of comparative Shopping Agents (ISAs) that allow consumers to costlessly search across many online retailers and buy at the lowest price. An ISA can be thought of as an institution that creates all or nothing type of competition in the following sense: Because consumers see all the retail prices with a single search, a retailer of a homogenous good should get all the demand if it charged the lowest price in the ISA, but should get absolutely nothing if it charged a price that was even slightly higher. One would expect these ISAs to reduce frictions and lead sellers of homogenous goods (CDs, books and videos) who join the institution to indulge in intense price competition. Yet many Internet retailers have rushed to join these ISAs. There is also ample evidence that instead of charging uniform prices, the prices charged by retailers inside the ISA vary substantially for any given consumer search. Furthermore, while some retailers do join ISAs, there are also others who simultaneously elect to stay out and block the entry of shopping agents to their sites. This paper offers a rationale for the above phenomenon. It traces out the set of economic forces that govern the emergence and functioning of these ISAs and their effect on market competition. Our investigation of this institution is predicated on a framework that highlights the role of consumer differences in retailer loyalty as well as the propensity to search the institution. An ISA creates differentiation in the pricing strategies of ex-ante identical retailers. In equilibrium, some retailers choose to join the ISA motivated by the mass of consumers that they can win, while others simultaneously elect to stay out and focus on extracting surplus from the store-loyal consumers who are willing to pay their reservation price. The nature of pricing practiced by the retailers that join the institution is such that the average price charged actually increases with the number of retailers joining. The average prices paid (minimum posted prices) by consumers that shop the ISA can increase or decrease when more retailers join, depending on whether or not the reach of the ISA is independent of the number of joining retailers. We show that when the reach of the institution is endogenous and when the traffic at the ISA confers complementary side-benefits such as advertising revenues, there exists a unique number of retailers who will join the institution. We show that the ISA will have the incentive to share the side-benefits with the inside retailers. In fact, there are conditions where the ISA will strategically plough back a portion of the side benefits into the retail market, creating a situation in which not only the ISA and the inside retailers gain, but also the outside retailers are better off (than in a world without an ISA). The extension to the case of heterogeneous retailer loyalty helps us to identify what type of retailers are most likely to join the ISA and how the institution affects the pricing strategies of different types of retailers. Finally, we also provide empirical validation for several results using pricing data gathered through 5 leading ISAs on 35 items in the books, CDs and movie video categories. We find support for the prediction that retailers inside an ISA use probabilistic pricing, for the result that the average price is increasing in the number of retailers in an ISA, and for the prices that consumers pay.