E-commerce: 'Net-style Nash Equilibrium

Five years ago, the first price-comparison Web sites were being hailed as heaven on earth for penny pinchers and the fast track to Hell for online merchants who failed to establish and protect a unique reason for being. That early assessment turns out to have been not so hot, says Michael Baye, an economics professor at the University of Indiana.

Five years ago, the first price-comparison Web sites were being hailed as heaven on earth for penny pinchers and the fast track to Hell for online merchants who failed to establish and protect a unique reason for being.

That early assessment turns out to have been not so hot, says Michael Baye, an economics professor at the University of Indiana. Baye and his colleagues have undertaken an exhaustive analysis of price-comparison sites and what they mean for Internet commerce. Oh, it turns out that consumers are indeed getting more or less what they were promised - direction to bargains, lower average prices overall - and the price-comparison sites are doing just fine, witness the growing number of portals offering such services of their own. However, the predictions of brutally efficient markets extracting every last nickel of profit from sellers have proven to be less than prescient.

The whys are interesting, if somewhat confusing, at least to those of us who bluffed their way through college economics.

The Web site containing Baye's research - www.nash-equilibrium.com - features an enormous data dump that only an economist could fully appreciate. So we'll focus on just a couple of key points here.

Five years ago, the difference between the lowest price and the average price surveyed was 13%. Today, it's up to 18%, which would make no sense whatsoever if the predictions of cutthroat competition leading prices to the bottom had indeed borne out. Also over that span, the difference between the highest and lowest prices climbed from 32% to 45%. Again, not what those peddling gloom for sellers would have expected.

What happened?

"It's taken firms awhile to figure out how to coexist in the market," Baye says. "If you look at the early data it's very clear that firms didn't really understand the nature of the game they were playing, and there was some movement toward the bottom [on prices]. But then over time firms have learned that to coexist in the market, they've got to use mixed strategies to keep their rivals from being able to systematically undercut their prices."

He calls the concept hit-and-run pricing.

"If my price changes every day or every week, you can't systematically know what price you have to charge to beat me," Baye says. "Firms have learned that the only way you're going to survive in this environment is to use hit-and-run pricing strategies and the consequence has been the increases in dispersion of prices" noted above.

Yet the consumer still manages to benefit.

"The fact that the average difference between high and low prices today is 45% compared with 32% in 2000 - doesn't mean that average prices are higher today; in fact, average prices are lower, largely because of growth in the number of online sellers," he says.

What we've got here is one of those Nash Equilibriums made semi-famous by Nobel Prize-winning economist John Nash before being made Hollywood famous by Russell Crowe in the movie "A Beautiful Mind."

"Obviously to the extent that any firms' position in the distribution of prices changes over time, the information that consumers obtain from price-comparison sites becomes stale over time," Baye says. "So just because hypothetically Buy.com is offering the lowest price today doesn't mean that it's going to be offering the lowest price for that same product tomorrow or next week. If you want to get the best deal, you're going to have to continually go back to the price-comparison site, which is a happy thing for the price-comparison site. It's a happy thing for other firms, too, because they may be charging the best price the next time the consumer logs on."

To the non-economist, it's called a win-win-win situation.

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