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Internet Commerce

• Products that lend themselves to the Internet.

• First, two types of Internet models– Full Internet: no brick and mortar, only virtual. No

costs for warehouses, trucks, stores, salespeople, and so forth. This was the original Amazon model.

– Partial Internet: Perhaps just for order taking (usual warehouses, customers pick up from brick-and-mortar retail outlet.

– Or some combination.

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Characteristics of Products that are Likely to Determine the Extent of the Internet Transformation.

• Look to the mail order industry as a guide.

• Size and Bulk relative to Value– Shipping costs would become very high relative to

the value of the product for bulky or cheap merchandise, making it uneconomic to purchase goods this way.

– Soil, canned vegetables, soda, and other similar items seem like very poor candidates.

– Electronic equipment, well graded diamonds, frozen gourmet food might be good candidates.

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• Perishability– This is important due to the delay in shipping.– You aren’t going to order hot food through the

Internet unless they have local delivery, as in Pizza delivery.

– Milk and other perishables wouldn’t do well being shipped nationally through normal shipping channels.

Crucial Product Characteristics

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• Experience Products– Products you need to touch, feel, see, and experience

before you buy.– Automobiles are experience goods, as are many

other goods. For many individuals they need to experience the particular car they plan to buy, not just the same model at a dealership.

– Vegetables and meat are often purchased only after inspection by consumer.

Crucial Product Characteristics

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Crucial Product Characteristics

• Immediate Gratification Factor (Impulse buying)– Some products you see and what to have

immediately.– They are often at the front of supermarkets near the

checkout stand.– Internet makes you wait for delivery (except for

digital products, discussed below).

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• There are essentially no sales taxes on Internet sales.

• This gives Internet sales an advantage over brick-and-mortar sellers that has nothing to do with economic efficiency.

• If Internet sales were to become important enough, more important that mail order, tax differential would probably be eliminated.

The Role of Taxes

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Internet Advantages

• Lowers cost compared to brick-and-mortar sellers. Here is the original ideal:– Just takes orders electronically and drop-ship.– No salesmen.– No warehouses.– No offices, or hardly any. Just management and

web design.

• The reality can be quite different.

• Why didn’t Internet firms follow this model?

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Types of Products Most Compatible with E-tailing?

• Digitized Products: no bulk, zero shipping costs, immediate gratification.– Computer software.– Songs (when format issues, piracy, and copyright issues are

resolved).– Videos (with same caveat)– Information (databases, telephone numbers, and so forth)– Books: when E-books become practical for most or many

readers.

• Other Information products: Auctions (Ebay), travel agencies (Expedia, Travelocity), Ticket sales, news, weather, etc.

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Markets likely to resist the Internet assault.

• Grocery Items : high bulk relative to value, distribution systems likely to be inefficient, many products are experience goods, perishability problems.

• Automobiles: experience goods

• Furniture: experience goods, costly shipping.

• Prescription Drugs: immediate need (instant gratification.

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Majority of Markets

• Can use Internet for advertising, information, maybe sales.

• Shoppers could then pick up orders at local store – this only makes sense if the Internet experience is faster or cheaper for consumers as opposed to going through the store.

• Current, relatively efficient distribution systems not impacted.

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Internet Profits

• Why have they been so elusive?– Prices have been too low in search of gaining

market and market share – flawed network thinking.

• Too Much Investment– Overly optimistic view of short term role of the

Internet.

• What should we expect?– Next few slides show why margins should be

small.

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Meaning of Profit Margins

• In competitive industries, economic profits are driven to zero for the industry (or at least for potential entrants).

• This mean that the return on investment is equal to the normal return in competitive industries (in equilibrium). Less competitive industries can earn above normal returns.

• The fact that there is a concept of ‘normal returns on investment’ does not imply that there is any such concept as a ‘normal returns on sales’!! The return on sales depends on the value added.

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The Concept of Value Added

• Usually: The larger the investment as a percentage of the sales revenue the larger the percentage of total value of the product sold that is created by the seller.

• This is the reason that supermarkets have such low returns on SALES (but not necessarily low returns on investment!)

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Implications for E-firms• Internet firms, particularly full Internet firms, are expected

to have lower costs than brick-and-mortar firms.• Who do Internet firms compete with? Brick-and-mortar

firms or other Internet firms? This is an important question.

• If other Internet firms, then returns on sales will be lower for Internet firms than the brick-and-mortar counterparts.

• If the competition is really between brick-and-mortar and Internet firms, then profitability depends on who is more efficient, and this will determine returns on sales. But in the end, even if Internet firms are more efficient, return on sales will be less.

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Advertising on the Net

• Original model was subscription based – AOL ISP model with specialized content.

• ESPN, Wall Street Journal, Slate, and a host of others tried this.

• Then advertising was added in, as in TV. • Only WSJ and a few others stayed with

subscriptions. Others found that when they charged user, number of users dropped dramatically, hurting ad revenue and dashing their hopes for large market share (they believed that network effects made first movers the winners.

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Advertising on the Net

• Net firms thought they could be solely advertising based.

• The TV model that they were thinking of was a flawed model. It was due to unusual historical factors, not economic forces.

• Pure advertising models almost never are used: magazines, cable networks, newspapers, all use both advertising and subscriptions.

• Based on these analogies, the model that will win in the end almost certainly will be a mixture of advertising and subscriptions.

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Advertising on the Net• Net advertising revenues seem unlikely to be large

enough to support many sites.• Banner advertisements are not going to be very effective.

Too small, too easy to avoid.• Compare to TV ads: TV ads interrupt, have sound and

music, can provide an aura about the product. Until Net Ads can do the same, they will never be as effective.

• Net ads do have an advantage of being very easy to monitor (click-throughs) and sites can be very specialized.

• Dot-com fever made the advertising model seem feasible for a while, although even dot-coms went to TV to get market share.

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Predicted Internet Advertising

Television Internet

1. Hours Viewing Media per Day 4 0.5

2. Size of Audience 265,000,000 132,500,000

3. Viewer-Hours per Day 1,060,000,000 66,250,000

4. Viewer-Hours per Year 386,900,000,000 24,181,250,000

5. Advertising Revenue $50,000,000,000 $3,110,000,000

6. Price per Viewer-Hour $0.129 $0.129

Table 6.1: Advertising Cost Per Hour of Activity

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Melt down

• What happened to cause the melt-down in Internet stocks?– Trying to sell products on the Internet that didn’t make sense.– Belief that first to market and market share leaders get to take

away all the winnings (misapplying network effects stories).• See “The great Net giveaway gimmick” as an example of the mentality.

– Installed base was used to determine stock valuations. As if profit per user were assured.

– Too much investment lead to lower returns.– Throwing out usual business rules: profits, business plans,

managers with experience.– Cash rich net firms overspent on advertising and each other,

causing a bubble that was amazing while it happened.

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Too Much Investment

• Impact of ‘too much’ investment.– As an analogy, even in the greatest oil find

imaginable, if firms have to bid on the fields, and if there are many excited bidders, prices can be bid so high that there are no profits after the oil is developed. Look to the sale of spectrum frequencies for an example.

– Additional investment depresses the prices that can be charged the results of the investments

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The role of auctions

• Is Ebay successful because of auctions?

• Interactive Pricing (Auctions) versus Listed Prices – Who benefits? Is it better for sellers? Buyers?

Could it be better for both?– Is this a form of Price Discrimination? – Are we going to move to a world of auctions?

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History of Haggling

• Was common until recent times in Modern Countries

• Why did it end? High cost of time

• Shopping with fixed prices is more convenient than haggling.

• Will the Internet allow haggling without the inconvenience? Perhaps, but to what purpose?