Best price and product design strategy for e-intermediaries

January 03, 2001

Two Levels Max

University Park, Pa. --- Despite the competition heating up in e-markets, buyers and sellers who use online auctions, travel agencies, comparison shoppers, investment brokers, or other electronic intermediaries or middlemen, can continue to expect a maximum of just two service and fee options - premium and basic.

Penn State's Dr. Hemant Bhargava, professor of management information systems, explains, "Contrary to standard economic theory that says, a firm selling in a broad market maximizes profits by offering multiple differentiated products at differential prices, we've found a different effect at work for these electronic intermediaries. " Analysis by Bhargava and colleagues has shown that, if the intermediary's cost of providing service is not strongly related to the level of service -a common situation for electronic services - then the intermediary maximizes profit by offering just two services: a high quality level of service and a low quality level.

For example, he says, "Web-based e-mail providers offer a "premium" service with a monthly fee and a "no-frills" free service. The premium service, which offers larger mail boxes and other technical features, usually costs about $30 to $40 a year. You don't get a middle-level service at, say, $20 a year."

A faculty member in Penn State's Smeal College of Business Administration, Bhargava adds, "Of course, the 'free' service isn't really free. Customers pay in the form of personal information and attention to advertising content."

The researchers also found that improving the quality of the lower level service hurts the intermediary's profits. So, the intermediary's interests are best served by offering only two levels - the best possible level of service and the least possible level needed to make the product worthwhile to consumers.

The researchers detailed their results in a paper, "Pricing and Product Design: Intermediary Strategies in an Electronic Market," published in the current issue of the International Journal for Electronic Commerce. Bhargava's co-authors, both at Carnegie Mellon University, are Vidyanand Choudhard, assistant professor in the Graduate School of Industrial Administration, and Ramayya Krishnan, the Cooper Professor at The Heinz School of Public Policy and Management.

Bhargava says even a brief canvass of the Web will show that the industry is already practicing this limited two-level product and pricing strategy. Online auctions, such as eBay, charge both buyers and sellers. However, the two level strategy explains why you can't bargain with eBay to let you sell your late Aunt Bertha's prize porcelain bird collection online for less than the usual 2 to 3 percent they normally charge sellers.

Online auction intermediaries create a network that aggregates buyers and sellers. The intermediary's value to buyers increases as the number of sellers increases. Similarly, its value to sellers increases as it aggregates more buyers.

Bhargava says this "aggregation benefit" is the key to understanding the results obtained in the researchers' s study.

"In a buyer-sided market, the intermediary's value to a buyer is a combination of the level of service it provides and the number of sellers it aggregates. So, it uses the premium service to derive maximum revenues from buyers who most value its service," he says. "It uses the low quality and low-priced service to lure everyone else into the market and extract a price for the aggregation benefit that it creates. Any qualities in between would simply take away profits from the high level service, since some of those customers would switch down to the new service. Similar reasoning applies in seller-sided markets.

"Some people thought that e-commerce would ease out intermediaries and encourage person-to-person commerce. However, that doesn't appear to be happening," the Penn State researcher says, In their paper, the researchers write,"We expect that electronic commerce, and the use of electronic intermediaries in facilitating it, will grow significantly in the coming decades. In particular, we believe that current Web-based technologies for distributed computing and data interchange will lead to increased use of computational tools and decision technology resources in organizational decision making. In inter-organizational situations - and perhaps also within an organization - electronic intermediaries will play an important role in supporting transactions between consumers and providers of these resources."
Editors: Dr. Bhargava is at by e-mail

Penn State

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