E- business Economics

Towards perfect competition

Perfect competition refers to a market where no individual buyer or seller can influence the market.
That is, the market forces of supply and demand determine the price and output of goods and
services. Perfect competition is a theoretical market structure based on a number of key
assumptions. Only when these assumptions are fulfilled can Pareto efficiency be achieved. The
assumptions
include that:
1. There are many buyers and sellers;
2. There is freedom of entry into and exit from the market;
3. There is perfect mobility of the factors of production;
4. There is perfect knowledge of the market;
5. There is a homogeneous product.
Perfect competition describes an efficient market because it leaves no excess supply or demand of
goods or services. In the real economy this rarely, if ever, happens. Most markets fail to match
supply with demand and, therefore, operate at less than optimal efficiency.

Internet’s effect on Perfect Competition

The internet has provided a mechanism for edging markets closer to that of perfect competition.
The abundance of information on websites means that buyers and sellers have access to greater
market knowledge. Transacting via the internet ensures a more cost-effective way of matching
supply and demand since there are no geographical or time constraints. The nature of competition
has been altered by the emergence of the internet. Both cost structures and the types of products
and services being offered to customers differ from traditional industries.
The internet can change the relationship between buyers and sellers. The reduction in transaction
costs of searching for products or services makes comparisons of prices easier for customers and
intensifies price competition among firms. The internet is characterized by the abundance of
information available which poses challenges for traditional economic theory where scarcity forms
the critical underpinnings. Easy access to a huge array of information facilitates consumers to
compare the prices and availability of products and services.

Because of the absence of significant search cost the bargaining power lies with the customer.
Thus, price transparency leads firms to lower prices.
Key economic characteristics of the internet
Cost of production and distribution
The internet can help to reduce production and d istribution costs and make firms operate more
efficiently. Market information on customers and logistics information gathered from suppliers,
distributors and manufacturers form the basis for improving efficiency. The cost of marketing and
advertising can be reduced using customer information effectively.

Disintermediation and reintermediation

Disintermediation refers to the removal of an intermediary somewhere along the supply chain of
products and services from seller to consumer. Disintermediation has become a feature of the e-
business and e-commerce environment because the internet facilitates greater communications
between suppliers and customers. Cost reduction is achieved by reducing the number of
intermediaries in the supply chain.

Economics of information
Information economics is distinctly different from the economics of physical products.
Information is easily produced and can be distributed among a large number of recipients including
suppliers, customers and firms.
The ease and scale of distribution does not diminish the value or quality of the product (Slater,
1998). Information is easily manipulated and altered to suit different needs of customers in
different markets. Information that is in high demand, such as financial data, prices of stocks and
shares and news items, constitutes high-value assets.
Where traditional economic theory is concerned with scarcity of resources, the internet is
characterised by an abundance of information. Information-driven products and services can be
reproduced and distributed for near zero marginal cost (the cost of producing an additional unit).

The way the economics of abundance works is best explained by the theory of the long tail
as described by Jack Schofield.

Figures 4.3 and 4.4 illustrate the short tail of traditional markets compared to the long tail
of online markets
The long tail theory has a real and significant impact on e-businesses. The long tail is named after
a type of power law curve created when sales of a product (CDs, computer games, films, etc.) or
the popularity of a website are plotted on a graph.
An example of the long tail can be seen in film distribution. Cinema releases are almost wholly
based on maximising capacity in theatres in order to create profits. This means that a relatively
small number of films are actually shown. The ones that are shown tend to be big budget
productions backed by significant marketing and promotion efforts. The market for films shown
in cinemas has no tail, they either succeed or they fail. However, if films can be distributed on
DVDs or even downloaded online then the economics changes. Firms can offer many thousands
of films to customers and the vast majority will only sell a few copies. Nevertheless, the long tail
ensures that the numbers mount up and contribute significantly to overall revenues. In other words,
the less successful films are, economically, as important as the blockbusters. Firms who distribute
media products via the internet incur no shelf space costs, no manufacturing costs and minimal
distribution costs. The sale of a product of low popularity achieves the same margin as a widely
popular product.

Transaction costs
Transaction costs are the costs incurred in using the market system for buying and selling goods
and services. Transaction costs include the costs of locating suppliers or customers and negotiating
transactions with them. Firms engaged in e-business have been able to reduce the transaction costs
at one or more stages of the buying and selling process.
There are six types of transaction costs:
1. Search costs;
These are the costs associated with buyers and sellers finding each other in the marketplace. The
sheer number and diversity of goods and services available in the modern marketplace can make
the cost of searching for them quite considerable. The internet provides a quick, efficient and cost-
effective way of searching for products using search engines
2. Information costs;
This is the cost incurred by buyers of gaining market knowledge on the price, quantity, quality,
availability and characteristics of goods and services offered by sellers. For sellers, information
costs are incurred through the process of learning about the financial condition and need
characteristics of buyers. Many e-businesses have reduced this transaction cost by providing up-
to-date product information on their website for potential customers to access.
3. Bargaining costs;
This is the cost incurred by buyers and sellers when negotiating a contract for a transaction to take
place. This may include the cost of using equipment to contact and communicate with the other
party to the transaction, the marketing of information, and the legal costs of drawing up contracts.
E-mail has become a cheap and effective way of communication between buyers and sellers
4. Decision costs;
The buyer incurs a cost of comparing prices in the marketplace and ensuring that the goods or
services match needs. For suppliers the decision costs are incurred when deciding whom to sell to
or whether to refrain from selling. E-businesses can speed up the evaluation process by specialising
in providing price information on a wide range of goods and services provided by many competing
firms.
5. Policing costs;
These are the costs incurred by buyers and sellers ensuring that the goods or services provided and
bought match the terms under which the transaction was negotiated and contracted for.
6. Enforcement costs.
These are the costs incurred by buyers or sellers in the event that the terms of the negotiated
contract are not met.

Network Externalities
Network externalities are defined as the increasing utility that a user derives from consumption of
a product as the number of other users who consume the same product increases. Network
externalities are the new drivers of the network economy. Network externalities occur when the
benefits of using one technology increase as the network of adopters expands
In economics, externalities refer to gains or losses incurred by others as a result of actions initiated
by producers or consumers or both and for which no compensation is paid.
Externalities can be either positive or negative. For example, the pollution created by chemical
plants is a negative externality for the community affected because everyone has to bear the burden
of the cost of the pollution without being compensated for it. Alternatively, positive externalities
may arise when benefits are derived where no additional cost is incurred.
In the case of network externalities, it is not the product or service that acts as the catalyst for
adding value, but rather the external factors related to the network with which the product or
service is associated (Chen, 2001).

E-businesses are interested in creating communities of buyers because they constitute an

additional service that is valued by customers. Firms may have chat-room facilities for customers
to review products and services and to offer advice on prices, quality, availability, substitute
products or any other aspect of the consumer process. Firms sometimes use the feedback from
customers posted on their websites for marketing purposes. There is a strong correlation between
market performance of products sold online and the positive or negative feedback given by
customers.
The economic phenomenon of network externalities illustrates ‘Metcalfe’s Law’.
Metcalfe's law states that the value of a telecommunications network is proportional to the square
of the number of connected users of the system (nSQ2). The use of ‘Metcalfe’s Law’ illustrates
the economic phenomenon of network externalities. Metcalfe’s Law states that the utility
(satisfaction) of a network increase with the square of the number of users. This concurs with the
assertion that as more users join the network, so it becomes increasingly attractive for others to
join too.

Switching costs are the costs a consumer pays as a result of switching brands or products.
Switching costs can be monetary, psychological, effort-based, and time-based
Switching costs include those borne by the consumer to switch suppliers and those borne by the
new supplier to serve the new customer. The switching costs of customers may include the
inconvenience associated with switching suppliers, such as the time and effort involved in
evaluating the value of a product or service. E-businesses need to include switching costs into their
business model in order to achieve customer loyalty through ‘lock-in’.
The ‘lock-in’ of customers refers to a situation where switching costs incurred by customers of
changing supplier exceeds the benefits of switching to that alternative supplier.

Firms can achieve ‘lock-in’ in several different ways including:

• Involving consumers in the design and productive processes;
• Creating network externalities through website community building;
• Ensuring ease of navigation of websites;
• Ensuring ease of transactions;
• Building trust in customer relationships;
• Creating a standard for integrating systems.
Critical Mass of Customers
The critical mass of customers is such amount of customers that allows a company operate self-
sufficiently, sustainably without any external investment.
Lock-in of customers and customer loyalty are two critical factors that determine the economic
viability of an online venture. Firms must achieve a critical mass of customers before profits can
be gained from e-business or e-commerce.
To achieve a critical mass of customers requires successful management of three phases:

• Customer attraction
The website must be attractive to gain the attention of customers. Here, the design, navigation and
transaction process all play a role. However, to attract customers effectively the website has to
tempt customers with an attractive product offering
• Customer retention
The products and services provided by the e-business must be of sufficient quality to meet or
exceed customer expectations. This builds customer loyalty and offers the best chance of repeat
business. Firms must also offer security in transactions and ensure privacy for customers in order
to build trust in the online relationship.
• New customer base
To reach a critical mass of customers it is necessary to search for new customers whilst retaining
existing ones. The e-business should be able to utilise feedback from existing customers to help
the marketing effort for finding new customers.

Pricing
When determining pricing, the types of considerations applied by traditional ‘bricks-and-mortar’
firms are relevant to online businesses too.
Cost price: the cost incurred when producing the products or services;
Sales price: the price charged to customers;
Profit: the sales price minus the total costs of production;
Mark-up: the percentage of the profit based on the cost price (sales price minus cost price, divided
by cost price);
Margin: the percentage profit based on the sales price (sales price minus cost price, divided by
cost price).
Other factors to be taken into account when determining prices:
1. The level of forecasted demand;
2. The level of competition;
3. The prices of rivals’ products;
4. The cost of marketing, advertising and promotion;
5. The position of the product on the product life-cycle;
6. Price elasticity of demand (how sensitive customers are to changes in price);
7. The availability and price of substitute products;
8. Distribution costs;
9. After-sales service costs.
Pricing strategies
Having taken into consideration the key factors in determining price, firms must then determine
their pricing strategy. The options available to firms will be dependent on the type of product they
produce and the nature and characteristics of the customers targeted. It is possible to divide pricing
strategies into four broad categories.
These include:

• Premium prices: prices above the industry average are charged. This occurs where the
product offers added value to customers in terms of quality, uniqueness, status or
availability.
• Average prices: the price charged reflects the market demand and supply dynamic.
• Discount prices: prices are discounted below that of the market price. Sometimes referred
to as a loss leader, this may be a short-term strategy to gain market share.
• Free: firms may give away products or services in an attempt to attract customers.

There are a number of other pricing strategies available to e-businesses that can help to improve
revenue and maintain the economic viability of the online venture.
• Price discrimination,
• Bundling,
• The pricing of information-driven products, and
• Congestion pricing.

1. Price Discrimination: Charging different prices according to subscriber usage rates (price lining)
or smart pricing where the charge relates to market conditions or differences in how customers
value the product. Effective price discrimination relies on gaining and using information on
customers. This gives rise to differential pricing where a firm can segment the market and charge
different segments different prices.
2. Bundling: Charging different prices according to subscriber usage rates (price lining) or smart
pricing where the charge relates to market conditions or differences in how customers value the
product. Effective price discrimination relies on gaining and using information on customers. The
rationale behind the strategy is that it is less expensive to sell an additional service to an existing
customer than it is to attract a new customer.
3. Price of Information products: Information products delivered online incur initial production
costs associated with the research and compilation of the information. However, thereafter,
additional units have near zero costs. There are also low transactions costs because of the effect of
the internet.
First, there is no clear link between inputs and output of such products.
Secondly, economies of scale derive from distribution effects rather than production. The costs of
distributing information products online are low, but there are high sunk costs (initial investment)
involved in setting up the infrastructure for production as well as the variable costs of researching
and compiling the information product.
4. Congestion Pricing: Congestion pricing is a concept from market economics regarding the use
of pricing mechanisms to charge the users of public goods for the negative externalities generated
by the peak demand in excess of available.