Have Web Access, Will Travel

The Internet has created an environment where customers have almost unlimited access to information relevant to any and all purchasing decisions, or what the Wall Street Journal recently dubbed the "Golden Age for consumers." How will this Golden Age affect retailers? How will it affect margins? What pricing strategies, other than offering lowest possible prices and accepting lowest possible margins, can retailers employ? Wharton’s Eric Clemons, Il-Horn Hann and Lorin Hitt set out to answer these and related questions, and thus whether the prices that retailers offered converged.

To determine whether prices in the electronic marketplace are, in fact, converging, the Wharton researchers examined the online travel agent industry–one of the fastest-growing segments in the online market. This industry has been in a ferment over price pressures, particularly since the launch of web sites that allow customers to perform their own searches or participate in auctions for unsold capacity. Still, the researchers found considerable price dispersion in the online travel industry, with ticket prices varying among online travel agents by as much as 25% for the same customer request. Given these results, the electronic market may not be very different from the traditional marketplace. If that is the case, web retailers need only understand the full range of the competitive strategies employed by their counterparts in traditional marketing, which will enable them to avoid pure price competition.

Traditional vendors have long used product differentiation strategies to avoid the effects of pure price competition. By customizing their products to appeal to the specific preferences of a particular customer base, vendors are able to segment the market, limit direct competition and charge a premium for their product. Differentiation can occur in a number of ways–through geographic location, range of products offered, or quality of products. The key is to offer something different or better, to create a niche.

According to the Wharton study, "The Nature of Competition in the Electronic Markets: An Empirical Investigation of Online Travel Agent Offerings," product differentiation is undoubtedly taking place on the Internet, at least in this segment of online industries. Although online travel agents are not creating new products, travelers have flight options and online travel agents often exploit heterogeneity in consumer travel preferences. The existence of alternatives allows the online travel agents to offer a different set of flights–based on timeliness, length of connections and number of connections–to different customers. Each of the five online travel agents in the study engages in product differentiation by targeting a specific type of traveler. For example, one online travel agent targets the business traveler for whom convenience is the top priority, offering expensive tickets with direct routes. Another online travel agent targets the price-conscious traveler, offering tickets at a lower cost but with more connections. Still other online travel agents cater to consumers who fall somewhere in between. By segmenting the market, the vendors ease direct competition and, therefore, can charge different prices.

Even after controlling for ticket quality and other characteristics, however, prices (for the same customer request) still varied by approximately 20%, further contradicting the theory that prices will converge in the electronic market. A few factors could explain these discrepancies in ticket prices. First, although it is often argued that consumers’ search costs disappear on the Internet, they seem to have been replaced by other transaction costs. These costs include the time and effort it takes to sign up for an online travel agent, learn a new interface and enter flight preferences into multiple online travel agents. Consumers are faced with a trade-off between the potential savings and a known cost. Therefore, it is rare that a consumer will access the entire universe of market data available on the Internet, enabling vendors to charge different prices.

Second, inefficiencies in online travel agents’ search processes enable vendors to charge higher prices. Because the current search parameters are inflexible, online travel agents must make compromises on these parameters. Each online travel agent may make different compromises and, as a result, present different results for the same customer request.

Interestingly, the findings illustrate that no one search engine dominates all the others, nor is any engine clearly inferior. Certain online travel agents are better for a particular type of request while others perform better for another type of request. Because online travel agents often know that their parameters are inferior with respect to some requests, in some cases an online travel agent will exploit transaction costs to sell more of the dominated tickets. And as long as search or transaction costs remain above zero, online travel agents can continue to charge different prices and, more importantly, be able to continue operating with inferior engines.

In addition to the other barriers to perfect price competition, online travel agents have used the design of their interface to price discriminate against certain customers. For example, an online travel agent may couple a very complex interface with lower ticket prices on the theory that people who are computer adept are more likely to search other online travel agent sites to find the best bargain. Or, an online travel agent may have a very user-friendly interface and offer only high-priced tickets, assuming that these users might not have the time or capability to search for a lower price.