The Bumpy Road of Electronic Commerce …

                               The Bumpy Road of Electronic Commerce

                                                            Andrew Odlyzko
                                                         AT&T Labs -- Research
                                                          amo@research.att.com


         Abstract: Electronic commerce is widely expected to promote "friction-free" capitalism, with consumers sending
         software agents to scour the Net for the best deals. Many distribution chains will indeed be simplified and costs
         substantially reduced. However, we are also likely to see the creation of artificial barriers in electronic commerce,
         designed by sellers to extract more value from consumers. Frequent flyer mileage plans and the bundling of
         software into suites are just two examples of the marketing schemes that are likely to proliferate. It appears that
         there will be much less a la carte selling of individual items than is commonly expected, and more subscription
         plans. Therefore many current development plans should be redirected. Electronic commerce is likely to be even
         more exasperating to consumers than current airline pricing, and will be even further removed from the common
         conception of a "just price." As a result, there are likely to be more attempts to introduce government regulation
         into electronic commerce.


1. Introduction

Electronic commerce (or ecommerce for short) is still small, at least if we consider only online consumer transac-
tions, such as ordering a book from amazon.com over the Internet. In a broader sense, ecommerce is much larger,
since financial, news, and legal information services such as Bloomberg, Reuters, and Lexis have total revenues in
the billions of dollars. In a still broader sense, electronic funds transfers are already huge, with daily transactions
in the trillions of dollars. All these types of transactions are expected to grow, and to become part of a much larger
and uniform system of electronic transactions. (For a survey of the current state of ecommerce, and expectations
for growth, see [Cohen et al. 1996].)
While we are rapidly moving towards the Information Age, food, shelter, and clothing will remain our most
important needs. However, their shares of the economy are decreasing, and the information content of their goods
is increasing. This is an old trend. Agriculture has moved from being the largest segment of the economy a century
and a half ago to a relatively minor industry, dwarfed by the medical sector, for example. Furthermore, the cost
of the basic ingredients in cereals and other foods is a small portion of the total price. As a further example of
the decreasing value of raw materials and factory labor, a single celebrity is often paid as much for endorsing an
athletic shoe model as all the workers in the undeveloped countries who assemble those shoes. We can expect a
continuation of this trend, with the work of the "symbolic analysts" (who, in Robert Reich's terminology, include
lawyers, software writers, and advertising executives) increasing its share of the economy.
The main concern of this essay is electronic trade in information goods, such as news, novels, software, music,
movies, as well as legal, medical, and credit information. How will these goods be distributed, and how will their
production be financed? Esther Dyson [Dyson 1994] predicts that almost all intellectual content will be available
for free. In her view, some content production will be supported by outside advertisers (who already pay for
most of the cost of newspapers, for example, as well as all the costs of the commercial TV networks). Some
content will likely be made available for free, as a form of advertising for other services by the producers (as the
Grateful Dead do in encouraging people to tape their performances, in the hope this will bring more people to
their concerts). While Dyson's vision will come true for a large part of the material on the Net, it seems unlikely
that it will be universal. Movie studios such as Disney attract large paying audiences to theaters and purchasers to
their videotapes through the quality of their products, and are likely to do so in the future. While some novelists
make more money from selling movie rights to their plots to Hollywood than from royalties on books, this is rare.
Each year, over a hundred times as many books are published as there are movies produced, and books bring in
much more money than movie theater tickets. Thus we can expect that content producers will usually want to be
paid directly for their work, as that will be the only feasible route to earning a living. Furthermore, Dyson herself
   




      This paper incorporates material from an earlier article on electronic publishing, [Odlyzko 1996].
[Dyson 1994] emphasizes that much of the value on the Net "will go to the middlemen and trusted intermediaries
who add value - everything from guarantees of authenticity to software support, selection, filtering, interpretation,
and analysis." How will these middlemen be paid? It seems likely that often they will wish to collect payment
directly from consumers, just as the online legal information service Westlaw collects fees from attorneys who use
it. The basic data in Westlaw is court opinions, which are freely avaialable. What gives Westlaw its lock on the
market is the control of its citation system.
Many of Dyson's predictions are likely to come true. In particular, huge amounts of intellectual property will be
available for free. I expect that this will apply to most scholarly publications, since their authors typically do not
receive direct financial benefits from their papers, and are interested in maximizing the circulation of their results
[Odlyzko 1996]. However, it seems likely that there will also be a flourishing ecommerce sector, with individuals
purchasing goods and services. The question is, how will ecommerce be conducted?
The usual expectation is that ecommerce will promote "friction-free capitalism," (cf. [Gates 1995]), with distri-
bution costs reduced. It is easy to see how this can happen, as the older communication systems such as the post
office, the telegraph, the telephone, and the fax have all served to make the economy more efficient. The Internet
creates many more possibilities for improving life. Classified ads, for example, bring in a large fraction of the
revenues of the newspaper industry, but can be replaced by a much cheaper and more convenient electronic sys-
tem. Other part of the common vision of ecommerce are more questionable, however, and that is what the rest of
this essay will discuss. It is often thought that instead of buying an entire newspaper, readers will pay for those
individual stories they are interested in. Someone wishing to purchase a VCR might send an "intelligent agent"
into the Internet to collect bids from suppliers for a unit that meets desired specifications, and then select the best
choice. While such scenarios will be feasible technically, it is extremely unlikely they will be dominant. Instead,
we are likely to see a proliferation of policies such as those of current music CD retailers who sell on the Internet.
Most of them do not allow software agents to collect their prices. We are also likely to see a strengthening of the
trend towards subscription services and bundling of products, as is done in software suites today. This will often
require redirection of development efforts.
This essay is devoted largely to an explanation of the economic reasons that are likely to lead to the creation of
"bumps" on the electronic superhighway. These reasons operate already in the current economy, and are respon-
sible, for example, for the U.S. airline pricing system, which is a source of frequent frustration and complaints.
In ecommerce, frustration and complaints are likely to be even more frequent. The reasons for this are twofold.
On one hand, the economic incentives to create artificial barriers will be greater in ecommerce than today, since
essentially all costs will be the "first-copy" costs of creating goods, and distribution will be practically free. On
the other hand, it will be much more transparent that the barriers are artificial. This will often collide with popular
notions of what is fair, and is likely to lead to attempts at much more intrusive government regulations than we
have seen so far. In the past governments have been involved primarily in security issues of the Net, and more
recently have gotten concerned about pornography. However, in the future they are likely to attempt to regulate the
conduct of business on the Net as well.
If the predictions of this essay come true, then some of the current development efforts will turn out to be misdi-
rected. Many systems are planned under the assumption that ecommerce will operate through ubiquitous micro-
payment schemes, with information goods sold in small units at extremely low prices. Certainly some products
will be sold this way, but the arguments in this essay show that much information will be sold via subscription
and other more complex marketing mechanisms. This will require different business cases and distribution mech-
anisms. These arguments also suggest that it will be necessary to prepare to comply with edicts from various
governments, edicts that will be be changing and will often be inconsistent.


2. Natural and Artificial Barriers in Commerce

Capitalism is excellent at inducing people to reduce barriers to commercial activities. However, it also produces
incentives to create artificial barriers. Some of the barriers are created by government action, such as those of
patent and copyright laws, which give owners of intellectual property a limited legal monopoly on the uses of their
creations. Other barriers are created by merchants. It is common for an airline passenger to have paid 5 times as
much as the person in an adjacent seat, with the only difference between the two being that the first one is not


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away from home on a Saturday night. The airlines would like to charge the business travelers (who are presumed
to be able and willing to pay) more than vacationers (who might drive a car instead or not travel at all), but do not
have a direct way to do so. Therefore they impose the Saturday night stopover restrictions to distinguish between
those two classes of customers. There have been several attempts by airlines to move towards a simpler system of
uniform pricing (sometimes by newcomers, such as People Express, sometimes by established carriers), but they
all collapsed. This suggests that there is an underlying economic logic behind this system, however exasperating
the results might be. If that is correct, though, we can expect similar moves in ecommerce.
The general tendency in the marketplace is to avoid "commoditization," in which there are many almost equivalent
products and services, and where price is the only consideration. Ford does not compete with Honda in producing
the most inexpensive Accord. Instead, it offers the Taurus as an alternative, and there are many features in which
the Accord and Taurus differ. Sometimes commoditization is hard to resist. In some cases this happens because
consumers learn there is little to differentiate products. Oil companies have pretty much given up on trying to
convince people that gasoline differs in anything other than octane ratings. In other cases, commoditization is
forced on an industry by government edict or effective private monopoly. Intel and Microsoft have reduced the
IBM-compatible PC industry to a commodity business, in which they collect almost all the profits, and the other
players scramble to find a niche that will enable them to do more than just break even. However, those are the
exceptions. The general ecological principle is towards evolution of species that fill different roles. Zebras do
not attempt to compete with giraffes, but exploit a different part of the ecosystem, and evolution does not lead
to a convergence of those two species. Similarly, in the world of business, companies try to differentiate their
products. Workstation producers could never in the past agree on a common version of Unix, even under the threat
of being overwhelmed by PCs, since that would have required giving up the distinctive features that bound them
to their customers. Even airlines, which are basically in the commodity business of moving people from one city
to another, try to differentiate themselves through frequent flier plans and special pricing schemes.
Ecommerce is likely to lead to a proliferation of pricing plans that will seem to most people to be much more
frustrating and less rational than even today's U.S. airlines. There will probably be a niche market for people who
care most about their convenience, and will use their intelligent agents to do their shopping for them. However,
what Sony, for example, might do is sell to that market only models of VCRs that are not available elsewhere,
and are hard to compare to those sold in other places. Stores that have physical buildings are likely to serve a
different clientele, and might also take further steps to differentiate themselves to prevent comparison shopping,
which will be much easier with many people sharing their experiences on the Internet. There is likely to be a
proliferation of frequent-shopper plans. Further, Sony VCRs sold in Sears stores might be slightly different from
those sold in WalMart, and model numbers and features might change rapidly to inhibit consumer rating services
(such as Consumer Reports, or various Internet-based group-rating schemes that are beginning to develop). There
are already artificial barriers to free information flow. Grocery stores routinely bar employees of other stores from
collecting extensive data on prices. The policy of Internet CD stores of preventing software agents from collecting
prices for comparison shopping is just an extension of such barriers to free information flow to ecommerce. We
can expect more such barriers.
While barriers to commerce of the type discussed above are usually perceived as unfair (an issue that I will deal
with more extensively in the last section), they can increase not just the producers' wealth, but economic efficiency
and social welfare. As a simple example, consider an independent consultant who can produce a technical report
that two different customers might be willing to pay $3,000, and $2,000 for, respectively. If she has to charge
a uniform price to the two customers, the most she can get is $4,000, obtained by pricing the report at $2,000.
However, if she charges the first customer $3,000, and the other $2,000, she will earn $5,000. If the consultant's
time and expenses to prepare the report are worth $4,500, she will not undertake the effort if a uniform price
is required. From an economic viewpoint it is therefore advantageous to allow her to charge different prices to
different customers. However, the customer who pays $3,000 is likely to resent it if somebody else obtains the
same product for $2,000, and often will not agree to the deal if all conditions are publicly known. This is caused
by a conflict between notions of economic efficiency and fairness.
There are many examples in the marketplace of behavior that appears even less fair. For example, in 1990, IBM
introduced the LaserPrinter E, a lower cost version of its LaserPrinter. The two version were identical, except that
the E version printed 5 pages per minute instead of 10 for the regular one. This was achieved (as was found by
independent testers, and was not advertised by IBM) through the addition of additional chips to the E version that


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did nothing but slow down processing. Thus the E model cost more to produce, sold for less, and was less useful.
However, as Deneckere and McAfee show in their paper [Deneckere & McAfee 1996], which contains many more
examples of this type (referred to as "damaged goods"), it can be better for all classes of consumers to allow such
behavior, however offensive it might be to the general notions of fairness. Consumers who do not need to print
much, and are not willing to pay for the more expensive version, do obtain a laser printer. Consumers who do need
high capacity obtain a lower price than they might otherwise have to pay, since the manufacturer's fixed costs are
spread over more units.
Barriers in commerce are an essential part of the current marketplace. Consider the book trade. Although people do
not think of it this way, current practices involve charging different prices to different users, and thus maximizing
revenues. A novel is typically published in hard cover first, with the aim of extracting high prices from those
willing to pay more to read it right away. Once that market is fully exploited, a somewhat cheaper trade paperback
edition is made available, to collect revenue from those not willing to pay for the hardbound copy. Finally, a regular
paperback edition is published at an even lower price. The used book market develops in parallel, for those willing
to read books marked up by previous owners, and so on.
How will ecommerce affect book publishing? Eventually we can expect that all books will be available electron-
ically (and will evolve towards new forms, made possible by digital communications). Costs of publishing will
come down, and this is going to increase the supply, and lead to many works distributed for free, by aspiring au-
thors hungry for the recognition that might lead to fortune. What about those electronic books that people will be
willing to pay for? With publishing costs reduced, we can expect that the authors' share of the revenues will rise,
say from the current 15% or so royalty rate to 50% or more, and so in effect the authors might become much more
influential than the publishers (or might become the publishers themselves). However, since publishers obviously
benefit from the present system of differential pricing, they (and the authors) are likely to have an incentive to
institute a similar system in the digital arena. The issue is how to do this. Bits are bits, after all, and are easy to
copy.
If we make only simple extensions of current copyright laws, we are likely to see a great change in the marketplace
for information goods. When I buy a book, I cannot make a copy of it and sell that copy to somebody else. On the
other hand, I can sell, rent, or give away the book I purchased to anyone I wish. Suppose we carry over exactly
the same rights to the digital world, with some combination of cryptographic techniques and laws guaranteeing
that unauthorized copies of digital "books" cannot be made. The ease of transactions on the Net (which is what
leads to the dreams of "frictionless capitalism") would then force major changes. With physical volumes, there
are substantial barriers to trade in books. Most people do not like reading books that are tattered or marked up
by others. They take their time reading books, and (especially for the ones they enjoy) like to retain them in their
libraries to be reread any time they wish. As a result of these natural barriers, a single copy is usually read by
only a few people. The economics of the present book publishing business depend on this phenomenon. In the
digital world, though, with high bandwidth networks and efficient intermediaries, I could buy a copy of a book
an hour before bedtime, read a new chapter, and then, just before turning off the lights, send that copy off for
resale. Instead of a million copies of a printed book, a thousand electronic copies might suffice. This would force
a dramatic change in the structure of the book publishing industry, and explains why there is an intense interest in
the creation of artificial barriers to ecommerce, either through revisions to copyright laws or through technological
methods.


3. The Bumps on the Electronic Highway

Some types of barriers to commerce are accepted as natural when dealing with physical goods. It would be pro-
hibitively expensive for the New York Times, say, to distribute 100 little sheets each day, each one with a separate
story, and having readers buy just the ones they were interested in. The accepted wisdom is that ecommerce will
lead to the electronic equivalent of just that, with readers selecting and paying for individual stories. It will cer-
tainly be possible to do so, as micropayment systems are being developed that will allow for processing of tiny
transactions, such as payment for a single story in the New York Times, or a "hit" on some aspiring poet's Web
page. However, the economic argument is that while such schemes might exist, and may be used in some situa-
tions, they will not be dominant. The example of book publishing in the previous section shows why producers
of information goods benefit from the natural barriers that exist in the physical world. Their incentives to create


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artificial barriers in the digital world will be even stronger. It will be harder to distinguish between consumers,
since transactions will tend to be impersonal, and arbitrage will be easy. Most important, distribution costs will be
negligible, so that only the "first copy" cost of creating a work will matter. Hence traditional, commodity-market
type of competition, in which the market price equals the marginal cost, will have to be avoided, since marginal
prices will be essentially zero. The incentive that low marginal costs provide to create barriers in commerce can
already be seen in many high technology fields. The "damaged goods" studied in [Deneckere & McAfee 1996]
come primarily from such areas. The pharmaceutical industry is notorious for selling products for hundreds of
times more than the cost of producing them, and for selling the same chemicals for human use for ten times the
price charged for veterinary purposes.
While the incentives to erect artificial barriers will be large in ecommerce, there will also be novel possibilities
created by the electronic medium. What kinds of barriers are we likely to encounter in ecommerce? The four
most important ones will probably be bundling, differential pricing, subscriptions, and site licensing. That they are
likely to be prominent in ecommerce has been pointed out before, especially by Hal Varian [Varian 1995a], [Varian
1995b]. In the rest of this section I will explain how they operate, and why they are attractive to content producers.
There are additional arguments in favor of subscription and site licensing plans. For example, security problems
are likely to be easier to solve in those cases. However, this essay will deal only with the economic arguments.
The basic assumption in the economic analyses below is that for each information good, an individual consumer
will purchase it only if the price is below some threshold (that consumer's valuation of the good). For simplicity, I
will only consider items that are independent of each other (such as stories in a newspaper). Much of the economic
literature cited below is concerned with goods that are related in one way or another. (For example, if I buy a
spreadsheet from Corel, I am unlikely to purchase another one from Microsoft. On the other hand, if I buy a
presentation package, I am more likely to buy a CD-ROM of pictures than I would otherwise.) I will not take
these factors into consideration, to keep the presentation simple, and bring out only the main factors that are likely
to influence the development of ecommerce. I will also assume, as is standard, that producers cannot in general
find out what an individual is willing to pay for a product, but can, through test marketing, say, obtain an accurate
statistical description of the valuations that the whole population of potential buyers place on that product.


3.1. Bundling

Bundling consists of offering several goods together in a single package, such as combining a word processor,
a spreadsheet, and a presentation program in a software suite (such as Microsoft Office), or else printing many
stories in a single newspaper. Bundling is common, and often seems natural. For example, right shoes and left
shoes are invariably sold together, and just about the only time anyone might regret this is when a dog chews
up one of a new pair of shoes. I will concentrate on bundling of goods that are almost unrelated, such as a word
processor and a spreadsheet program. Why should the pair of them together sell for much less than the sum of their
separate prices? It is useful to have seamless integration of the two, to make it easier to move material between
them, to have common command structure and icon layouts, and so on. That seems to argue for charging more
for the bundle than for the pieces! However, bundling, with a lower price for the bundle than for the components,
or even without any possibility for purchasing the components separately, is common. The reason is that it allows
the producer to increase revenues by capturing more of the "consumer surplus" that arises when customers pay
less than they are willing to do. Since in general prices have to be the same for all customers, bundling can be
used to smooth out the uneven preferences people have for different goods and services. For example, suppose we
were dealing with a proposal to start a newspaper that would have two sections, a business page and a sports page.
Suppose also that there were just two potential readers, Alice and Bob. Suppose also that Alice needs to keep up
with the financial world, and so is willing to pay $0.50 for the business page, but only $0.20 for the sports page,
since she does not particularly care about sports, but might like to keep up with lunchtime conversations. Suppose
that Bob's preferences are reversed, in that he is an eager sports fan, willing to pay $0.50 for the sports page, but
only $0.20 for the business page, since all he cares about is occasionally checking on his retirement fund. Under
those conditions, how should the proposed newspaper be priced? If each section is sold separately, then a price of
$0.20 for each will induce both Alice and Bob to buy both sections, for total revenues of $0.80. If the price is set at
$0.50 for each section, then Alice will buy only the business page, and Bob only the sports page, for total revenue
of $1.00. On the other hand, if the two sections are bundled together, then a price for both of $0.70 will induce


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both Alice and Bob to purchase the newspaper, and will produce total revenues of $1.40. Thus the economically
rational step is not to offer the two sections separately, but only bundled together.
Bundling has been studied extensively in the literature, starting with the paper of Burnstein [Burnstein 1960]. A
few other references are [Adams & Yelen 1976], [Bowman 1967], [Economides 1993], [Krishna et al. 1996],
[Schmalensee 1982], [Stigler 1963], [Varian 1989], [Wilson 1993], [Wilson 1996]. Unfortunately there is no
simple prescription that can be given as to when bundling is better than selling items separately. Depending on
the distribution of consumer preferences, bundling can be either more or less profitable for the producer, as was
already shown by Adams and Yellen [Adams & Yelen 1976]. However, there are some general guidelines. One is
that bundling becomes more profitable as marginal costs decrease. (This may partially explain why software suites
spread at about the same time as unpaid support provided to users by software houses decreased.) Another is that
bundling becomes more attractive when consumer preferences are negatively correlated (as in the example above,
where Alice and Bob had almost opposite tastes). However, negative correlation in valuations is not necessary for
bundling to be profitable, as was first pointed out by Schmalensee [Schmalensee 1982], and as will be shown in
the example below. Random variations in preferences are sufficient as a result of the law of large numbers.
How much of a difference can bundling make to a producer's bottom line? Unfortunately the published literature
is practically silent on this point, for reasons I will discuss later. (There is one intriguing computation in [Stigler
1963], based on reported revenues of movie theaters in different cities.) Let us therefore consider some artificial
examples, a bit more realistic than the Alice and Bob one presented above. Consider two books, A and B, say
"The Tannu-Tuva Cookbook" and "Sherlock Holmes in Antarctica." Suppose that among one million potential
customers, book A is valued at $1 by 100,000, at $2 by another 100,000, and so on, up to $10 by 100,000, and
suppose the same distribution of valuations applies to book B. Suppose further that the valuations of the two books
are independent. Thus there are about 10,000 customers who value book A at $3 and simulataneously book B
at $5, and similarly about 10,000 customers who place values $9 and $2 on A and B, respectively. Under these
conditions, if the publisher is to sell these books separately, revenue will be maximized when the price of each is
set at $5. About 600,000 people will purchase each book, for total revenue from sales of both books of $6,000,000.
(This maximum is not unique, as the same revenue can be achieved by pricing each book at $6, in which case about
500,000 people will buy each.) However, if the two books are sold together, revenue can be made much higher.
Since there are 10,000 people who value the bundle at $2 (exactly the 10,000 who value each book at $1), while
there are 90,000 who value it at $10, a short calculation shows that the revenue-maximizing price is $9. At the
price of $9 per bundle, 720,000 people will purchase it, for total revenue of $6,480,000, exactly 8% higher than if
the books were sold separately. Since profits are the revenues minus the fixed costs of producing the books, they
would increase much more dramatically.
What weakens the case for bundling is that most people have no interest in most goods. In the example of the
books "Sherlock Holmes in Antarctica" and "The Tannu-Tuva Cookbook," a more realistic assessment would be
that in a population of 1,000,000, each book would be valued at zero by 90% of the population, with 10,000
valuing it at $1, 10,000 at $2, and so on. If the 100,000 people who do place a positive value on book A are
distributed independently of those who value book B at $1 or more, then there are only 10,000 people who place
positive values on both A and B. Bundling under these conditions does not produce much benefit. However, even
in cases of extreme indifference, bundling can be profitable if there are enough goods. Consider an information
service with 1,000 items (news stories, pictures, or songs). Suppose that in a large population, each individual is
totally uninterested in 900 of the items, and values 10 at $0.01 each, 10 at $0.02 each, and so on, with 10 valued
at $0.10 each. If the items are to be sold individually, a revenue-maximizing policy is to charge $0.05 for each.
Each customer will then purchase 60 items for a total of $3.00. However, if the collection is sold as a whole
(which involves no extra cost to producers in case of information goods, and also no cost of tossing out mounds of
unwanted boxes to consumers), then a price of $5.50 will induce each person to buy, for a gain of 83% in revenues
(and more in profits).
So far we have compared only sales of unbundled products (pure unbundling) to those of bundles (pure bundling).
However, it is often advantageous to use mixed bundling, where both bundles and separate goods are offered. In
the example of the books "Sherlock Holmes in Antarctica" and "The Tannu-Tuva Cookbook," with the distribution
of valuations assumed above, a price of $10 for the bundle and $5 for each book separately would produce revenue
of $7,400,000, about 14% higher than pure bundling, and over 23% higher than pricing the books separately. (Note
that the optimal combination above has the paradoxical property that the price of the bundle is exactly the price of


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the pieces. Under the assumption of the model, people who value book A at $7 and book B at $3 will purchase the
bundle, but if the bundle is not available, will only purchase A.) Adams and Yellen [Adams & Yelen 1976] have
shown that mixed bundling is always more advantageous to the producer than pure bundling.
Toy models like the one above are amusing to play with, and help illustrate the advantages to producers of bundling.
If the distribution of consumer valuations is known, one can determine numerically what the optimal policy is for
the producer [Wilson 1993], [Wilson 1996]. Unfortunately the basic assumption that consumers know what value
they place on various goods, and purchase them precisely when the price is below their value, is questionable. In
practice people behave in much more complicated ways. An old joke illustrates this:

               Waiter:       And for dessert, we have chocolate mousse, apple pie, and ice cream.
               Customer:     I will have apple pie.
               Waiter:       Oh, I forgot to mention that we also have Peach Melba.
               Customer:     In that case I will have mousse.

While this is a joke, actual behavior is often just as paradoxical. Catalog merchants have learned that the attrac-
tiveness of an item is affected strongly not just by its price and description, but also by its placement among other
offers. Consumer choices are complicated. Some of the seemingly irrational behavior can be explained on the
basis of different consumers having different sensitivities to prices. For example, the phenomenon of regular sales
has been modeled successfully this way in [Varian 1980] and later papers. Other interesting phenomena emerge
if one assumes that consumers do respond to price signals in an economically rational way, but with some delay
(see [Richardson & Radner 1996], for example). However, there is no complete theory. Experimental economics
has shown that in economically optimal solutions can be attained even with small groups of agents, provided they
are working in a constrained environment and are trying to optimize their wealth, although even there paradoxes
abound (cf. [Cook & Levi 1990], [Hagel & Roth 1995]). In general settings, though, human behavior is hard to
model. There are nontransitivities in preferences, choices are determined by behavior of others (so a person is
more likely to see a movie that colleagues have seen to have something to talk to them about as well as because
that person is likely to trust their judgement), and so on. Companies collect extensive data from test marketing, but
that data is noisy, and typically involves only small variations in test parameters. There seems to be no unambigu-
ous empirical demonstration that a well defined demand curve exists. Thus economic models discussed above do
indicate that bundling is likely to be advantageous to producers, but do not prove this.
What happens in the real marketplace, with a variety of customers and competitors, and where there is already
much experience with a variety of marketing plans? What we see there is extensive evidence of bundling, which
confirms the prediction of the economic models. In many situations, such as that of physical newspapers, there is
an obvious motivation for bundling to reduce costs. However, there is also evidence of bundling's success when
there are practically no physical costs involved. Software suites such as Microsoft Office are just one example.
Cable TV does not charge for each channel separately, but for packages (bundles) of them. Finally, the big and
profitable online information services in the financial and legal arena, such as Reuters, Bloomberg, and Lexis, all
operate on a subscription basis or appear to be moving in that direction. (The "pay-per-view" approach made more
sense when the computing infrastructure for online access was expensive, and therefore there were high marginal
costs of providing access.) All this evidence confirms that bundling is likely to be common in ecommerce.


3.2. Differential Pricing

Charging different prices to different consumers is already common. Various senior citizen or student discount
programs are just some of the most widely spread practices. Scholarly journals typically charge much higher prices
to libraries than to individuals, sometimes 10 times higher. For a thorough discussion of such price discrimination
and its economic and legal status, see the survey [Varian 1989]. A producer would like to charge according to the
consumer's willingness to pay, but the consumer will usually be reluctant to reveal such information. However, it
is sometimes possible to correlate willingness to pay with other features. Airlines offer much cheaper tickets for
those willing to be away from home on Saturday night. The theory is that business travelers, who are willing to


                                                         7
pay a lot, will not be willing to put up with such inconvenience. In information services, online services such as
Prodigy and CompuServe offer stock market quotes that are delayed by 15 or 20 minutes for no extra cost, beyond
the basic subscription. Real-time quotes uniformly cost extra, on the theory that those who need them for their
trading will pay more.
The software industry relies on differential pricing in many products. Student or demo versions typically are the
same as the main packages, except for artificial limitations on what they can do. They either cannot produce
large executables, or cannot handle large files, or cannot use extended precision. We are likely to see many more
examples of such differential pricing. Electronic publications may offer a high-resolution version at one price, a
lower-resolution version at a lower one, and sometimes might offer a fax-quality version at no charge. There are
already interesting experiments in book distribution, with authors making some parts of their manuscripts freely
available on the Internet, to advertise their work, to update it with lists of current errata, and to make available
features that draw on the unique capabilities of the electronic medium. There are also likely to be differentials
based on timeliness, as with stock market quotes; old issues might be offered at low or no charge. There might be
extra charges for links to cited works or other desirable features.
Differences in quality of offered products might be the only way to preserve some of the features of public libraries.
In the digital realm, without some artificial barriers, there would be practically no difference between buying and
borrowing. Hence the traditional library policy of unrestricted lending is not compatible with ecommerce, and we
are likely to see artificial barriers. Databases might be available to library customers but only inside the library,
at special terminals, for example. Librarians would then become gatekeepers, restricting access to material more
than making it freely available.


3.3. Subscription vs. Pay-Per-View

Offering access to a database or a movie channel on a subscription basis is a form a bundling. The alternative is
to charge for each movie, or each download of a Web page. There is much discussion of how such "a la carte"
shopping might become prevalent. One attraction of programs consisting of small applets that can be downloaded
on demand appears to be the perception that this would allow producers to charge according to how frequently
the software is used. However, past experience with pay-per-view systems has been discouraging. Except for a
few events, such as championship boxing matches, they have not succeeded in attracting much revenue. All the
arguments in favor of bundling apply, and suggest that pay-per-view systems will not be common. Furthermore,
there are additional arguments, supported by empirical data on consumer behavior, that argue against pay-per-view
schemes. Consumers appear to have a strong predilection for reducing risk, even when this predilection results in
lower than optimal expected financial payoff. A certain $10 gain is usually preferred to a wager with a 90% chance
of winning $15, and a 10% chance of losing $20, even though the latter has expected payoff of $11.50. People
also tend to use small deductibles when purchasing fire or casualty insurance, even when they could easily bear the
loss from a larger deductible. (Since few insurance companies operate with an overhead of less than 30%, a larger
deductible would almost surely lead to savings in the long run.)
Similarly, consumers appear to have a strong preference for subscription services. To a large extent this is probably
explainable by general risk aversion. I may prefer to pay a higher price for a word processor now, even if I do not
need it much, to have free use of it when I lose my job, and need to send out lots of job applications, but will not be
able to afford extra charges. This preference for subscription services is present even among librarians, who are not
spending their own money, and with a large number of users of their resources might be expected to have a stable
and predictable usage pattern. Even so, they have often expressed their unease about paying "a la carte" for access
to databases, since they feared they could not predict what this would do to their budgets. It is difficult to quantify
the strength of this preference for subscription services, but it exists and is strong. In the 1970s, the Bell System
experimented with charging for local calls. Typically, customers were given a choice of the traditional flat rate
option, which might cost $7.50 per month, and allow unlimited local calling, and of a measured rate option, which
might cost $5.00 per month, allow for 50 calls at no extra charge, and then cost $0.05 per call. Anyone making
fewer than 100 local calls per month was better off with the measured rate option. Careful studies of consumer
behavior were carried out by Bill Infosino, Gerry Ramage, John Rotondo, and others at AT&T. They observed
that typically around 50% of the customers who were making almost no local calls at all, and thus would have


                                                          8
benefited from measured rate service, still stayed with the more expensive flat rate service. The preference for flat
rate pricing for Internet access is another example of this phenomenon.
The main conclusion to be drawn from this discussion is that subscription services do offer substantial value to
consumers, even if that value may seem to be irrational. As a corollary, they also offer value to producers. People
are willing to pay a lot just to be able to occasionally use certain features. Software producers complain about all
the heavy users of their products who do not pay for their high usage. However, these producers benefit from the
many users who hardly ever use their system. I seldom use Microsoft Word, but when I do use it (typically because
somebody sends me a Word document), I do need it, and so am willing to purchase it for just such occasions.
Hence we can expect that even if large systems consisting of downloadable applets do become practical, they will
be available on a subscription, and not on a per-use basis.


3.4. Site Licensing

Site licensing, in which a company or a university pays a flat fee to allow everyone in that institution to use some
program or access a database, is very common in the computer and online information industries. In some forms,
it has been present for a long time in other areas as well. For example, scholarly publishing can be thought of as an
example of site licensing. Typically a university will buy a single copy of an esoteric journal, which is then placed
in a library, to be consulted by anyone on campus.
In software, site licensing has many attractive features. It simplifies the enforcement problem (which is nontrivial,
since many corporations report they spend more on policing software use than on the purchase of that software).
It also encourages new users to try out a package, and thus stimulates more usage. In addition, though, site
licensing has a strong direct economic argument behind it. We can think of site licensing as a variant of bundling.
In ordinary bundling, a producer assembles together several goods into a bundle, to smooth out the differences
in valuations that individual consumers place on those goods. In site licensing, a producer assembles together a
group of consumers to smooth out the differences in valuations that different people place on a single product. As
an example, suppose that in a company of 1,000 employees, 900 are totally uninterested in a software package,
but 10 feel it is worth paying $10 for it, 10 feel it is worth $20, and so on, up to 10 who feel it is worth $100.
If the software manufacturer had to sell copies of the package to individuals, the best price would be either $50
or $60 for a copy, and the revenue in either case would be $3,000. However, if the management of the company
has an accurate estimate of how much the employees value the product, it should be willing to pay $5,500 for a
site license. This would be a much better deal for the producer, even though it would bring in only $5.50 for each
person entitled to use the product. Hence we can expect further spread of site licensing. (For some other aspects
of site licensing, see [Varian 1995b].)


4. Fairness, Legality, and Efficiency

Economic arguments show that there is value to many of the artificial barriers in commerce. It is value not just
to producers of the goods and services, but to society. Moreover, the incentives to create such barriers apply to
individuals as well as large corporations. If Alice plays the piano, and Bob performs magic tricks, they might be
able to obtain a higher total income by bundling their services through offering a combined act to nightclubs. The
result might be the difference between starvation and relative comfort. In ecommerce, a group of budding poets
might collect larger revenues if they sell access to their combined works, instead of acting individually.
While economics will lead to the creation of barriers in ecommerce, this will frequently clash with popular notions
of what is fair. There is already much grumbling about airline pricing and senior citizen discounts. Moreover,
many of the grumbles result in laws restricting commerce. Several cities in the United States have passed laws
decreeing that women's shirts should not cost more to launder than men's. There is a general perception of what
is fair, often codified into laws. Some is based on ideas of non-discriminatory treatment (as with laundry pricing
practices). Some goes back to the ancient notion of a "just price," which is supposed to reflect a modest markup
over the producer's costs. However, in ecommerce, even more than in the modern physical economy, cost is a
poorly defined concept.


                                                         9
In ecommerce, the concepts of "increasing returns" [Arthur 1994], in which producer profits increase as usage
increases, and customer lock-in, in which someone trained in using a particular spreadsheet faces a major barrier
of retraining in switching to another one, are among the ruling ones. This means that the many traditional tests of
illegal monopolistic behavior do not apply. It can make excellent sense to give away a software package, since the
major benefit to the producer will come from sales of upgrades. Other examples of economically sensible behavior
that is not accepted by society exist. U. S. courts stopped IBM from requiring users of its tabulating machines to
purchase their punched cards from IBM [US 1936]. Today, most economists would argue that this decision was
a mistake, since in effect what IBM was attempting to do was to charge the heavy users more than the light ones,
to enlarge the market. (See [Stigler 1963] for economic arguments against another decision, [US 1962], which
barred movie distributors from requiring movie theaters to book whole series of movies instead of selecting them
individually.) While the general issue of what practices are legal is at best murky (cf. [Bork 1993], [Bowman
1967], [Varian 1989]), there may be legal problems with some of the barriers that are likely to be erected. Even
when there is no legal difficulty, there can be extensive public action, as in recent protests against pharmaceutical
firms' pricing, and against use of child labor in less developed countries. (With reputations, whether of celebrity
endorsers or producers themselves, becoming increasingly important, public protests can be powerful weapons.)
Issues of fairness (see [Zajac 1995] for extensive discussions of their influence on public policy) are likely to be
much more pronounced than in the past. One reason is that the barriers on the electronic superhighway are likely
to be frequent. Another is that those barriers will be much more visible as artificial. In print book publishing,
most people seem to think that hardcover books sell for more than paperbacks because they cost more to produce.
However, the differences in costs are minor, and the price difference is just a form of price discrimination. On the
Web, it will be clear that a low resolution version of a work is just a degraded version of the high resolution one. It
will also be much easier to organize protest movements than in the past.
Public perceptions of what is fair depend on culture, are often inconsistent, and do often clash with economic
incentives. Furthermore, the rapid evolution of technology, markets, and laws, will lead to a continuation of the
unstable situation we have. There may be serious protests against the "winner-take-all" society [Frank & Cook
1995] that electronic commerce might be seen to promote, where millions of aspiring novelists work hard to catch
the public's attention, but a small handful manage to catch all the material rewards. Even without general protests,
there will be increasing temptation to ask governments to intervene, and that will produce serious difficulties for
ecommerce. Barlow's "independence declaration" [Barlow 1996] might appeal to many, but is totally unrealistic.
Government has been involved in setting up the Internet, and is getting more involved all the time, through issues
such as the fair use of Scientology documents on the Net, assignments of names, and provision of wide access
to the Net. The U. S. Telecommunications Act of 1996, which nominally deregulated telecommunications, also
brought in extremely intrusive government regulations, to deal with thorny issues of setting up a "level playing
field." We should be prepared for more intervention of this type, whether they are successful or not.
Many issues will be complex. As an example, only a tiny fraction of the public understood any of the arguments
about the U. S. telecommunications deregulation debate, with its technical points about access to local wires. Also,
few people follow the details of the debate about revisions to copyright laws. As was argued in an earlier section,
ecommerce requires some revision. However, there are a variety of ways to do this, and the precise ways in which
different proposals affect different players is not clear to the public. (See the discussions by Samuelson [Samuelson
1996a], [Samuelson 1996b] of the proposed revisions to U. S. copyright law [USPTO 1995], as well as the survey
paper [Okerson 1996] and the book [Patterson & Lindberg 1991].) Therefore we can expect an increased demand
for lobbyists, lawyers, and public relations experts. Even in the non-governmental arena, it is reported, for example,
that "in preparing a commemorative CD-ROM for the 500th anniversary of the first Columbus voyage to America,
IBM spent over $1M clearing rights, of which only about $10K went to the rights holders; everything else went
into administrative and legal fees" [Lesk 1995]. Although systems are being developed for automatic tracking of
rights to copyrighted material and the automatic payment of fees, it is unlikely that such systems will see wide
usage. Content owners will probably be reluctant to rely on them, and possibly let valuable rights slip away.
The conclusion to be drawn from this essay is that electronic commerce will increase the efficiency of the economy.
However, it will also create artificial barriers, and we will have to learn to live with them.




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5. References

[Adams & Yellen 1976] Adams, W. J., & Yellen, J. L. (1976). Commodity bundling and the burden of monopoly, Quart. J.
Economics, 90, 475-498.


[Arthur 1994] Arthur, W. B. (1994). Increasing Returns and Path Dependence in the Economy, U. Michigan Press.


[Barlow 1996] Barlow, J. P. (1996). A cyberspace independence declaration, email broadcast message of Feb. 9, 1996, available
at URL
http://syninfo.com/IAN/02136002.htm and many other Net sites.


[Bork 1993] Bork, R. (1993). The Antitrust Paradox, 2nd ed., Free Press.


[Bowman 1967] Bowman, W. S., Jr. (Nov. 1967). Tying arrangements and the leverage problem, Yale Law J., 67, 19-36.


[Burnstein 1960] Burnstein, M. L. (1960). The economics of tie-in sales, Rev. Economics and Statistics, 42, 68-73.


[Cook & Levi 1990] Cook, K. S., & Levi, M., eds., (1990). The Limits of Rationality, Univ. Chicago Press.


[Deneckere & McAfee 1996] Deneckere, R. J., & McAfee, R. P. Damaged goods, J. Economics and Management Strategy, to
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[Dyson 1994] Dyson, E. (1994). Intellectual value, first published in Dec. 1994 in Release 1.0, republished (in an abbreviated
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[Economides 1993] Economides, N. (1993). Mixed bundling in duopoly, working paper, available at URL
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[Economides 1996] Economides, N. The economics of networks, Intern. J. Industrial Organization, to appear. Available at
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[Frank & Cook 1995] Frank, R. H., & Cook, P. J. (1995). The Winner-Take-All Society, Free Press.


[Gates 1995] Gates, B., Myhrvold, N., & Rinearson, P. (1995). The Road Ahead, Viking.


[Hagel & Roth 1995] Hagel, J. H., & Roth, A. E., eds. (1995). The Handbook of Experimental Economics, Princeton Univ.
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[Krishna et al. 1996] Krishna, A., Kopalle, P. K., & Assuncao, J. L. Bundling of complementary goods: The impact of compe-
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[Lesk 1995] Lesk, M. (1995). The seven ages of information retrieval, to be published.


[Odlyzko 1996] Odlyzko, A. M. (June 1996). On the road to electronic publishing, Euromath Bulletin, 2(1), to appear, and to
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[Okerson 1996] Okerson, A. S. (July 1996). Who owns digital works?, Scientific American, 275, 64-68. Text available elec-
tronically at URL http://www.sciam.com/WEB/0796issue/0796okerson.html


[Patterson & Lindberg 1991] Patterson, L. R., & Lindberg, S. W. (1991). The Nature of Copyright: A Law of Users' Rights,
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[Richardson & Radner 1996] Richardson, T. J., & Radner, R. Monopolists and viscous demand, to be published.


[Samuelson 1996a] Samuelson, P. (1996). Intellectual property rights and the global information economy, Comm. ACM 39,
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[Samuelson 1996b] Samuelson, P. Technological protection for copyrighted works, Emory Law J., to appear.


[Schmalensee 1982] Schmalensee, R. (1982). Pricing of product bundles, J. Business, 57, S211-S230. Comments on S231-
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[Stigler 1963] Stigler, G. (1963). United States v. Loew's Inc.: A note on block booking, Supreme Court Review, 152, 152-157.


[US 1936] International Business Machines Corp. v. United States, 298 U.S. 131 (1936).


[US 1962] Loew's Inc. v. United States, 371 U.S. 38, 52 (1962).


[USPTO 1995] Intellectual Property and the National Information Infrastructure, The Report of the Working Group on Intel-
lectual Property Rights, B. A. Lehman, Chair, U. S. Patent and Trademark Office, Sept. 1995. Available at URL
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[Varian 1980] Varian, H. R. (1980). A model of sales, Am. Economic Review, 70, 651-659. Erratum on p. 517 of vol. 71 (1981).


[Varian 1989] Varian, H. R. (1989). Price discrimination, 597-654 in Handbook of Industrial Organization, vol. I, R. Schmalensee
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[Varian 1995a] Varian, H. R. Pricing information goods, available at URL http://www.sims.berkeley.edu/ hal/people/hal/papers.html.


[Varian 1995b] Varian, H. R. Buying, renting and sharing information goods, available at URL
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[Wilson 1993] Wilson, R. (1993). Nonlinear Pricing, Oxford Univ. Press.

[Wilson 1996] Wilson, R. (1996). Nonlinear pricing and mechanism design, 249-289 in Handbook of Computational Eco-
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[Zajac 1995] Zajac, E. E. (1995). Political Economy of Fairness, MIT Press.


Acknowledgements

I thank Stevan Harnard, Hsueh-Ling Huynh, Bill Infosino, Steve Lanning, Peter Linhart, Gerry Ramage, Ryan
Siders, Hal Varian, and Ed Zajac for their comments and the information they provided.



                                                             12