SIXTEEN

Price Buster

BY DOUGLAS A. BLACKMON

July 17, 2000

Once and for all: Is it all those price-grinding business-to-business marketplaces and deep-discount retailing sites on the Internet that are slaying inflation?

Absolutely not.

Electronic commerce, despite its dizzying growth, “just isn’t big enough to account for anything,” says Lee Price, Commerce Department undersecretary for economic affairs.

Indeed, online transactions are still such a small slice of the U.S. economy that their impact on the country’s overall economic performance is slight. Moreover, the streak of annual low inflation numbers began years before Amazon.com Inc. existed or anyone other than computer geeks had heard of the Internet.

In the first quarter of 2000, online retail sales totaled $5.26 billion, according to the federal government, or just 0.7% of the total economy’s $747.8 billion in retail sales. The government doesn’t yet release measures of business-to-business electronic commerce, but Mr. Price estimates that those sales similarly amount to less than 1% of commercial transactions.

“The Internet is still a very small fraction of all sales,” says Eric Brynjolfsson, a business professor at the Massachusetts Institute of Technology. “So even though there are clearly some lower prices, you multiply that by the share of sales in the whole economy, and it really doesn’t make much of a dent.”

But mathematical certainty isn’t the whole story.

Many New Economy prognosticators maintain that the Internet eventually will be a major factor in pricing. The idea is that prices will be driven downward as business-to-business online markets allow an endless number of suppliers to bid competitively for contracts with big manufacturers.

Retail e-commerce sites, the thinking goes, will cut consumer prices by pitting a multitude of product sellers against one another, allowing Web-surfing buyers to quickly identify the lowest possible price for any good. Web-based search engines will also provide buyers with more information—and bargaining power—about products than ever before.

Whether those predictions come to pass will depend on several factors, most importantly how much economic activity finally does move online. But there are other issues, too. Some Web sites, such as Priceline.com Inc. and Webvan Inc., attract large volumes of business, but don’t necessarily push down prices for their competitors in the traditional economy. Indeed, economists say the Internet’s biggest impact on inflation may actually come not from price competition, but from how the Web subtly reduces the routine costs of doing business.

In some respects, the Internet in its infancy has borne out the expectations of sharp price cuts in the goods sold online. Freemarkets Inc., a publicly traded B2B exchange based in Pittsburgh, has hosted online reverse auctions—in which suppliers bid for factory’s component orders—involving $5.4 billion of transactions. Among the companies using Freemarkets are Owens Corning, SmithKline Beecham PLC and Visteon Corp., the auto-parts unit spun off by Ford Motor Co. last month.

Sandy D. Jap, an assistant professor of marketing at MIT, studied the results of auctions of about $500 million of goods by one of Freemarkets’ biggest suppliers last fall and earlier this year. Those auctions attracted new suppliers, reduced prices and cut the costs of transactions, she says. “We found that you definitely save money,” she says.

Freemarkets says that on average, online prices in the auctions have been 15% lower than what companies previously paid for the same products.

“All of the factors are in place for kind of a downward price pressure inherent in the Internet to have an effect on the national and global economy,” says Glen Meakem, Freemarkets’ chairman and chief executive officer.

But Ms. Jap also found that pure price competition isn’t necessarily the most effective way to deal with key suppliers, and that could shape the Internet’s ultimate impact on inflation, regardless of how many sales go online.

Relying heavily on Internet auctions, Ms. Jap says, would run counter to recent efforts by many big manufacturers to develop ever more complex relationships with their suppliers. In return for a preferred status, for instance, suppliers take on expanded responsibilities including design and engineering work, all of which require long-term investments. Those kinds of relationships become a tough sell if the manufacturer begins launching price wars on the Internet.

“We found that suppliers tend to feel more exploited in an open reverse auction rather than the traditional sealed bid,” Ms. Jap says. “If a buyer were to rely on these reverse auctions repeatedly in the future, the suppliers will feel beat up and the supply base will consolidate. They either exit the industry or consolidate. The long-term picture could be very bleak for a buyer. You could see a very powerful supplier.”

As a result, Ms. Jap says, big manufacturers are likely to use Web technology more to cut costs by streamlining their relationships with suppliers and to give periodic “reality checks” on pricing through open auctions.

Retail sales on the Internet have encountered similar results. Early on, seemingly innumerable entrepreneurs created competing “virtual” markets, all of them freed by the Web from the burden of operating brick-and-mortar stores. Soon, more than 6,000 sites, according to one study, were selling books, for instance. Prices fell sharply at market leaders, such as Amazon.com and barnesandnoble.com Inc., often below the company’s costs. But according to a study by Mr. Brynjolfsson, the one operation that had the lowest prices nearly all of the time, Books.com, went out of business. Barnes & Noble acquired the shuttered company’s Web domain name late last year.

It turns out that while Web markets almost always restructure how prices are developed, they may not drive them down. Buyers place a value on—and are willing to pay for—the familiar brand of a particular seller, on the security of being able to see a product at a real store before buying it, or in a trusted relationship with a particular merchant or supplier. Mr. Brynjolfsson found that instead of using the Internet to demand the lowest possible prices, customers are willing to pay up to $3 a book more at Amazon than other sites.

“Consumers perceive a product coming from Amazon as having a different value than a product coming from a generic bookseller,” Mr. Brynjolfsson says.

Look at Priceline, where customers can offer their own prices for airline seats and other products.

Priceline sells some seats at lower-than-normal prices, but its inventory comes largely from seats that airlines have determined will go empty otherwise. The result is that Priceline creates a new discount market for customers with very flexible travel plans, but doesn’t significantly affect the supply and demand—or push down prices—for business and vacation travelers, who buy most airplane tickets.

Webvan, the online grocer operating in Seattle and Atlanta, competes mostly by promising top-notch service, such as perfectly selected produce, and delivery of goods to a customer’s kitchen counter. But its prices are generally no lower than those of old-fashioned supermarkets.

Instead of pure pricing pressure, the explanation for why inflation has remained in check may have more to do with the Internet’s technology siblings than the Web itself. First, the cost of technology itself has fallen steeply in the past 10 years, according to the government. Computer prices, for instance, declined by 26% a year between 1995 and 1999. That decline in the cost of technology has cut the country’s overall inflation rate by a big one-half of one percentage point in recent years, says Mr. Price, the government economist.

Besides reducing the inflation rate, the falling prices have made technological innovations accessible to far more companies. Back in the late 1980s, when giant corporations drew gasps as they announced that tens of thousands of people were being laid off, it seemed impossible that any company could continue its most basic functions with so many workers vanishing.

But rather than employing thousands of clerks, for example, to process weekly payroll checks and type memos, companies began cranking out payroll and correspondence using then-exotic software that would look rudimentary today. The same goes for basic word-processing programs, cheap high-quality printers and, later, e-mail. The combination of those during the 1990s began to seriously reduce the number of workers needed to create the millions of letters and documents that are the backbone of business. Now, Internet markets, with or without price auctions, allow big companies to communicate with each other instantly, examine each other’s inventory and alter orders to maximize efficiency of their factory operations.

The spread of that kind of basic technology, often over the Web, continues to accelerate. The Internet’s broadest impact on inflation may be as a vehicle for democratizing digital efficiency into the most mundane parts of the economy.

“It’s very hard to draw the boundaries of what you want to see as the cause and what you want to see as the effect,”Mr. Price says. “My view is that where the Web and technology are going, there are going to be lots of salesmen and purchasing people’s jobs for whom technology is just more efficient. . . . That is where the action is.”

Mr. Blackmon is a staff reporter in The Wall Street Journal’s Atlanta bureau.