Searching for Search Costs

Search costs — the time and money spent locating the best product at the best price — are a familiar and often unwelcome aspect of everyday life. Think of the nail-biting hours you logged on the phone last December when trying to get your hands on a PlayStation 2 or the teeth-gritting experience of driving from dealership to dealership in search of the perfect car.

But search costs look considerably more attractive from a seller's point of view. They buffer profit margins by making it difficult and time-consuming for buyers to find the best deal. Eliminate search costs, and fierce price competition is likely to ensue, making brand largely irrelevant and driving prices close to marginal cost.

E-commerce threatened to do just that: make vast amounts of information readily available, leading to slashed prices and razor-thin margins. But recent studies suggest that the Internet's impact on pricing has been less dramatic — especially online — than some may have feared.

The Internet has helped drive significant price declines in life insurance and cars, both markets in which buyers use the Internet to gather pricing information but typically make purchases offline. In a working paper for the National Bureau of Economic Research (NBER), economists Jeffrey R. Brown and Austan Goolsbee find that the rising use of specialized comparison shopping sites caused prices for term life insurance policies to fall 8% to 15% between 1995 and 1997. Many other factors, such as improvements in risk management, also contributed to lower prices in this period, says Brown, but the Internet explained up to half of the total decline.

In another NBER study, Fiona Scott Morton, Florian Zettelmeyer, and Jorge Silva-Risso calculate that car buyers who used Autobytel.com, an online referral service, saved 2% on average (roughly $450), compared with off-the-street customers, in 1999. While the possibility that Autobytel.com tends to attract good bargainers may explain part of this finding, econometric tests indicated that using the service independently lowered prices, Scott Morton explains.

By contrast, over the same period, Internet retail prices began to climb. A team of researchers at Carnegie Mellon University reports that after falling between the spring and fall of 1999, online book prices were flat or rising for several months. This trend picked up in 2000, when Amazon.com raised prices across the board by 10% to 20%, bringing them level with offline prices, according to an article by David D. Kirkpatrick in The New York Times (Oct. 9, 2000).

One possible explanation for the difference in online and offline price behavior lies in the intangibility of Web-based transactions, which is likely to increase the importance of trust and branding, relative to price, as Erik Brynjolfsson, associate professor of management at the MIT Sloan School of Management, and Michael D. Smith, assistant professor of information systems at Carnegie Mellon, wrote in the spring 2000 issue of Management Science (“Frictionless Commerce: A Comparison of Internet and Environmental Retailers,” pp. 563–85.)

In addition, price is typically secondary to convenience when people buy products such as books online, says Jill Frankle, director of e-commerce, retail, of Gómez Advisors, an e-commerce research firm based in Lincoln, Massachusetts. But it is a much more salient consideration when it comes to large offline purchases in categories like insurance and cars. In those categories, the Internet's ability to reduce search costs can result in lower prices by empowering consumers to negotiate more successfully, Frankle says.

But before buyers see more dramatic savings, the Internet will have to drive down sellers' operating costs as well. Greater transparency may well force prices to a single level, but the real question is how low the bottom lies, according to Lee Spirer, a vice president at Mainspring, a consulting firm based in Cambridge, Massachusetts.

Scott Morton and her colleagues suggest that some of these changes are already beginning to take place. By their estimate, reduced search costs account for only 15% of the savings associated with using an online car-referral service. The remaining 85% is attributable to the service's bargaining power and the fact that online customers cost dealers less to serve. In fact, savings in areas ranging from sales staff to inventory turns may even allow dealers to cut prices and increase their margins at the same time. And that means that lower prices can be good news for both buyers and sellers.

Studies cited:

• “Does the Internet Make Markets More Competitive? Evidence From the Life Insurance Industry” by Jeffrey R. Brown, assistant professor of public policy at Harvard's Kennedy School of Government, and Austan Goolsbee, associate professor of economics at the University of Chicago Graduate School of Business (http://www.nber.org/papers/w7996).
• “Internet Car Retailing” by Fiona Scott Morton, associate professor of private enterprise and management at the Yale School of Management; Florian Zettelmeyer, assistant professor of marketing at the Haas School of Business, University of California, Berkeley; and Jorge Silva-Risso, senior director of marketing science at J.D. Power and Associates (http://www.nber.org/papers/w7961).
• “Pricing Strategies on the Web: Evidence From the Online Book Industry” by Karen Clay, an assistant professor at Carnegie Mellon's Heinz School of Public Policy and Management; Ramayya Krishnan, professor of management science and information systems at Heinz; and Eric Wolff, assistant professor of accounting at Carnegie Mellon's Graduate School of Industrial Administration (http://www.heinz.cmu.edu/~kclay/bookpricing.pdf).