Online retailers play pricing games

Why haven't price comparison sites flattened prices online? Game theory has the answer.
Written by Paul Festa, Contributor
Think you've found the lowest price online? Better double check.

That's the advice of economists who research why a plethora of online price comparison systems haven't succeeded in leveling prices on the Internet.

"A lot of early studies predicted that all firms would be forced to price their goods at cost and prices would be driven down," said Michael Baye, a professor of economics at Indiana University's Kelley School of Business. "That hasn't happened. There is still considerable price dispersion online."

And the prices don't just fluctuate from merchant to merchant--they can vary from day to day on the same site.

It wasn't supposed to be this way. Online price comparison sites--designed to guide consumers to the lowest prices--were expected to level prices all around, all but evaporating profit margins for retailers.

Comparison engines abound online and are increasingly a staple of large portal sites.

Google launched its Froogle test site in 2002 and recently expanded it to the United Kingdom. Bertelsmann has a stake in Shopping.com, which in October made a successful initial public offering. Yahoo in March purchased Kelkoo. And AOL launched its InStore comparison site in September.

Other comparison engines include Shopzilla, which used to be called BizRate.com and still runs the BizRate.com customer review site. CNET Networks, publisher of News.com, operates Shopper.com.

So if online consumers have so many shopping engines to tell them the lowest price for a given item, how can online merchants get away with charging more?

The answer, Baye said, is in game theory.

Shoppers, merchants and comparison sites are all engaged in a deadlocked game in which no single party can improve its hand given the strategies of the others. This situation is described as a Nash Equilibrium, named after the Nobel Prize-winning economist John Forbes Nash Jr., who was the subject of the 2001 movie "A Beautiful Mind."

Specifically, merchants are using what Baye calls "hit-and-run" pricing strategies, varying their prices in order to keep the competition from being able to consistently undercut them.

Baye compares the pricing strategy to that of a specific game, soccer.

"In a penalty kick, if the goalie consistently jumps to the right, the kicker can score every time," Baye said. "The goalie has to mix up his strategies so his opponent can't predict whether he's going to the right, going to the left, or in the middle."

As a result of retailers' need to keep their competitors guessing, consumers will see prices fluctuate day to day or week to week. That's good news for price comparison sites, which otherwise would have little to compare.

"This is the information paradox," Baye said. "The only way a price comparison site is going to attract consumers is by providing valuable information. But if in doing so they created this world where all merchants charged the same price, who would bother going to a price comparison site?"

Despite the dose of chaos, consumers still benefit from the system and have increased their gains as it matured. Five years ago, the difference between the average price online and the lowest price was 13 percent. Today, it's 18 percent, according to Baye's research.

Baye and his research colleagues have posted their research at Nash-Equilibrium.com. In the past five years they have analyzed between 20 million and 30 million prices gleaned from comparison sites.

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