The Internet stock-price free fall late last year has been explained by theories ranging from the bursting of the "new-economy bubble" to an oversupply of electronic-commerce offerings. But the essential cause of the slide may be something more fundamental: most Internet companies lack a pricing model that provides a solid platform for revenue growth, not to mention earnings that could justify their lofty price-to-earnings multiples.

Many e-business practitioners accept a number of discouraging assumptions about the nature of pricing on the Internet. They believe, for example, that all Internet shoppers are motivated chiefly by price and that the Internet makes it possible to make price comparisons quickly and easily. As a result, they think they have no choice but to use low prices to acquire and retain customers, even though doing so risks stirring up vicious price wars.

These beliefs have driven Internet companies to take a host of limiting, and potentially irreversible, pricing actions, including:

• Setting unsustainably low prices at launch to enlarge the customer base, which then resists price increases because it quickly comes to accept low prices as fair and reasonable
• Setting identical price levels for all customers
• Failing to adjust prices in response to changing environments, though the Internet makes it easier than ever to do so

Myth

The assumptions behind these practices are, in fact, largely unsound. Amazon.com is the clear leader in on-line books, for example, but it seldom has the lowest on-line prices. It is difficult to find a product category in which the cheapest on-line retailer has the highest sales. Moreover, our research shows that only about 8 percent of active on-line consumers are aggressive price shoppers.

Also, it isn’t true that ease of shopping encourages price comparisons and drives down prices overall. The majority of Internet users visit only the small number of sites where they feel comfortable. Our research has found that more than 90 percent of compact-disc shoppers and 80 percent of book shoppers typically visit only a single site—most often, not the one with the lowest prices.

Furthermore, the predicted rash of Internet price wars never materialized. Real price wars have the effect of narrowing price bands and pushing prices down throughout an industry. But a recent study carried out by researchers at the Massachusetts Institute of Technology found that Internet price bands are actually quite broad: booksellers’ prices varied by an average of 33 percent and CD sellers’ by 25 percent—greater variation than you find even in the off-line world. The price transparency that the Internet allows, and the speed and ease with which companies can match the price moves of their competitors, have made most e-businesses acutely aware of the importance of competing on some basis other than best price.

Reality

That basis is savvy, dynamic, customer-sensitive pricing. Because the transparency of supplier pricing has been much trumpeted, e-businesses tend to overlook the amount of customer transparency available. Yet it is so abundant that it should make the Internet a pricer’s paradise.

In the off-line world, for instance, tests of price elasticity are often expensive and time-consuming. They are therefore usually limited to a small set of products over a narrow range of price levels. By contrast, the Internet provides for continuous, real-time price testing that produces instant customer responses. If an e-business wants to know the sales impact of a 3 percent price increase, it can conduct a test by trying this out on every 50th visitor to its site. With the help of Internet service firms to conduct and interpret such research, e-businesses can gain extremely rich insights into the role price plays in their customers’ buying decisions.

The ability to change prices instantaneously also makes it easier for more companies to use sophisticated pricing techniques, including yield or revenue management, that once were appropriate for only a limited number of specialized industries, such as airlines and car rentals. Business-to-business commodity companies with on-line price lists are no longer tied to annual or semiannual pricing cycles or price books and can react quickly to variations in customer demand. While preprinted entertainment tickets have to be segmented primarily on the basis of the location of the seats, tickets sold on-line can also be segmented on the basis of the number of seats available and the level of customer demand before a show.

By allowing businesses to examine buying patterns of consumers, or how their session-clicking behavior responds to different price levels, the Internet also allows businesses to tailor prices to individual customers. A company can offer every 50th customer a price change and track the response, for example, not only to gain a better understanding of a segment’s price indifference band but also to extrapolate the future buying behavior of customers from their past behavior. Businesses can even let customers place themselves in segments, as Books.com did before it was acquired by Barnes & Noble.¹ Suppliers can also make use of electronic coupons, which ferret out price-sensitive people, or of incentives aimed at customers reluctant to make purchase decisions. Whichever technique a company may choose, the Internet maximizes its chances of making a sale at the highest possible price.

In short, the Internet brings into existence a whole new world of pricing precision and flexibility. Companies that survive in this medium will invest in systems to help them interpret real-time customer information on buying behavior and price sensitivity, and they will tailor their offerings and prices accordingly.