Free Rider Issues And Internet Retailing Comments Of: Judith A ...
Free Rider Issues and Internet Retailing
Comments of:
Judith A Chevalier1
Professor of Economics and Finance
Yale University School of Management and
Research Associate, National Bureau of Economic Research
Introduction
The Internet allows consumers to shop a wide variety of retailers with relatively
low search costs. To a first approximation, one would expect this technology to improve
matches between consumers and goods, to create competition in previously uncompetitive
markets, and to lower transaction costs for consumers. Allowing the sale of one’s
products over the Internet raises many issues for manufacturers. In this paper, I take up
the issue of free-riding.
My starting point for this discussion is my view that free-riding amongst retailers
is possible, and that manufacturers may have legitimate reasons for wanting to control
this type of behavior. In particular, we know that free riding can occur when sales and
service support for a product are efficiently done at the retail level, and when that effort
cannot feasibly be sold separately from the product itself. In those circumstances,
revenues from the sale of the product have to cover the sales and service effort. Retailers
that do not provide such sale and service effort find themselves in a lower cost position
from retailers that do provide ancillary services. Absent vertical restrictions implemented
by manufacturers, low-service retailers may undercut high-service retailers. This
1 These comments represent the views of the author, Judith A. Chevalier. They should not be construed to
reflect the views of Yale University, the National Bureau of Economic Research, or Chevalier’s coauthors
from the research papers cited herein.
diminishes the incentives of high-service retailers to provide service, ultimately
diminishing the viability of the product.
Historical Context
Manufacturers have had to grapple with these free-rider issues in many arenas
prior to the advent of Internet commerce. In particular, manufacturers have had to
consider whether and how to offer service-intensive products for sale at outlets such as
large discount department stores or warehouse clubs, where high sales service effort is not
expected. Similarly, manufacturers have long had to consider the role of retail catalogs in
their supply chain. By allowing ones products to be sold through retail catalogs, a
manufacturer’s product can achieve wide distribution to remote locations. Futher, the
catalog operator may, in some cases, have costs considerably lower than brick and mortar
retail outlets, allowing lower final prices on the manufacturer’s goods. Internet retailers
provide a service that is extremely similar to the service provided by catalog retailers.
However, as the Internet effectively greatly lowers the cost of disseminating “catalogs” to
those consumers who are likely to buy particular products, the advent of Internet retailing
has magnified the extent to which manufacturers are facing these issues.
Application of free rider issues to the Internet
There are many free-riding situations possible in association with the Internet. In
particular, Internet retailers can free-ride off of the sales and service effort of brick and
mortar retailers, and brick and mortar retailers can free-ride off of the sales and service
effort of Internet retailers. For example, I can use Amazon.com to search for books on a
particular topic and read Amazon customer reviews of those books. Amazon cannot
prevent me from then purchasing that book at Buy.com, a competing Internet retailer, or
from my local brick and mortar bookstore. In this latter circumstance, my local brick
and mortar retailer is free-riding off of the sales and service effort provided by Amazon.
Similarly, however, I could purchase a stereo from Amazon.com that I had listened to at a
local electronics retailer. In that circumstance, Amazon.com is free-riding off of the sales
and service effort provided by my local electronics retailer.
The manufacturer of these products may be concerned about both types of free-
riding. If I do not make my book purchases at Amazon, and instead free-ride off of their
customer reviews and search features, Amazon’s incentive to produce and maintain those
features diminishes. Without access to features of this sort, my overall book purchasing
may decline, hurting overall sales of the manufacturer’s product. Similarly, if the local
stereo store’s incentive to providing costly “listening” service is diminished by customer
free-riding off of their promotional effort.
As pointed out in my recent research with Dennis Carlton (2001) 2, there are
important differences between the two free-rider situations. Most of the sales and service
effort provided by an Internet retailer takes the form of site features such as product
reviews, photographs, etc. Most of the sales and service effort provided by a brick and
mortar retailer will take the form of interactions between sales people and individual
customers. Carlton and I note two important distinctions between this sales and service
effort. First, the sales and service effort exerted by an Internet retailer largely takes the
form of a fixed cost, while much of the sales effort of the brick and mortar retailer
appears to be a variable cost. Second, the sales and service effort provided by an Internet
2 J.A. Chevalier and D.C. Carlton, “Free Riding and Sales Strategies for the Internet”, Journal of Industrial
Economics 49:4, December 2001, 441-462,.
retailer is more likely to be easily verifiable by a manufacturer than the sales and service
effort of a brick and mortar retailer.
In principle, then, it may be simple for a manufacturer to compensate the Internet
retailer with a fixed fee for providing detailed product information features on its web
site. Gertner and Stillman3 provide some evidence that such contracting does indeed take
place. However, it would be very difficult to enforce a contract in which a manufacturer
compensated a brick and mortar retailer for every minute that the retailer spent
demonstrating the manufacturer’s product for a customer. For this reason, free-riding by
Internet retailers off of the sales and service effort of brick and mortar retailers may be
more of a concern for manufacturers. For retail service intensive products, manufacturers
may have an interest in adopting sales strategies on the Internet that protect the margins
of brick and mortar retailers.
Resale Price Maintenance
Were Resale Price Maintenance (RPM) legal, it might be an attractive mechanism
for manufacturers to use to allow the sale of their products over the Internet, while
protecting brick and mortar retailers from free-rider problems. For example, Carlton and
Chevalier (2001) study fragrance manufacturers. It is essentially impossible for an online
retailer to provide one service widely offered by brick and mortar retailers--- the
opportunity to try on the product before buying it. With RPM in place, a consumer who
had tried on a fragrance at a department store would have little reason to buy the
fragrance online; the consumer cannot get the fragrance more cheaply online. However, a
habitual user of the fragrance or a consumer living far away from a brick and mortar
3 R. Gertner and R. Stillman, “Vertical integration and Internet strategies in the apparel industry,” Journal
of Industrial Economics 49, December 2001, 417-440.
retailer of the fragrance might purchase the product online, even if the online retailer
charges a high price and offers low service. Nonetheless, presumably, a RPM policy
would hurt Internet retailers relative to brick and mortar retailers.
While explicit RPM agreements may be unenforceable, manufacturers can
effectively create RPM arrangements by refusing to deal with retailers whose general
business model relies on discounting products. For example, in the market for online
beauty products, one could point to several retailers who appear never to discount
products from the manufacturers’ suggested retail prices, even in circumstances in which
other online retailers discount those same products.4 My understanding is that the
manufacturer could offer its products for sale only to those retailers. This is a strategy
Carlton and Chevalier (2001) identify as common for fragrance manufacturers.
Unauthorized retailers
One issue that may be of particular concern to policymakers is the question of the
extent to which manufacturers are allowed recourse against “unauthorized retailers.” This
issue is not new to Internet retailing, but may be occurring on a larger scale with the
advent of Internet commerce. For example, Amazon.com has been selling many Sony
consumer electronics products for years, despite the fact that it was not an “authorized
retailer” of those products until June of 2002. Many manufacturers, including Sony,
claim that they are not obligated to honor their standard warranty when consumers
purchase products from unauthorized retailers. The risk in this particular case is small,
and indeed, my correspondence with Amazon.com in 2000 suggests that Amazon stood
ready to honor Sony’s warranty terms. However, in general, one might imagine many
4 Whether and how many consumers buy high-priced products when those products are available from
other Internet retailers at lower prices is a separate issue. See J. Chevalier and A. Goolsbee, “Measuring
prices and price competition online: Amazon and Barnes and Noble”, NBER working paper no. 9085, July
2002.
circumstances in which consumers engaged in comparison shopping are unaware that the
same product at different retailers may effectively come with different warranty terms.
Exclusive sale through manufacturer websites
There is an important caution in attempts to regulate contracts between
manufacturers and Internet retailers. Manufacturers are more likely to vertically integrate
into distribution using online sales channels than using brick and mortar sales channels.
Carlton and Chevalier (2001) show that some manufacturers that do not operate physical
retail outlets sell through dedicated manufacturer sale sites. Furthermore, some
manufacturers that distribute to non-dedicated brick and mortar retailers are acting as the
exclusive seller of their products online. For an example not detailed in that study,
consider Playmobil USA (www.playmobil.com). Playmobil is a popular brand of high-
end construction/action figures for children. They are not distributed through the “mass
market” discounters, but they are widely distributed through “mom and pop” toy stores.
Playmobil had previously entered into a Final Judgment in which it agreed to cease using
Resale Price Maintenance practices with its retailers. 5 Until September of 2002, Playmobil
allowed retailers to advertise Playmobil products on their websites, but Playmobil did not
allow its retailers to sell Playmobil products online. In an environment in which
manufacturers cannot use exclusive territories, resale price maintenance, or other vertical
restrictions to mitigate free-rider problems among retailers, eliminating online retailers
altogether remains a viable option for some manufacturers. Carlton and Chevalier (2001)
show that manufacturer web sites tend to have very high prices relative to both online and
brick and mortar retail outlets. For example, Playmobil USA sells goods at its
manufacturer website at the manufacturer’s suggested retail price. After September of
5 United States v. Playmobil USA, Inc., Civ. No. 95-0214, 1995 WL 366524 (D.D.C. May 22, 1995) 110
2002, many retailer web sites advertised Playmobil products at significant discounts from
the MSRP. However, when retail prices, retail availability, and service are taken into
account, it is not clear whether Playmobil will be a more vigorous competitor to other
action figure brand products under the new or old Internet retailing policies.
