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Red Queen Pricing Effects in E-Retail Markets

Michael Baye and John Morgan

No 2005-07, Working Papers from Indiana University, Kelley School of Business, Department of Business Economics and Public Policy

Abstract: A standard “solution” offered to the deleterious effects of all-out price competition is for firms to engage in differentiation strategies. This solution, however, depends critically on the inability of rivals to imitate a successful differentiation strategy. With imitation, we show how “Red Queen” pricing effects can arise: All firms have an incentive to vertically differentiate and increase markups, yet imitation by rivals drives prices down toward pre-differentiation levels. Thus, the price premia arising from differentiation strategies in eretailing critically depend on the number of other firms that imitate the strategies. Based on data from Shopper.com, we find that an online firm that unilaterally differentiates itself from its rivals by participating in CNet’s Certified Merchant program enjoys a 5 to 17 percent price premium. However, when other firms also follow this strategy, the price premium vanishes.

Keywords: Pricing; Product Differentiation; Red Queen Effect; Internet; Reputation (search for similar items in EconPapers)
JEL-codes: D4 D8 L13 M3 (search for similar items in EconPapers)
Date: 2005
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