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How e-commerce reshapes markets and firms’ strategies

The development of e-commerce has affected both demand and supply fundamentals of markets, changing the way competition works. In the effort to develop a frictionless and welfare maximizing digital single market across the EU, it is necessary to carefully review the disruptive forces on e-commerce on markets and firms’ strategies.

By: Date: May 7, 2018 Topic: Innovation & Competition Policy

Online purchases are growing rapidly within the European Union, generating benefits for the broader European society. Electronic commerce (e-commerce) is growing rapidly in the EU at an average annual growth rate of 22%, surpassing €200 billion in 2014 and reaching a share of 7% of total retail sales (European Commission, 2015). E-commerce has not contributed to the decline of total sales starting in 2007, as it has remained on a steady upward and even accelerating trend (see Figure 1).

Figure 1: Evolution of total and online retail sales in goods, 2000-2014 (Bln €)

 Source: Duch-Brown and Martens (2015)

 

OECD (2018) identifies three broad categories of products that are commonly sold online:

  • Tangible consumer goods such as clothing and footwear, cosmetics and healthcare products, and consumer electronics. E-commerce in physical goods necessarily involves some form of physical delivery.
  • Services for offline consumption such as transport (e.g., train, bus, plane), accommodation (e.g., booking of hotel rooms) and tourist services.
  • Digital content services such as films, television programmes, e-books, online music and video games. In this case, the entire transaction including delivery occurs online.

The development of e-commerce has affected both demand and supply fundamentals of markets, changing the way competition works (see Lieber and Syverson, 2012 and OECD, 2013).

On the demand side, it is generally accepted that the Internet lowers search costs for consumers. Consumers have access to an enormous amount of information online. For example, they can visit websites (such as online marketplaces and price comparison platforms) that enable quick and readable access to aggregate information, such as price quotes from different online sellers for the same good or service. Alternatively, they can take advantage of the efficient, intelligent matching algorithms of the web search platforms. In this way, consumers are able to easily compare existing offers and make the best possible choice based on their preferences. Considering these new opportunities, it is not a surprise that one of the main conclusions of the E-commerce Sector Inquiry of the European Commission was that price transparency has increased with online trade.

Moreover, e-commerce reduces geographical barriers and therefore leads to broader geographic scope for transactions. As empirical studies (see for example, Forman, Goldfarb and Greenstein, 2005 and Sinai and Waldfogel, 2004) suggest, the Internet helped individuals located in rural areas to overcome the problem of distance in trade with retailers that are located in big cities. In fact, the trade participation rate in rural areas significantly increased, reducing the importance for individual consumers to be located in cities.

However, for cross-border e-commerce, additional barriers are in place. Figure 2 shows that consumers mostly prefer to buy  domestically online. Nevertheless, in recent years there has been a small tendency of individuals to be more engaged in cross-border e-commerce. Consumer surveys on behalf of Google show concerns over possible difficulty with returns (reported by 23% of respondents in a simple average across Member States), lack of trust (21%), customer service (17%),  delivery costs (14%), payment arrangements (11%), the complexity of possibly having to deal with a foreign language (11%), and price (10%).

Figure 2: National and cross-border purchases by e-shoppers, EU-28, 2012 and 2016 (% of individuals who bought or ordered goods or services over the internet for private in the previous 12 months).

Source: Marcus, Morales and Petropoulos (2017)

On the supply side, firms that sell cross-border identify a range of challenges. Particularly prominent are delivery costs, the complexity of dealing with foreign taxation, concerns with data protection when selling abroad, and payments from other countries that are not sufficiently secure. More generally, lack of language skills, and differences in consumer protections and technical rules (labelling, packaging and so on) also play a role as they contribute to increase the cost of cross-border transactions (see TNS, 2015, for relevant statistics).

The digital single market strategy adopted by the European Commission in May 2015 has set as a major goal the removal of such impediments to cross-border e-commerce in the EU28, through a series of legislative actions. As we move forward with the strategic goal of creating a single market, cross-border e-commerce is growing and the national borders play a smaller role in online trade. That also has implications for market competition and its broader geographic definition due to the Internet.

The emergence of alternative Internet distribution models such as online platforms makes it easier for retailers to access consumers that are in distant (cross-border) locations. This is particularly important for small retailers which, with limited investments and effort, can become visible and sell products to a large consumer base in multiple Member States through such marketplaces and platforms, as they significantly reduce associated transaction costs.

The E-commerce Sector Inquiry provides novel insights on firms’ strategies in the full range of the vertical chain – namely, both in the upstream level where goods are manufactured and the retail level. It finds that the increased price transparency leads to an increase in price competition both in online and offline channels. It may also affect other dimensions in which firms can compete such as quality, brand image and innovation. At the same time, monitoring of prices becomes easier. The firms use automatic software programmes that observe the prices of their competitors in real time and adjust their own prices accordingly.

A key observation of the inquiry is the divergence in the views of retailers and manufacturers of branded goods on what the most important parameters of competition are. Manufacturers consider product quality, brand image and the novelty of the products as the most important parameters of competition. In contrast, retailers consider price as a major parameter of competition.

The interplay between online and offline channels is crucial. The inquiry indicates that there exists free-riding between these two channels, but with uncertain direction. On the one hand, consumers can use pre-sale services of bricks-and-mortar shops to receive better product information before purchasing it online. On the other hand, consumers can search and compare products online before purchasing in bricks-and-mortar shops. The e-commerce survey reports that 72% of manufacturers acknowledge the existence of free-riding by online sales on offline services. 62% acknowledge the existence of free-riding by offline retail on services offered online. It is difficult to conclude the overall direction of the free-riding effect. But, given that the offline distribution channel incorporates higher costs, it is the free-riding of online retail on the offline one that generates the greater concerns.

Furthermore, e-commerce contributes to lower information asymmetries. The possibility to easily switch between different distribution channels and receive better information about products and services can significantly reduce asymmetric information between buyers and sellers. Akerlof (1970), with his well-celebrated “market for lemons”, showed how the quality of goods traded in a market can degrade if buyers and sellers do not have equal access to information by reducing the risk for market failures and by leading to more efficient transactions.

As a result of these market trends, manufacturers have increased incentives to obtain a greater influence and control over their distribution networks, in order to better control price and quality of their products in the downstream market. This is done by: (i) increasing their presence to the retail market (vertical integration); (ii) increasing the use of selective distribution systems (i.e. systems in which manufacturers set the distribution criteria that retailers must meet to become part of the distribution network and where all the unauthorised retailers are prohibited); (ii) with a more extensive use of other vertical restraints imposed on retailers that vary from pricing restrictions and platform bans to the exclusion of pure online players from distribution networks. Such vertical restraints are imposed in most cases as a part of the selective distribution system in place. For example, in online trade, manufacturers tend more often to offer retail price recommendations as a way to ensure the appropriate positioning of their products in the downstream market.

Platform bans refer to a new strategy by the manufacturers that emerged in the last few years. In such cases manufacturers do not allow the retailers that participate in their distribution system to use marketplaces to sell their products. A currently open question is whether these platform restrictions should be allowed or not. Especially, when in such restraints small retailers for whom access to marketplaces is particularly important for their growth. The so-called Coty case is probably the most known relevant case.

Coty Germany GmbH is a supplier of luxury cosmetics established in Germany. Coty, in its selective distribution system, prohibited its authorised distributor, Parfümerie Akzente GmbH, to sell its luxury goods through the marketplace Amazon.de. The case reached the European Court of Justice (ECJ) which ruled that the prohibition is lawful and, in fact, intensifies competition. The ECJ’s reasoning was that market competition is multidimensional and, apart from the price component, there are also other relevant dimensions like product quality and brand image. It concluded that the platform ban was necessary to preserve the brand image and in this way to intensify competition.

As e-commerce grows and firms are more involved in online trade, the development of a frictionless (digital single) market across EU – where fair and innovation-inducing rules apply – should be the priority. Frequent market analysis, which identifies the disruptive forces of e-commerce, is a necessary step towards this direction.


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