Behind the Big Billion - Flipping the Kart and Snapping the Deal

Consuming the surplus – Why the rise of e-retailers may not be good news to the consumers

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages”

Adam Smith, An Inquiry into the Nature & Causes of the Wealth of Nations, Vol 1

If we rephrases Churchill quote on Democracy as: “Market economy is the worst form of economy, except for all the others”, there would be few who would stand up to argue.

But one also needs to keep in mind what Adam Smith said in his book written in the year of American Independence, the land of market economy, regarding the self-interest of butcher, brewer and baker which makes the market economy work.

And therein lies the beauty of the market economy, no one is expected to be a saint, yet the end results are near heavenly. Of course, economists came and identified cases of market failure, and grudgingly accorded a role for the inefficient government to play the role of an impartial umpire.

In the recent past, the Indian media has rejoiced the multi-billion dollar valuation of our very Indian entrepreneurs, the Bansals of the Flipkart fame. Not many of us may have followed the subsequent news that Flipkart is no longer an “Indian” company, as it is registered in Singapore and owned by a Singapore based holding company. Not that this aspect makes any difference, market economy does not expect any benevolence from any quarter for it to work efficiently.

The media also heralded the recent arrival of Jeff Bezos, the man behind Amazon, and of the impending clash of the e-commerce giants – Flipkart and Amazon, in India. We are told that the only beneficiary from this increased competition is the customer.

Here is where I would like to disagree, and try to present an alternate, and a very likely scenario.

Let’s keep in mind that none of these firms are here to do charity. Jeff Bezos, the Amazon honcho has famously been called the Apex predator- the most intelligent and patient sort, who will not stop till Amazon is the last retailer standing. Amazon makes a wafer thin profit, if any, but its sales keep increasing at a dizzying rate, and so does its stock market valuation. It is for this reason that Matt Yglesias, the Slate columnist, had once characterized Amazon as a “charitable institution being run by elements of the investment community for the benefit of consumers.” Bezos took issue with this in a letter to shareholders. His argument is that Amazon isn’t a charity; it’s a business—a business whose strategy is to make its customers as happy as possible. Bezos had said “Proactively delighting customers earns trust, which earns more business from those customers, even in new business arenas. Take a long-term view, and the interests of customers and shareholders align.”

I find it difficult to accept Bezos viewpoint at face value. A large market share of any e-retailer coupled with recent advancements in big data analytics provides for the first time the possibility of the retailer keeping most if not all of the economic benefits of the market economy.

To understand this, we first need to get down to the basics of supply and demand, and how an open market price determination provides economic benefits to both the buyer and the seller. The gain, called the producer’s surplus and the consumer’s surplus occurs because of the way the final exchange price is determined by the intersection of the supply and demand curve. This is illustrated in the figure[1] below-

The consumer surplus is the gap between the price that the consumer is willing to pay for a good and the price that he actually pays. It is thus a measures of the benefit that buyers receive from a good as the buyers themselves perceive it. There is a similar explanation for a producer surplus. These surpluses together are what makes market efficient and contribute to its perceived beneficial aspect.

The economists have been telling us ever since the first book on economics was written that monopolies are bad, for it concentrates market power, and allows the monopolist firm to determine the final sale price by controlling the supply. But the economists’ objection to monopolies was not on the grounds of justice or fairness, but because they cause the so called deadweight losses, the shrinking of the economic surplus comprising of the producers surplus and the consumers surplus. The economist does not care who gets the surplus provided somebody gets it. There is inefficiency if the size of the surplus shrinks.

The current scenario of increasing market share of e-retailers like Amazon and Flipkart, coupled with advanced big data analytics allows the possibility of the e-retailer keeping all the economic surplus with itself, without being blamed by economists for inefficiency or causing deadweight losses. Of course, if this aspect of price discrimination becomes more generally known, the e-retailers will be accused of a more insidious form of price gouging, for which public has shown little sympathy or tolerance.  The economic surplus can be appropriated by the e-retailer by knowing the consumer so well as to determine the price that he/she is actually willing to pay for the product, and price it accordingly. This is called perfect price discrimination, and recent academic research has already found some evidence of the adoption of such price discrimination by e-retailers. In such a case, the price offered by the e-retailer would perfectly follow the demand curve, giving the product to the consumer at a price just below the subjective value attached to it by the consumer.

Few web surfers among us would have failed to note how the ads seem to be chasing us. It’s near spooky how the ads shown on random web pages that we surf through are for products that we may have searched for on our favorite search engine or e-com site. They know us. This is predictive analytics at its very basic manifestation. It doesn’t take much more to make a good guess of how desperately we want to own that product, assess our paying capacity, and estimate the highest possible price that will still entice us to buy. And that’s how the retailer can keep all the consumer surplus for itself. In the last one year, I have bought the same product online at discounts ranging from 20% to 80%. With such variation, the concept of fair price itself has lost its meaning, and I am ready to believe that any price is a fair price. Did the e-commerce site correctly assess my need for the product?

Welcome to the new reality of super-efficient analytics powered marketplace of the future.

So next time you see these e-retailers fighting it out, don’t rejoice, for the battle will end soon, and it will be time for us to pay exactly the value we place on the product. The economic surplus is not lost to society, it is just transferred to the e-retailer

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[1] "Economic-surpluses" by User: SilverStar - Own work. Licensed under Creative Commons Attribution 2.5 via Wikimedia Commons - http://commons.wikimedia.org/wiki/File:Economic-surpluses.svg#mediaviewer/File:Economic-surpluses.svg