It’s Called ‘Price Coherence,’ and It’s Surprisingly Bad for Consumers

 
 
In many markets, a product is offered at the same price regardless of whether it is sold directly by a retailer or through an intermediary. Research by Ben Edelman and Julian Wright uncovers the hidden costs for consumers.
 
 
by Carmen Nobel

Consumers often have the following choice: Either buy something directly from a retailer, or buy it indirectly through an intermediary, which partners with the retailer to attract more buyers. Think purchasing a plane ticket straight from the airline versus on Expedia.com, ordering takeout from a restaurant versus on Grubhub.com, or paying cash versus using a credit card.

In many cases, consumers pay the same price for a given product or service, whether buying it directly from its source or through an intermediary. Economists call this "price coherence." It's usually borne of contractual restrictions imposed by the intermediaries, who want consumers to focus less on price differences and more on the benefits of value-added services that they provide, such as distribution, one-stop shopping, easy scheduling, payment processing, and other conveniences.

“Although price coherence may seem to offer benefits at no cost, it actually raises prices for buyers”

If an intermediary like Expedia charges the same price as an airline, for example, then many consumers will choose to use the intermediary. After all, Expedia offers hotel upgrades, coupons, and even cashback rebates to frequent customers, not to mention the convenience of keeping customer information on file. While the intermediary charges a fee for its service, buyers widely perceive that the costs are borne by others, namely sellers. Sellers in turn pay the fee with the understanding that the intermediaries' benefits attract desirable customers.

"On the face of it, price coherence seems good for consumers because they get a benefit for choosing the intermediary, and they pay no additional fee," says Benjamin G. Edelman, an associate professor at Harvard Business School in the Negotiation, Organizations & Markets unit. "But actually, it's not so good for consumers."

Edelman explains the problem in the paper Price Coherence and Excessive Intermediation, co-authored with Julian Wright, an economics professor at the National University of Singapore. The paper discusses various markets in which an intermediary is optional for a transaction, including travel booking networks, restaurant ordering services, online rebate services, and some kinds of insurance.

Overall, the researchers find that price coherence actually leads to inflated retail prices, unnecessary usage of the intermediaries' services, and an overall reduction in consumer welfare. The best things in life may be free, but price coherence isn't one of them.

Sellers Pass Fees Onto Buyers

"Although price coherence may seem to offer benefits at no cost, it actually raises prices for buyers," Wright says. "That's because sellers must pay fees to intermediaries for every intermediated transaction with a buyer, and they must cover those fees by raising prices for consumers."

Online travel websites charge the airlines around $3 per flight segment, for example—or a total of $12 for a standard domestic round-trip flight. To cover these fees, airlines increase their retail prices. So all buyers essentially end up sharing the fees, even if they choose to forego the intermediary.

Thus begins a vicious cycle of increasing costs.

With price coherence in place, intermediaries need not worry that buyer demand will decrease as they increase the fees they charge retailers. Rather, they can offer rebates and benefits to attract buyers. The more benefits the intermediaries offer, the more buyers they attract. The more buyers they attract, the more transactions will go through the intermediary. The more transactions go through the intermediary, the more retail prices increase to cover the intermediary's fees.

Consider OpenTable.com, the best-known restaurant reservation website in the United States.

The company woos diners with its OpenTable Dining Rewards Points program, which keeps track of diners' honored reservations. After following through on 20 reservations, a diner receives a $20 discount, valid at any OpenTable partner restaurant. Essentially, diners receive a buck per meal for reserving a table through OpenTable.

"You might know the restaurant isn't going to be full, and that you won't even need a reservation," Edelman says. "But you end up with this strange incentive to book through OpenTable, not because you love OpenTable, not because you needed a reservation, but because you want the dollar. It looks like free money, a rebate on a purchase that you were going to make anyway."

Indeed, a consumer pays no reservation fee to use OpenTable. However, OpenTable charges restaurants $1 per person for each honored reservation, plus $199 per month, plus an initial set-up fee of more than $1,000. Because most reservations are parties of at least two diners, restaurants pay at least $2 per OpenTable reservation, on top of the other fees. The restaurants must offset their costs.

"One might imagine a restaurant charging a reservation fee to the specific diners who book through OpenTable, but to date that hasn't happened—and it seems there are pretty strong norms against it," Edelman says.

Instead, the restaurants raise menu prices—for everyone. Albeit indirectly, consumers pay for the intermediary services.

"To me, this seems pretty screwed up," Edelman says. "The system encourages excessive consumption of OpenTable. As diners, we should leave that OpenTable web server alone so that the restaurant doesn't have to pay two dollars and raise menu prices."

Edelman and Wright say a "coordination failure" keeps buyers from seeing the forest for the trees—that is, they don't consider how their individual transactions affect the market as a whole. "If buyers could coordinate, they would take into account the higher price that results from their individual decisions to join the intermediary, and collectively they would prefer not to join the intermediary," the authors write in "Price Coherence and Excessive Intermediation."

Edelman points out that some intermediaries offset some of the problem with useful services that the sellers don't offer. "In fact, I like OpenTable," he says. "It can be useful to make a reservation early in the morning, when no one would be available at the restaurant to answer the phone. I'd be willing to pay something for that convenience. Same for Expedia, which can be easier than using an unfamiliar airline's website—here too, a fair number of customers might be willing to pay. But what should we say to customers who aren't interested in these benefits, and who really just prefer lower prices? That's a reasonable perspective, but to date these customers haven't had good options, as price coherence forces them to pay for services they don't want and may not even use."

Competition Only Exacerbates The Problem

What happens when multiple intermediaries compete in any given market? After all, it's an economic truism that competition among businesses is good for their customers. But in markets with price coherence, competition can actually make things worse for buyers, according to the researchers.

Their paper describes a competitive bottleneck that happens when sellers turn to multiple intermediaries in order to reach as many buyers as possible. To gain competitive advantage, each intermediary introduces more and more buyer-side benefits like rebates, coupons, prizes, and so on. The more benefits they introduce, the higher the fees they charge to the sellers, exacerbating the cycle described above. Consumers end up bearing the cost of the benefits, even those who don't—or can't—take advantage of them.

Edelman cites the credit card industry, for example. "When Visa wants to compete with American Express, it doesn't introduce a new Visa Basic card; instead, Visa adds Visa Signature or Visa Signature Preferred," he says. "These are cards that have even higher merchant fees than Visa's regular cards. It's not accidental that they're adding to the higher end of their product line. That's where they're under the most pressure from American Express. And as they compete, they're producing more and more expenses for merchants. A merchant who used to pay a two-percent transaction fee might now pay 2.25 or 2.50 percent."

As a result, merchants raise their retail prices. This is bad news for low-income, cash-strapped consumers who may not qualify for any credit card, let alone a card that offers premium benefits. "The low-end consumers end up paying retail prices that are inflated that much further, even though they can't take advantage of the intermediary's benefit," Edelman says. "They definitely get the short end of the stick."

Regulatory Implications And Next Steps

Edelman and Wright plan to continue their research, sussing out practical responses to the impractical aspects of price coherence.

"Our first price coherence paper develops a theory model showing what happens in affected markets," Edelman says. "Our companion paper, Markets with Price Coherence, explores the history of affected markets. One might also ask what should happen in response. Is there anything that a seller can do? Is there anything that a group of consumers could do? And how should regulators respond? Our paper, Price Restrictions in Multi-sided Platforms: Practices and Responses, offers some suggestions."

"Price Coherence and Excessive Intermediation" does broach the idea that regulators tackle the subject of price coherence—either by curbing regulations that support it, or by directly overseeing the fees that intermediaries charge to sellers. This already has happened to some extent in the credit card industry. The European Commission last December announced formal plans to cap credit card interchange fees, for example. In the United States, there's the Durbin Amendment, an eleventh-hour addition to the Dodd-Frank Wall Street and Consumer Protection Act, which regulates swipe fees for debit cards.

Besides payment cards, the paper notes historical or ongoing regulatory investigations in several other markets with price coherence: travel booking sites, hotel booking sites, insurance brokerages, insurance comparison services, online retail marketplaces, search engine advertising, real estate brokerages, and e-book sellers.

Edelman and Wright hope their research will encourage a new focus as policy-makers examine affected markets. "Regulators haven't recognized the structural similarities across these contexts," Wright says. "Our paper shows that some of the solutions for credit cards are relevant for other markets also."

About the Author

Carmen Nobel is the senior editor of Harvard Business School Working Knowledge.

Post A Comment

    • Nefri Erickson
    • Partner, Erickson Estrategia
    I agree, except that in an open market platform the customer is better informed of all the options and its prices.
    • Bruce Horwitz
    • TechRoadmap Inc.
    This is just another version of the "Commons" problem. What's good for the individual (viz., cash back) is bad for the community (higher prices for all).

    Note that the retailer, at least in some cases, can make a price differential for NOT using the intermediary (e.g., lower gasoline prices for cash payment)

    Also note that the retailer, while paying for the intermediary, is often also getting value. Credit card companies pay the retailer even if the purchaser doesn't pay his bill. Open Table's $20 rebate helps (perhaps) reduce the rate of no-shows. Etc.
    • Wayne Lingard
    • CEO, Process Way Consulting Ltd
    Interesting article and a reason why I have never bought into the whole collecting airmiles with your credit card. You are paying for it in some way, it is not free! I like the idea of regulation aganist this type of thing or at least capping it, after all the internet was supposed to provide everyone with better options around purchases, and some even said it would make things cheaper! (Fools?). What I have also noticed is now if you go direct to the seller, they are starting to price well above the intermediary almost forcing the situations you have described...I wondered why then I realized...they had purchased the intermediatery and so it was an easy way to push the price up and blame someone else ! If you control the supply chain, you can do whatever you like. This is pretty old school business practice just set in a digital environment. Great article look forward to the development in this area. Thanks
    • Kapil Kumar Sopory
    • Company Secretary, SMEC(India) Private Limited
    Businesses have tricks of their trade to lure customers by offering attractive offers too cleverly for the customers to understand what is the real factor behind such offers. No business would run on loss and, therefore, such means are devised after due research ensuring that in the ultimate there is a gain anyway. In a sense, the customers get hypnotized and avail such offers without examining in depth whether or not there is in fact an advantage by going ahead in the way the offer is placed before them. Thus there is need to be careful accept what is really worthwhile.
    • Gamaliel Pascual
    • NUIVI
    If there is "coordination" failure on the part of the consumers, is there "coordination success" on the part of the sellers (e.g. airlines)?

    Is there successful signalling going on among the sellers such that the "margins" exacted by the intermediary(ies) are preserved? And that the sellers have somehow all coincidentally agreed to keep prices uniform regardless of whether the consumer books with the seller directly or through the intermediary?
    • bowlweevils
    • in bed in the dark, poor compared to usual standard
    Wayne's comment brings up another factor that existed in some markets.

    Wayne points out that those credit card airline miles aren't free, and thus the internet, which was supposed to make things cheaper is not doing that.

    The contrast is not just between using credit cards with miles rewards or without, and the effect on customers who do both. There are two other factors, human factors.

    With the purchase of airfare, the pre-internet model generally involved use of a travel agent. So we have an internet with higher prices due to some people using credit cards and some people using cards with rewards - but overall, airfare is probably cheaper due to the elimination of the travel agent.

    And the elimination of the travel agent is not just the direct costs, but also the cost in time and effort of traveling to the travel agent.

    But if you are old enough to remember this period, you probably know that you went to a travel agent because they were the only ones who could directly compare prices and options like non-stop vs one-stop, alternative flight times, etc. Otherwise, it was you, on the phone with the airline csr, and it was a nightmare.

    And at a more basic level, I prefer to use credit cards because they are less time consuming than cash. I always have the card, and don't need to go to the bank/atm to get more. I always have enough of it. I always have the exact amount, which means the days of letting mountains of coins build up are over. But even the act of taking the cash out of your wallet, looking through the bills there, and selecting the combination of bills to use - do I want to use the $20 or the $10 and two $5s? Or worse, the "I know I have another dime around here somewhere" interaction. It's a dime and you know that you are wasting your time and everybody else's compared to the value the dime because you decided to pay the exact amount in cash. And you did it partly because you thought of that mountain of coins at home and wanted to get rid of the coins in your pocket instead of adding to the mountain.

    What happens when you don't have enough cash but don't know it until the cashier rings up the items? Now we have "manager, we have a void at register 6" while your items are placed to the side and you go run to the atm and get back in line.

    I'm happy to pay extra for not having to do that. And for not having to wait for the person ahead of me in line to do that.

    That is the point of the credit card. That is the value they add.
    • Dennis Clarke
    • Chief Procurment Officer, Ministry of Finance, Grenada
    Thanks for this research. I was under the misguided impression that the direct alternative was always the cheaper option.
    • Daniel Wallace
    • Partner, Tailwind Discovery Group
    There may be a bit of over-reaching here. First, most of the intermediary fees cited here seem minuscule in the context of the purchases to which they are applied ($12 on an airline ticket that would cost several hundred, credit card fees that result in price increases of 1/4 to 1/2 percent, Open Table rewards that amount to perhaps a 1% rebate). Absent empirical evidence to the contrary, it is not clear that these fees actually have a significant impact on either sellers or buyers.

    There is also a presumption that buyers always act rationally, respond purely or primarily to price, and always seek the lowest price (or greatest number or reward points, etc). The field of behavioral economics has shown us that these presumptions are often wrong.

    Second, the article ignores the benefits of intermediation. I can't speak for other users of Open Table, who may actually use it to get the reward points (I doubt that many do, given the tiny size of the reward). I use it to discover new restaurants. It does a great job of aggregating information, letting me explore, make discoveries and choices, and act on those choices immediately by clicking the reservation button. Yes, the restaurants pay for that. It's a marketing expense. I dined last night, and am dining again tonight, at restaurants that I discovered through Open Table. If you asked the owners of these restaurants whether they were happy to have paid $1 to get me as a customer, I'm guessing that they'd say yes. (That, of course, is because they haven't met me. If they had, all bets would be off.)

    This also isn't a one-size fits all issue. For reasons that aren't entirely clear to me, I use aggregators like Kayak (itself intermediated by Bing - and yes, I will admit to be the one person who uses Bing, if only for this purpose) to compare flight options and prices. But I typically buy directly from the airline. In fairness, I should probably pay for the aggregation.

    There also are situations where intermediation hasn't worked so well. Groupon's stock price is 1/5th of what it was 5 years ago. Many retailers discovered that instead of sampling programs that created new, loyal customers, their Groupon deals were either giving huge discounts to existing customers or giving non-customers a chance to buy something cheap that they would never buy at full price (I've used precisely one Groupon, which was to drive a Lamborghini on a race track). Having discovered there wasn't value in this form of intermediation, many retailers stopped using it.