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."