Amazon, Wal-Mart Price War – A Different Take
Number of articles have been written on Amazon and Wal-Mart’s war on book prices this holiday season. Let’s take a different look at the same story and how it can possibly help the economy and the consumers by – increasing the pie.
First, the story. Wal-Mart recently decided to start its own price war, taking on Amazon in the online book market. Wal-Mart began by marking down the prices of ten best-sellers—including the new Stephen King and the upcoming Sarah Palin—to ten bucks. When Amazon, predictably, matched that price, Wal-Mart went to nine dollars, and, when Amazon matched again, Wal-Mart went to $8.99, at which point Amazon rested…From a game-theory perspective, price wars are usually negative-sum games: everyone loses. A recent study found that, if competitors do match price cuts, industry profits can get cut almost in half. (Read more: here)
So the final prices were $9.00 (Amazon) and $8.99 (Wal-Mart). Where is the pie here?
I did some research to find out what exactly is the price elasticity of demand for books. Its a difficult number to calculate and I wasn’t very hopeful until I found this research article. This research intended to determine demand for books and was conducted in Norway. The research took into account number of demographic parameters into consideration. One of the numerous conclusion of the article was:
All sets of results imply a direct price elasticity of books well below ?1, but we note that the estimated standard errors are quite large. In this respect the results are rather uncertain. On the other hand, the corresponding elasticities are surprisingly unambiguous, and thus they seem to be quite robust to the different econometric specifications and datasets employed. They all suggest that book demand is quite price sensitive, confirming the results obtained previously by Bittlingmayer (1992), Hjorth-Andersen (2000), and Prieto-Rodr´?guez et al. (2004).
For our calculations, lets assume that demand is fairly elastic and it is –1.5.
So if the prices fell from $10.00 to $9.00 (say) then prices fell by 10%. Which means the books expected to be sold will increase by 15%. Which in turn means that the revenues will grow from 10X to 10.35X (9 x 1.15X). A value creation of 0.35X or 3.5%. While this number may look small in percentage terms, it is substantially big when we can find the real value of X (in 2006 3.13B books were sold) and substitute.
What Amazon and Wal-Mart have unintentionally done is to increase the total pie (the total revenues that can be earned by them). Yes, the margins may have taken a hit, but don’t we know that NPV is a better measure than IRR.
Do you think this research if conducted and analyzed in the US can change prices in the longer run? Thoughts?
A good analysis on this price war has also been done here.
