A Model of Retail Competition in Service and Price : Pure Play Internet vs. Bricks-and-Mortar Retailers

Why does Amazon.com make low or no profits, whereas, its bricks-and-mortar rival Borders makes substantially higher profits? Why is price dispersion high in certain categories and low in others? Why are prices for the same item higher at bricks-and-mortar retailers than they are at pure play Internet retailers? To answer these questions, we analyze the competition between a pure play Internet retailer and a bricks-and-mortar retailer in both retail service and price. We develop a game theoretic model that includes both horizontal and vertical differentiation. In this model, the Internet and the bricks-and-mortar store are two alternative distribution channels located at the two ends of a "Hotelling main street." Consumers are heterogeneous in their locations on this street, so they find different levels of attractiveness each channel, and there is not a unanimously preferred retail channel. In addition, consumers' willingness to pay for retail services is heterogeneous, although all of them prefer higher retail service to lower service. Given the presence of consumer heterogeneity in both the horizontal dimension (channel preference) and the vertical dimension (willingness to pay for retail service), the two retailers decide the optimal levels of price and service in a two-stage game. In this game, retailers make service decisions first and price decisions next. The analytical results show that in equilibrium, the bricks-and-mortar retailer will provide better service, charge a higher price and earn greater profits than the pure play e-tailer when consumer heterogeneity in willingness to pay for retail service is sufficiently large compared to that in retail channel (location) preference. These results explain why Borders makes more profits than Amazon and why price dispersion is higher in the books and CD categories than it is in others