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 / First Quarter 2000 / Issue 18(originally published by Booz & Company)


To Hal Varian, the Price Is Always Right

But consider a more realistic hypothetical from one of the Internet's most successful e-tailers: the Dell Computer Corporation. Suppose Dell will give you a 15 percent discount on the purchase of a Pentium V microprocessor-based PC if you agree to buy within the next 12 hours. After that, the discount vanishes. Or Dell will sell you a custom-configured machine for a 20 percent discount, if you agree to accept delivery in 30 days instead of five. How about a 30 percent discount if you promise never to call the customer-service line and only to use Web-based technical support?

Yield management thus gives Dell's individual and institutional customers the chance not only to customize their computers, but also to customize how those computers are purchased. Dell, in turn, has the opportunity to brand its customers' purchasing experience. Everything's negotiable.

"The Internet is a terrific medium for any company that wants to use yield-management techniques to manage its pricing and segment its customers," Mr. Varian says. The Net is the place where "operations research and economics are going to be reunited" - where economic theory meets business practice.

But does the Internet really let companies segment their markets? Or does it empower the customers to segment themselves? An excellent case can be made for either proposition. Mr. Varian sees this tension around "segmenting segmentation" as a real opportunity for companies to allow their customers to customize. "The company sets the menu," he says. "The user chooses."

That answer, however, may be a bit too glib even for the Internet Economy. Take auctions. EBay runs them; so do a swarm of other entrepreneurial dot-coms. More recently, established giants such as G.E., Boeing and Ford have begun looking to import auction mechanisms online. But that creates all kinds of questions that intrigue Mr. Varian. Just what kind of auction should it be? Should the auction be "open-cry" or "sealed-bid"? Should the style be English, with bids increasing in an open format; Dutch, with the opening price continually discounted until the available goods are gone, or Vickrey, a sealed-bid auction where the winner offers the highest amount, but pays only the second-highest amount? Should there be a human auctioneer? A software auctioneer? No auctioneer at all?

What makes these questions especially provocative is that they run smack into "The Revenue Equivalence Theorem," which argues that most of the popular auction formats will yield the same revenues, on average. After all, if one kind of auction consistently yielded higher revenues than the others, why on earth would anyone bother to conduct a Dutch auction? But if, in theory, all auction formats yield the same revenues, then why are there so many different genres and styles of auctions? There must be rational reasons. In other words, what is the best mechanism for which auctions?

This turns out to be one of the more interesting questions in both economic theory and practice. Economists are well aware of how the heat of emotions rather than cool logic can drive auction-market behavior. Auctions are microcosms of both rational marketplaces and less-than-rational human behavior. In the real world, there are multiple reasons why some auction genres are more desirable than others. Maximizing revenue is certainly the primary objective. However, managing perceived fairness, maximizing the number of participants, and making sure the winning participant can afford the prize also are all legitimate auction-design criteria.

For Mr. Varian, the Internet is the greatest medium in the history of economics for testing all manner of hypotheses about which auctions work best under what circumstances. The challenge of profitably matching auction formats with industry structure or organizational culture or financial behavior may well launch a thousand doctoral theses - and several hundred Internet consultancies and startups, as well - although Mr. Varian concedes this was an area he had not anticipated would take off the way it has. "EBay was a blind spot for us economists," he acknowledges. "We don't think in terms of flea markets."

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