Pricing and Product Design: Intermediary Strategies in an Electronic Market

Authors: Hemant Bhargava, Vidyanand Choudhary, Ramayya Krishnan

Electronic intermediaries play an important role in many Web-based electronic markets, adding value for participants by offering services such as matchmaking and trust. This paper presents an economic model of intermediation where the intermediary offers services to two types of actors: consumers and providers. When consumers are heterogeneous, differentiated on their willingness to pay for intermediation, the intermediary can potentially offer two (or, generally, multiple) levels of service quality to target various consumer segments. How should electronic intermediaries choose their levels of service and prices for these services?

Our analysis highlights the aggregation benefit that consumers derive from having access to multiple providers through the intermediary. We model this benefit as a network effect. According to prior research on vertically differentiated digital goods, it is optimal to offer only one quality level in the market, and segmentation causes cannibalization and lowers profits. In the case of intermediation, however, the aggregation benefit — by providing additional utility to consumers — makes it optimal for the intermediary to offer both levels of service. The intermediary’s profits increase upon decreasing the quality of the lower quality service, suggesting that the two quality levels should be differentiated as much as possible. If the intensity of the aggregation effect is large, the intermediary should make the service free for providers: the loss of revenue from providers will be offset by the increase in revenue from consumers. If the intensity is large relative to the lower quality service, then all consumers subscribe to the intermediary’s service.