By Justin Hibbard From the November 1999 issue

Red Herring Magazine

Underlying the latest wave of Internet business models is a common theme that holds profound implications for all
business: consumers are gaining power. Demand-aggregation systems, reverse auctions, comparison-shopping engines,
zero-margin retailers -- these models assume that consumers have unprecedented access to product information and a
surfeit of merchandise to choose from. Under such conditions, consumers can play retailers against each other, demand
low prices, and expect exceptional service.

"This is consumer nirvana," says Marc Andreessen, a cofounder of Netscape Communications. "Products will get cheaper,
margins will go down, and retail will be an even more intensely competitive business." In July Mr. Andreessen invested
$1 million of his own money in Accompany, an Internet startup that pools consumers' buying power and uses it to secure
volume discounts from retailers, distributors, and manufacturers.

For all its wonders, the Internet isn't the only force behind the rise of consumer-centric business models. Other
advances in information technology and shifts in global economics are tilting the balance of power from sellers to
buyers, creating an environment that rewards businesses designed around empowered consumers. Regardless of whether
these models work (and some will not), they foreshadow a retailing future in which consumers are in control.

In the United States, signs of consumers' rising power are evident in inflation rates that are the lowest in more than
a decade. Last year's 1.6 percent rise in the Consumer Price Index -- a measure of the change in prices that consumers
pay for goods and services -- was the smallest annual increase since 1986. For each of the last two years, U.S.
citizens have paid less for commodities like gasoline, clothing, television sets, computers, and auto parts than they
did the previous year.

In almost every sector of U.S. retailing, the current watchword is deflation -- a steady decline in prices brought on
by an oversupply of nearly everything. Over the last 15 years, the capacity of retailers to stock and sell products has
more than doubled while consumer demand has increased by less than half. In the last two years, depreciating Asian
currencies have lowered the cost of imports from Asian countries, adding to a glut of inexpensive merchandise in the
United States. The result: products are stacking up and prices are falling.

CAVEAT VENDOR In a deflationary economy, consumers gain leverage. If consumers can't find the right product at the
right price at one retail outlet, they're likelier than ever to find it at another. "If ever there was a seminal piece
of evidence that the consumer is now king, it is the growing persistence and breadth of deflation," writes Carl
Steidtman, chief retail economist at PricewaterhouseCoopers, in a recent report entitled "The New Retail Economy."

With prices falling, consumers are gaining more purchasing power. Low prices, a booming stock market, rising home
values, and larger inheritances are increasing the total wealth held by U.S. households. Household wealth as a
percentage of income rose from 500 percent of income to 595 percent during the last three years, according to the U.S.
Bureau of Economic Analysis. During the same period, retail spending grew by more than 2.8 percent a year -- well above
the 30-year average of 1.9 percent, according to the U.S. Census Bureau.

Though several forces unrelated to technology are tipping the economic scales toward consumers, technology's impact is
substantial. During the last ten years, retailers have built supply-chain information systems that reduce their costs
and let them provide larger selections to consumers at lower prices. "Supply-chain economies of scale are one reason
that prices have been falling in general merchandise," says Robin Lanier, senior vice president for industry affairs at
the International Mass Retailing Association.

To order goods from their suppliers, about 70 percent of large general merchandisers use a communications protocol
known as electronic data interchange (EDI) that runs over private computer networks, according to the National Retail
Federation. By replacing paper-based purchasing with EDI, a large department store can slash the cost of processing a
purchase order from $50 to $5, according to AMR Research, an IT research firm. Retailers like Sears (NYSE: S), which
has used EDI for ten years, pass on those savings to consumers. "When your costs are lower, you can afford to sell
products at lower prices," says Pete Rector, director of vendor management at Sears.

Additional savings come from inventory-management technology. Retailers like Wal-Mart (NYSE: WMT) Stores have installed
systems that collect data at checkout stands and automatically alert warehouses when it's time to ship replenishments.
By using data-mining software to analyze sales histories, Wal-Mart can determine exactly when to restock warehouses,
with precise quantities. As a result, fewer goods sit in warehouses for fewer days, which saves Wal-Mart money and thus
enables it to offer discounted prices year-round. Last year, Wal-Mart says, its inventory systems helped save it about
$1.4 billion.

Sales-history tracking and quick restocking also increase the likelihood that a store will have a product in stock.
More well-stocked stores mean more stores that consumers can choose from -- which in turn means more competition for
the consumer's business.

RETAIL SPIN But the technology shifting power to consumers more than any other is the Internet. Last year, nearly 9
million U.S. households shopped online for retail goods, and that number will surge to 40 million by 2003, according to
Forrester Research (Nasdaq: FORR), an IT consultancy. Though Internet purchases last year represented only 0.5 percent
of all retail sales, according to the National Retail Federation, the rules of Internet commerce are raising the
standards by which consumers judge all retailers.

Young consumers, in particular, are internalizing the rules of Internet retailing. According to Forrester, 47 percent
of 16- to 22-year-olds are online and control $37 billion in income, and 62 percent will be online by 2003. A recent
survey by the firm found that these consumers believe that instant access to detailed information about products and
prices is a given, that they believe that choice among products and merchants is a basic right, and that they expect to
get many products and services free. "This is a consumer power shift," says James McQuivey, the Forrester analyst who
wrote the report. "Over the last 100 years, power has shifted from manufacturers to retailers, and now it's going from
retailers to consumers."

What is it about the Internet that gives consumers such a sense of entitlement? By its very nature, the medium favors
buyers, particularly in its ability to reduce "search costs" -- the time, money, and labor required to obtain product
and price information. Historically, search costs have benefited sellers because the difficulty of gathering
information from sources like libraries and retail stores prohibits most consumers from knowing all their choices. The
result is an "ignorance premium" that sellers can add to their prices, says Erik Brynjolfsson, an associate professor
at MIT's Sloan School of Management. "Sellers don't have to face consumers who are really informed about competitors'
prices," he says.

The Internet is eroding this seller's advantage. For years, car dealers benefited from consumers' difficulty in
obtaining invoice prices -- the amount that dealers pay manufacturers for cars. Subtracting an invoice price from a
dealer's sticker price reveals the dealer's profit margin -- a powerful negotiating weapon for consumers. Until four
years ago, to obtain invoice prices car shoppers had to locate obscure reference books or write to manufacturers.
Today, Internet auto marketplaces like Autobytel.com (Nasdaq: ABTL) and CarPoint post invoice prices on their Web
sites. "The Internet has furthered the overall trend toward the consumer being in charge," says Mike Morrissey,
spokesperson for the National Automobile Dealers Association.

Rather than ignore the power that the Internet provides to consumers, some traditional retailers are changing their
business models to accommodate informed shoppers. "Old business models need to change to keep up with consumers' use of
technology," says Jeff Lyons, senior vice president of mutual funds at the discount brokerage Charles Schwab (NYSE:
SCH). As online investing gained popularity in the mid-'90s, Schwab realized that the Internet was making it easy for
consumers to compare mutual funds from many brokerages. In response, the company added a service to its Web site called
Mutual Fund OneSource, which lets consumers research hundreds of funds -- including those sold by Schwab's competitors.
Schwab decided that it was better to inform consumers about competing products than not to interact with them at all.

The Internet's assault on search costs is spawning new business models, too. This summer, two startups -- Deja.com and
Epinions.com -- launched Web sites that let users quickly locate product reviews, ratings, and comparisons supplied by
other site visitors. People from around the world post information that could take hours to find in a library (one
posting on Deja.com gives current gas prices in the French Alps). Users can rate the usefulness of reviews to weed out
bad advice. Although the sites rely primarily on advertising for revenue, they encourage users to criticize any
company, including these same advertisers. "If we help consumers decide not to buy things, they'll come back and use
the site more often," says Mike Speiser, a cofounder of Epinions.com.

Whether Epinions.com and Deja.com can make money remains to be seen. In addition to advertising revenue, Epinions.com
is selling its content to other Web sites through syndication (see "Now in Syndication"). Deja.com is pursuing deals in
which it takes a percentage of sales generated by consumers it directs to e-commerce sites. Neither company sells
products directly; they see more potential profit in simply providing information about products. "The Internet tends
to drive gross margins down and drive companies to offer things at a single low price," says Tom Phillips, CEO of
Deja.com.

PROFIT-PARING PLAN Indeed, some researchers say that by making it so easy to compare products and prices, the Internet
can erase profit margins. In a 1998 paper entitled "The Emerging Role of Electronic Marketplaces on the Internet,"
Yannis Bakos, a professor at New York University's Stern School of Business, argues that lower search costs inevitably
lead to lower prices. When buyers can easily compare all sellers' prices for the same item, the sellers are driven to
match the lowest price. "This effect will be most dramatic in commodity markets, where intensive price competition can
eliminate seller profits," the paper says.

Is the Web giving consumers so much power that retailers can't make a profit? Some online retailers, including Buy.com,
have conceded the point. They're willing to sell products below cost and rely on other revenue streams, like
advertising, for profits. (See "Less Than Zero Margins," March.)

But this business model assumes that most online consumers shop for the lowest prices. A study completed this year by
researchers at MIT calls that assumption into question. The researchers found that Internet retailers with the lowest
prices on books and CDs were not the ones with the largest market share. Rather, market-share leaders like Amazon.com
(Nasdaq: AMZN), Barnesandnoble.com (Nasdaq: BNBN), and CDnow (Nasdaq: CDNW) had the best-known brands but not always
the lowest prices. The conclusion: the largest segment of Web consumers is willing to pay higher prices for
trustworthiness, convenience, and excellent service. Without those features, low prices alone won't retain customers.

This criticism has also been leveled at a consumer-centric Internet business model called demand aggregation.
Practitioners of the model, including Accompany and Mercata, promise low prices through volume discounts. Their Web
sites offer buying cycles that last up to several days. During a cycle, the more consumers that sign up to buy an item,
the lower the price drops. But if low price is the only benefit that demand aggregators offer, their business model
suffers from the same problems as zero-margin retailing. Moreover, unless demand aggregators are willing to sell
products below cost, zero-margin retailers will consistently beat their prices.

Mercata says its goal isn't to drive margins to zero. "We want to make money some day," says Tom Van Horn, the
company's CEO. Mercata derives revenue from gross margins on the products it sells. The company forecasts how many
consumers will buy a product and then negotiates a volume discount from a manufacturer or distributor before selling
the product on its site. Once a group of consumers has registered to buy the product, Mercata buys a bulk order from a
supplier and quickly resells it to the consumers. The price for an item drops as more people register, but the
consumers always pay Mercata slightly more for an item than Mercata pays for it.

Mr. Van Horn admits that zero-margin retailers may beat some of Mercata's prices in the short term. But in the long
term, he expects that the zero-margin business model will be unsustainable. Unlike most zero-margin retailers, Mercata
intends to offer customers more than low prices. "If group deals are our first value proposition, our second is
customer service," he says. In May, Mercata hired Keystone Fulfillment, a logistics specialist, to handle its
warehousing, shipping, and customer service.

Unlike Mercata, Accompany doesn't derive revenue from margins added to the cost of goods it sells. Rather, the company
facilitates a volume purchase between buyers and a seller and collects a small percentage of the total transaction.
Whether the products are sold below cost is up to the seller. In theory, zero-margin retailers like Buy.com could sell
products on Accompany's site. Accompany provides a service to retailers by lowering their cost of acquiring customers.
"We think of our business as a customer-acquisition tool," says Jim Rose, Accompany's CEO.

Because Accompany never owns the inventory it sells, it doesn't handle fulfillment. It relies on suppliers to ship
products, take returns, and staff the front lines of customer service. (If a customer's problem persists, suppliers can
route calls to Accompany's staff.) What Accompany gains by running a business free of costly warehouses, it loses in
control over customer service. The company screens suppliers before selling their products and makes them agree to
provide a basic level of customer service, but whether suppliers honor these agreements is up to them.

Regardless of whether demand aggregators succeed, they are another sign of how power is shifting toward buyers. For
consumers, this shift amounts to paradise. For businesses, it presents both a threat and an opportunity. Companies that
craft business models around empowered buyers will have an edge over those that don't. Companies that continue to
assume that consumers are weak and uninformed will suffer.