eBay or the Highway

Its size is its selling point—and its curse. 

This is the second in an occasional series on the economics of e-commerce. The first was about

eBay is the popular Internet site that allows anyone with a credit card and a modem to begin bidding at auction. Just 5 years old, eBay is worth $13.8 billion—13 times more valuable than Sotheby’s, the venerable auction house that has been around for 256 years. The truth, however, is that eBay’s business model owes a lot more to low culture than high culture. From an economic perspective, the most interesting thing about eBay is that it has become the world’s largest classified ads section. That might not be especially glamorous or cutting-edge, but with almost half a million new auctions each day and dozens of imitators, eBay has perhaps the best chance among the major e-commerce Web sites of changing the way Americans shop.

How eBay Works

eBay describes itself as a “person-to-person online trading community.” In other words, eBay itself doesn’t actually own any of the merchandise being offered on its Web site. Instead—like the classifieds section—eBay just provides a parley-ground for buyers and sellers. Sellers provide a couple of pictures and a short description of their item. Buyers may browse the site or search directly for the item they require. But, unlike the classifieds, the first person to answer the ad doesn’t necessarily get the item. Instead, potential buyers have a week or so to place bids, and the item goes to the highest bidder (unless the final price is below a seller-specified minimum value, in which case there is no sale).

eBay has become popular among all sorts of sellers. Some are just ordinary folks trying to get rid of stuff from their attics. One funny guy, a mortician from Great North, Maine, has a an annual “couch sale,” in which he sells off the odds and ends found underneath his sofa cushions. (This year, he found a human pacemaker, which sold for $16.61.) Other sellers are oddballs hawking such treats as exclusive rights to the domain name “” Still others are charlatans and media whores offering such items as a human kidney, human soul, or a $135,805 counterfeit painting. But many sellers, perhaps most, are small businessmen who put medium-sized inventories of Persian rugs or antique armoires, for instance, up for auction. Why do these sellers prefer eBay to selling through a regular shop?

How Auctions Really Work

One theory is that the auction format is more advantageous for sellers. That may be true in some cases, but it’s hardly a general rule. For instance, suppose an ordinary shopkeeper prices a Persian rug at $300 and sells it to the first guy who walks through the door who is willing to pay that price. Suppose also that the next two guys who walk through the door would have paid $350 and $400 respectively for that same rug.

It’s true that an auction would yield the seller a higher price than pricing the rug at $300.

But our seller still wouldn’t have gotten the very best price. In the scenario above, the auction would have settled on a price of $351—not $400. That’s because, as soon as the bidding hit $350, the second buyer would drop out, and the third buyer (who values the rug at $400) would bid $351 and win the auction. In other words, the auction format only guarantees the seller the value that the second-highest bidder places on the good. If the shopkeeper had a good sense of the market, he could have just priced the rug at $399 and sold it to the guy who values it at $400.

In sum, there is no general rule about whether auctions fetch higher or lower sales prices. It all depends upon how certain the seller can be about market demand. The less certain he is, the more likely that he will benefit from an auction as compared with setting a fixed-price. This is why auctions have historically been popular when it comes to selling unique goods like fine art and real estate. This also might explain why eBay is so full of relatively rare used goods and collectibles, which, like fine art or real estate, are of uncertain value. But it also suggests that eBay is a bad way of selling things popular items like, say, computers—even used computers—where the market demand is pretty well known.

Finally, there’s another reason why auctions might be bad for both sellers and buyers. It’s a phenomenon that economists call the “winner’s curse.” Briefly, the idea is that when bidders are competing for something of uncertain value (like a Persian rug as seen through a fuzzy picture on the Web), some will overestimate its actual value and some will underestimate it. Since the item goes to the highest bidder, it’s likely that the auction “winner” will be one of the people who overestimated. In theory, therefore, it is also likely that he or she will be disappointed with the actual rug—the winner is ultimately a loser. This may provide a short-term benefit for sellers, who get higher prices. But in the long run, buyers who are consistently disappointed will stop using auctions. (Click here for a more complete explanation of the “winner’s curse.”) eBay has a community rating system that allows past buyers to rate the quality of goods sold by frequent sellers. This is intended to stymie bait-and-switch artists. But the New York Times has recently published a series of articles alleging that the community rating system is easily manipulated.

There is, however, at least one good reason why buyers might be partial toward eBay’s auction format—it’s a lot more exciting than the mall. Economists have always been puzzled by the popularity of activities—like gambling—in which the odds are obviously stacked against consumers. The Nobel-prize-winning economist Milton Friedman has offered the startling explanation that gamblers gamble because they enjoy it. (Click here to read one economist’s account of his eBay obsession.)

Ebay’s Real Advantage

The biggest factor in eBay’s success, however, is probably that it offers low overhead. That is, an auction Web site is just about the cheapest way to bring buyers and sellers together. This has nothing to do with the fact that it’s an auction site and everything to do with the fact the Web allows 10 million registered users to peruse 4 million offerings at negligible cost.

One might assume that this cost-savings would be passed along to consumers—making eBay a far better way to shop. Right now, this may well be true. eBay sellers pay only a small fee (between 25 cents and $2) to list their items and a small commission if the items sell ($1.87 on a $50 sale, for instance, and $13.13 on a $500 sale). For each individual seller, of course, these fees are probably less than the cost of renting a shop or printing flyers. For eBay, however, these fees added up to $267 million in net sales last year. Buyers pay nothing to use the site, and they too presumably benefit from the sellers’ savings through lower prices.

Sadly, economic logic suggests that this may not last. eBay’s size and popularity make it a perfect example of what economists call a “network effect.” That is, the value of the Web site to each individual buyer and seller increases as more people use the Web site. That’s because buyers are more likely to find what they want as the number of sellers increases. And sellers are more likely to find a high bidder as the number of buyers increases. And so on.

But “network effects” also give sites like eBay a type of monopoly power—which will only increase as the site becomes more popular. That is, it is very hard for a competing site to displace the original. This of course describes any Web business—take, which has gotten a lot of mileage out of being first. But it’s doubly true for a site like eBay, since eBay benefits not just from brand recognition but also from its very size. Only eBay can promise sellers 10 million registered buyers. (And it can retain those 10 million buyers, because it attracts the best sellers.) To take one example, Yahoo! offers an almost identical service for free—yet sellers still choose eBay. So eBay’s monopoly power would, in theory, allow it to raise sellers’ fees to the point where much of the Web’s cost-savings are erased.

 Lawrence Summers, the current treasury secretary and a former economics professor, recently gave a speech called “The New Wealth of Nations” in which he argued that “network effects” and monopolies are going to be “the central driving thrust of the New Economy.” Summers got a lot of attention because he also seemed to suggest that this is not such a bad thing. His argument is more or less that monopolies may represent the price that we have to pay for the benefits of the New Economy. Certainly, no one is forcing people to use eBay—if they do use it, it must mean that eBay is better than the alternatives. And it’s certainly a good thing if buyers and sellers are allowed to make mutually beneficial exchanges that they wouldn’t make otherwise. But it’s a little disheartening to realize that eBay’s success may eventually mean more to its stockholders than its customers.