How does free riding on customer service affect competition?

The free-riding problem occurs if the presales activities needed to sell a product can be conducted separately from the actual sale of the product. Intuitively, free riding should hurt the retailer that provides that service, but the author shows analytically that free riding benefits not only the free-riding retailer, but also the retailer that provides the service when customers are heterogeneous in terms of their opportunity costs for shopping. The service-providing retailer has a postservice advantage, because customers who have resolved their matching uncertainty through sales service incur zero marginal shopping cost if they purchase from the service-providing retailer rather than the free-riding retailer. Moreover, allowing free riding gives the free rider less incentive to compete with the service provider on price, because many customers eventually will switch to it due to their own free riding. In turn, this induced soft strategic response enables the service provider to charge a higher price and enjoy the strictly positive profit that otherwise would have been wiped away by head-to-head price competition. Therefore, allowing free riding can be regarded as a necessary mechanism that prevents an aggressive response from another retailer and reduces the intensity of price competition.

Key words: free riding; sales service; selling cost; channel conflict; retail competition; competitive strategy; game theory

History: This paper was received August 31, 2005, and was with the author 6 months for 2 revisions; processed by Florian Zettelmeyer.

1. Introduction

Imagine a college student planning to purchase some audio equipment. Not knowing precisely which product fits her needs best, she might visit a Tweeter store, recognized for its high level of customer service, and ask for the assistance of knowledgeable salespeople. The salespeople expend time and effort to help the college student by listening to her situation carefully, letting her try many different products, and finally identifying the product that fits her needs best. Because Tweeter must incur all these selling costs, they will be reflected in the price of the audio equipment. Knowing this, the student goes to a local discount audio store, which does not offer any sales service, and purchases the same audio equipment that Tweeter recommended, but at a lower price.

What this frugal college student has done is "free ride" off of Tweeter's selling effort, or service, to resolve the matching problem between her needs and the available audio products. (1) She enjoyed the opportunity to try some equipment and Tweeter's expert advice, an experience most discount retailers cannot offer, and then obtained the discount retailer's lower price. This free-riding problem can occur whenever the presales activities needed to sell a product, such as providing informed sales advice to consumers, can be conducted separately from the actual sale of the product. Therefore, it is possible for one retail store to engage in the presales activity necessary to sell the product, but for a different, lower-priced store to make the final sale. As the selling costs incurred for such presales service have grown increasingly significant, the free-riding problem has become more and more substantial for many retailers. (2)

Conventionally, free riding in a retail market should hurt the profit of the retailer that provides the service (for a survey in a distribution channel environment, see Antia et al. 2004, Coughlan et al. 2001; also see Carlton and Chevalier 2001). The cost of free riding for the retailer that offers presales service is clear, but its benefits, if any, may be more difficult to discern.