Regulators in Washington should immediately launch an investigation into Amazon’s e-commerce business.
In a recent article (and subsequent blog post), I argued that Amazon’s negative cash flow might result from the company’s decision to devote its revenue and raised capital to subsidize engagement in short, medium or even long-term price predation instead of (or in addition to) making legitimate investments. In addition, I demonstrated that losses sustained during this predatory campaign could be recouped without a rise in consumer prices.
In the last month, Amazon has involuntarily disclosed vital information regarding its corporate strategy that enables us to apply these theoretical insights to Amazon’s business model and assess the possible predatoriness of certain practices for the first time.
Amazon Plans to Exit the Fulfillment Business
In early March, news broke that Amazon had abruptly stopped buying products from many of its wholesalers. Bloomberg’s Spencer Soper explained that the move allows Amazon to offload the costs of purchasing, storing, and shipping products to its suppliers. In a boilerplate statement published in Bloomberg, Amazon responded: “We regularly review our selling partner relationships and may make changes when we see an opportunity to provide customers with improved selection, value, and convenience.”
This prosaic comment inadequately describes the magnitude of Amazon’s move. Amazon’s noisy purge has finally revealed a crucial part of its recoupment strategy: leveraging its growing monopoly power to offload variable costs associated with storage and shipping onto its wholesalers and suppliers.
First, it is necessary to take a step back and explain the difference between Amazon and Amazon Market Place (AMP), the two ways in which Amazon orders are fulfilled.
If an item is sold by Amazon, that means that the wholesaler’s inventory is completely owned and fulfilled by Amazon. The wholesaler sends a large portion of their inventory in bulk to Amazon’s fulfillment centers, where it is stored until a customer decides to buy it. Amazon then packs and ships the items to customers. It also incurs all the costs associated with these activities, many of which are variable costs. In exchange, wholesalers pay a per-unit fixed fee. The introduction of same and next-day delivery into the FBA scheme seems to further increase the cost of this service. Amazon’s shipping costs, which include sortation and delivery centers and transportation costs, amounted to $27.7 billion as of 2018. Amazon also required suppliers to sell their goods on the platform for the same price those goods were offered on other websites until last week.
On the other hand, when an item is sold on AMP, fulfillment costs are allocated to the wholesalers. Customers will purchase through Amazon Prime as usual, but the wholesaler incurs the costs of fulfillment. The wholesaler can use the Amazon Prime brand name but must also comply with the shipping rules. Under certain schemes, the wholesaler must pick, pack and ship the item to the customers. In addition, in order to participate in certain AMP schemes, such as Fulfilled by Merchant (FBM), the wholesaler must own its own warehouse to control inventory and fulfillment—which can be costly to acquire—and incur all the variable costs associated with its operation. Finally, FBM wholesalers must ship Prime orders on the same day.
The differences between the two types of services are obvious. When ordering an item directly from Amazon, Amazon must incur all the variable costs associated with storage and shipping in exchange for a low per-item fixed fee (purchasing the item form the suppliers). This model is similar to the one employed by Uber (also a notorious negative cash flow firm): Uber charges its customers a fixed fee prior to the beginning of their ride and pays its drivers a variable fee determined by the length and time of the journey.
On the other hand, in AMP orders Amazon incurs none of the variable costs associated with fulfillment. Under this extremely profitable scheme, Amazon has no variable costs of its own. In other words, it is no longer in the retail business. Instead, it is only a “virtual mall” in which wholesalers have to pay Amazon’s “rent”—the variable costs associated with fulfillment.
In light of this comparison, it becomes obvious that Amazon’s goal should be to constantly increase the ratio of AMP orders. And Amazon is successfully doing so: In 2007, 26 percent of Amazon’s annual sales were fulfilled by merchants. By 2013 it was 40 percent, and by the fourth quarter of 2018 it reached an all-time high of 52.5 percent. In its latest 10k, Amazon itself stated that it will continue to implement this cost-shifting strategy by further mitigating the “costs of shipping over time in part through achieving higher sales volumes, optimizing our fulfillment network, negotiating better terms with our suppliers, and achieving better operating efficiencies.” Only instead of calling it monopolistic coercion, Amazon cleverly uses terms like “fulfillment network optimization” and “better negotiation terms” to describe this cost-dumping scheme. This week’s Bloomberg report simply illustrates how Amazon is doubling its efforts to achieve these targets.
The increase in the rate of AMP sales is deeply correlated with Amazon’s overall market share of e-commerce. From less than 20 percent in 2011, Amazon’s e-commerce market share is currently around 50 percent. Thus, it appears that Amazon’s market share is closely tied to its ability to accomplish its “fulfillment network optimization” goals by bullying wholesalers to move from selling directly to Amazon to AMP.
.
Following a Successful Predatory Pricing Campaign, Amazon Is Proceeding to the Recoupment Phase
The figures mentioned above should be cause for alarm. Instead of (or in addition to) achieving greater technological or scale efficiencies, it appears that Amazon may be deploying a much blunter tool as part of its recoupment plan. In essence, it seems that Amazon is using its ever-increasing monopoly power as the “only mall in town” to forcefully transfer the variable costs associated with storage and shipping onto its wholesalers and suppliers. Despite the fact that we lack direct evidence regarding Amazon’s plans, in its 2018 10k the company does admit that its business could suffer in the future if it fails to “engag[ing] third parties to perform services.”
From an abstract legal framework perspective, this set of facts demands further scrutiny from regulators in Washington. On its face, it appears as a classic price predation case:
In Time 1 (the apparent onset of the predation campaign), Amazon decides to absorb all the variable costs associated with its fulfillment services. This decision naturally attracts merchants who are happy to transfer their existing fulfillment costs onto Amazon. Amazon’s decision also attracts consumers, who are happy to have products arrive at their doorstep promptly, reliably, conveniently and inexpensively. It is obvious that this below average variable costs (AVC) predation campaign harms other e-commerce and brick and mortar stores who are deprived of their clientele, due to the fact that these competitors of Amazon are unable to subsidize the cost of fulfillment. In addition, this pricing campaign harms competitors in another manner: Wholesalers and suppliers who notice the transition of consumers from Amazon’s competitors to Amazon follow suit. This migration process of consumers and suppliers to Amazon is long and expensive but nonetheless effective.
Time 2 is the beginning of the recoupment stage. After gaining sufficient control of the e-commerce market, Amazon can leverage its monopolistic power to slowly shed the variable costs that were an essential element of the predation scheme in Time 1 onto the suppliers who were lured to join the platform. At this stage, Amazon can tell its suppliers that if they want to do business, they must do it through Amazon. Ultimately, recoupment will be accomplished when Amazon shifts enough of its own retail activity to AMP activity. At that stage, the variable costs associated with its continued predation would be more than offset by the profits it will generate from “renting out” the “storefronts” in its virtual mall.
This cost-shifting strategy might ultimately coerce Amazon’s wholesalers and suppliers to engage in price predation in order to keep their stores on Amazon’s platform. In other words, wholesalers and suppliers will at times have to price products at below their average variable cost in order to survive on the platform.
Additionally, this type of recoupment by Amazon will not necessitate any noticeable rise in consumer prices. The fact that Amazon recently decided to stop requiring third–party suppliers and wholesalers to match the prices of their goods does not mean that those suppliers will now charge higher prices for consumers. Instead, Amazon can suppress a rise in prices by utilizing its monopoly power to discipline non-compliant suppliers. For example, Amazon can simply move the goods offered by noncompliant suppliers who raise their prices to the third or fourth search engine results page. If anything, this decision further demonstrates Amazon’s current tremendous market power and its ability to dictate pricing without the aid of explicit contractual obligations, which were necessary when the company had a smaller market share.
Therefore, the more likely future scenario is that Amazon, through implicit means, will require wholesalers and suppliers to drastically reduce their profit margins by assuming the enormous variable costs associated with free same and one-day delivery in order to stay in business. If this scenario comes into fruition, the results of this type of cost-shifting scheme will be extremely harmful for competition. Instead of investing money in creating new and better products, manufacturers who will also absorb the costs incurred upon wholesalers will have to scale back innovation or even close shop, despite the fact that at the present moment they are presumably both efficient and profitable.
Considering these observations, it becomes apparent that regulators in Washington should act fast and immediately launch an investigation into the way in which Amazon operates its e-commerce business.
Shaoul Sussman’s paper, “Prime Predator: Amazon and the Rationale of Below Average Variable Cost Pricing Strategies Among Negative-Cash Flow Firms,” was published last month in Oxford’s Journal of Antitrust Enforcement.
(Editor’s note: This post has been corrected. An earlier version misstated the terms Amazon uses to differentiate between items sold by Amazon and items sold by third-party sellers.)
Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.
