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This paper analyzes retailers' adoption of e-commerce in a technology adoption race framework. An internet-based firm with no traditional market presence competes with an established traditional firm to adopt the e-commerce technology and sell to a growing number of consumers with on-line shopping capability. The focus of the analysis is on identifying how consumer loyalty, differences in firms' technology and consumers' preferences for the traditional versus the virtual market, and the expansion in market size made possible by the internet can affect the timing and sequence of adoption by firms, as well as the post-adoption evolution of prices. The model's implications are used to discuss empirical evidence on adoption patterns for different product categories and firm types.

Since early 1990s, the ‘electronic commerce’ technology has been adopted by many traditional firms and also by new, entirely internet-based firms.2 Yet, traditional and internet-based firms have exhibited different tendencies to embrace the new technology and the rates of adoption by these two types of firms have varied considerably by product category. In some industries, such as book and CD retailing, purely internet-based firms like Amazon.com were successful early adopters. In other industries, such as clothing and apparel, established traditional firms like Gap adopted the technology early. In general, internet-based firms tended to be the first movers. On the other hand, established firms sometimes moved first, but usually they followed, either quickly or with some delay. This delay in the adoption of e-commerce by established firms has drawn attention in the literature.3 Fear of cannibalizing an existing sales channel or technological incompatibility of the two sales channels may prevent or delay going on-line. Internet-based firms also face obstacles to adoption, such as the lack of an established brand, trust, a loyal customer base, or a network of warehouses and distribution facilities. These adoption patterns pose several questions: How do traditional and new firms differ in their adoption patterns? In what type of environments are we likely to observe early adoption by new or by established firms? Are adoption patterns systematically related to the main differences between traditional and virtual markets? What can be said about inter-industry differences in the diffusion of e-commerce? We develop a model of the adoption of e-commerce technology by retailers to assess the patterns of adoption. Since the decision of whether and when to adopt is dynamic in nature, the analysis of adoption patterns require a dynamic framework rich enough to incorporate basic differences between traditional and internet-based firms and between traditional and virtual market environments. We use a continuous-time technology adoption model, where at each point in time firms decide whether to adopt the e-commerce technology and then choose prices, given the adoption decisions up to that point. We derive the implications of the model for the timing and sequence of adoption by firms to understand which firm is likely to adopt first, whether the gap between adoption times is large, and how the adoption times depend on the parameters characterizing the traditional and virtual market environments. The predictions of the model can explain observed adoption patterns across firm types and product categories. The result is a simple characterization of market environments that encourages early adoption by established firms and market environments that facilitate early entry by new firms. The tractable model can be applied to other market settings to address questions of adoption. The structure of the model reflects important differences between traditional and virtual markets, as well as between traditional and internet-based firms. While a long list of such differences can be made, the main elements we consider reflect a desire to maintain analytical tractability and empirical relevance.4 First, firms' costs and consumers' utility across traditional and virtual markets differ. Potential cost savings can arise in the virtual market from low-cost electronic transactions and diminishing need for inventory, retail space, and labor, as well as elimination of intermediaries. For some goods, convenience of on-line transactions and savings in shopping time and transportation costs may enhance utility, but for other goods, delayed consumption or the inability to inspect the good physically may result in a utility loss. Second, some consumers have a preference for the good sold by the established firm, resulting from the established firm's reputation or from consumers' trust in an established brand name built during the firm's long presence in the traditional market. The importance of such reputation and brand name effects in on-line markets has been emphasized in recent empirical literature.5 We refer to such brand preference by consumers as “loyalty”. Initially, we assume that loyalty is specific to the established firm, so a prior presence of the established firm in the traditional market creates an important asymmetry between the two firms. Third, the internet can increase an established firm's market size by extending its geographic reach or by expanding hours of shopping. The market expansion effect is represented by a set of consumers who have no access to the traditional firm's physical shop and can only buy on-line, provided that they have internet access. The analysis reveals that either firm can lead in adoption depending on the parameters. We identify conditions under which the only subgame perfect adoption equilibria are in open-loop strategies which depend only on calendar time. In these equilibria, one of the firms is always a leader in adoption. We also identify conditions under which a firm always wants to pre-empt its rival. The new firm is a leader in adoption when it faces an established firm with low levels of loyalty in an environment where the physical shop of the established firm has low marginal cost, the virtual market provides low incremental profit over the traditional one, and there is little opportunity for market expansion through e-commerce. On the other hand, the established firm leads if it enjoys relatively high loyalty, it has relatively high marginal cost in the traditional market, the incremental profit from e-commerce is relatively high, and the market expansion effect is relatively large. We assess the relevance of these predictions in explaining the entry patterns in various industries. We also consider several extensions of the model and the analysis. One is a discussion of the closed-loop strategies that allow firms to condition their adoption decisions on their rival's actions, in addition to calendar time. Equilibria in closed-loop strategies emerge under certain parameter restrictions and involve either pre-emptive or waiting strategies by firms. We compare the nature of these equilibria with the equilibria in open-loop strategies and discuss their empirical relevance. As another extension, we consider growing loyalty for the new firm. Many internet-based firms have invested heavily in loyalty programs and some early adopters, such as Amazon.com, seem to enjoy significant loyalty. Allowing the new firm to develop loyalty over time results in earlier adoption by the new firm, regardless of whether it is a leader or a follower in adoption, but does not alter the adoption behavior of the established firm. We also discuss how our results may change when more than two firms can adopt the technology. The technology adoption framework we develop is related to earlier models of technology adoption, such as Fudenberg and Tirole (1985), Quirmbach (1986), Jensen (1982) and Reinganum (1981). Our analysis extends these models to analyze entry decisions in richer market environments. The approach here differs from the earlier literature in three main ways. First, in earlier models, the consequences of competition between the firms at any point in time were summarized by an exogenously given reduced-form profit function. Here, the market game at any point in time, and the resulting profit functions, are endogenously determined by the adoption decisions, as well as by the fundamentals of the model. This allows us to investigate the sensitivity of our results to the parameters of the market game. Second, the loyalty for the established firm introduces an important asymmetry between firms that leads to pure-strategy adoption equilibria, in contrast to the exclusively mixed-strategy equilibria of previous models, which assumed symmetry. The existence of pure-strategy equilibria helps to explain observed adoption patterns. Third, while previous models assume market stationarity, we allow the market to grow over time. In this sense, the model can be generalized to analyze firms' entry decisions into growing markets when strategic interaction is important. As in Baye et al. (1992), Narasimhan (1988) and Varian (1980), mixed pricing strategies emerge naturally in our model. Recent empirical evidence suggests the relevance of mixed-strategy pricing in on-line markets.6 Mixed-strategy equilibria also lead to simpler period payoff structures for firms and makes the dynamic model tractable, compared to the pure-strategy equilibria that emerge in common vertical and horizontal product differentiation models. The evolution of on-line prices in the model is also broadly consistent with the emerging empirical evidence.7 The rest of the paper is organized as follows. Section 2 discusses major factors influencing adoption and empirical evidence motivating our model. Section 3 presents the model, followed by the characterization of equilibrium in Section 4. In Section 5, we analyze the model and its empirical implications. Extensions to the model are considered in Section 6. Section 7 reconciles the model with the empirical evidence. Section 8 concludes. All proofs are in the Appendix.

We analyzed retailers' incentives to adopt electronic commerce, emphasizing the effect of technology, preferences, consumer inertia, and market expansion on entry decisions and post-entry dynamics of prices. While other explanations, such as favorable financial markets, ample venture capital, and irrational behavior by entrepreneurs, can account for early adoption by new firms, the model here has focused on important differences between the traditional and virtual markets, and between established and new firms. The results provide a simple characterization of market environments conducive for adoption of e-commerce by new versus established firms and the observed adoption patterns can be explained by equilibria resulting from the model under different parameter configurations. The model provides guidance for assessing what might happen in other sectors that have not yet embraced e-commerce. Furthermore, the post-adoption price dynamics is broadly consistent with available empirical evidence. The analysis also demonstrates that the simple technology adoption framework can be extended to analyze entry decisions in more complicated market environments. Similar applications can be made in other settings where it is important to recognize the features of the market environment in the stage game. As an extension, it would be interesting to endogenize the diffusion of internet access among consumers by making the diffusion of the internet among consumers a function of firms' adoption and pricing decisions. This extension would allow firms to influence consumers' adoption decisions using their adoption and pricing strategies. Another promising avenue of research is to introduce a process by which loyalty develops over time endogenously as a result of competition, in contrast to exogenous loyalty used here.