Short answer:
"Free Shipping" works in certain cases and has potential to become gamechanger in online retailing.
Long Answer:
Free shipping is a Marketing Expense . Retailers pass on the money to customers instead of buying billboards/ ad spots with that. So, the real profitability does not just depend on the additional purchases by a customer due to free shipping, but also whether that additional purchases are more than the additional sales the traditional marketing effort would have generated.
A sales promotion can bring most profit only if there is a way to discriminate between high price sensitive and low price sensitive customers (Ref: Farris and Quelch, In Defence of Sales Promotion, Sloan Management Review,1987)[1]. Free shipping to everyone will only bleed money. So, the right thing to do is to find out the right segment of customers who are more sensitive to such offer.
Amazon Prime has managed to create the discrimination wall in two ways. First, the persons who paid money upfront for prime are the ones who really value the money spent on shipping. Now they will make far more purchases than they used to do. Second, they have given Prime free to students. For that students had to register their ".edu" email id. They perfected discrimination between people who are sensitive and people who are not.
Walmart.com followed suite, but they discriminated price through a different filter. They made shipping on several items free to all customers from mid-November to 31st December. In this case, they used the specific items and date to discriminate between Christmas deal seekers and other regular purchasers.
Why Free Shipping Will be a Gamechanger in Online Retail
Now, at retailing and ecommerce industry, what Wal-Mart and Amazon do, does not only affect their own companies but also become an industry expectation. Many of the smaller competitors could not match the free shipping offer. So Amazon and WalMart.com did not really poach each other’s customers, but customers from small no-name ecommerce players. In academic world, this strategy is called limiting competitive encroachment as explained in the paper “Price Promotions: Limiting Competitive Encroachment” by Rajiv Lal[2]. As a result of this free shipping onslaught, we will see death of many small etailers ( similar to the death of many Mom and Pops' stores during the advent of Wal*Mart).
[1] Farris and Quelch: Sloan Management Review: Fall 1987 ( could not find link to the original article online, lots of references in net)
[2] Rajiv Lal: Price Promotions: Limiting Competitive Encroachment: Marketing Science: 1990: http://www.jstor.org/pss/183781
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