1998 TheEmergingRoleofElectronicMark

(Bakos, 1998) ⇒ Yannis Bakos. (1998). “The Emerging Role of Electronic Marketplaces on the Internet.” In: Communications of the ACM Journal, 41(8). doi:10.1145/280324.280330

Subject Headings: Electronic Marketplace, Zero Marginal Cost.

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Abstract

Internet-based electronic marketplaces leverage information technology to match buyers and sellers with increased effectiveness and lower transaction costs, leading to more efficient, "friction-free" markets.

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Markets play a central role in the economy, facilitating the exchange of information, goods, services, and payments. In the process, they create economic value for buyers, sellers, market intermediaries, and for society at large. Recent years have seen a dramatic increase in the role of information technology in markets, both in traditional markets, and in the emergence of electronic marketplaces, such as the multitude of Internet-based online auctions.

Functions of a Market

Markets (electronic or otherwise) have three main functions, summarized in Table 1: matching buyers and sellers; facilitating the exchange of information, goods, services and payments associated with market transactions; and providing an institutional infrastructure, such as a legal and regulatory framework, that enables the efficient functioning of the market.

In a modern economy, the first two functions are provided by intermediaries, while the institutional infrastructure is typically the province of governments. Internet-based electronic marketplaces leverage information technology to perform these functions with increased effectiveness and reduced transaction costs, resulting in more efficient, "friction-free" markets.

Table 1. Functions of a market
Matching buyers and sellers
• Determination of product offerings
 - Product features offered by sellers
 - Aggregation of different products
• Search (of buyers for sellers and of sellers for buyers)
 - Price and product information
 - Matching seller offerings with buyer preferences
• Price discovery
 - Process and outcome in determination of prices
Facilitation of transactions
• Logistics
 - Delivery of information, good, or service to buyer
• Settlement
 - Transfer of payment to seller
• Trust
 - Credit system, reputations, rating agencies like Consumer Reports and Better Business Bureaus
Institutional infrastucture
• Legal
 - Commercial code, contract law, dispute resolution, intellectual property protection
• Regulatory
 - Rules and regulations, monitoring, enforcement

Matching Buyers and Sellers.

Markets “clear” by matching demand and supply. This process of matching buyers’ demand with sellers’ product offerings has three main components: determining product offerings, search, and price discovery. The behavior of buyers, sellers, and intermediaries is motivated by their desire to maximize their private utility. When markets function well, this also leads to an efficient allocation of productive resources. Viewed this way, markets are the engine and steering system of our economy.

Markets provide sellers with information about demand that allows them to employ economic inputs such as capital, technology and labor, and develop products with characteristics that match the needs of buyers. Sellers determine a schedule of product offerings that they expect will maximize their profits based on:

information about buyer demand;
the cost of inputs;
the available technology for production and distribution of the information, goods and services purchased by the buyers; and,
the transaction costs of administering production, distribution, and payment.

Buyers select their purchases from the available product offerings after considering factors such as price and product characteristics. In obtaining and processing this information, buyers face search costs. These costs include the opportunity cost of time spent searching, as well as associated expenditures such as driving, telephone calls, computer fees, magazine subscriptions, etc. Typically, sellers exploit these search costs by raising their prices, and thus enjoy higher profits. Similarly sellers may face search costs in locating qualified buyers for their products, such as market research, advertising and sales calls.

A key function of markets in our economic system is price discovery, which is the process of determining the prices at which demand and supply “clear” and trade occurs. For certain markets, such as financial markets, this is their primary function. Markets can employ a number of mechanisms for price discovery. For instance, some financial markets use one or more of the several types of auctions to determine prices, such as the “call market” auction at the opening of a trading day at the New York Stock Exchange, when bids are accepted up to a certain time and exchange occurs when the market opens. This is the first price that is communicated via the stock market ticker to the market at large, kicking off a day of “continuous market” trading. Other markets, such as the traditional automobile dealership, employ negotiation between buyers and sellers until a price is reached. In still other markets, such as the typical department store, merchants make firm offers that customers can either take or leave.

Facilitation of Transactions.

The matching function of a market establishes a bilateral relationship between a buyer and a seller. After a transaction is agreed upon, the product sold must be transported to the buyer (logistics), and payment must be transferred to the seller (settlement). Markets typically incorporate mechanisms for logistics and settlement: when a travel agent uses an airline reservations system to book a flight, the system will generate the itinerary and the ticket, and will process a credit card payment. Furthermore, market transactions require the establishment of a certain level of trust, which protects buyers, sellers and intermediaries from the opportunistic behavior of other market participants. For instance, this trust role may include banks issuing letters of credit, credit reporting bureaus, or rating agencies such as Consumer Reports and Better Business Bureaus, which keep track of product information and seller reputations, and thus discourage opportunistic behavior. Finally, markets provide the physical infrastructure that allows transactions between the buyers and the sellers to take place. This includes real assets such as physical structures and trading floors, computers and communication networks, and transportation systems.

Institutional Infrastructure.

The institutional infrastructure specifies the laws, rules and regulations that govern market transactions, such as issues related to contract law, dispute resolution, and intellectual property protection, and provides mechanisms for their enforcement. In addition, the dynamics of electronic markets may raise certain antitrust issues. For example, there are large economies of scale in distribution, as a single online retailer or intermediary can serve a very large market. There are also potential demand-side economies of scale in payment mechanisms and software. These may lead to a winner-takeall market structure [1] with one or a few firms dominating the market.

How the Internet Affects Markets Electronic marketplaces, especially Internet-based markets, are having a major impact on the roles of markets discussed previously [2, 12]. Product Offerings. Two major emerging trends distinguish products in electronic marketplaces from their traditional counterparts: increased personalization and customization of product offerings, and the aggregation and disaggregation of information-based product components to match customer needs and to support new pricing strategies. Electronic marketplaces support personalization and customization in two ways:

Consumer tracking technology allows the identification of individual buyers; information about these buyers, such as relevant demographics, consumer profiles, or comparison with the known preferences of similar consumers, can be used to discover or estimate their specific preferences.
Information-rich products lend themselves to cost-effective customization; for instance, delivering an electronic newspaper tailored to the interests of an individual reader need not be more costly than delivering the same copy to all subscribers.

Current personalization and customization technologies use either rule-based systems like Broadvision (www.broadvision.com) that draw upon sets of expert rules, or collaborative filtering systems like the Firefly Network (www.firefly.net) that utilize the feedback and experiences of consumers with a profile of likes and dislikes similar to the targeted buyer.

This allows the practice of “one-to-one marketing,” which is based on understanding individual consumers. For instance, establishing a dialogue and a sense of community among customers can create value by enabling the sharing of experiences, problems and solutions, but also allows the collection of important information about individual consumers.

The ultimate objective is to provide customized services according to individual preferences, whether expressed or inferred. Increased selling effectiveness comes from being able to design appropriate products to address the needs of individual consumers, and from being able to identify the moment when a customer’s purchasing decision is most likely to occur and to be prepared for that moment, one step ahead of the competition.

When determining their product mix, sellers must decide which product components or features will be included in each product offering. For example, the developer of an operating system must decide which features to implement, and whether they will be marketed and priced individually or in a single bundle. These decisions are driven by the relative cost of different product bundles, which includes the following types of costs:

Production cost: the cost of producing additional units for inclusion in the bundle, including storage, processing, and communications costs incurred in the process.
Transaction and distribution cost: the cost of distributing a bundle of goods and administering the related transactions, such as arranging for payment.
Binding cost: the cost of binding the component goods together for distribution as a bundle, such as formatting changes necessary to include news stories from wire services in a newspaper bundle.
Menu cost: the cost of administering multiple prices. If a mixed bundling strategy is pursued, where the available components are offered in different combinations, then a set of n goods may require as many as 2n prices (one for each subset of one or more goods).

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Internet Marketplaces and Competition

Impact of Lower Search Costs.

The ability of Internet marketplaces to reduce search costs for price and product information may significantly affect competition. Bakos [4, 5] shows that lower buyer search costs in electronic marketplaces promote price competition among sellers. This effect will be most dramatic in commodity markets, where intensive price competition can eliminate all seller profits. It will also be significant in markets where products are differentiated, reducing the monopoly power enjoyed by sellers, and leading to lower prices and seller profits. Figure 3 shows the equilibrium prices for a differentiated good with zero marginal cost, which consumers value at [math]\displaystyle{ r }[/math] and has a degree of differentiation [math]\displaystyle{ t }[/math]. As search costs fall from very high to moderate, new markets emerge, and both sellers and buyers benefit. However, if search costs continue to fall, sellers are made worse off since buyers can more easily find the lowest-cost seller, while buyers benefit from the lower prices and their improved ability to find products that fit their needs.

As search costs fall from very high to
moderate, new markets emerge, and
both sellers and buyers benefit.
However, if search costs continue to fall,
market prices fall and sellers are made
worse off, while buyers benefit from the
lower prices and their improved ability
to find products that fit their needs.
buyer search cost
Figure 3. The impact of buyer search costs in a differentiated market

The dynamics of friction-free markets are not attractive for sellers that had previously depended on geography or customer ignorance to insulate them from the low-cost sellers in the market. As geography becomes less important, new sources of product differentiation, such as customized features or service or innovation, will become more important, at least for those sellers who don.t have the lowest cost of production. Also, like an arms race in which both sides develop increasingly powerful weapons, sellers can exploit the reduction in menu costs to compensate for the lower search costs in electronic marketplaces. Specifically, sellers can make it difficult to compare the price of alternative product offerings, and they can attempt to collect information about buyers that allows more effective price discrimination. Airlines, for example, have implemented extremely complicated and ever-changing fare structures, flight restrictions, and ticket availability, sometimes offering hundreds of fares for travel between certain pairs of destinations.

It is also interesting to note that when informational inefficiencies prevail, a large number of sellers does not necessarily result in a competitive and efficient market. If search costs are high, individual sellers do not have a strong incentive to lower their prices because few buyers would discover them. As the number of sellers increases, it becomes more difficult for buyers to locate discounters, and thus the market may become more monopolistic as the number of sellers increases ! This behavior is likely in certain markets with little or no advertising, such as some markets for professional legal and medical services. Internet marketplaces could provide price cutters with the means to reach a larger fraction of the buyers, and thus undermine the monopolistic nature of these markets.

While there is much speculation about the effect that electronic marketplaces have on prices, thus far there has been little systematic analysis. One exploratory study by Bailey and Brynjolfsson [3] did not find much evidence that prices on the Internet were lower than prices for the same goods sold via traditional retail channels. Their analysis was based on data from 52 Internet and conventional retailers for 337 distinct titles of books, music compact discs, and software. Bailey and Brynjolfsson provide several possible explanations for their unexpected findings, including the possibility that searching on the Internet during the sample period was not as easy as is sometimes assumed, that the demographics of the typical Internet user encouraged a higher price equilibrium, that many of the Internet retailers were still experimenting with pricing strategies, and that Internet retailers were differentiating their products (for example, via delivery options or customized recommendations). Clearly, more empirical research is needed in this area.

Increasing Differentiation and Lowering the Cost of Product Information.

A higher degree of product differentiation leads to an increase in seller profits, which may partially or completely offset the decrease caused by lower search costs. Sellers in electronic markets will thus want increasingly to differentiate their products, possibly utilizing the personalization and customization technologies discussed earlier.

Buyers in a differentiated market face two types of search costs: the cost of obtaining price information and the cost of obtaining information about the product characteristics of a seller’s offering. If sellers can control the type of electronic market introduced, they should favor a system emphasizing product information rather than price-shopping.

A key variable for such a system is the cost of product information relative to the cost of price information about the product. For instance, an electronic marketplace designed to promote priceshopping makes it easy to compare price information, but might still require a higher-cost inquiry (such as a visit) to obtain detailed product information. For example, a buyer looking for a computer monitor on the Internet can easily compare prices from a large number of sellers, but then must obtain and evaluate the monitors’ specifications, assess the sellers’ reputations and return policies, and ideally locate a display model at a showroom or at a colleague’s office.

By contrast, an electronic marketplace can be designed to promote competition based on product features. For example, high-quality multimedia product descriptions in standardized formats could help identify product offerings matching the buyer’s preferences, while price information could be left out of these descriptions or could be obscured by offering a large number of prices and making it difficult for the buyers to figure out which price actually applies.

The Role of Electronic Intermediaries

It has been argued that as friction-free electronic marketplaces lower the cost of market transactions, it will become easy to match directly buyers and sellers, and as a result, the role of intermediaries may be reduced or even eliminated leading to “disintermediation” (see [9, 10]). While the growth of Internet marketplaces may lead certain types of intermediaries to extinction, the discussion in the previous sections suggests that electronic marketplaces will more than compensate for this by promoting the growth of new types of electronic intermediaries. These intermediaries will perform functions that include matching buyers and sellers, providing product information to buyers and marketing information to sellers, aggregating information goods, integrating the components of consumer processes, managing physical deliveries and payments, providing trust relationships and ensuring the integrity of the markets.

Presently, Internet-based electronic intermediaries often “freeload” on traditional intermediaries for various reasons, such as the physical experience that is still important in several markets before a buyer can select an appropriate product offering. For example, car buyers may test drive a vehicle at a traditional dealer, and subsequently purchase it through Auto-by-Tel. This clearly cannot be sustained sustained as electronic intermediaries gain a significant market share. Instead, the physical experience component might be unbundled to a physical intermediary. Auto-by-Tel, for example, may pay a fee to the intermediary where the test drive took place, a service that could be provided by a traditional dealership, but also by a specialized showroom or a car rental company.

Internet-based electronic marketplaces are still at a formative stage, and it is hard to fully predict their impact on the structure of markets. However it is becoming clear that they will promote greater economic efficiency, and help sustain economic growth. In the process, they are creating major transformations, full of strategic opportunities for intermediaries ready to compete by adding value for buyers and sellers rather than by exploiting information asymmetries.

References

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	Author	volume	Date Value	title	type	journal	titleUrl	doi	note	year
1998 TheEmergingRoleofElectronicMark	Yannis Bakos			The Emerging Role of Electronic Marketplaces on the Internet				10.1145/280324.280330		1998