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A Strategic Analysis of Electronic Marketplaces

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    A Strategic Analysis of Electronic Marketplaces A Strategic Analysis of Electronic Marketplaces Document Transcript

    • A Strategic Analysis of Introduction Electronic Marketplaces Buyers often face substantial search costs in order to obtain information about the prices and product offerings of sellers in a By: J. Yannis Bakos market. These costs introduce Graduate School of Management inefficiencies into market-intermediated University of California, Irvine transactions and detract from the ability of Irvine, CA 92717 markets to provide an optimal allocation of productive resources. Interorganizational information systems can create “electronic Abstract marketplaces” by serving as intermediaries between the buyers and the sellers in a vertical market, in the Information systems can serve as process reducing the cost buyers must intermediaries between the buyers and incur to acquire information about seller the sellers in a vertical market, thus prices and product offerings. This article creating an “electronic marketplace.” A focuses on the role of buyer search costs major impact of these electronic market and certain other economic factors that systems is that they typically reduce the determine the practical significance and search costs buyers must pay to obtain the strategic dynamics of electronic information about the prices and product marketplaces in commodity and offerings available in the market. differentiated markets. Economic theory suggests that this reduction in search costs plays a major role in determining the implications of Simple microeconomic models typically these systems for market efficiency and assume that buyers can costlessly acquire competitive behavior. This article draws full information about the prices and on economic models of search and product offerings of sellers in a market. examines how prices, seller profits, and For example, this assumption underlies buyer welfare are affected by reducing the central result of convergence to a search costs in commodity and unique competitive price-taking differentiated markets. This reduction equilibrium in competitive markets. In results in direct efficiency gains from certain oligopolistic settings, it leads to the reduced intermediation costs and in result that sellers will not be able to keep indirect but possibly larger gains in prices above marginal costs and thus will allocational efficiency from better-informed realize zero profits, known as Bertrand’s buyers. The economic characteristics of paradox. There is little disagreement that electronic markets, in addition to their costless, perfect information about market ability to reduce search costs, create prices is an unrealistic simplification. Yet numerous possibilities for the strategic the actual implications of deviations from use of these systems. this assumption for market prices and for the conduct and welfare of firms and consumers have been the subject of much Keywords: Interorganizational systems, debate. In real-world markets, the evident electronic markets, strategic variability of prices and the emphasis on information systems dissemination of information through advertising and other media suggest that the cost and the availability of price and ACM Categories: K.1, K.4.3, K.6.0 product information are important determinants of economic behavior. The goal in this article is to demonstrate how economic theory can provide insights into the benefits of electronic markets, the strategic options of the parties involved, and their likely strategic conduct. Although these questions have already Page 1
    • been addressed in the information allows the participating buyers and sellers systems literature (e.g., Cash and to exchange information about prices and Konsynski, 1985), the contribution of this product offerings. The use of the term article lies in providing a supplementary “electronic marketplace” in this article has line of reasoning grounded in economic a narrower, system-oriented focus theory; it emphasizes the underlying compared with Malone, et.al.'s (1987) reasoning and the resulting strategic more general use of the term “electronic implications. The interested reader can market” in referring to the corresponding find the model specifications that extend governance mechanism. existing economic theory and the complete mathematical formulations in The role of electronic markets Bakos, (1987), chapters 6 and 7. As discussed in later sections of this The next section reviews the concept and article, the cost that buyers incur in order the role of electronic marketplaces. This to acquire information about prices and is followed by a discussion of the product characteristics enables sellers to implications of search costs in commodity extract monopolistic rents in otherwise markets and shows how in price- competitive markets and creates competitive markets, even a small cost of inefficiencies in the allocation of economic search on the buyers’ part may enable resources and the distribution of economic sellers to maintain prices substantially wealth. Electronic markets require major above their marginal cost; in this scenario, fixed investments in system development, the introduction of a market system but, once in place, they promise to reduce providing price information can the marginal costs of interorganizational dramatically reduce seller profits and coordination and handle larger volumes of increase buyer welfare. Next is a market transactions in a more timely discussion of search costs in differentiated fashion before they reach their point of markets. The heterogeneity of product saturation. If they are able to fulfill this offerings and consumer tastes in such a promise, they are likely to proliferate market allows sellers to exploit buyer because of these superior search costs and enjoy increased profits. cost/performance characteristics. An interesting outcome in this setting is Furthermore, some authors have argued that an electronic marketplace improves that information technology will favor allocational efficiency by enabling buyers coordination through market-based rather to locate sellers that better match their than hierarchical governance mechanisms needs; these efficiency gains are (Malone et al., 1987), resulting in an comparable in size to the reduction in increased role for electronic markets. search costs. Finally, the last discusses the implications of the economic Real-world electronic market systems characteristics of electronic market typically offer valuable features beyond systems for the strategic conduct of the posting of prices and product buyers, sellers and intermediaries. characteristics. For example, airline reservation systems allow ticketing and Electronic Marketplaces billing in addition to their market-related functionality. In this article the focus is We are witnessing an increase in the primarily on the role of electronic markets number and functionality of information in bringing together a supplier and a systems that cross organizational customer; it is recognized, however, that boundaries, such as systems linking one once this relationship has been or more firms to their customers and/or established, through an electronic market suppliers. The term interorganizational or by any other means, interorganizational information systems (IOS), first information systems can play an important introduced by Barrett and Konsynski role in supporting the resulting bilateral (1982), is now widely used to characterize relationship. these systems. An electronic marketplace (or electronic market system) is an interorganizational information system that
    • Electronic markets may require sizable Economic characteristics of electronic investments from their participants in market systems hardware, software, employee training, and organizational transformations. Such In order to use economic theory to investments may become worthless understand the strategic implications of should the organization decide to join a electronic markets, we must focus on their different system or to revert to the most salient characteristics, especially the previous mode of operation. Competing ones that distinguish them from other intermediaries may need to compensate types of capital investments. In that potential system participants for their context, five characteristics of electronic switching costs or invent technology that market systems can explain, from an minimizes these costs in order to lure economic perspective, their strategic them away from rival systems. potential as well as their impact on the structure and efficiency of markets. 4. Electronic market systems typically require large capital 1. An electronic market system can investments and they offer reduce customers’ costs of substantial economies of scale obtaining information about the and scope. prices and product offerings of alternative suppliers as well as suppliers’ costs of An intermediary usually must incur large communicating information system development and maintenance about their prices and product costs (both fixed and variable); it will then characteristics to additional face relatively small incremental costs for customers. each additional transaction until the capacity of the system is approached, This cost reduction is likely to affect the resulting in substantial economies of monopoly power of the suppliers or the scale. Furthermore, technological and monopsony power of the customers in a organizational resources and expertise vertical market that is moved “on-line” by acquired during the development and the introduction of an interorganizational operation of one system may be information system. It will also have transferable to other systems, resulting in implications for the efficiency of that economies of scope. market in terms of the search costs experienced by buyers and their ability to 5. Potential participants in locate appropriate sellers. electronic markets face substantial uncertainty regarding 2. The benefits realized by the actual benefits of joining individual participants in an such a system. Occasionally this electronic market increase as uncertainty remains even after an more organizations join the organization joins the system. system. This uncertainty can affect the strategic behavior of buyers, sellers, and potential This property, known in economics as intermediaries, by inducing them to adopt network externalities (Katz and Shapiro, a “wait and see” strategy where they delay 1985), can affect the dynamics of the introducing or joining a system in the hope introduction and adoption of electronic that they will learn from the experiences of market systems, e.g., by favoring the first other organizations. intermediary introducing such a system. Competitive moves and technological 3. Electronic markets can impose developments can affect the strategic significant switching costs on significance of the above factors. In some their participants. markets, for example, competition among systems, new technology, and even
    • government regulation are increasingly limiting the ability of intermediaries to Commodity Markets exploit switching costs. Furthermore, while the above economic characteristics Products in commodity markets are determine the strategic potential of essentially identical across all sellers, as electronic marketplaces, they are not is often the case, for example, in the exclusive to these systems. The reduction markets for agricultural grain products or in buyer search costs is the single gold bullion. Buyers will typically choose attribute that is most specific to electronic the seller with the lowest total cost, which marketplaces; in other aspects, especially will usually include the price paid to the in terms of the last two characteristics seller plus any search, transportation, and above, electronic market systems may not other similar costs. This section examines be very different from other types of how buyers behave when they search for capital investments, including investments a seller in a commodity market. Because in strategic information systems. of the simple structure of a commodity market, most search models in the For instance, better transportation literature can be used to study the impact systems or advertising media can of electronic marketplaces by examining decrease the search cost of buyers. their outcome when the marginal cost of Competing standards in the personal search is substantially reduced. The key computer and workstation markets offer insight offered is that under virtually any network externalities, because the wide assumptions about the nature of the adoption of a standard results in increased market and the search process, electronic availability of hardware and software marketplaces are likely to destabilize products as well as large numbers of other profitable monopolistic outcomes, thereby, compatible users. Adoption of any reducing seller profits and increasing computing platform, creates switching buyer welfare. costs due to the cost of converting software and retraining users. Several Rules of search in commodity markets industries require large capital investments as the price of entry, and The perfectly competitive or monopolistic most new technologies are characterized markets of simple microeconomic theory by uncertainty about their actual benefits. assume that buyers are fully informed Electronic marketplaces, however, are about the prices of all sellers. This leads unique that they typically exhibit all five of to a single market price and offers buyers these characteristics. no incentive to compare the prices of different sellers. Stigler’s (1961) seminal Information systems researchers face the work titled “The Economics of Information” task of extending economic theory in the stimulated economists to ask how firms appropriate areas, drawing the proper and individuals behave, and how markets conclusions, and bringing the relevant function, when buyers and sellers do not results into the information systems field have perfect information about the (Bakos and Kemerer, 1990). In this spirit, consequences of their actions. In the the following two sections focus on the case of search costs, it can be shown that ability of electronic marketplaces to sequentially rational rules (i.e., rules that reduce the cost buyers face in obtaining describe a strategy that rational economic price and product information, and they actors would want to follow to the end) will illustrate how economic analysis can be be based on a reservation price, which is applied to study the forces driving the set so that the expected gain from economic and strategic implications of this searching once more equals the cost of technology. The discussion is the search (Rothschild, 1974). subsequently expanded to include the strategic impacts of three other Several authors have pointed out that the characteristics of electronic marketplaces actual distribution of seller prices may be identified above: large fixed costs, network unknown at the beginning, or it may externalities, and switching costs. change over time. For example, when there is only a small number of sellers,
    • finding the price of one seller may change pay the slight premium rather than embark the expected price distribution for the into another expensive search. The result remaining sellers. Search models can be is that all sellers gradually raise their extended to cope with these contingencies prices to reach the monopolistic level. At by allowing for the dynamic updating of this point no seller has an incentive to buyer beliefs (Rothschild, 1974). Another lower the price; because of the high concern is that in some real markets it search costs he or she will not be able to may be unrealistic to expect buyers’ prior attract enough additional demand. beliefs to reflect accurately the actual distribution of seller prices, in which case These models of buyer search are limited rules based strictly on a reservation price to the extent that they offer a theory only are not robust and can lead a buyer with about the buyers’ side of the market. The inaccurate expectations to a grossly variability of seller prices is exogenous suboptimal outcome. Gastwirth (1971) and usually disappears when one tries to proposed combining the two into hybrid close these models by allowing profit- rules that are both robust and preserve maximizing behavior on the sellers’ side; the reservation price property: buyers will at equilibrium, all sellers charge a single search up to a certain maximum number price. Buyers then do not have to search, of times or until the best price discovered undermining the motivation for the is less than their reservation price (which development of these theories. On the gets dynamically updated as new other hand, these models can information is gathered about seller demonstrate how even modest search prices). costs can lead to prices substantially higher than marginal costs, even in The impact of search costs in commodity markets and when the sellers commodity markets behave competitively (i.e., without any collusion). More recent work in this area Most search rules proposed in the suggests that the key in avoiding the literature, including the ones reviewed above problems lies in introducing above, have the following properties: (1) asymmetries in the buyer and seller sides seller prices decrease as the cost of of the market (i.e., allowing for search decreases; (2) the amount of heterogeneous buyers and sellers). search increases as the cost of search decreases; (3) the amount of search For example, in the real world not every increases as seller prices become more buyer has access to an electronic market dispersed; and (4) ceteris paribus, as system. Salop and Stiglitz (1982) have seller prices become more dispersed, studied a setting with two types of buyers buyers’ total costs decrease (buyers need who face different search costs. This is to search more when there is a wide similar to a scenario in which certain variety of seller prices, but they are buyers have access to an electronic compensated by better deals). market that provides information about seller prices at a low cost, while buyers The search costs faced by buyers allow without access to the electronic market the sellers to maintain prices at system face higher search costs. Their equilibrium substantially above their analysis suggests a mixed price marginal cost; it can be shown that, under equilibrium in which certain sellers charge certain assumptions about buyer behavior, high prices to take advantage of buyers at equilibrium all sellers charge the same with high search costs. Buyers with low price, and it is the one that would have search costs induce the entry of low- been charged by a monopolist. The first priced sellers. As the proportion of buyers half of this result was first proved by with low search costs increases, the Diamond (1971) and the second half by average price charged by sellers gradually Salop and Stiglitz (1977). What happens decreases from the monopoly price to the in this case is that if search costs are high competitive price. enough, each seller will slightly increase his or her price knowing that the We have seen that in almost any setting, unfortunate buyers that visit will prefer to as the cost of buyer search decreases, it becomes more difficult for sellers to
    • sustain high prices. Reducing the cost of At the Eurobond market’s 1987 annual obtaining information about seller prices in meeting in Oslo, Salomon Brothers led the a commodity market may thus undermine big American trading firms into a monopolistic outcome. Under certain successfully opposing proposals for a assumptions, for example, prices are computerized real time price-quotation monopolistic for high enough search costs system for the trading of Eurobonds and become indeterminate (no (Economist, 1987). Such a system would equilibrium) when search costs fall below have made market information available a certain threshold (Bakos, 1987). As instantly to all subscribing investors and long as the cost of search is still traders, regardless of their size or significant, sellers are still likely to enjoy location, and could have marked the some excess profits, although smaller beginning of the end of big trading profits1. than under the monopolistic equilibrium. If the search costs decrease enough, all Similarly, in the domestic market for U.S. profits enjoyed by the sellers eventually government fixed income securities (which are competed away. In either case, the has a daily turnover of over $100 billion), result is a net welfare gain from improved big bond dealers had a virtual monopoly in search efficiency (as fewer resources are real-time bond prices in the mid-1980s. expended in non-productive search Thus, they enjoyed an edge in trading and activities) and from the reduction or were able to profit by charging a price elimination of inefficiencies that differential to their customers. Despite the characterize monopolistic markets (such fact that a General Accounting Office as pricing marginal buyers out of the study in 1987 called for better public market). Finally, lower prices result in a access to bond prices, these dealers were transfer of wealth from the sellers to the understandably opposed to an open buyers. Electronic market systems are trading system that might threaten their socially desirable when their net welfare monopoly profits. Improvements in gains outweigh their development and computer and telecommunication operating costs. technology, however, allowed financial data vendors to gain access to timely The role of electronic marketplaces bond price data in the late 1980s. As a result, these vendors, including Reuters A commodity product bought from Holdings PLC, Telerate, and Quotron, different sellers can differ only in its price. made inroads in that market by posting We have seen that sellers can still realize bond price data and eventually by substantial profits, however, as long as matching smaller buyers and sellers. In comparison shopping is costly for their an ironic twist, the opposing bond dealers customers. As computer and eventually were forced to join these telecommunications technology in the electronic systems themselves to take form of electronic market systems make advantage of their superior efficiency, in the distribution of information more the process paying millions of dollars in efficient, the opportunities for fat and easy fees (Herman and Power, 1990). profits will shrink. Commodity markets may be destabilized by price wars that In agreement with the economic wipe out any excess profits enjoyed by the arguments presented, the government sellers. As articulated in the following bond business turned from a gold mine to quote by John Phelan Jr., at the time chairman of the New York Stock Exchange, “Technology and communication bring efficiency. Money is made in inefficiency” (Hansell, 1989, 1More recently, other developments have p. 92). Sellers may thus attempt to delay combined to severely damage profits in the the arrival of electronic market systems, or Eurobond market, while actions taken by the they may try to control their development. dealers to protect these profits caught the attention of the regulatory authorities; the A case in point is the European market for profitability of this market has suffered as a government and blue chip bond issues. result.
    • a mine field in just two years; several preferences determine the location of dealers are losing money, and the rest their ideal product or product mix, and enjoy razor-thin profit margins (Herman some type of distance metric in the and Power, 1990). Although the product attribute space is used as a electronic market systems were not the proxy for consumers’ utility loss when only structural change (for example, the they are not able to purchase their entry of many more participants, including ideal product or product mix. several Japanese houses, has made that market more competitive), these systems • The brand substitution formalization of seem to have played a significant role in product differentiation is often that process. As discussed in more detail attributed to Chamberlin (1933). In later in this article, there is gradually a this class of models, consumers may consensus being formed among major purchase several brands, according to bond dealers that they need to control a brand's prices, desirability, and the electronic trading, especially because they ability of any given pair of brands to provide much of the data on which such substitute for each other. trading is based. It may be difficult to achieve this goal, however, without The advantage of brand substitution provoking government regulation. models is that they allow multiple brands to compete for the attention of any Differentiated Markets particular consumer; in spatial models consumers consider only the products Certain markets, like government bonds or closest to their ideal product vector and most agricultural and mineral products, typically buy the one most desirable. deal in commodity products, yet the Spatial models on the other hand focus majority of markets are characterized by more clearly on product characteristics differentiated products. Differentiated and on the dynamic aspects of markets are commonplace because buyer competition through the reformulation of preferences are heterogeneous for most existing brands or through the introduction types of products. Furthermore, these of new ones (Perloff and Salop, 1985; markets are attractive to sellers because Schmalensee, 1978). Their typical they offer substantial profit opportunities. assumption that consumers purchase only Differentiated markets involve a variety of one product at a time is acceptable in product offerings and consequently the most real markets. search problem becomes more complex; buyers need to consider both the price of Modeling search costs in differentiated a particular seller and the characteristics markets of the corresponding product offering. In this section we focus on describing a The economic literature on search costs model of search in differentiated markets suggests that heterogeneity of consumers appropriate to study the implications of and product offerings is central to the electronic marketplaces. ability of sellers to exploit buyer search costs and thus extract monopolistic rents Models of product differentiation (Reinganum, 1979; Shilony, 1976). It is thus appropriate to extend standard Economists have been interested in models of differentiated markets to take differentiated markets since the late account of search costs. 1920s. A number of models have been proposed for their study, which generally One good candidate is the “unit circle” or fall in two categories: “city around the lake” model of spatial differentiation (Salop, 1979) in which seller • Spatial differentiation models trace offerings and buyer preferences are their origin to Hotelling’s (1929) located along a unit circle; buyers face a formalization of spatial competition. In that class of models, product attributes are treated as choices of location in an n-dimensional space. Consumer
    • “transportation” 2 cost when they buy from evident when high search costs threaten a seller whose offering is not identical to the very existence of a market. In their preference. Bakos (1987) modeled differentiated markets, a sufficiently large the impact of search costs by requiring search cost will force buyers to stay out of each buyer to incur a certain cost in order the market even if they are offered a zero to be informed about the location (i.e., the price; they would find the expected cost to product attributes) and the price offered by locate an acceptable seller too high, even some seller; he must then decide whether if they knew that such a seller is to purchase one of the products already guaranteed to exist. It follows then that identified, keep searching, or give up. high search costs can lead to a market breakdown. This is in contrast to the case At the unique symmetric equilibrium each of free information, where some buyers seller charges a price that depends on the may stay out of the market because of search and transportation costs; the high transportation costs, but sellers higher these costs, the higher the prices always service their “local” markets. An and profits enjoyed by the sellers (Bakos, important implication of this analysis is 1987). Each buyer searches until a that electronic market systems providing product close enough to his preferences is product and price information may located. As the search cost decreases, generate substantial allocational buyers become more demanding and efficiencies by enabling customers to keep searching until they find a product locate suppliers that better match their closer to their ideal preference. If the needs. search cost becomes zero, buyers look at all product offerings and purchase the one As search costs decrease, so do price best serving their needs, resulting in a premiums and seller profit margins. The socially optimal allocation. If there is a best strategy for a buyer in such a market large number of products, seller profits will is to determine a “price and be low but still not zero because product inconvenience” threshold and keep differentiation prevents all-out price searching until a satisfactory product is competition. If a higher degree of product located. Consequently, customers with differentiation can be sustained e.g., lower search costs become more through advertising, buyers become less demanding and are willing to make fewer willing to purchase an offering significantly compromises concerning their ideal different from their ideal product (i.e., their product. Buyers are better off in two “transportation” cost increases). In that ways: first, they enjoy lower prices case, sellers will enjoy an increase in because of the increased competition profits, which may partially or completely among sellers; second, and potentially offset the decrease caused by lower more important, they enjoy allocational search costs. efficiencies from being better informed about the available products, thus making The ability of electronic marketplaces to purchases that better suit their needs. improve market efficiency is particularly Role of electronic markets It was argued that an electronic market system in a differentiated market is likely 2The term transportation cost originates from to promote price competition and reduce the spatial interpretation of the unit circle the market power of sellers. It may thus model, where the buyer must travel to the create a net welfare gain by lowering the seller's location or have the product shipped, search cost of buyers and also enabling the larger the distance between buyer and them to locate products better matching seller, the higher will be the transportation their needs. If the search cost becomes cost. In the context of the model presented low enough, buyers will look at all product here, the transportation cost formalizes the offerings and purchase the one best fact that the more a product offering differs serving their needs, resulting in a socially from a buyer's ideal preference, the less optimal allocation. It follows that such a desirable it become for that buyer. system will be socially desirable when
    • these welfare gains outweigh its price competition, reduce the airlines’ development cost. market power, and result in more demanding customers who are less willing It is interesting to note that when to compromise on their preferred product. informational inefficiencies prevail, a large Airlines have experienced all these number of sellers does not need to result impacts (Smith, 1987). in a competitive and efficient market. Under certain circumstances the market We saw that in a differentiated market may become more monopolistic as the sellers can take advantage of buyers’ number of sellers increases! This can search costs. Although no formal happen, for example, if a buyer can distinction was made between the role of acquire information about a product only price and product information, it is actually by purchasing it. In this case, buyers the price information that is most often but from the first seller they visit. As damaging to sellers’ profits. In that a result, individual sellers do not have a context, sellers have an incentive to strong incentive to lower their prices manipulate electronic markets in order to because they would attract few buyers increase the cost of obtaining price and even these buyers may interpret the information. When this is combined with lower price as a signal of poor quality. As readily available information on product the number of sellers increases, it characteristics, it discourages buyers from becomes more difficult for buyers to locate searching for price deals and results in any specific discounter, This decreases higher profits for the sellers. In the airline the incentives of individual sellers to cut industry, for example, American and their prices and thus results in a more United attempted to bias CRS screen monopolistic market. This behavior is displays to discourage price comparisons; likely in certain markets with little or no in a similar tactic, most airlines now offer a advertising and no cheap way to assess wide gamut of thousands of active fares quality ex ante (or even ex post), e.g., and promotions to confuse these professional markets for legal and medical comparisons. Another approach is to services. In a setting of this type, increase the degree of product electronic market systems could differentiation, which was the major disseminate product information e.g., objective in the introduction of frequent through a rating service that promotes the flier programs. Finally, sellers and sharing of buyer experiences with the intermediaries operating electronic market product as well as provide price cutters systems can appropriate some of the with the means to reach a larger fraction buyers’ gains through user fees. For of the buyers; the monopolistic nature of example, airlines are imposing transaction these markets could be undermined as a fees beyond a certain level of CRS result. utilization, both to generate additional revenues and to discourage searching for Airline computerized reservation systems the lowest-priced fares (Dahl, 1991). (CRS) fit well the model of electronic market systems in differentiated markets Increased competition, fueled by the discussed earlier, and they have been deregulation of the airline industry and the increasingly prominent in recent years. computerized reservation systems, was The two dominant systems were adversely affecting the profitability of flight developed by American Airlines (SABRE) operations for most airlines in the early and United Airlines (Apollo).3 The 1980s. The airlines that pioneered preceding discussion suggests that these reservation systems, however, were systems should be expected to promote enjoying high profits from system-related revenues. In 1980-1982, American Airlines commanded a 40 percent gross margin on its SABRE revenues, while flight operations yielded as little as 5 3United percent. TWA made more money in the spun off Apollo into a subsidiary same period on PARS (its reservation named Covia, now owned jointly with several system, which eventually was merged into other airlines. WorldSpan in a joint venture with
    • Northwest and Delta) than from its airline. As a result, airlines with established It was argued in the previous two sections reservation systems enjoyed stock price that electronic markets usually favor the premiums as recently as mid-1987 (Smith, buyers by lowering buyer search costs 1987). As these systems have started and thus reducing sellers’ profits and competing among themselves, however, market power. This may create a problem operating margins have been falling, and for sellers in markets where technological current SABRE profit margins have developments make a market system declined to the low teens. Air travelers feasible, or even imminent. In the long are the only group made unambiguously run it may be impossible to avoid some better off as a result of these systems. loss of market power, especially when this power is based on exploiting high buyer search costs. System revenues may Finally, it may be interesting to note that compensate for this decline in the short- the implications of search in differentiated run, but, as several systems are markets are consistent with the traditional introduced, their profits are likely to be transaction cost analysis of appropriate competed away. In SABRE’s case, for governance structures. It was suggested, example, even customer lock-in through for example, that market inefficiency legally binding contracts did not prevent (deviation from a Pareto optimal outcome) the eventual loss of market share; increases when the cost of obtaining competitors would offer to foot the travel information about a specific product agencies’ legal bills to induce them to offering is high, which is typically the case switch to their systems (Smith, 1987). If for complex products. If this inefficiency the sellers collude to prevent an electronic has resulted in hierarchical governance market, they may induce buyers to structures, an electronic marketplace may introduce such a system themselves, or promote market-based governance they may encourage a third-party mechanisms, suggesting that electronic intermediary to enter the picture. marketplaces may favor markets over hierarchies, in accordance with Malone, et.al.'s (1987) predictions. The potential profits of electronic markets can actually put sellers in a prisoner’s dilemma situation. We saw that sellers as Strategic Conduct in a group have no incentive to introduce a Electronic Markets system offering price and product information, which makes them all worse The preceding sections discussed how off. Yet each of them individually might interorganizational information systems benefit from introducing such a system, can create “electronic marketplaces” by because the revenues that can be gained serving as intermediaries between the by charging buyers directly and indirectly buyers and the sellers in a vertical market, for the system’s services would probably reducing the buyers' search costs in the outweigh the lost profits of an individual process. Also discussed were the seller due to increased competition. This implications of this reduction in search may explain why sellers often precipitate costs and the potential of electronic the introduction of electronic market markets to affect the efficiency of systems, in spite of the potential of these interorganizational transactions and the systems to reduce their market power. market power of buyers and sellers. We now turn to the strategic potential of The best strategy for sellers may be to electronic markets and inquire whether control the type of system that is their economic characteristics are likely to eventually introduced. If they orchestrate favor early movers and large the introduction of systems that intermediaries. emphasize product rather than price information, buyers will use these systems Market power and the introduction of to locate the most appropriate product in the market. Sellers would be able to electronic marketplaces maintain their profits and in addition appropriate some of the buyers’ benefits through user charges. Such systems may
    • be able to support a certain degree of Venture (EJV) group, which came to be implicit collusion and thus maintain a known as the “Gang of Six” and currently relatively cooperative outcome: other includes Salomon, Goldman Sachs, sellers could “get the message” and stay Morgan Stanley Group, CS First Boston, away from systems that emphasize price Citicorp, Shearson Lehman Hutton, and information. Established systems can possibly others. It has been reported that raise the barriers of entry for third-party group members are ready to commit up to information providers and thus delay or $100 million to launch their own electronic avoid the competition from systems market, and they plan to provide research, offered by non-industry participants. analysis, and related news in an attempt to differentiate themselves from the other Naturally, buyers have the opposite competing systems (Herman and Power, incentives and would like to create an 1990). electronic market that facilitates comparisons among sellers’ prices as well This effort faces several obstacles, as product offerings. The functionality of however, as the Electronic Joint Venture an electronic market is therefore likely to group is likely to encounter conflicts of depend on whether it is introduced by a interest with current or potential members. buyer or a seller. In a market that is more For example, Citibank owns Quotron, and concentrated on the seller side, like most any attempts to recruit Merrill Lynch could consumer and several industrial markets, be stymied by the latter’s interest in a single buyer may be too small to Bloomberg Financial Markets; both introduce a market system, may not be Quotron and Bloomberg would be likely sufficiently interested, or may lack the competitors with an EJV system. clout to induce seller participation. Furthermore, there is fragmentation Sellers, on the other hand, have higher among the sellers in the bond market stakes in such markets, leading to because a group of bond brokers is stronger incentives to introduce a market planning to introduce its own proprietary system. This provides another system; this will result in competition explanation for the observation that most between six or more systems serving the electronic market systems are pioneered bond market. by sellers, although, theoretically, such systems are most beneficial to the buyers. Early mover advantage Buyers may form coalitions, however, and introduce jointly owned systems, or a third The focus thus far has been on the impact party organization with the necessary of introducing an electronic market system technological expertise may enter the on market prices and profits. As pointed market. out earlier, however, electronic marketplaces may be able to generate It is more difficult for sellers to control the substantial efficiencies, which can be outcome in commodity markets. In the translated into profits for the system case of the domestic government bond operators. This is likely to create interest market, big bond dealers refrained from among potential intermediaries, thus introducing an electronic market system, introducing competition to the market for which allowed financial data vendors to electronic intermediation. A well-known make inroads in that market, as discussed result of microeconomic theory is that earlier. In order to reassert its position, firms in competitive markets earn no Merrill Lynch, which has a minority interest profits in the long run, except for a fair in Bloomberg Financial Markets, has return on their capital assets. Excess transformed this system into an electronic profits are possible, however, under such marketplace by making it available to deviations as informational inefficiencies, other dealers (Clemons, 1991). the ability of some firms to create and Bloomberg has become the premier exploit barriers to entry, or the source of real-time data for trading in technological sophistication that allows corporate bonds and also gets price feeds other firms to enjoy profits from innovation for government bonds through the primary even if they lack any significant market dealers. Meanwhile, other big bond power. In this context, three dealers formed the Electronic Joint
    • characteristics of electronic marketplaces up costs of hundreds of millions of dollars identified earlier may allow intermediaries for a new entrant in that market. The that move early in offering electronic saturation of the existing market (virtually market systems to maintain a competitive all travel agents subscribe to a CRS), the advantage: large requirements for capital relatively low marginal costs enjoyed by investment resulting in substantial the existing players, and the possibility of economies of scale and scope, switching a retaliatory response create enough costs imposed on their participants, and uncertainty about the benefits of entry to network externalities. deter new systems and limit the aspirations of marginal players. Capital investment Switching costs The large investments in sunk and fixed costs that are required to develop Firms connected to an electronic market electronic market systems are likely to system may face substantial technological play an important strategic role. These and organizational costs if they decide to costs can raise barriers to entry (Spence, switch to an alternative system; such 1979) and can offer advantage to early switching costs can play an important movers (Fundeberg and Tirole, 1983;, strategic role. The study of the strategic 1985). Incumbent firms may overinvest in implications of switching costs has the beginning and keep investing emerged as an active field in economics sufficiently to discourage new entrants with the work of Farrell (1985), Farrell and (Bernheim, 1984). Traditionally, the final Shapiro (1987), and Klemperer (1986;, outcome in such competition based on 1987a; 1987b), and von Weizsaker strategic investment is determined by the (1984). Analytic models of switching costs underlying economies of scale, which usually predict aggressive behavior of typically favor established entrants early movers, who try to build a locked-in (Coursey et.al., 1984), and by the customer base that can be subsequently uncertainty about technological and exploited. demand characteristics (Arvan, 1986). In the case of electronic marketplaces, It is often assumed in the information network externalities (discussed later) are systems literature that interorganizational likely to be just as significant, if not the information systems create substantial dominant factor. Uncertainty about the switching costs because of sunk actual capacity of the market may induce investments in hardware, software, user intermediaries to offer more systems than training, and organizational changes, as the market can support; in that case well as non-technology barriers such as consolidation and a war of attrition are the trust in organizational partners or long- likely outcomes. term contracts (e.g., Bakos and Treacy,, 1986; McFarlan, 1984). The larger the The dominance of American’s SABRE and switching costs, the fiercer the competition Covia’s Apollo in the market for airline to recruit uncommitted users and the reservation systems illustrates the larger the proportion of system benefits significance of strategic investment. appropriated by the intermediaries in the These systems are profitable, yet their long run. underlying technology could certainly be duplicated by a sophisticated On the other hand, the ability of switching intermediary. It is also unlikely that a new costs to create early mover advantage in entrant could legally be denied access to electronic marketplaces is mitigated by the needed information, and, subject to technological progress when technology contract-term limitations recently facilitating access to competitive systems established by the U.S. government, it becomes available or when the takes only 30 days for a travel agent to changeover to a new generation of the switch to a new reservation system technology offers an opportunity to switch (Hopper, 1990). The economics of the to a new intermediary. Similarly, the large communication networks and arrival of new potential users can spark massive transaction processing centers competition among intermediaries to required to support a CRS result in start- recruit these users to their systems; if
    • intermediaries cannot price discriminate competed away and the technology between new and existing users, their becomes a “strategic necessity” (Clemons ability to profit from switching costs is and Kimbrough, 1986). Sustainable significantly reduced. In view of mounting advantage based on information evidence that system participants are technology typically requires leveraging often able to overcome high switching unique resources that cannot be easily costs, an interesting topic for future replicated or leapfrogged by potential research in this area is the identification of competitors (Clemons and Row, 1987) or the switching costs imposed by different continuous innovation that will keep the types of electronic market systems on system a moving target beyond the reach their participants and the integration of of its competitors. In the case of these results with the economic theory of electronic marketplaces, specific industry switching costs. expertise, a locked-in customer base, or the ability to deal with certain Network externalities organizational and system complexities are promising areas to look for sustainable Electronic market systems with large advantage. installed bases create more value for their participants, who are provided with a Early movers may be stranded with a bad wider selection of potential buyers and technology and offer a system that soon sellers. These “network externalities” becomes obsolete, diminishing the create an early mover advantage (Katz advantage of their strategic investment. and Shapiro, 1985) because early movers Technological and market developments, enjoy the opportunity to build a larger such as falling processing costs and the installed base. Unless the technology increasing availability of software-defined evolves in a way that subsequently networks (SDNs) and the integrated penalizes early movers or removes services digital network (ISDN), may access barriers between different reduce the cost of the infrastructure systems, late movers are at a required to offer an electronic disadvantage. marketplace. Early movers may also find to their chagrin that technology has been Network externalities can interact with developed that reduces the switching switching costs to reinforce each other, costs they worked hard at imposing and increasing the aggressiveness of diminishes the role of the standards they intermediaries in the early stages of have established. Finally, a successful introduction and the advantage of early system enjoying network successful early movers. Network externalities may leave no alternative to externalities make established systems other industry participants but to form a more attractive to new users, reducing the coalition and offer a credible competing need for intermediaries to compete for system. these users on a price basis. This is significant because competition for Citibank, for example, was a leader in newcomers is one of the major checks in introducing automated teller machines the ability of intermediaries to exploit (ATMs) in the New York market. Its switching costs. extensive ATM network allowed it to lower its operating costs and played an Sustainability of early mover advantage important role in the revival of Citibank’s Individual Banking Unit, which enjoyed an Experience suggests that any advantage increase in its retail market share from 4 gained by moving early in offering an percent in 1977 to 13 percent in 1988. electronic market system will most likely However the strategic impact of this ATM create only a window of opportunity. network did not last long. Citibank’s Advantage based purely on technological commanding technological leadership sophistication is difficult to sustain induced the other major consumer banks because of the open and rapidly evolving to cooperate and offer a competing nature of the technology. When network of compatible ATMs. This seems interorganizational information technology to have left Citibank without a durable becomes commonplace, profits are advantage from its ATM network as its
    • competitors were able to match its This advantage is likely to persist as long installed base of ATMs (Glaser, 1988). as BZW’s coverage advantage can be maintained, a remarkable achievement in In the eastern Pennsylvania market, view of the fact that the deregulation of Girard Bank started installing ATM London's financial markets, known as the machines in 1975, and it soon introduced Big Bang, has resulted in a drastic its proprietary George ATM network, decrease of revenues for London expecting to capitalize on its traditional brokerage firms (Clemons and Weber, strength in the retail market. Philadelphia 1990b). Similarly, Bloomberg Financial National Bank (PNB) rapidly responded to Markets and the EJV group hope to Girard’s George ATM network with MAC, control real-time prices for bond issues its own ATM network; although PNB was traded outside the exchanges by virtue of not able to match George’s ATM base on their position as the major dealers in its own, it made participation in MAC several issues; if they succeed in available to other banks since MAC’s defending this control against regulatory initial launch. In 1982 Girard was challenges, their systems could enjoy a acquired by Mellon Bank of Pittsburgh; sustainable advantage compensating George was merged with Mellon’s them for the reduction in their trading Cashstream and evolved into a shared margins. ATM network as well (Clemons, 1990). Possibly as a result of the rapid responses Clemons (1990) proposed system in this market, these ATM networks topology as an important factor affecting generally did not provide any competitive the ability of electronic marketplaces to advantage to their participants, as generate profits for their operators; he confirmed in a study by Banker and argues that the point of customer contact Kauffman (1988); the systems had is a critical resource in determining the become a “strategic necessity.” appropriability of system benefits and the sustainability of these profits. In the airline reservations market, CRS Intermediaries are more likely to operators have lost their ability to impose appropriate system benefits, and to severe switching costs and have seen the sustain this appropriation, in systems benefit of network externalities dwindle where they control the market transactions because of government regulations and the access to customers (such as the limiting contract terms and requiring airline reservation systems); these airlines to equally provide their flight benefits will be less sustainable in information to all intermediaries. Malone, systems where the suppliers or the et.al. (1989) have argued that this ability customers retain control over individual to benefit from an uneven playing field transactions and provide themselves with tilted to the intermediary’s advantage will the link to the intermediary (as is the case eventually diminish in all electronic of inter-bank ATM networks). marketplaces; intermediaries who attempt to keep their customers at a disadvantage Role of information intermediaries will see their market share dwindle. Responding to this trend, an in an attempt Economies of scale and scope in the to sustain its competitive advantage development of electronic marketplaces through continuous innovation, American and in the provision of electronic Airlines is shifting its focus from CRS intermediation services may become an operation to superior utilization of the important element of the competitive information provided by the SABRE game. Four areas where such economies system (Hopper, 1990). may arise include the following (Bakos, 1991): (1) building and managing systems In the financial industry, Barclays de Zoete of substantial size and functionality relying Wedd (BZW) has leveraged its unique on complex communication networks, ability to provide coverage for the widest requiring large investments in sunk costs range of securities in the London market,. and specialized expertise; big It enjoys a sustainable advantage from its intermediaries can leverage this TRADE system for automatic order investment over a larger number of execution (Clemons and Weber, 1990a).
    • system participants; (2) system partners. For example, Texas Air has development which is often characterized agreed to sell to EDS 50 percent of its by a steep learning curve that allows the System One (the fourth-largest CRS) for development of subsequent systems at a over $250 million as part of an agreement smaller cost; (3) economies of scope, that would outsource to EDS the operation especially in development expertise, the of most of Continental’s computer sharing of operational facilities, and data systems. AT&T is negotiating with TWA, collection (where data collected during Northwest, and Delta for a piece of third- system operation becomes a valuable largest WorldSpan. Even AMR (the asset); and (4) network externalities as the parent of American Airlines) has indicated number of participants in an electronic a willingness to sell up to 50 percent of marketplace increases, the market SABRE, the largest CRS, at $15 million becomes more successful, providing more for each 1 percent, placing on it a total benefits (e.g., liquidity) to its individual value of $1.5 billion (Business Week, participants. 1990). The typical strategy to secure economies A substantial part of the economies of of scale and scope in intermediating scale and scope enjoyed by large electronic markets is to achieve dominant intermediaries comes from the computer market share in an industry or provide and communications networks underlying intermediation services across a number all electronic marketplaces. If access to of industries. As traditional technology the necessary infrastructure becomes with low entry costs is replaced by available, players with expertise in systems based on information technology, particular industries may introduce market which has large fixed costs, the new systems, resulting in a proliferation of economics of intermediation may favor such systems. The government- firms with access to a wealth of resources, sponsored infrastructure of the Minitel which can leverage their know-how in system in France illustrates this possibility, different industries and defray their having sparked thousands of development expenses among several intermediation services, ranging from systems. Firms with related matching buyers and sellers of vintage organizational and technological expertise wines to brokering industrial parts. are attempting to build on their customer bases, establish themselves as Similarly in the U.S. market, information utilities, and dominate the intermediaries like AT&T, MCI, SPRINT, provision of intermediation services. IBM, the regional phone companies (RBOCs) General Electric (through its GEISCO and other third party value added network subsidiary), and General Motors (through providers are increasingly offering access its EDS subsidiary) are emerging as major to their network infrastructures through players among the firms positioning to expanded telecommunications services, compete in this arena. such as high capacity switched digital services, ISDN, and complete customized These information intermediaries are likely network management. As network to enter individual markets in partnerships services become commodity offerings with with industry participants that can provide relatively low fixed charges, they are likely industry-specific expertise. Conversely, to cease being a major factor in the buyers and sellers in a number of provision of electronic market systems. industries are discovering that they cannot The advantage currently enjoyed by big develop these systems competitively intermediaries is thus likely to dissipate, without the help of a partner with systems except possibly in the offering of very expertise. Even well-established, complex large scale systems spanning sophisticated players like the providers of wide geographical areas. airline computer reservation systems are succumbing to this trend. As maintenance 6. Conclusion costs increase and systems require major upgrades to incorporate developments in This article focuses on the potential of communications and user interface electronic marketplaces to reduce buyer technology, airlines find that they need
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    • Stigler, G. "The Economics of Information." Journal of Political Economy, (69) June 1961, pp. 213-225. von Weizsaker, C. C. "The Costs of Substitution." Econometrica, (52) 1984, pp. 1085-1116. About the Author J. Yannis Bakos is assistant professor of managment at the Graduate School of Managment, University of California, Irvine. He received his B.S. and M.S. degrees in electrical engineering and computer science from MIT an dholds an M.S. in management and a Ph.D. from MIT's Sloan School of Management. He focuses his teaching and research on opportunities for the strategic use of information technology. He has special interest in the application of industrial organization theory to the study of interorganizational information system snad their competitive implications. Professor Bakos also tracks and forecasts developments in end-user computing and coporate information systems architectures, especially in view of advances in communication stechnology. He lectures primarily in the areas of coporate telecommunication networks, information systems outsourcing, and the use of infomation technology for competitive advantage.