Characteristics of Electronic Markets

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Characteristics of Electronic Markets ...

* This article has been accepted for publication and is forthcoming in the Handbook on Electronic

    Commerce, Springer-Verlag, 1999. Do no distribute or reference without author permission. ? Strader, 1998.

    Electronic Markets: Impact and Implications

    Troy J. Strader and Michael J. Shaw

    Department of Management, Iowa State University, Ames, IA, USA

    Department of Business Administration, and Beckman Institute for Advanced Science and

    Technology, University of Illinois at Urbana-Champaign, Urbana, IL, USA

In this chapter we survey the economic impact of electronic markets (e-markets). We

    identify and analyze examples of e-markets, the impact of e-markets on the structure of

    industries, buyer and seller cost differences for traditional and electronic markets, revenue

    source implications for sellers and transaction intermediaries, and determinants of e-market

    success. The overall issue addressed is whether there are economic incentives for electronic

    markets, or are they just a passing fad?

(Electronic Markets; Transaction Cost Economics; Information Economics; Industry

    Structure; Consumer Behavior; Business Strategy)

    1. Introduction

     Commercial transactions have taken place for centuries, but currently there is a revolution

    taking place that is transforming the marketplace. This transformation is occurring because

    the relationship between organizations and consumers is increasingly being facilitated

    through electronic information technology (IT). This is generally referred to as electronic

    commerce (e-commerce), with a major component of e-commerce being electronic markets

    (e-markets). The number of products available on-line is growing steadily, but not enough is

    understood about this rapidly evolving phenomenon. In 1996 the number of losers exceeded

    the number of winners by 2 to 1 for Internet commercial ventures (Rebello et al., 1996). A

    question that arises from the current growth of electronic markets is whether there are

    economic incentives for buyers and sellers to participate in them, or whether they are a

    passing fad. The purpose of this chapter is to address this issue.

     Past work has focused on the theoretical relationship, generally based on transaction cost economics analysis (Williamson, 1985), between IT and transaction governance (markets vs. hierarchies) (Bakos, 1991; Benjamin and Wigand, 1995; Gurbaxani and Whang, 1991; Malone et al., 1987; Malone et al., 1989; Malone and Rockart, 1991). Our study involves a cost-based economics analysis similar to previous work, but we compare traditional markets with electronic markets instead of markets with hierarchies. Williamson states that the economic institutions of capitalism (namely markets and hierarchies) have the main purpose and effect of economizing on transaction costs (Williamson, 1985). Our thesis is that, in many instances, electronic markets enjoy transaction cost advantages over traditional markets. Because of these transaction cost advantages we can expect a continued growth in online markets in many industries.

     The following sections describe the findings of our study. In Section 2 we present some examples of electronic markets to provide background for the remaining sections. The remaining sections describe the impact of e-markets from three perspectives: buyers, sellers, and other organizations associated with commercial transactions. In Section 3 we identify the impacts that e-markets have on industry structures. We discuss traditional retail industry structure, industry structure for non-digital product e-markets, and industry structure for e-markets associated with digitized products. In Section 4 we evaluate the characteristics of traditional and electronic markets from a buyer perspective. We derive a number of revenue implications for sellers and other organizations from this analysis as well as the analysis from the previous section. In Section 5 we evaluate the cost-based differences between traditional and electronic markets from a seller perspective. In Section 6 we discuss the impact that e-markets have on revenue sources for product/service providers, transaction intermediaries, Internet service providers (ISPs), and state and federal government. Finally, in Section 7 we identify some factors affecting the success of e-markets, and in Section 8 we discuss our overall conclusions.

2. Electronic Markets: Description and Examples

     The shift toward electronic commerce is revolutionary because it involves linking consumers to electronic marketplaces, not just electronically supporting hierarchical transactions within and between organizations (commonly referred to as the problem of enterprise integration). The involvement of consumers, in addition to product/service providers, dramatically increases the potential magnitude of change. A significant portion of the GDP is consumer transactions. As of the fourth quarter of 1997, more than 66% of the GDP was personal expenditures (Stat-USA, 1998). Past growth in enterprise integration systems missed these transactions. The revolutionary nature of electronic commerce provides adequate incentive to study electronic markets to increase our understanding of their impact on the market's participants, traditional and newly created industries, as well as the economy as a whole.

2.1 Electronic Market Description

     Electronic markets are the foundation of electronic commerce. They potentially integrate advertising, product ordering, delivery of digitizable products, and payment systems. An

    electronic marketplace (or electronic market system) is an interorganizational information system that allows the participating buyers and sellers to exchange information about prices and product offerings. The firm operating the system is referred to as the intermediary, which may be a market participant - a buyer or seller, an independent third party, or a multi-firm consortium (Bakos, 1991). E-markets provide an electronic, or on-line, method to facilitate transactions between buyers and sellers that potentially provides support for all of the steps in the entire order fulfillment process. The business process model from a consumer's perspective consists of activities that can be grouped into three phases: prepurchase determination, purchase consummation, and postpurchase interaction (Kalakota and Whinston, 1996). Each of these phases can be supported electronically in a complete e-market, but e-markets today generally support only the prepurchase determination activities, although they are moving toward more purchase consummation.

2.2 Electronic Market Examples

     A number of electronic markets are available to consumers to buy products ranging from music CDs to automobiles. The following are current examples of products and/or services that are available through electronic markets.

     Flowers. Calyx & Corolla have used e-commerce to radically alter the way new cut-

    flowers are moved from the growers to the consumers. Traditionally, the value chain that supplied cut flowers involved a grower, jobber to transport to a wholesaler, and finally a florist. From a survey of Boston florists in July 1995, the price, including delivery charge and tax, for an example arrangement of flowers was $60. Calyx & Corolla are able to provide an electronic market to customers to buy directly from growers with the flowers being shipped using Federal Express. Their delivered price is $54 (Applegate et al., 1996). Much of this is due to the elimination of some of the intermediaries between the growers and the customers. The price paid to the firm providing the electronic market is generally lower than the profits made by the traditional wholesaler and retailer intermediaries.

     Clothing. Similar to the cut-flower example, is an example in the shirt industry. The cost

    per high quality shirt in a value chain that includes a wholesaler and retailer is $52.72. The elimination of these intermediaries reduces the cost to $20.45, a reduction of 62% (Benjamin and Wigand, 1995).

     Automobiles. Thanks to the World Wide Web, new car shoppers have more options,

    including access to valuable information, such as what a car really does cost a dealer. As a result, consumers are increasingly locking in better deals online. What’s more, the trend has

    attracted the attention of some of the biggest car dealers, financial institutions and insurance companies. Electronic markets now exist than enable consumers to shop for and buy a new car, insure it and take delivery without ever setting foot in a dealership (Calem, 1996). A search of the directory of automobile dealers on Yahoo in late 1996 showed that 79 different dealers or locator services were listed (Yahoo).

     Music. Jason and Matthew Olim founded CDnow Inc. from the basement of their Ambler,

    Pennsylvania home. Jason Olim, a jazz fan frustrated by skimpy selections in music shops, came up with the idea of a cyberstore that could offer every jazz album made in the U.S. and 20,000 imports. Shoppers place their orders with CDnow (, which, in turn, contacts distributors. Most disks are delivered to the customer’s door in 24 hours. Add in

advertising revenues, and CDnow expects to hit $6 million in sales in 1996, triple the

    previous year’s revenue, with 18% operating margins (Rebello et al., 1996).

     Books. Books are another product that consumers purchase on-line. One bookseller on

    the Web is Books. Their site advertises a spotlight book, book of the day,

    titles in the news, featured books, and books that are hot this week. Some of their books are

    discounted as much as 30%. By clicking on book titles, and some authors, more detailed

    information can be accessed (Amazon). It is no longer necessary to either go to a bookstore

    to buy a book or to find mail order bookstores through a print advertisement. Also, Web

    advertising is likely to be more current than print ads.

     Electronic Magazines (E-zines). With no printing or circulation costs, online magazines

    once held the promise of low overhead and quick profitability. Now most Web publishers

    have amended their business models and expect years of losses before turning a profit a

    model much closer to print publications. Though analysts and publishers expect mainstream

    advertisers to up their antes in Web ads, most e-zines are exploring alternative ways of

    making money in the short term, including sponsorships, alliances and even subscriptions.

    Most online publishers have a rosy outlook now that the Internet has become a media focal

    point and mainstream advertisers better understand the Net. Jupiter Communications, a

    New York-based Internet research company, predicts that the total number of online

    consumers will jump from 13 million in 1996 to more than 35 million in 2000. Adam

    Schoenfeld, vice president and senior analyst at Jupiter, said that the universe of ad dollars

    online both on the Web and on dedicated online services would grow to $5.3 billion by

    2000 (Glaser, 1996). A growing number of online consumers, as well as a growing amount

    of Net based ad money, provides an environment where electronic magazines with good

    content may flourish in the future.

     Airline Tickets. Discount airfares you won’t find anywhere else are popping up on the Internet. American Airlines and Cathay Pacific Airways are using their Web sites to reduce

    the thousands of seats that are unsold on flights every day. American began selling fares on

    20 routes as much as 70% below the lowest fares consumers would be quoted through a

    travel agent or American’s 800 number. Besides filling empty seats, airlines want to cut

    distribution costs by selling directly on the Internet instead of through travel agents (Rosato,


     Stock and Securities. All of a sudden, innovations in technology, particularly the Internet, are bringing profound changes to Wall Street that hold a lot of promise, and a lot of

    peril, for the powerful firms that make their money in the securities business. For many

    people, the Internet could replace the functions of a broker. For example, almost a dozen

    small companies are trying to sell their stock directly to the public using Web sites like those

    run by Direct Stock Market and IPO Data Systems. And two small California companies,

    Real Goods Trading and Perfect Data, have set up electronic bulletin boards that allow their

    shareholders to trade stock without a broker, dealer or market maker. Because it allows

    traders to find each other easily, the Internet may ultimately make it possible to have a stock

    exchange that exists only in cyberspace, with no trading floor, directly open to every investor

    with a computer and a modem (Eaton, 1996).

     Three sets of issues and research questions arise from an analysis of these examples. First,

    what is the impact that electronic markets have on the costs relevant to a consumer’s choice

between traditional retail markets and electronic markets? Second, what is the impact that

    electronic markets have on seller costs, as well as the structure of the value chains needed to

    provide products? And third, what impact do electronic markets have on other organizations

    involved in commercial market transactions? These three issues are addressed throughout

    the remainder of this chapter. 3. Impact of Electronic Markets on Industry Structure It is apparent from the examples above that the diffusion of electronic markets in an

    industry has an impact on the structure of the value chain involved in supplying the products

    and/or services to the final consumers. This is mainly due to the disintermediating effect of

    information technology identified by Davenport in his research on business process

    reengineering (Davenport, 1993). Although, in some instances, intermediaries may be

    added to transactions facilitated through an electronic market. Based on the examples above

    we have identified two phases that industry structures potentially go through as electronic

    markets diffuse across the industry. The degree of change is determined by features of the

    industry and its products. This is discussed in more detail at the end of this section.

     An example of a traditional market is shown in Figure 1. The industry transformation

    phases are described in relation to this example.

    MarketSeller 1Information

    ExchangeSeller 2


    Seller 3

    Product Distribution Network



    Figure 1. Traditional Market Industry Structure

     In a traditional market (for a non-impulse purchase), the customer searches out

    information about the products available and their prices, quality and features. This

    information comes from a wide range of sources including advertising, traveling to retail

    stores, and so forth. At some point they stop their search because they realize further

    searching will probably not benefit them. Once the information gathered has been analyzed, the consumer decides where to buy the product. The product is then either purchased and transported home by the customer or is delivered to them through a distribution network.

     Electronic markets affect the consumer purchase process. The first phase in the transformation of the structure of an industry is the digitization of the market mechanism. This is described in Figure 2.

     Seller 1

    ElectronicSeller 2Market


    Seller 3

    Product Distribution Network



Figure 2. Industry Structure with an Electronic Market

     An electronic market provides a mechanism for reducing the search costs (money, time and effort expended to gather product price, quality and feature information) for consumers. The phenomenon “search” can be described as a buyer canvassing various sellers to ascertain the most favorable price (Stigler, 1961). Search also reduces the likelihood that sellers will be able to charge significantly higher prices than their competitors because the consumer is unaware of the other prices (a form of regional oligopoly or monopoly). The result is that consumers can buy products for lower prices, intermediaries such as wholesalers are eliminated from the value chain, a new industry that provides access to electronic markets is created, and firms that produce products are able to maintain a profit margin comparable to the traditional markets.

     The second phase in the transformation of the structure of an industry is the digitization of the product itself as well as its distribution. Examples of digitizable products include books, newspapers, magazines, computer software, movies and music. These products involve a cost structure with increasing returns and low marginal reproduction costs. Increasing returns accrue when a business incurs large up-front expenditures to develop a new product/service and the incremental cost of producing each new unit is minimal (Hagel and Armstrong, 1997). For example, if a consumer wants a new version of Navigator software

    from Netscape, the software can be downloaded from one of their sites on the Internet (Netscape). This eliminates the need for Netscape to maintain an inventory of software on CDs or diskettes that must be physically shipped to the consumer. Another example would be either evaluating or purchasing anti-virus software from McAfee (McAfee). If a software company charges for their software then they can receive payment before the software is allowed to be downloaded. This can be especially easy as electronic payment methods become more widely used in the future. This further transformed industry structure, that results from the digitization of products and their distribution, is described in Figure 3.

     Seller 1


    Market andSeller 2Distribution


    Seller 3

    Information and

    Digitized Product

    * convergence of marketing, order

    processing, distribution, payments

    and product development

    Figure 3. Industry Structure with an Electronic Market and Distribution Network

     The electronic market and distribution network enables a wide range of seller and customer activities to converge into one place including marketing, order processing, distribution, payments and even product development processes that involve several separate firms. This makes these activities easier and more convenient while also reducing the costs involved. Value chain costs can be further reduced by digitizing the industry’s product. Examples of digitizable products were given earlier. Digitization of the product reduces inventory and packaging costs. Digitized products can then be distributed electronically to the consumer which minimizes distribution costs which would otherwise be paid to the firms in the distribution network and passed on to the final consumer. These cost-based differences are discussed in more detail in Section 5. Beyond the cost benefits, cycle time for order fulfillment is minimized which may result in improved customer satisfaction. Digitized information can be distributed in minutes while shipping a product generally takes days (or longer to some parts of the world). The characteristics of the phases in the transformation of industry structures enabled by e-markets are summarized in Table 1.

Table 1. The Phases of Industry Structure Transformation Enabled by Electronic Markets

     Traditional Market Electronic Market Electronic Market and

    (example: retail store) (Phase 1) Distribution (Phase 2)

    Required Transactions that do Accepted standards for Description standards industry not require describing the product plus product that is characteristics hierarchical through the electronic feasibly digitized

    governance market

    Market No Yes Yes digitized?

    Product and No No Yes distribution


    Examples of Wholesalers and some Phase 1 intermediaries intermediaries forms of brokers (ones plus firms in the removed that simply gather and physical distribution

    analyze information network

    for consumers) Examples of Firms that provide Phase 1 intermediaries

    intermediaries access to the electronic

    added market (ISPs or firms

    that operate electronic

    markets or electronic

    auctions) and possibly

    new forms of brokers

    (such as online better

    business bureaus)

     The overall impact of electronic markets on industry structures is not strictly cost

    reduction and disintermediation. It is more complex than that. New intermediaries and costs

    may be added to a value chain, but in many instances the potential benefits outweigh these

    costs. In the next section we discuss a model that identifies costs relevant to differentiating

    between traditional and electronic markets from a buyer perspective.

    4. Traditional and Electronic Markets: Buyer Cost Perspective

     Electronic markets provide buyers with an additional sales channel through which they

    can buy products. Although there may be certain benefits derived by buyers in electronic

    markets (lower prices and search costs), it also increases the complexity of their decision

    process by adding another option to consider. It may also add new forms of consumer risk.

In this section we describe a model to compare the cost-based differences between traditional

    markets (such as retail stores) and electronic markets.

4.1 Buyer Perspective Relevant Costs

     From the consumer perspective (demand side of a transaction), the potentially relevant ), Bcosts that we have identified include: 2. search costs (SC), B 3. risk costs (RC), B1. product price (P4. distribution costs (DC), B

    5. sales tax (T), and B

    6. market costs (MC). B

     The product price is the sum of the production costs, coordination costs, and profits of the

    value chain that provides the product or service. Search costs include the time, effort and

    money involved in searching for a seller who has the product demanded at an acceptable

    price with acceptable product features and quality. The cost of the time and effort involved

    would be determined by the value the buyer places on their time and effort. Risk costs

    include the costs involved in minimizing transaction risk as well as the costs associated with

    losing value in a transaction. The risk dimensions typically considered are economic risk,

    performance risk, and personal risk (Simpson and Lakner, 1993). Economic risk stems from

    the possibility of monetary loss associated with buying a product. Performance risk

    represents the consumers’ perception that a product or service may fail to meet expectations.

    Personal risk relates to the possibility of harm to the consumer resulting from either a

    product or the shopping process. An additional form of risk that is potentially important to

    Internet shoppers is privacy risk. Privacy risk reflects the degree to which consumers

    envisage a loss of privacy due to information collected about them as they shop (Jarvenpaa

    and Todd, 1997). Additional costs of concern include distribution costs, the costs associated

    with physically moving the product from the seller to the buyer, and sales tax. Market costs

    are the costs associated with participating in a market. Traditional markets are assumed to

    be costless to the buyer, while e-market costs may include fixed access costs and/or

    transaction (variable) costs paid to the firm(s) that operate the e-market.

4.2 Comparison of Buyer Costs in Traditional and Electronic Markets

     Assuming rational decision making, the buyer’s objective is to minimize the sum of the

    individual costs subject to the constraints that the product quality and features, including

    how soon the product can be received, must be acceptable. Figure 4 summarizes the findings

    of our evaluation of the costs relevant to a buyer’s choice between traditional and electronic



     Market MarketPB






Figure 4. Comparison of Buyer Costs in Traditional and Electronic Markets

     Prices in electronic markets are generally lower than in traditional markets. If they were higher then there would be little incentive for consumers to switch to the newer e-markets. One explanation for why prices are lower is that search costs are lower. It is generally easier to gather relevant information, and compare a wider range of prices, in on-line environments. This is especially true as the number of products offered online increases. In traditional retail markets a buyer would have to either drive around town or call several sellers. This takes more time and costs more. Given this additional information in the e-market, buyers are likely to be able to find a price that is lower than in a traditional market. The question then is why aren’t all products purchased in e-markets? One reason is that there are

    additional risks associated with buying online. It is apparent that buyers have incentives to participate in e-markets. These on-line markets provide access to specialized knowledge, fulfill the need to communicate with sellers, allow them to find and talk to other buyers with similar needs or experiences, enable access to multimedia information, allow participation at their convenience, integrate the consumer process, and enable sellers to tailor their products to individual needs (Champy et al., 1996). Given that there are incentives for buyers to participate in e-markets, the next issue is whether there are incentives for sellers to participate. Without any sellers in the e-market there would be no transactions.

    5. Traditional and Electronic Markets: Seller Cost Perspective

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