e-business basics - transaction costs
It is interesting to note the ways in which eBusiness is driving down the costs of transactions, as it is relatively easy to check prices (price discovery) and then to transact the deal on-line; of course these are two of the key attractions of eBusiness. These phenomena challenge some of the economists’ key notions about firms. However, with a little consideration, it can be seen that established economics models can deal with eBusiness, it is just that some of the rules of the game have changed.
Participation in many markets is no longer the sole preserve of large firms, which used to be the only organisations that had the necessary resources and know-how. Indeed, eBusiness can lead one can question the need for large firms at all.
Useful insight can be gained from the work of Ronald Coase (1937), which describes transaction costs, arguing that firms exist precisely because these costs were reduced compared with conducting these key tasks in the open market.
“In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.”
(Coase, R. 19371)
To summarise Coase’s article, these transaction costs are:
- Search and information costs
Most of us have experience of using services like eBay, Google and Kelkoo to check out prices for a range of goods and services within a few minutes. This simply was not possible before the Internet, and seeking out suppliers, product details and prices would have entailed telephone calls, writing for catalogues or perhaps looking at lists and advertisements in trade magazines.
Search and information are two of the key abilities and enablers of eBusiness. Major websites such as Google, Amazon, Ebay and BBC depend heavily upon a search engine that represents a main differentiator from ‘old economy’ businesses that sold advertising, books and videos, auctions or news. Information itself, by being ‘digitised’ can be distributed more cheaply and efficiently and old information that was perhaps uneconomic to maintain in printed form, can still yield revenues.
Evans and Wurster (2000) describe ‘Navigation’ as being characterised by: abundant connectivity, common information standards, infinite choice, negligible searching and switching costs, fluidity (tasks or functions can be achieved in different ways or with different combinations of participants), and lack of a centre which all adds up to a system that is more like an ‘eco-system’ rather than a traditionally engineered system. They see that there is no longer any reason that a physically defined industry would continue to enjoy the privileged position of offering the ‘navigation’. If the navigation function drives a large portion of competitive advantage, then a business loses control of a main source of profit if the navigation is recast as a separate entity.
- Bargaining and decision costs
Marketplaces, auction sites and simple online stores enable buyers and sellers to agree a deal and to transact it quickly. In the past, businesses would have had to rely on credit references (which may still be advisable), personal introductions and so on, and might then spend some time meeting or on the telephone to agree a deal. An individual in one country can now agree a deal on eBay with someone in another country based on his or her feedback ratings and then make and receive payment instantly.
A process that is potentially more efficient and viable with e-Business reduces bargaining and decision costs. Price discovery, necessary for perfect competition, becomes far more easily accessible through comparison-shopping, portals and industry marketplaces. This is possibly a double-edged sword for retailers, many of which have competed solely on price, but it has surely been the driver of much of the early on-line shopping volumes. Auctions (e.g. eBay) and Dutch Auctions (e.g. Letsbuyit.com) have created a market with millions of private and commercial participants who are able to trade worldwide from their own p.c. The following quote from eBay gives an illustration of the sheer scope of their business.
“EBay’s mission is to provide a global trading platform where practically anyone can trade practically anything. Our Marketplace: On any given day, there are more than 12 million items listed on eBay across 18,000 categories. In 2002, eBay members transacted $14.87 billion in annualized gross merchandise sales (GMS, the value of goods sold on eBay).” http://pages.ebay.com/community/aboutebay/overview/index.html
A look at eBay’s 3rd quarter 2006 results shows that the above figures have grown approximately five-fold since 2002, with 60 million items for sale and 212 million users accounting for 13% of global Ecommerce.
- Policing and enforcement costs.
eBusiness gives rise to its own set of problems for regulation and enforcement, especially with regard to intellectual property rights, which will be dealt with in a separate learning note. However, services like eBay have largely automated their systems for policing and enforcement and actually rely on their members to point out instances of fraud or other bad practice.
Low marginal costs
In some kinds of eBusiness, the marginal cost of serving a customer can tend to zero, especially when the product or service is delivered as a download – a good example would be supply of software. Development costs can be spread across many millions of copies which are then downloaded online and for which the firm pays very little in telecommunications charges.
Such business models are likely to have high fixed costs and very low variable costs. This means that there is much to be gained from market domination. There is also likely to be scope for price discrimination, if the firm is able to separate customers into separate groups that are willing to pay different prices.
Asymmetries of information
One of the classical causes of market failure is ‘asymmetries of information’ in which parties with access to poorer information are disadvantaged by the effect of higher costs. Evans & Wurster (2000) cite the example of motor dealers that traditionally had sole access to market prices and other information that would be useful, such as data on reliability and customer satisfaction, yet this was not freely available and integrated into the buying process.
In the market for relatively new used cars, in which quality and specifications are reasonably consistent, on-line services have been developed that help consumers decide what to buy, and to seek the best deal for the vehicle they want. This is an example, in economics terms, of eBusiness reducing asymmetries of information as a cause of market failure in some industries or sectors.
Price discovery remains a challenge and in one study, the difficulty in establishing true prices including delivery and taxes was cited as the biggest frustration found by some consumers, although the biggest attraction of electronic commerce was nevertheless the speed of searching for products (Malaga, 20012).
1Coase, R. (1937): The Nature of the Firm Economica Nov 1937 Vol 4 no.16 p 390
2Malaga, R, (2001): Consumer Costs in Electronic Commerce: An empirical Examination of Electronic versus traditional markets, Journal of Organizational Computing and Electronic Commerce, Volume 11, Number 1 (March 1, 2001). Pp 47-58
Author: Steve Whiteley, January 2007
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