transaction costs in the information age: the impact of information and communcation technology on...

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T R A N S A C T I O N C O S T S I N T H E

I N F O R M A T I O N A G E

THE IMPACT OF INFORMATION AND COMMUNCATION

TECHNOLOGY ON MARKETS, HIERARCHIES,

AND INTERMEDIARIES

E.METSELAAR

9222758

Supervision: Drs. C. Metselaar

University of Amsterdam

Social Science Informatics

Thesis, August 1998


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TABLE OF CONTENTS

1 INTRODUCTION ................................................................................................ 1

2 TRANSACTION COST THEORY ........................................................................... 3

2.1 CLASSIC TRANSACTION COSTS .............................................................. 32.2 INTERMEDIARIES AND TRANSACTION COSTS ............................................ 42.3 NETWORK ORGANISATIONS: MARKETS OR HIERARCHIES?......................... 6

3 TRANSACTION COSTS IN THE INFORMATION SOCIETY........................................... 9

4 THE OPTIMAL NUMBER OF SUPPLIERS.............................................................. 11

5 THE ROLE OF THE INTERMEDIARY.................................................................... 14

5.1 ELECTRONIC MARKETS THROUGH INTERMEDIARIES ............................... 165.2 PREDICTIONS FOR ELECTRONIC MARKETS ............................................. 17

6 THE ROLE OF NON-SPECIFIC ASSETS ............................................................... 19

7 DISCUSSION ................................................................................................. 20

6 REFERENCES................................................................................................ 22


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1 INTRODUCTION

Anyone who wants to form a business to deliver information will have the means of reaching customers. And anyperson who wants information will be able to choose among competing information providers, at reasonable pric-

es. Thats what the future will look like say, in ten to fifteen years.

Al Gore, Vice president of the United States (in Wigand & Benjamin, 1993)

Considerable changes are taking place in the eco-

nomics of marketing channels, patterns of physical

distribution, and the way economic activity is organ-

ised. These changes are in large part caused by the

emergence of information and communication tech-

nology (ICT) and the growing importance of the In-

ternet. However, the exact relationship between ICT

and economic organisation is still subject to a lot of

research and speculation. The theory of transaction

cost economics provides a foundation for empirical

research and theory building in this area.

The predictions made by Malone, Yates, and Ben-

jamin (1983) have led to a lot of reactions from

scholars in this field. In their article Malone et al.

predict ICT will decrease transaction costs, and this

will lead to increasing reliance on co-ordinating eco-

nomic activity through market mechanisms in stead

of hierarchical relationships. In this thesis these pre-

dictions are further investigated. The question that is

going to be answered is: How does ICT influence

the co-ordination mechanisms in the economy?

Transaction cost theory and the predictions that are

derived from this theory by Malone et al. (1987) form

the main theoretical foundation that is used in find-

ing an answer to this question. The influence of ICT

on the forming of markets and hierarchies is investi-

gated and the role of the intermediary in the elec-

tronic world will be examined.

The first chapter of this thesis explains some of the

underlying ideas that have led to predictions about

the changes that ICT will bring. Firstly classical

transaction costs are explained, the dichotomy be-

tween markets and hierarchies is introduced, and

some definitional problems concerning transaction

costs are explored.

Chapter two starts with predictions that are made

about the effect of ICT on markets and hierarchies.

These are derived from applying transaction cost

theory to the electronic world. It is assumed that

transaction costs will be very low in the future, due

to ICT.

The predictions that are made are then further in-

vestigated in the following chapters. Firstly the elec-

tronic market versus electronic hierarchy debate will

be considered, with ideas about the optimal number

of suppliers and about virtual organisations. We

show that there are not only economic arguments

that determine the amount of suppliers considered

by a company, but also there are other factors that

play a very important role.

Secondly the role of intermediaries in the electronic

age is investigated. We argue against the idea that

there are only two options: classic intermediaries will

disappear or they will grow in number. In stead four

possible scenarios for the future of intermediaries

are suggested. Moreover, by pointing out the added

value intermediaries might have in a transaction, we

will show that the role of the intermediary is just as

important, and maybe more so, in the electronic

world.


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Thirdly, we will concentrate on a point of critique on

the transaction cost theory. The critique is aimed at

the role of asset specificity in transaction cost theo-

ry. This critique also has big implications for the

predictions that were done by Malone et al. (1987).

In the final chapter, the arguments that were not in

correspondence with earlier predictions are summa-

rised. The implications are outlined, and sugges-

tions are made for future research.


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2 T RANSACTION COST THEORY

Networks are the fundamental stuff of which new organisations are and will be made.

Manuel Castells in The rise of the network society (1997, p. 168)

2.1 CLASSIC TRANSACTION COSTS

As early as in 1937 Coase pointed out that there are

two distinct ways in which economic activity can be

organised. On the one hand there is the market, in

which resource allocation is taking place through

changes in relative prices. On the other hand there

is the firm. Here, resource allocation is guided by

entrepreneurial decisions. Normally, these decisions

take the form of command, directions or, more gen-

erally, authority. This authority is what the firm (or

hierarchy) distinguishes from the market. The ex-

planation given by Coase for the fact that firms exist

lies in the fact that market transactions have a cer-

tain cost aspect, which might be reduced in a firm

(Pitelis, 1993).

Williamson (1975) extended Coases original ideas,

by developing a more precise framework in which

the term market costs was eventually replaced by

transaction costs. Transaction costs are all the costs

that are made for the delivery of some good or ser-

vice, except the actual production costs. This means

that all costs for finding the right supplier, negotiat-

ing about prices, creating contracts, and controllingthe execution of the contracts belong to transaction

costs. Some authors refer to co-ordination costs in

stead of transaction costs (Bakos & Brynjolfsson,

1993; Kay, 1993). According to Bakos and

Brynjolfsson: ...the cost of setting up a relationship,

search costs, and transaction costs, ... can be col-

lectively labelled: co-ordination costs (1998, p. 3).

It is however remarkable that they do not give a

clear description of what transaction costs actually

are. Apparently they are part of co-ordination costs,

because if search costs and the cost of setting up a

relationship are added to transaction costs, the en-

compassing term co-ordination costs is introduced.

Some scholars are clearer on this point. Kay (1993)

points out that the term transaction is rather ambig-

uous in Williamsons theory. He proposes to use

both the term co-ordination and transaction. He re-

lies heavily on the original ideas of Coase, citing:

within the firm ... in place of the complicated market

structure with exchange transactions is substituted

the entrepreneur - co-ordinator, who directs produc-

tion. It is clear that these are alternative methods of

co-ordinating production. (Coase, 1937, in Kay,

1993, p. 257). Kay further proposes to use the term

transaction costs for exchange relationships, and

co-ordination costs in other cases. It would then be

possible to study co-ordination cost economics, en-

compassing costs of organisation as well as ex-

change costs.

This critique is mainly aimed at the fact that William-

son sometimes uses transaction costs in the sense

of exchange costs in market and hierarchy situa-

tions. This means that Williamson sees transactionscost economics as a study of internal markets ver-

sus external markets, whether capital markets, la-

bour markets or intermediate product markets. Ac-

cording to Kay this is a distorted representation of

hierarchy (1993, p. 256). If Kay refers to the original

definitions that were given about hierarchies, where-

in authority plays an important role, he is right. If

authority is first given as the factor that distinguishes

markets from hierarchies, it is rather strange to sug-

gest that internal versus external markets form the


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difference. However, it seems like Kay means

something else by the distorted representation. In

his opinion, it is simply almost never the case that

internal markets exist. For now, we leave this dis-

cussion for what it is, and go on trying to explain

transaction cost theory. We will use the term trans-

action costs and co-ordination costs interchangea-

bly, focussing on the factors that are the cause of

transaction costs.

Transaction costs arise as the result of three human

and environmental factors (Williamson, 1975):

1. Bounded rationality: This means it is impossi-

ble to be sure that all information about a cer-

tain market is available. When one has to

choose for a certain supplier in a market, there

is always the chance that a better supplier ex-

ists, but was not found. Another situation could

be that it is sometimes impossible to decide

whether for example service, quality of goods,

or delivery speed is actually going to be satis-

fied by the supplier. This becomes even a big-

ger problem when the product information is

rather complex (Malone et al., 1987).

2. Opportunism: Suppliers will bargain for higher

prices than absolutely necessary, because

(they claim) they are the only one who can de-

liver the requested goods or services.

3. Asset specificity: Some goods are so depend-

ent on space and time that they will become

more expensive then expected. Agents will in-

vest in specific assets, which they tend to lock

into transactions by generating sunk costs and

thus high costs of exit. They will use this posi-

tion for bargaining. An example of asset speci-

ficity is site specificity. If a natural resource is

available at just one location and is only mov-

able at great cost, this natural resource can be

called site specific.

All these factors might lead to high transaction costs

in markets. In hierarchies however, these three fac-

tors play a less important role because a reduction

in the number of exchanges and the ability to use

authority to end prolonged disputes in a certain ex-

change. This does not mean that there are no

transaction costs at all in hierarchies, they are just

lower. However, if it the transaction costs in markets

become lower than in hierarchies, no more internali-

sation will occur (Williamson, 1975). One could for

example imagine a marketing department in search

of new customers that will become too expensive

compared to marketing agencies in the market.

Ciborra (1993) explains the existence of these two

organisational forms by making a distinction be-

tween goal congruence and product/service uncer-tainty. If both are low, markets appear, if both be-

come higher, markets will shift towards hierarchies.

Ciborra adds clans to the classical dichotomy as

the organisational form that appears when both fac-

tors become extremely high. Companies with clans

as the predominant form of organisation rely heavily

on agreements made between members of teams.

This means that they surpass the authoritative or-

ganisation principle that forms the basis of hierar-

chies. Clans will not be considered in this thesis.

Despite the vast amount of critique the transaction

cost approach has evoked, the theory has been

(and still is) often used for theorising as well as em-

pirical research in the field of organisational theory

and economics (Pitelis, 1993). This has not only

been concentrated on the market-hierarchy dichot-

omy, but also on the role of the state, the rationale

of international firms, the role of intermediaries in

the market, and the effects on organisations in the

information society (Malone, 1987; Pitelis, 1993).

2.2 INTERMEDIARIES AND TRANSACTION

COSTS

In some situations, markets are co-ordinated by so-

called market makers or intermediaries. These in-

termediaries are the main co-ordinators of the mar-

ket. They bring together sellers and buyers, serving

as sales channels or distribution channels.


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Transaction cost theory is often used in the explana-

tion of the role of intermediaries. Companies have to

choose whether to make or buy a certain channel

activity. In other words, they have to decide between

internalising channel activities within the organisa-

tional boundary or rely on the market (Sarkar, But-

ler, & Steinfield, 1993).

The, rather abstract, description of intermediaries

above is however not complete. They do not just co-

ordinate the market, by bringing demand and supply

together, they also create added value for different

parties in the process, by bearing some parts of the

transaction costs. Cutting these costs up in different

parts shows this.

Intermediary functions that benefit consumers in-

clude assistance in search and evaluation, needs

assessment and product matching, risk reduction,

and product distribution/delivery. Intermediary func-

tions that benefit the producers include creating and

disseminating product information, reducing expo-

sure to risk, and reducing costs of distribution

through transaction scale economies. Finally, pro-

ducer and consumer interests are often in conflict,

and intermediaries might balance and integrate the-

se interests (Sarkar et al., 1993).

We will now give a more detailed description of the-

se functions (after Sarkar et al., 1993).

Benefits for consumers:

Search and evaluation: A consumer choosing

between different sorts of intermediaries, actu-ally chooses between alternative search and

quality criteria. For example, choosing a de-

partment store over a speciality store repre-

sents a choice between two different quality

and search standards. The department store

has more variation, but overall less quality,

while the speciality store has less variation, but

(presumably) more quality.

Needs assessment and product matching: Cus-

tomers often do not know exactly what their

needs are. An intermediary might be helpful in

determining these needs. Examples are hard-

ware stores, who make it their task of providing

information about the products, but also about

the usefulness of the product for the customer.

Customer risk management: By providing con-

sumers with the option to return faulty products

or providing additional warranties, intermediar-

ies reduce the customers exposure to the risks

associated with producer error. Additionally, the

intermediary may further reduce the risk by

providing the option to return a product for anyreason at all. The intermediary thereby reduces

the risk of failure to identify needs accurately or

failure to match them with the characteristics of

different products.

Product distribution: Distribution is critical in

determining the value of consumer goods. It is

evident that certain products only have value if

they are close enough in the vicinity of the pur-

chaser.

Benefits for producers:

Product information dissemination: Intermediar-

ies inform consumers about existing products

and the appearance of new products. Produc-

ers rely on several intermediaries, like tradition-

al retail stores, catalogue and mail order hous-

es, advertising agencies, and media outlet to in-

form consumers. Sometimes the role as distrib-

utor and information provider are tightly linked,

as in traditional retail.

Purchase influence: Intermediaries have sever-

al means to influence consumers purchasing

behaviour. Some of these are: product place-

ment, biased advice, commission compensation

schemes, shelf space payments, and special

discounts.


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Provision of customer information: Intermediar-

ies are able to provide detailed information

about customers. There are even intermediar-

ies that have specialised themselves in collect-

ing and analysing customer information, like

market research firms. If producers can not get

any specific information about customers, the

aggregated sales numbers from the intermedi-

aries still is valuable information.

Producer risk management: The risk of con-

sumer fraud and theft can be lessened by the

use of intermediaries. Normally the intermediary

is exposed to the direct risks of fraud and theft.

Economies of scale: Finally intermediaries give

easy possibilities for economies of scale. Pro-

ducers in search of buyers for their products are

best off by turning to an intermediary that pro-

vides a big potential client base.

Integration of needs

Intermediaries deal with the problems that arise

when consumer interests conflict with those ofproducers. These tensions are very likely to

arise in almost all market situations. For exam-

ple, consumers are best off with complete, ob-

jective information about the products. Produc-

ers however, would prefer to influence the con-

sumers purchase decision, by working in a bi-

ased market. Intermediaries often determine

the balance between the consumers need for

information and the producers need for influ-

ence.

It should be noted that producers do not perform all

the functions that are beneficial for the consumer.

Being aware of this, lots of producers will use inter-

mediaries, not just for their own sake, but also for

the customer.

It is clear that significant (transaction) costs are as-

sociated with the functions described above. This

means that some of the transaction costs that exist

in a direct producerconsumer relationship are

transferred to the intermediary. The intermediary will

however make money from the margins he charges

to the consumers. Also, many intermediaries are in

the position to charge a fee to producers for their

services.

2.3 NETWORK ORGANISATIONS: MARKETS OR

HIERARCHIES?

It seems like the notion of virtual organisations has

been around for quite a while. Toffler (1980) already

struggled with the terminology that had to be applied

to this new organisational form. We do not yet have

a vocabulary for describing these organisations of

the future (p. 264), so he claims. Nowadays there

seems to be a number of interrelated terms for the-

se organisations: virtual organisation, network-

based forms of organisation or simply network-

organisation. These terms will be used interchange-

ably throughout this thesis.

Virtual organisations provide businesses with oppor-

tunities to enter new markets, gain strategic ad-

vantage and reduce transaction costs (OTA, 1994).

Additionally these organisations can benefit from

greater flexibility and responsiveness, stronger

managerial control, and reduced production costs

(Mowshowitz, 1997). What do these organisations

look like and how do they fall into the dichotomy of

markets and hierarchies, if at all?

Definitions of a virtual organisation include a basic

set of ideas: outsourced non-core competencies; a

focus on core strength/business; little or no physicalpresence or traditional infrastructure; a network of

business alliances; optimal use of human capital;

and a heavy reliance on ICT. Virtual organisations

have outsourced the physical and administrative

attributes of traditional business, and expanded and

combined intellectual activities such as problem

solving (Asteroff, 1998). Figure 1 shows how a vir-

tual organisation can be distinguished from a fully

integrated firm.


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It should be noted that companies that only do busi-

ness through the Internet, without having retail out-

lets, are not necessarily virtual organisations (like

Amazon or CDNow). These companies can have a

strong infrastructure, in-house Web hosting, invento-

ry stockpiles and a lack of an outsourcing strategy. It

is more appropriate to label these organisations as

internet-centric, because the Internet is their only

sales channel (Asteroff, 1998). To be able to trans-

fer old-fashioned transactions to the Internet, it is

necessary to capture the rules that the business

processes are build on. Only recently this trend has

gained attention and this will probably be one of the

main issues for future corporations who want to start

using the Internet for their transactions (Hurwitz

Group, 1997; Wentholt, 1998).

In Mowshowitz opinion, virtual organisations are

able to explore and track the abstract requirements

needed to realise some objective while simultane-

ously, but independently, investigating and specify-

ing the concrete means for satisfying the abstract

requirements (Mowshowitz, 1997, p. 33). He labels

the dynamic technique for accomplishing all this

switching. Switching is only possible when the core

firm has a pool of suppliers, designers, etc. to

choose from.

Castells (1997, p. 191) identifies five kinds of net-

works or virtual organisations:

Supplier networks: these include subcontract-

ing arrangements between a client (the focal

company) and its suppliers of intermediate

production inputs.

Producer networks: all co-operation arrange-

ments that enable competing producers to pool

their production capacities, financial and hu-

man resources in order to broaden their prod-

uct portfolios and geographic coverage.

Customer networks: forward linkages of manu-

facturing companies with distributors, market-

ing channels, value added resellers and end

users, either in major export markets or in do-

mestic markets.

Standard coalitions: are initiatives by potential

global standard setters with the explicit pur-

pose of locking-in as many firms as possible

into their propriety product or interface stand-

ards.

Technology co-operation networks: facilitate

the acquisition of product design and produc-

tion technology, enable joint production and

Management

Design

Marketing /Sales

Production

Supplies /Inventory

Firm

Management

Producers, Inc

Designers, Inc

Suppliers, Inc

Marketers/Distributor, Inc

Core Firm

Fully integrated firm Virtual organisation

Figure 1: Fully-integrated firm and virtual organisation (from OTA, 1994)


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process development, and permit generic sci-

entific knowledge and R&D to be shared.

Williamson does not describe network-based organ-

isations like listed above in his theory. Neither does

he provide a clear answer to the question whether

virtual organisations belong to markets or hierar-

chies. Some elaboration on his theory however,

gives us a clue where such organisations would fit

in. Transaction costs can be classified in those that

support co-ordination between buyers and sellers

(markets) and those supporting co-ordination within

the firm, or the industry value chain (hierarchies).

Looking at the different forms of networks above,

some of these networks look like markets, whileothers look more like hierarchies. The supplier and

the producer networks are more like markets, the

customer, and technology co-operation networks,

and the standard coalitions are more like hierar-

chies. Terms that could be used in this context to

identify these different forms of networks are: dy-

namic virtual organisations and static virtual organi-

sations. Naturally, the static organisation is more

like a hierarchy and the dynamic resembles a mar-

ket.

Because the authoritative component of hierarchies

is often absent in these networks, it is necessary to

see them as a special form of a hierarchy. But, fol-

lowing the logic of Ciborra (1993), there is high goal

congruence and the product/service is rather specif-

ic. All members in the network know, presumably,

what they are going to do together.

The supplier and producer networks tend to have a

somewhat large pool of potential partners. It is

therefore legitimate to place these organisations

more on the market side of the spectrum. It should

be noted, however, that at the moment that the large

pool exists, there is only the core firm. It is only

after the teaming up of different parties that the or-

ganisation starts behaving like one, for the outside

world. Trying to realise some objective during the

period of existence (Mowshowitz, 1997).

Network based forms of organisation depend heavi-

ly on modern ICT (OTA, 1994). In the next chapter

we will investigate some of the predictions made

about the role ICT plays in shaping economic reality.

This will be done by applying transaction cost theory

in the world of electronic interaction between pro-

ducers, consumers and intermediaries.


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3 T RANSACTION COSTS IN THE INFORMATION SOCIETY

Certainly all the things were seeing today electronic commerce, networked organisations, outsourcing moreand more things that arent your core competency all of this ... can perhaps be explained by the fact that infor-

mation technology is reducing the cost of co-ordination.

From an interview with Tom Malone (in IEEE Internet Computing, 1997, p. 12)

In an influential paper called: Electronic markets

and electronic hierarchies, the impact of information

and communication technology (ICT) on the devel-

opment of hierarchies and markets is discussed

(Malone et al., 1987). It is argued that transaction

costs will change, indeed become lower, in the in-

formation society. The reason for this is that all fac-

tors that form the core of the transaction cost theory

are altered by the use of ICT.

1. Bounded rationality will play a less important

role, because it becomes easier to gather and

analyse vast amounts of information. Due to

ICT the complexity of product descriptions can

be much higher. Before ICT, complex product

descriptions were partly the cause of bounded

rationality. In other words, what was complex

before is simple now (Malone et al., 1987).

2. Asset specificity will diminish, because flexible

manufacturing systems allow rapid changeover

of production lines from one product to anoth-

er. The locking in of assets in the transactionwill play a less important role (Malone et al.,

1987). An addition to this could be that infor-

mation will become a more important asset

and because of its relative independence of

time and space its asset specificity is lower

then traditional products and services.

Malone et al. do not state anything about opportun-

ism, but following their line of reasoning the effect of

ICT on opportunistic behaviour might be stated as

follows:

3. Opportunism will be difficult to maintain as ICT

makes it possible to search for more suppliers

and it will be easier to compare different sup-

pliers and their terms. Bargaining power of dif-

ferent parties will be undermined and knowing

this their opportunism can not be as big as it

was before the occurrence of ICT.

If these predictions are true, it can be concluded that

in the future, markets will have an advantage in the

electronic world above hierarchies. Malone and col-

leagues state: the overall effect of this technology

will be to increase the proportion of economic activi-

ty co-ordinated by markets (Malone et al., 1987, p.

489).

This effect is further strengthened by two other de-

velopments: the electronic brokerage effect and the

electronic integration effect (Malone et al., 1987).

Electronic integration happens when different par-

ties integrate their databases with product infor-

mation, price, lead times etc. This will make tighter

coupling of these parties possible with fewer errors

in production and more flexible ways of production.

This electronic integration effect will occur more

often in hierarchies than in markets.

The other effect, electronic brokerage, will occur

solely in markets. Here the electronic market in itself

will provide the functions that a broker in a normal


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market does. Through the electronic market it will be

possible to contact many potential buyers and sup-

pliers. The system that is used for this will also help

in matching the different parties with each other. In

short it will:

1. increase the number of alternatives that can be

considered,

2. increase the quality of the alternative eventual-

ly selected, and

3. decrease the cost of the entire product selec-

tion process.

There are two predictions that follow from these

three arguments that will be further explored. The

first prediction is that in the electronic market, there

is no place for intermediaries. The second predic-

tion is that the relative amount of hierarchies will

decrease in favour of markets. We will start with

investigating the second assumption. After that the

role of intermediaries in the electronic world will be

further analysed.


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4 T HE OPTIMAL NUMBER OF SUPPLIERS

... most existing businesses must walk a fine line on the Net. They risk upsetting partnerships with distributorsand retailers. Conflict with an existing sales channel was the biggest impediment to selling online cited by re-

spondents to a recent ... poll.

Business Week, 11-06-1998

Theories about the optimal number of suppliers de-

liver an argument in favour of the opinion that ICT

will not automatically lead to more market like situa-

tions, as predicted by Malone et al. (1987). Bakos

and Brynjolfsson (1993) most extensively describe

this idea. The following line of thought is mostly

based on their observations. As stated before,

Malone et al. (1987) believe that the impact of IT in

business will be a reduction of co-ordination costs,

with more market like arrangements as a conse-

quence. There is however a limit to the number of

different suppliers a buyer firm might consider.

The optimal number of suppliers is determined by

trading off the cost of further searches against the

expected benefit from identifying a better supplier.

Better in this sense means that the supplier has a

competitive price, offers a better product, or more

generally has a better fit. When there are only a

few suppliers, the co-ordination costs are quite low,

but the costs of a bad fit are extremely high. The

more companies that are added to the number of

potential suppliers, the higher the co-ordination

costs become but the lower the costs of a bad fit.

This latter effect is explained by the fact in the large

pool of suppliers there is much more chance that a

good fit will exist. The sum of the co-ordination

costs and the cost of bad fit will determine the op-

timal number of suppliers. When co-ordination costsbecome lower, the optimal number of suppliers will

increase (see Figure 2).

0

2

4

6

8

10

12

14

1 2 3 4 5 6 7 8 9 10 11 12 13

number of suppliers

costfo

rthefirm

costs of bad fit, t(x)

total costs, t(0)

co-ord costs, t(0)

co-ord costs, t(1)

t(0) : before ICT

t(1) : after ICT

total costs, t(1)

Figure 2: The optimal number of suppliers when co-ordination costs become lower


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CONTRACTIBLE NON-CONTRACTIBLE

SPECIFIC Many Few

NON-SPECIFIC Many Many

Table 1: Investment characteristics and number

of suppliers

Despite this compelling economic argumentation

which leads to the conclusion that reducing co-

ordination costs through ICT leads to more suppli-

ers, or market like situations, there are some argu-

ments which might lead to a contradictory conclu-

sion. To explain this we must concentrate on other

factors beside the co-ordination costs. It seems that

the use of ICT also has impact on the bargaining

power of potential suppliers. As ICT makes it easier

to integrate the processes of suppliers with buyers,

the relationships that are formed between the differ-

ent parties can be stronger then they were in the

past. Suppliers will have to invest in these relation-

ships by making specific non-contractible invest-

ments. Specific in the sense that these investments

can only be used in the relationship with this particu-

lar buyer and non-contractible in the sense that a

third party (like a court) will not be able to judge

whether the investments that were done are suffi-

cient. Buyers are forced to provide their suppliers

with incentives to make these kinds of investments.

If a buyer decides that it will use the maximum num-

ber of suppliers for its needs, it is clear that, from the

suppliers point of view, it has no use to put effort in

the relationship-specific non-contractible invest-

ments.

It is easily understood that when the buyer firm de-

creases its pool of suppliers, the remaining suppliers

have more bargaining power then when the number

of suppliers is very large. This bargaining power can

lead to more incentives to make non-contractible

investments. These investments will compensate for

the reduced bargaining power of the buyer firm.

Specific non-contractible investments are often as-

sociated with ICT. An example of this could be a

parts manufacturer for an aeroplane constructor.

The parts manufacturer will not be motivated to in-

vest in ICT to integrate with the constructor if the

constructor has many manufacturers to choose

from. However, if the investments are contractible

this situation will not appear, because every parts

manufacturer that exists can then make the invest-

ments.

Summarising it is clear that buyers require their

suppliers to make investments in their relationships.

If the suppliers can use these investments in a later

stage with other buyers, the investments are non-

specific and if they can be contractually specified,

the buyer can determine the optimal number of sup-

pliers by considerations like economies of scale. If

ICT decreases the co-ordination costs, a potentially

large number of suppliers can be used. If, however

the investments made by the supplier have to be

specific and are non-contractible, it makes more

sense to use a small number of suppliers, otherwise

none of them will be motivated to make the invest-

ments. These arguments are summarised Table 1

and provide a clear argumentation why ICT will not

just increase the number of suppliers (a market situ-

ation) but will also decrease their number in certain

situations (a hierarchy situation).

Bakos and Brynjolfsson (1993) have clearly shown

that the current developments in ICT might some-

times lead to more market like situations and some-

times to more hierarchy like situations in the elec-

tronic marketplace. The assumption has been that

co-ordination costs will decrease. If this assumption

is left for a moment, another scheme unfolds. If the

transaction cost increase in the electronic market-

place, for example due to globalisation, the trend

towards fewer suppliers can also be expected. This

is however not very likely so we will leave that situa-

tion out of our considerations here.

Other arguments against the idea that firms will use

an unlimited supply of companies in their relation-

ships can be deduced from theories about virtual

organisations. Mowshowitz (1997) notes that too

much switching can lead to excessive costs. Fur-


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13

thermore, extensive use of switching may create an

image problem for virtual organisations. Companies

also risk upsetting partnerships with distributors and

retailers (Business Week, 11-06-1998). To maintain

the appearance of consistency and reliability for

their partners, virtual organisations must create the

illusion of permanence. Stiles (1997) also warns for

the different relationship that will develop between

producers and customers. The informational ad-

vantage that manufacturers and vendors had over

customers is diminished. Customers will become

well informed, also about other players in the mar-

ket. Therefore the selling company should heavily

invest in client-binding and image creation.

Summarising, there are three main reasons why

firms limit the pools of suppliers, clients, etc. they

choose from:

1. It is not beneficial for relationships with part-

ners to undermine their bargaining power.

2. Excessive switching will cost too many re-

sources.

3. Excessive switching can create a negative im-

age for the outside world.


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14

5 T HE ROLE OF THE INTERMEDIARY

The Net is starting a slow sweep of change through the workplace, rebuilding the order of things, creating wholenew middlemen, forcing changes on others, and leaving some behind. At the end of the day, you end up with

more intermediaries, not fewer.

Paul Saffo, director of the Menlo Park Institute for the Future (Business Week, 1998)

Both the electronic brokerage and the electronic

integration effect leave little place in economic

reality for intermediaries. Until now not much

attention has been paid by the different authors

to intermediaries. They do however form a large

proportion of economic life. There are essential-

ly two opposing views about intermediaries in

the electronic future. In the first view it is argued

that the electronic brokerage effect will cause

many producers to outsource functions they do not

wish to execute themselves. In this case, the num-

ber of intermediaries is likely to increase. If however,

ICT will be used to link directly to customers, therole of the intermediary seems redundant and they

will disappear from economic life (Stiles, 1997;

Sarkar, Butler, & Steinfield, 1993).

To solve this paradox it might be necessary to look

more closely at the possible scenarios. Table 2

summarises four possibilities, instead of the two

predicted above. These scenarios start with two

assumptions, one in which the use of intermediaries

without ICT is cheaper than direct producer-

consumer links. In the other situation direct links

with consumers are more profitable than the use of

intermediaries. After the emergence of networks and

ICT, two things can happen. Direct links may be-

come cheaper or the use of intermediaries may be-

come cheaper. Quadrant 1 and 4 are stay the

same scenarios in which the existing organisation

of the market is strengthened by ICT. Quadrant 2

and 3 are more interesting, the former showing how

intermediaries might disappear and the latter show-

ing how a new brand of intermediaries might ap-

pear, so-called cybermediaries (Sarkar et al., 1993).

This reasoning is purely based on cost aspects of

certain relationships. However, we have seen that

the added value of the intermediary is very big. It

was noted that producers have good reasons to use

intermediaries, most importantly the mediating role

they play between consumers interest in objective

information and the producers interest in manipula-

tion. It could even be argued that some of the roles

that are performed by the intermediaries are exactly

the specific non-contractible investments that were

identified in the discussion about the optimal num-

ber of suppliers.

Due to ICT some producers might easily perform

some of the intermediary functions themselves.

However, it is more likely they will use ICT to differ-

entiate their products, reach new customers, offer

new services, and improve relationships with their

customers. The truth will probably be that producing

firms will use ICT to use more outsourcing and sim-

T1T2+T3

T1T2+T3:(ICT) 3. Cybermediarieswill appear

4. Intermediariesstay with ICTusage

Table 2: Transaction costs between producers and con-

sumers (T1); producers and intermediaries (T2); interme-

diaries and consumers (T3), with and without ICT


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15

ultaneously establishing electronic presence to the

end consumer. The innovative intermediary will use

this development to couple the different electronical-

ly present producers in one package for the end

consumer.

A good example of such a new intermediary is Car-

Point (www.carpoint.com). The site offers an attrac-

tive interface with options for learning about new

and used cars from different manufacturers. It lists

cars for sale and there are possibilities for soliciting

a bid electronically from a car dealer. CarPoint

makes money by charging dealers about $1600

(monthly) to get their inventories listed. The site

offers possibilities for comparisons between differentcars from different manufacturers. This is really

added value, because you could never get a Mer-

cedes dealer to explain (objectively) the different

characteristics of a Mercedes with a BMW, or any

other brand (Fortune, 1998).

Next to the added value the intermediaries deliver,

there is yet another argument in favour of keeping

the intermediary. The power of intermediaries, often

stemming form their current direct relationship to

end consumers, may force producers to abandon

efforts to fully bypass intermediaries for fear of retal-

iation (Sarkar et al., 1993). This problem might be a

transition problem, because at the moment only a

small number of customers use ICT to buy goods

and services. If an bypassed intermediary retaliates,

it will no longer deliver the goods to the rest of the

consumers, but rather switch to an alternative pro-

ducer.

An example of what can happen if the intermediary

is cut out of the sales process is Apple Computers.

After the enormous success of direct sales through

the Internet by Dell, Apple decided to also start sell-

ing their products through this medium. In the be-

ginning there were big successes, the company

claimed. There is however a drawback. The, limited

amount, of resellers that still sold Apple computers

next to PCs became even smaller than it was. This

might turn out very badly for Apple. The few sup-

porters left of their system will now also decide to

stop selling these machines, because the customer

can do business with Apple directly. This will lead to

the situation wherein new computer buyers come to

the stores to get informed about computers, but will

never see an Apple computer. In this scenario, the

only users that will be left is the old customer base

on which Apple has to depend for the coming years.

It is clear that when no new customers enter the

Apple community, this community is going to shrink,

maybe until there is nothing left.

A final example that explains the important role of

the intermediary is provided in a personal interviewwith the one of the owners of a Dutch travel organi-

sation called Ocean Wide. This organisation organ-

ises trips on boats in the arctic regions. One of the

founders of the organisation is now trying to figure

out whether it would be more profitable to start with

direct sales to customers. Doing this, the 18%

commission travel agencies get from Ocean Wide

can be saved. However, the travel agencies job is

not just selling the trips. They also arrange the ac-

commodation of the passengers and the flights to

the nearest harbour. All these things will have to be

arranged by the people from Ocean Wide them-

selves if they start relying on direct sales. According

to the founder that is not very practical because

'...we dont know anything about flights or hotels.

And whats more, the travel agencies get enormous

discounts, because they generate a lot of flights.

They can probably offer a whole package, including

the trip, transportation and accommodation, cheaper

than we ever could. Letting the customers arrange

their own transportation and accommodation is also

not an option. If you go on a trip in the arctic re-

gions, you want everything arranged for you. This is

true, even when customers can get easy access to

all this kind of information, through ICT, they proba-

bly still want a full package. If Ocean Wide itself

gathered all the information about flights and hotels

through ICT, they still would not have the intermedi-

aries benefit of discounts on flights.


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16

I once measured the amount of time I spent on di-

rect sales, which we do sometimes in the Nether-

lands, and the sales arranged through agencies. It

proved that 30% of the trips that were booked in the

Netherlands consumed as much as 70% of my time.

The other 70% of the trips were booked through

intermediaries and that only consumed 30% of my

time. I imagine what would have happened if I could

have used the 70% time spent with direct sales on

finding new intermediaries. This man also explained

that the intermediaries very often provided infor-

mation about trends and wishes of customers. If

they say there are about 20 potential clients who

want to visit the south of Greenland, we change our

schedules to get those 20 people on our ship.

So it can be concluded that, even when intermediar-

ies charge a commission, their added value is often

so big that it would be unwise to bypass them. Even

when ICT makes it possible to set up a cheap direct

sales system, a lot of the intermediaries advantages

disappear.

5.1 ELECTRONIC MARKETS THROUGH

INTERMEDIARIES

Whether or not companies will start using intermedi-

aries, or will cut them out of their processes is prob-

ably dependent on a few factors. As we have seen

in the previous paragraphs, disintermediation can

have adverse effects, for example if the previously

used intermediaries were very committed to the

product. Car dealers did not use intermediaries be-

fore, but now that Carpoint and other likewise sites

have been created, they can do nothing but start

using these intermediaries. The examples have

shown that there are not only economic reasons

behind decisions about intermediaries, but also

things like loyalty and providing information play an

important role.

In our opinion the conditions that lead to different

outcomes: yes or no intermediaries and yes or no

electronic markets, depend in some part on the dis-

tinction between business-to-business relationships

and business-to-consumer relationships.

The number of business-to-business relationships

proved to be limited by several reasons: switching

may become too expensive, create a negative im-

age and undermine bargaining power. This is not

changing due to ICT, so the prediction by Malone et

al. that more and more market like relationships will

evolve is quite dubious. So in the business-to-

business case it is logical that businesses will stick

to a limited number of suppliers to fulfil their needs.

This will especially be true if there are specific and

non-contractible arrangements involved. One could

for instance imagine a group of companies workingtogether for several generations. The loyalty in-

volved will create an atmosphere wherein it will be-

come almost impossible to switch to a (electronic)

market situation. These kinds of issues are typically

non-contractible. However, if this is not the case, the

number of suppliers will only be limited to the costs

of switching, and the appearance for the outside

world. Again this does not necessarily leave us with

an increasing proportion of markets. This is howev-

er, where the intermediary might step in. If compa-

nies do want to use a very large pool of potential

partners, switching costs and outside appearance

will become important issues. It might then become

necessary to outsource the switching to specialised

intermediaries who know the market. Because the

intermediary can deliver these kinds of services to

several companies in search for the same products

or services, they can lower the costs needed for

searching, contracting, and switching considerably.

The intermediary can serve as the communication

portal, and thus a consistent picture is held up for

the outside world.

For business-to-consumer relationships, other as-

pects play a role. In the world before ICT, customers

are very much used to the role of intermediaries.

This will make it easy for electronic intermediaries to

create a market. On the other hand, companies, like

Apple, are aware of the possibilities that ICT has for


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17

dealing directly with end-consumers. This will some-

times make sense, usually in areas where there are

not many competitors. If there is an enormous

amount of companies trying to sell the same kind of

products through direct channels with the consum-

ers, it is clear they can not get a big part of the mar-

ket if they do not make use of channels that know

the customer (intermediaries again). It will be easier

for these intermediaries to attract a considerable

proportion of the market. The selling companies will

have to compete with prices and quality to get a

positive ranking from the market maker. Another

option, but for the customer not positive, is that the

intermediaries become biased, by bribing or other

means. They will then promote a certain member of

their pool more than others. If this happens very

frequently, the state may intervene, or alternative

unbiased channels will appear.

These considerations lead to the conclusion that if

there are markets to appear they will usually be

created by market makers or intermediaries. It is

simply too much trouble to search globally for inter-

esting partners. This is true for the business-to-

business situation and for the business-to-consumer

situation. A consumer would not take the trouble,

when buying a new PC, to start comparing different

kinds of hard disk vendors, chip vendors, video card

vendors, etc. It is more likely he/she will go to one

point where all this information is gathered. The

same reasoning applies the other way around. A

hard disk vendor will not try to create a considerable

market through its own direct sales channel, but will

depend on others to do this for him/her.

5.2 PREDICTIONS FOR ELECTRONIC MARKETS

The distinction between business-to-business rela-

tions and business-to-customers relations is also

recognised by Forrester research. They claim that:

... businesses are ahead of consumers in embrac-

ing the Internet. Even the slow-growing business

markets are bigger than fast-growing consumer sec-

tors. (Business Week, 11-06-1998).

For business purchases through the Internet, they

predict that early adopters will probably spent

around $200 billion in the year 2001. Early adopters

are found in the area of durable goods, like high-

tech hardware and computers, and in the area of

wholesaling office supplies, electronic goods, and

scientific equipment.

Later adopters might be the service industry and

transportation. Services like doctors, lawyers, and

accountants will slowly adopt e-commerce, because

they generally provide their services in person. It is

predicted that the sales by 2001 will be around $19

billion. The transportation sector is often already

committed to EDI, so Internet sales might only be$300 million.

Consumer purchases are maybe quite a bit lower.

Early adopters like travel, computer hard- and soft-

ware and books, music, and entertainment might

only be worth $16 billion. Half of this for travel, and

the other half equally divided by the other industries.

It is expected that flyers will increasingly browse the

Internet for bargain sales. The computer hard- and

software is an ideal sector for e-commerce. Buyers

know how to use the Internet, and there is no need

to sniff, squeeze, or try on merchandise. Online

sales of books, music, and entertainment may raise

total spending in stead of decreasing sales from

brick-and-mortar merchants.

Later adoption is expected for housing, food, and

services for consumers. The Internet is a great

place to browse for houses, apartments, and mort-

gage loans, but transactions are still being done the

old-fashioned way. Predictions for food and bever-

age sales through electronic channels in 2001 are

low ($460 million). Supermarkets do not have to fear

for their business. Health care is still a face-to-face

business. The same is true for most other services,

except computer fixes and updates, which are an

online natural (Business Week, 11-06-1998).

These numbers do not give an indication about the

relative proportion of markets and hierarchies, nor


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18

do they make a case for the intermediary. What they

do indicate is some developments that were ex-

pected, namely a lot of business going on through

electronic channels, are indeed happening. It also

gives an indication about the relative proportion of

business-to-business and business-to-consumer

sales that are expected. Intermediaries can use

predictions like these to search for a market they

think will be interesting for them.

Remarkably, the predictions for business-to-

consumer sales are very low. This might be caused

by several factors. One of the main reasons could

be that the number of end consumers on the Inter-

net is not as high as the number of businesses. An-other explanation could be that the consumers that

are on-line are still so used to the traditional chan-

nels that they do not change easily. It might also be

that the electronic channels that are available are

still too fragmented. In that case, it can be expected

that electronic intermediaries, who bring some of

these channels together, might generate much more

sales then is predicted now.


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19

6 T HE ROLE OF NON - SPECIF IC ASSETS

While higher levels of knowledge may normally result in higher levels of output per unit of input, it is the pursuit ofknowledge and information that characterises the technological production function under informationalism.

Manuel Castells in The rise of the network society (1997, p. 17)

In the previous two chapters the concepts bounded

rationality and opportunism were used to give an

account of how developments in ICT do not neces-

sarily lead to more market like situations, as predict-

ed by Malone et al. (1987). There is however one

factor of their argumentation that has been left out of

the discussion, namely asset specificity. It was ex-

plained that asset specificity is an important factor

that could drive transaction costs up. However, this

basic assumption of transaction cost theory has met

considerable critique.

Shortly, this critique states that assets that are non-

specific are much more difficult to protect in terms of

patents and property rights (Kay, 1993). This strug-

gle for protection of the non-specific asset will drive

the transaction costs up. It is therefor logical to cre-

ate hierarchies in cases where assets are highly

non-specific. This in contradiction to the argument

by Williamson that asset specificity (with bounded

rationality and opportunism) will lead to changes

from a market situation to a hierarchy. He claims

that if asset specificity is absent in contractual situa-

tions, then discrete market contracting is unprob-

lematic, thus non-specific assets are more likely in

markets.

An example (after Kay, 1993, p. 249): If knowledge

leaks from firm A to firm B, and firm B uses this

knowledge to improve its competitive position, firm A

is clearly put at a disadvantage. These problems for

firm A are a consequence of the fact that this asset

is, and can not be specialised by use or user. Pa-

tenting may be ineffective in protecting the intellec-

tual property rights of an innovation. Firm A might try

to license the knowledge, but the licensing contract

may incur significant transaction costs for the licen-

sor (firm A), due to the absence of asset specificity.

Another, obvious, solution for firm A could be the

internalisation of the transaction. In other words,

creating a hierarchy like relationship, one way or the

other, with firm B. This relationship could for exam-

ple take the form of a technology co-operation net-

work, as described by Castells (1997).

This critique on Williamson is interesting, because

the arguments made by Malone et al. also depend

partly on the role of asset specificity. If in some cas-

es asset unspecificity leads to forming of hierar-

chies, the argumentation used by Malone et al. that

ICT decreases asset specificity might lead to a

complete other conclusion. The role of decreasing

asset specificity is not used for forming markets, but

for forming hierarchies.

The question remains whether asset specificity will

indeed decrease due to the use of and the devel-

opments in ICT. In our opinion this is indeed thecase. Examples like the one given in this chapter

may be easy to find. The importance of knowledge

and information as an economic commodity in-

creases as many scholars have shown (Toffler,

1980; Castells, 1997). The appearance of words like

knowledge worker, knowledge management, infor-

mation brokers, and knowledge assets are also

quite indicative.


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20

7 D ISCUSSION

Experts see a big role for sites that bring together buyers and sellers and provide value by offering trusted ad-vice, personal service, or other benefits. This ... is the start of the third wave of Internet commerce: not just saving

money, not just selling existing products online, but generating new wealth.

Business Week, June 11, 1998

The predictions made by Malone et al. were purely

based on economical reasons. However, it appears

that purely economical reasoning can lead to con-

clusions that can be totally contradicted when other

than economical aspects are also taken into ac-

count. This was seen in two situations. The first sit-

uation was the conclusion that could be drawn from

decreasing co-ordination costs. This would automat-

ically lead to possibilities for more suppliers. If how-

ever the bargaining power of these suppliers was

also taken into account, it became clear that too

many suppliers is not an option. Another argument

in this context had to do with the reliability of a firmfor the outside world. This reliability can be nega-

tively influenced when firms decide to switch often

and rapidly between suppliers and client groups. A

final economical argument was that excessive

switching between different suppliers could lead to a

big increase in costs.

Another interesting fact was that decreasing costs of

communication could explain the disappearance of

intermediaries in the electronic market place. If

however other than purely economic roles of inter-

mediaries were added in the argumentation, it

proved that there certainly are aspects of intermedi-

aries that make them essential. The intermediary

delivers services to the consumer and the producer

and might balance the conflicting interest these two

parties often have. The success of electronic inter-

mediaries is proven on the Internet. They range

from portals to the web (Yahoo, a search engine) to

creators of new niche markets (FastParts, couples

parties in search of mechanical parts). Some try to

work like consumer magnets, drawing buyers with

useful info or services and steering them to manu-

facturers and service providers, in return for a fee,

or a cut of the transaction (Business Week, 11-06-

1998).

Looking back at the predictions made by Malone et

al. in 1987, it looks like these predictions were not

correct. The markets situations they envisioned did

sometimes develop due to ICT, but this happens

most of the time through intermediaries. However,

there was no place for these intermediaries in their

argumentation, they assumed direct contact be-

tween producers and consumers through shared

database systems. Nonetheless, their argumenta-

tion provided a good framework for investigating the

role of ICT on (electronic) markets, hierarchies and

intermediaries. And, whats more, the world of elec-

tronic businesses is still developing. More and more

people are getting access to the Internet and com-

panies that previously were afraid that the electronic

market was too small, may very well change their

opinion in the near future.

Unfortunately, no predictions were made about the

number of markets and hierarchies, or even the

exact amount of the relative proportion. Future re-

search in this area should try to concentrate on ex-

act numbers and bring some quantitative data in the

dispute. Limited to the world of ICT, it would be in-

forming to see how many organisations use inter-


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21

mediaries for their sales process, how many suppli-

ers are chosen, how many companies are normally

served by an intermediary, and of course how many

intermediaries there are. This will undoubtedly raise

questions about exact definitions about what an

intermediary is exactly, as well as the other terms

that are used in the dispute. For example, one of the

issues could be whether or not the telecommunica-

tion provider can be seen as an intermediary.

The question that was posed in the beginning of this

thesis was: How does ICT influence the co-

ordination mechanisms in the economy? Of course

there is not one answer to a general question like

this. However, it proved possible to investigate thematter in some detail. Hopefully this kind of research

will be continued in the future, preferably with some

quantitative data.

A final suggestion for further research has to do with

the different roles of intermediaries. There were

several benefits for the consumer as well as the

producer when they used an intermediary. It would

be interesting to investigate how the different func-

tions of intermediaries are separately influenced. It

could very well be that some of the functions will be

more influenced by ICT than others.

Concluding the idea that there is no place for inter-

mediaries in the electronic world is strongly contra-

dicted by the arguments delivered in this thesis.

Purely economic reasons were not enough to ex-

plain the effects that ICT might have on the number

of intermediaries. The same was true for the devel-

opment of electronic markets at the expense of hi-

erarchies. There are very good reasons for compa-

nies to limit the number of suppliers and thus the

prediction that all will be markets in the future

proved false.


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22

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