The Economics of Electronic Commerce
This book is written in the belief that the tenets and teachings of economics are vital to an
insightful analysis of the broad spectrum of issues affecting commercial uses of the Internet and the next-generation information infrastructure. Our digital future is being decided on the Internet, where prototypical products and services have been test-driven by an odd collection of individuals. Just a few years ago, commercial uses of this somewhat chaotic and decentralized network of networks seemed highly unrealistic. Today, while the government and large corporations are grappling with proposals on how to build the national information infrastructure, major components of......
The Economics of Electronic Commerce
PREFACE
This book is written in the belief that the tenets and teachings of economics are vital to an
insightful analysis of the broad spectrum of issues affecting commercial uses of the
Internet and the next-generation information infrastructure. Our digital future is being
decided on the Internet, where prototypical products and services have been test-driven by
an odd collection of individuals. Just a few years ago, commercial uses of this somewhat
chaotic and decentralized network of networks seemed highly unrealistic. Today, while
the government and large corporations are grappling with proposals on how to build the
national information infrastructure, major components of commercial use of the
Internet—users, technologies, and digital contents—are already converging, aided by the
rapid acceptance of the user friendly World Wide Web. What The Economist called an
"accidental superhighway" has become the hottest commercial medium. While there is a
considerable uncertainty about who will be the winners and what products and
technological standards will dominate this new arena, the basic foundation for a totally
unique competitive market has been laid and so has the stage for a fundamental market
analysis using economics.
Defining Electronic Commerce As a Market
Electronic commerce goes far beyond simply "doing business electronically." Doing
business electronically means that many conventional business processes such as
advertising and product ordering are being digitized and conducted on the Internet.
However, the Internet is not a mere alternative channel for marketing or selling products
online—i.e. the most recent alternative to mail-order business, catalog shopping, home
shopping networks and direct marketing. Instead, the electronic marketplace enables
sellers to innovate the whole business processes from production to customer service—
which were said to occur in stages—by integrating them in a seamless whole, where, for
example, product choices and prices are updated according to consumer information in
real-time on Web stores. These process-related changes will significantly impact intra-
business organization, business-to-business relationships, and business-to-consumer
interactions.
On top of all this, old and new products alike are being released from their physical
constraints and are being converted into digital products that can be delivered via the
global network and paid for using digital currency. With digitization and digital payment
systems, the electronic marketplace becomes a separate and independent market needing
no physical presence for stores, products, market institutions, or sellers and buyers. New
technologies such as the World Wide Web, digital signatures and encryption, and
electronic currencies are tools of the trade in the nascent world of electronic commerce.
From an economics perspective, our interest in this world lies in analyzing how these
tools are used, how the products are chosen, what level of prices and competition will
prevail, and ultimately whether a market exists or fails.
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What Is This Book About?
This book is not about how to use the Web or how to set up a Web page for a successful
business. Instead of presenting a user's guide for electronic commerce tools, this book
will introduce readers to the underlying economic aspects of electronic commerce.
Electronic commerce clearly crowns the list of technology-related media topics, as
evidenced by the abundance of literature covering the technical and legal aspects. Specific
subjects span a wide spectrum from fundamental design and implementation prerequisites
such as copyright protection and privacy in transactions to discussions on whether the
electronic marketplace will materialize at all! However, in virtually all of these
publications, the economic aspects have largely been neglected.
This book is about electronic commerce as a market. At the core of electronic commerce
is the meeting of sellers and buyers to trade digital products using digital processes.
Production, product delivery and payments are all handled electronically as are marketing
and consumer searches—the electronic equivalent of shopping. Except for online
delivery, non-digital product sellers will as well be affected by the Internet's unique
business processes in such areas as disseminating product information, tracking sales and
collecting customer information, application engineering and customer service.
Given this market setting, electronic commerce is a suitable candidate for microeconomic
market analysis. However, existing literature on the Internet is limited to teaching readers
how to use the Internet. Topical literature dealing with digital copyrights, online
marketing, and electronic payments on the other hand is usually geared toward the
technical and legal aspects of these new technologies. In this book, while paying attention
to the current status of some of the intertwined issues of electronic commerce in
technology, standards, policy, and legal issues, we focus on many economic issues and
aspects of electronic commerce that other existing literature does not cover. Six major
issues are identified: quality and the role of intermediaries; digital copyrights; advertising;
consumer searches for product information; product selection and pricing strategies; and
electronic financial and payment services. As the market has not yet consolidated around
one solution in most cases, for each of these issues we provide our readers with an
understanding of the short- and long-term implications and economic ramifications of
various proposals and guidelines under consideration.
Applying standard economic analyses to an entirely new industry will lay the foundation
for the development of radically new business models. Given the urgency of the issues
and the immediate applicability of the economic analysis, our primary focus will be to
provide detailed analysis for those involved in the actual production, marketing, and
distribution as well as for professionals doing business in the electronic marketplace. As
electronic commerce progresses towards a full-fledged marketplace, economic analysis
will take on an increasingly greater importance. It is already clear that those businesses
that achieve early success from applying these theories will enjoy a distinct comparative
advantage in this newly defined world of business. Given this, our audience is not limited
to professionals and students of the world of economics but also includes business
professionals and casual readers. The economic topics we explore are related to the basic
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aspects of doing business electronically and are relevant to anyone interested in entering
the realm of electronic commerce—be it as an entrepreneur, an investor or an established
business.
How Is This Book Organized?
The Economics of Electronic commerce is divided into three parts. Part 1 sets the general
framework necessary for later in-depth analysis of the issues. In a concise and succinct
manner, Chapter 1 defines electronic commerce as a market, and discusses the
characteristics of the electronic marketplace and its sellers and buyers, and presents an
overview of current issues and research activities. Chapter 2 defines the "raison d'etre" of
the electronic marketplace—digital products. Although digital products are often equated
with online information products, we adopt a much broader definition. Digital products
include not only software and online contents but also advertisements and product
information, payment information, digitized processes and communication. Many
physical products are also digitized—for example, digitized house keys, concert tickets,
currencies and smart products. Finally, Chapter 3 presents an overview of the Internet
network and technology, concluding with an in-depth review of various pricing strategies
for the network.
Part 2 revisits each of these issues in depth. Each chapter presents a summary of the issue,
a brief review of relevant literature in economics, and an analysis focusing on the
economic perspectives. Each of the seven chapters can be read separately if readers are
interested in a specific topic. Each chapter provides a summary of economic models and
issues sufficient to allow readers to follow later discussions. In Chapter 4, we analyze the
critical problem of quality uncertainty and discuss the role of intermediaries in preventing
market failure. Chapter 5 focuses on the need for copyright protection as a means to
promote market efficiency and product quality in electronic commerce. Chapter 6
analyzes how sellers can signal product quality to their buyers using advertising and other
marketing strategies. Looking at quality from the other side, Chapter 7 evaluates how
electronic commerce is affected by buyer initiatives to find about product quality and
prices. Three related topics in product selection strategy—product choice and
customization, the use of information about consumer preferences, and discriminatory
pricing—are explained in Chapter 8. Finally, Chapters 9 and 10 are concerned with the
financial and monetary effects of doing business electronically. Chapter 9 focuses on
online financial services while Chapter 10 is devoted to electronic payment systems,
especially those systems based on digital currency and their impact on the monetary
system and policy.
Part 3 contains the final two chapters in which we summarize our conclusions, adding a
strategic perspective. We also point out areas in this emerging marketplace deserving
future research.
At the end of each chapter, we provide a list of academic and technical literature for
advanced economic study. Although it is not our intention to produce a reference or a
user's manual for Internet users, we do provide information, in sidebars, on technically
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advanced topics and terms. In addition, we include examples whenever possible to make
our discussion more concrete and specific. The online references to these and other
related sites and documents found at the end of each chapter will allow readers to further
explore these and other examples on their own.
Acknowledgments
This book is a result of collaboration among the authors but many thanks are due to our
colleagues who provided us with interesting materials, read the manuscript and made
invaluable suggestions. For their help, we would like to thank John Allison, Valerie
Bencivenga, Scott Freeman, Mark Lemley, R. Preston McAfee, David Sibley and Bruce
Smith as well as anonymous reviewers. Alok Gupta's collaboration for the section on the
infrastructure pricing is specially acknowledged. Susan Kutor suffered most while
reading and correcting often incomplete chapters, and we are indebted to her for her
suggestions and corrections. We'd also like to thank our editor Thomas Stone, who
tirelessly worked to make this project perfected, and Amy Lewis, Tim Micheli and the
staff at Macmillan Technical Publishing. Finally, we would like to acknowledge financial
support from the Information Technology and Organizations program at the National
Science Foundation and the program managers, Drs. Su Shing Chen and Les Gasser, and
the support from the Information Technology Program of the State of Texas.
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Chapter One: Electronic Commerce and the Internet
1.1. Developments in Inter-networking _____________________________________ 1
Distributed and Networked Computing _________________________________ 2
Open Network ______________________________________________________ 3
Two-way Communications and the Web ________________________________ 7
1.2. What Is Electronic Commerce? _______________________________________ 9
Electronic Commerce Examples _______________________________________ 9
Electronic Commerce as a Communications Network ____________________ 11
Electronic Commerce of Digital Products_______________________________ 12
Commercial Potential of the Internet __________________________________ 15
1.3. Market Characteristics of Electronic Commerce_________________________ 16
Current Commercial Uses of the Internet_______________________________ 17
User Characteristics ________________________________________________ 19
Competition and Market Organization_________________________________ 20
Business Organization and Virtual Firms ______________________________ 22
Legal Environment _________________________________________________ 23
1.4. Current Issues in Electronic Commerce _______________________________ 25
Contents and Quality _______________________________________________ 26
Copyrights vs. Users Rights __________________________________________ 28
Interactive Advertising and the Use of Consumer Information _____________ 30
Internet Intermediaries______________________________________________ 32
Security and Privacy of Internet Transactions___________________________ 33
Pricing Strategies for Digital Products _________________________________ 34
Online Taxation, Regulation and Other Legal Issues _____________________ 35
1.5. Summary ________________________________________________________ 36
References___________________________________________________________ 37
Suggested Readings and Notes __________________________________________ 38
Internet Resources ____________________________________________________ 39
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Chapter One: Electronic Commerce and the Internet
Our objective in this and the next two chapters is to provide you with a framework for
understanding the economic impact of the new business medium by defining electronic
commerce and the nature of digital products. Opinions regarding the future shape of the
Internet and electronic commerce may vary widely, but consensus reigns that commercial
uses of the Internet will have an immense effect on businesses, governments, and
consumers. The question is, "In exactly what areas and in what ways will they be
affected?" A shared definition of electronic commerce is the first step toward presenting
the answers.
In this chapter, we discuss the characteristics of computing environments that have made
the Internet the infrastructure for electronic commerce. In Section 1.1, we present an
overview of how computing and networking environments have evolved into the Internet.
Our objective is to highlight differences between the Internet and previous computing and
communications environments in order to give a clearer understanding of the importance
of the Internet as a commercial medium.
In section 1.2, we review commercial and non-commercial uses of computing and
communication technologies, and define what electronic commerce is within the context
of changing technologies. It will be evident that conventional distinctions between
commercial and non-commercial uses of the Internet are no longer valid. In Section 1.3,
we discuss the market characteristics of electronic commerce, pointing out the differences
from traditional physical product markets as well as issues arising from the novice nature
of electronic commerce. To wrap up our introduction in Section 1.4, we introduce readers
to key issues in electronic commerce and look at how economic analysis may help to
resolve many uncertainties. While these snapshots put the issues in perspective, later
chapters will deal with each in depth.
1.1. Developments in Inter-networking
The Internet is a network of networks. Each network is comprised of computers
connected by wire- or wireless medium such as radio signals that enable component
computers to "talk" to each other. Once computers are networked, files on one computer
can be accessed from any other computer on the network; messages can be exchanged,
and limited resources such as printers can be shared. Large or small, each network is
owned and managed by a company or a single group with the exception of the Internet.
The Internet is not owned or managed by any single entity although its component
networks are independent units managed and usually paid for by the network's owners.
(We discuss in detail the Internet technology and infrastructure in Chapter 3, Section 3.6;
in this chapter, we focus on general characteristics of the Internet as a market
infrastructure). Computers on these component networks become a part of the larger
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Internet when they use the same standard for cross-communication known as the TCP/IP
protocol—the language of the Internet. In terms of connectivity, therefore, any computer
"speaking" TCP/IP protocol is Internet-enabled.
The Internet is clearly the largest network of computers in existence today. There are,
however, many non-Internet networks such as commercial online services that are quite
large in their own right. The sudden dominance of the Internet as a model mechanism for
information transfers and commercial transactions may seem accidental in view of these
large networks. However, the Internet or Internet-like networks have two overriding
factors in their favor to become a market infrastructure: distributed computing and
openness.
Distributed and Networked Computing
A distributed computing environment consists of multiple sites (or computers) that are
capable of performing the same type of functions or executing a portion of a task. This is
in contrast to a mainframe computer environment where shared users send commands and
receive results via dumb terminals connected to the computer. In a mainframe
environment, all of the computing necessary to process a task is done at the central
computer, the host, while terminals are used only for inputting instructions and displaying
results. The Internet, on the other hand, is an example of distributed computing where
host and client computers are each capable of independent computing.
The distinction between a host and a client is based on which machine (or program)
provides content and service. A client machine typically establishes a connection to a
host—known also as a server—and initiates a request for a service, for example to
download a file. A Web browser, for example, is a program that runs on a client machine,
while an httpd, which sends out HTML files (Web pages) upon request by a browser, is a
program that runs on a server.
However, this distinction between a server and a client is only arbitrary. In a distributed
computer network, each connected computer can act either as a server or a client. This
potential is not obvious to many Internet initiates who use their computers as clients only.
But the strength of a distributed computer network such as the Internet is its connectivity
that supports peer-to-peer relationship. What this means in terms of a market is that each
computer or user connected to a peer-to-peer network is a potential provider of contents,
i.e. a seller, as well as a buyer. Any personal computer connected to the Internet is
capable of hosting a Web site or sending a file instead of simply acting as a tool to visit
Web sites and download files. The traditional division between corporations as content
providers and consumers as buyers is still evident in the way some commercial online
services organize their services where subscribers are targeted only as "readers" or
customers. Such customers are assumed to be "surfing" the net just like television viewers
and newspaper readers are passively consuming the contents provided by the sellers.
On the contrary, the strength of the Internet lies in the potentially interactive environment
where consumers regard themselves also as the content providers. The proliferation of
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personal homepages, which is often dismissed as a transitory "fad," indicates that the
Internet users understand the power of the medium in providing content. Nevertheless,
the majority of Internet users are assumed to remain passive. To "surf" the net, it may be
adequate to have a passive communication device which connects and downloads files
without the capability to act as a host. A stripped-down network computer—a Web-
browsing machine with a limited processing power—resembles a television receiver or a
dumb terminal of the bygone era.
Even when consumers are not "selling contents" on the Internet, the medium's
interactivity enables sellers to collect information using the medium itself about
consumers' tastes and their preferences for product quality, price and customer service.
Unlike the broadcasting media, the networked Internet facilitates two-way interactions
between sellers and buyers, the result of which can also be fed seamlessly into
production, marketing, transaction and consumption processes. In short, a network means
a worldwide system of interaction—be it for business or for communication—where
computers connected to the network are simply points of presence.
As the conventional distinction between a seller and a buyer is lost in a distributed
network such as the Internet, transactional processes undergo a similar transformation. A
typical commercial transaction involves many agents and processes, each of which
performs a specific function—production, assembly, marketing, delivery, payment
clearance, insurance, certification, and so on, which typically occur in stages. Different
intermediaries have evolved to fulfill one or more of these functions in the physical
market. Intermediaries are now evolving to fulfill these functions in a distributed
computer network, where they may be processed simultaneously by different agents. The
scope of market activities undertaken by these agents will be defined as the commerce on
the Internet matures. However, the organization of agents in electronic commerce will be
sufficiently different from physical markets. For example, the traditional difference
between a wholesaler and a retailer is lost in the digital marketplace since a producer only
needs to transmit one copy to an intermediary. An efficient market organization is more
likely since activities of each agent involved in a transaction, from production to payment
and consumption, may be monitored and evaluated more efficiently, and new product
strategies and pricing can be implemented rapidly and concurrently. Such changes in
market organization are the subject matters of later chapters.
Open Network
Distributed computing presupposes a network. Large corporations, governments and
research organizations have maintained extremely large networks of computers often
made up of several layers. For internal communication and computing needs, computers
are typically connected in local area networks (LANs) using physical connections such as
cables. These LANs can then be interconnected into wide area networks (WANs) via
telephone lines or satellite links. And private value-added networks (VANs) have been in
operation for over two decades to facilitate company-to-company transactions using
electronic data interchange (EDI). The disillusioning truth in this image of an
interconnecting system of cogs is that not all LANs and WANs can communicate with
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each other, because of both technical and policy choices made by network owners. VANs,
in particular, are limited to paying members and use proprietary communications
standards. A need exists for a means to bridge the gaps between the different sized cogs
that will allow them to communicate. The Internet is one such means.
The Internet is unique as a networking environment in that it is based on open standards
which allow any computer or network to connect to it using TCP/IP protocols. Internet
Protocol (IP) is the most basic layer in communication protocols for the Internet and
handles addressing and delivery while the Transmission Control Protocol (TCP)
maintains message integrity. Being an open network is similar to postal communication
system. Once you have a mailing address you can send and receive messages using the
postal service. There is no restriction to become a mail user and the use of mail is not
limited to a specific type of messages. Similarly, once you obtain an Internet address for
your computer—an IP address or a domain name—linking to the rest of the computers on
the Internet is a matter of connecting a cable or dialing through a modem.
The openness of the Internet facilitates interoperability between different computer
platforms and supports the exchange of human-readable messages. because of this, the
potential of electronic commerce over the Internet far surpasses that of EDI or private
VANs. The use of EDI was projected to be one of the most important business
developments that would have made paper-based business transactions obsolete. And
through the use of EDI, businesses have obtained significant cost savings and gains in
efficiency and competitiveness. Nevertheless, actual use of EDI has fallen far short of
projections.
The primary reason for the limited use of EDI is its requirement for asset specific
investments. A large amount of capital investment is necessary to construct an EDI
system since EDI transactions depend on proprietary software. Each time interaction with
a new EDI system becomes necessary, new hardware and software must first be
developed. But perhaps most significantly, EDI transactions are limited to machine-to-
machine communications based on machine-readable forms. Due to these factors, EDI is
limited to a small set of pre-determined transaction data while normal communications
between companies are conducted via paper, telephone, fax, and other conventional
methods.
The Internet, in contrast, offers a very different medium of communication. The strength
of the Internet lies in its versatility in transmitting various file formats and the nature of
open-end networking. Using a wide variety of application software, users of the Internet
can conduct many activities that EDI simply does not support. The rapid growth of the
World Wide Web, for example, has demonstrated the importance of communicating
multimedia contents and the user-friendly interface. At the same time, the ease in using
Web browsers and the authoring software such as Hypertext Markup Language (HTML)
have enabled all computers that are connected to the Internet to become content providers
instead of being simply receivers of information. These advantages have spurred the use
of the Internet as a tool for communications and commercial transactions. Electronic
commerce based on an open Internet will affect all aspects of a market instead of
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duplicating traditional seller-to-buyer market relationship, yielding up a whole new area
of economic research.
The Internet with such advantages, however, has a series of potential problems. While the
openness of the TCP/IP protocol suite is the reason why the Internet is growing so fast, it
also poses a serious problem as a commercial medium due to the fundamental lack of
security measures in the TCP/IP (Bhimani 1996). Compared to private VANs, the Internet
has many weaknesses in this respect. Messages can easily be wiretapped and
eavesdropped during transmission. The messages could then be altered and sent to
another party. Because of this, the receiving party cannot be assured of the identity of the
original sender. Challenges exist to meeting many essential security requirements for
computer transactions: confidentiality, authentication, data integrity, and nonrepudiation.
How serious are these security problems when the Internet is used for commerce? After
all, access control for any computer on the Internet can be achieved by using access
passwords, firewalls, or by simply disconnecting from the network when not in use. In
general, only those files designated for sharing by owners can be transferred. To secure
confidential and authenticated messages, encryption and digital signature technologies are
already being adopted that provide content level security. Such security measures are
applied to each message being transmitted just as a secure envelope with a tamper-
resistant seal protects a message within. Alternatively, the transfer medium may be
secured such as the communication line itself. The next generation Internet protocols will
incorporate security measures on TCP/IP layers thereby securing the transfer conduit
itself (Hinden 1996) In short, with adequate access control and content security via
encryption, today's Internet offers a rather robust, albeit imperfect, security.
While the level of performance guarantee for the Internet is lower than that for private
networks, the chance for a catastrophic failure is lower for the Internet compared to a
private network which is controlled and administered by a central authority. A message
traveling on the Internet will be re-routed if a part of the Internet fails. At the same time,
an eavesdropping on the Internet is neither targeted nor specific as in the case of private
networks. Since private networks carry designated information over the same network,
the result of a security breach will be more severe than on the Internet where packets of
message travel in mixed jumbles. When the next generation of Internet standard is
implemented along with content level encryption, the security of the Internet may become
a concern in mostly isolated instances.
While security and reliability will significantly increase in the next generation Internet, its
ever-increasing traffic due to multimedia, real-time and broadcasting applications may
not result in any noticeable improvement in terms of network congestion. More efficient
compression technologies, faster modems and larger pipelines will certainly increase the
absolute size of the Internet bandwidth. However, cheaper and more abundant integrated
circuits and powerful microprocessors have been overwhelmed by concurrent, or often
outpacing, increases in the demand for computational power. Similarly, congestion may
become a more critical issue in electronic commerce than network security problems that
have worried many prospective online marketers.
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Sidebar: Who controls the Internet?
From its beginning in 1969 as ARPAnet (after Advanced Research Projects Agency of
the U.S. Defense Department), connections to the Internet have been based on open
standards to provide flexibility and robustness in order to maintain communications
capability even under a catastrophic disaster or a serious system failure in some of the
network's component computers.
As the Internet grew into a network of networks, no single computer or network acted as
a central authority. However, as in other social organizations, there are certain groups
whose opinions matter.
At the top of these groups is the Internet Society or ISOC (http://info.isoc.org/
index.html), shown in Figure 1.1. The Internet Society is a volunteer membership
organization which appoints the Internet Architecture Board, or the IAB
(http://www.iab.org/iab/). The IAB is responsible for maintaining interoperable standards
for communications as well as Internet addressing.
Figure 1.1: The Internet Society home page
The Internet Engineering Task Force or IETF (http://www.ietf.cnri.reston.va.us/) is
another volunteer organization that sets up working groups to deal with operational and
short-term technical problems. Anyone can participate in these working groups. Their
reports are recommendations for voluntary adoption or may be sent to the IAB for more
official treatment. As a participant and a user of the Internet, any network needs to follow
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both IAB and IETF decisions and reports. Ignoring the recommendations by these bodies
often leaves no choice but to disconnect from the Internet.
Two-way Communications and the Web
The Internet can be thought of as a two-way broadcast system with the capacity of
sending targeted messages to individuals. It combines the characteristics of two-way
communications such as telephone and fax (one-to-one communications) with those of
broadcast media such as radio and television (one-to-many communications). It is not an
exaggerated prediction that the Internet, spurred on by the World Wide Web (WWW or
the Web) will someday supercede all these communication media.
The significance of the World Wide Web cannot be overemphasized in the development
of the Internet and electronic commerce. The Web has been touted as a multimedia
presentation tool that is capable of enticing more attention from viewers through
interactive activities compared to earlier text-based file transfer programs (see Sidebar:
Predecessors of the Web). But the even greater significance of the Web technology lies in
its capability for two-way, many-to-many communication. Today's Internet marketers
concentrate on developing colorful and jazzy Web pages to elicit visitors' attention. The
premise of this advertising, which is based on broadcast media, is to maximize the
number of "eyeballs" and their attention span using the most common denominators such
as sex and violence. But Internet marketers have discovered that advertising methods
based on one-to-many broadcasting attract responses, often negative, from the viewers.
And unlike over-the-air commercials or mass-mail advertising, users of email can simply
click a reply button to express their opinion, and their messages travel back over the same
medium to the source of those advertisements.
A two-way broadcast system, which gives the same level of reach, at a low cost, to
everyone connected to the network, also means that large corporations and companies do
not necessarily dominate the marketing and distribution in the market. If word processors
have made desktop publishing possible, the Web and its authoring language (HTML)
have made everyone a potential publisher. And with email, these potential publishers
have access to the same marketing medium as large corporations.
Increasingly, Web browsers are becoming Web publishers. As the number of Web surfers
grows, more and more of these net-travelers are putting up their own Web pages to
establish their points of presence. Subscribers to America Online, Inc.
(http://www.aol.com), can now make their own personal Web pages on the access
provider's Web server. Today, Web servers usually reside on expensive workstations
because of their system requirements. But within a few years Web servers will be as
simple as Web browsers and as easily installed and maintained on small computers.
Personal Web servers and the personal Web contents residing on these servers will
establish a truly two-way communication and will be a significant factor in growing
Internet communication and commerce.
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Predecessors of the Web
The World Wide Web is only the most recent development designed to simplify the user
interface for file transfer by automating transfers and enriching content presentation. Until
very recently, the most frequently used method for transferring files was the File Transfer
Protocol (FTP) which requires a remote login and allows only authorized users to
connect. If you don't want to limit access, an anonymous FTP can be set up that allows
guest logins by virtually anyone on the Internet. Automated anonymous FTP programs
were the next step in presenting non-technical connections to users, but users still had to
log out and log in whenever they wanted to connect to another site. The next development
following the automated FTP programs was Gopher service, which allows users to log
into many sites in one session. Simple and consistent, a Gopher client presents users with
a series of menus in a hierarchy. FTP reached the pinnacle of its popularity in 1993, and
Gopher service was rapidly increasing in 1994.
However, the World Wide Web has reversed the growth of both. It has replaced FTP as
the easiest and most popular way to transfer files, and has replaced Gopher as the
preferred method for presenting files and information. Similar to Gopher, the Web allows
users to browse different sites in one session, but instead of hierarchical menus it uses
jumps via hypertext links to other Web pages. Each Web page is essentially a different
connection, which admittedly slows down data access. But unlike previous methods, the
Web has an added feature of being able to transmit and display non-text files. This
capability to present digitized audio and video files compensates in many cases for the
loss in speed. Perhaps the most important feature, however, is the authoring program,
HTML, which is easy enough for non-technical persons to construct their own Web
pages. This enables them to be content providers as well as content receivers. This
combination of advantages is fast eclipsing its "competitors." While the Web
transmission grew from almost zero to over 30% of the total data sent over National
Science Foundation NET—the Internet's backbone until 1995—the share of FTP
transactions has fallen by a third (see Figure 1.2). Many files previously designated for
public access under anonymous FTP and Gopher servers are now being moved to Web
servers and eventually the Web may replace all other file transfer regimes.
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Figure 1.2: Types of data sent over the NSFNET backbone
FTP Telnet Usenet irc Gopher email Web
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Jun-93 Dec-93 Jun-94 Dec-94 Mar-95
Source: Data from http://www.mit.edu:8001/people/mkgray/net/web-growth-
summary.html.
1.2. What Is Electronic Commerce?
In this section, we define what electronic commerce is. This is not as simple as it sounds,
since electronic commerce is a fast-moving target. The definition is ever changing and
expanding to include more and more sectors of the economy as the influence of electronic
communications extends. A conventional definition emphasizes technological aspects in
an attempt to provide a lasting concept. As the following sections illustrate, we prefer to
stress the economic aspects and define electronic commerce as a new market offering a
new type of commodity, i.e. digital products, through digital processes. Sellers of physical
products are affected as well by digital processes—e.g. online ordering, market research
and payment settlement—and are part of this new market.
Electronic Commerce Examples
Technology is transforming many aspects of business and market activities. In its
broadest sense, electronic commerce refers to the use of electronic means and
technologies to conduct commerce—including within-business, business-to-business and
business-to-consumer interactions. The enabling technologies, of course, are also used for
non-commercial activities such as entertainment, communication, filing and paying taxes,
managing personal finance, research and education, which may still include the services
of online companies. As a result, it is somewhat difficult—and sometimes arbitrary—to
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separate electronic commerce areas from non-commercial applications of the same
technologies and infrastructure.
Nevertheless, what characterizes electronic commerce is the pervasiveness of technology.
For example, Mobil (http://www.mobil.com) gas stations in St. Louis are testing a
windshield-mounted radio device by which customers can get credit card approval and
activate a gas pump by the time they get out of their cars. Customer preferences are also
recorded in the device so that a cup of coffee or a newspaper can be delivered to their cars
while they are pumping gas. Office Max (http://www.officemax.com) plans to install
kiosks in banks and malls, which offer access to the company's full inventory of products
and allow customers to order and pay for products to be delivered. Personal services for
those pressed for time are moving from telephone to the Internet with easy customization
for product selection, payment and delivery. In Boston, several online grocery shopping
businesses (notably Peapod at http://www.pea-pod.com) deliver groceries, while
Streamline (http://www.streamlined.com) adds dry cleaning and video rental services.
While these may be cutting-edge applications, conventional electronic commerce areas
include:
• searching for product information
• ordering products
• paying for goods and services
• customer service
all conducted online. The use of the Internet to support marketing and customer-interface
is only part of electronic innovation that is changing the way firms do business. With
Intranets, corporations distribute internal memos and announcements to their employees;
need-based information finds those who need to be informed; and knowledge exchange
and scheduling communications flow worldwide in a timely fashion. With direct
connection to suppliers—i.e. an extended Intranets—the same technology is used for
manufacturing and supply chain management. 3M (http://www.mmm.com), for example,
expanded its EDI service to the Internet, allowing its over 2,000 suppliers and business
customers access to its EDI transactions via any way they choose—private value added
networks, phones and faxes as well as the Internet. To sum up, for within-business and
business-to-business applications, electronic commerce include:
• internal electronic mail and messaging
• online publishing of corporate documents
• online searches for documents, projects and peer knowledge
• distributing critical and timely information to employees
• managing corporate finance and personnel systems
• manufacturing logistics management
• supply chain management for inventory, distribution and warehousing
• sending order processing information and reports to suppliers and customers
• tracking orders and shipments
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The Economics of Electronic Commerce
and countless other business activities. More important than the mere number of areas
being affected by electronic commerce is the fact that these activities can be integrated
into a holistic business process. Thus, all the areas mentioned above are not really a
separate application but rather one aspect of the whole electronic commerce process. For
example, inventory and supply management is tied to production as well as to the demand
data collected from consumers ordering via Web stores. In short, the business potential of
electronic commerce is the ability to innovate and integrate business and market
processes. The most obvious and immediate use is achieving transactional efficiency.
Electronic Commerce as a Communications Network
At the core of traditional electronic commerce is the use of electronic means to expedite
commercial transactions and improve efficiencies in business processes and
organizations. In this vein, electronic commerce on the Internet means online ordering
and payments. The narrowest definition of what electronic commerce is holds that
electronic commerce on the Internet is a networked electronic data interchange (EDI)
with a more flexible messaging system. Traditional EDI is limited to signals that only
computers can read and that correspond to information on electronic forms used in
standard business transactions such as ordering, invoicing and shipping. An open EDI
using the Internet means that EDI messages may be sent and received via email. In the
next level of sophistication, EDI can use electronic forms made available on Web pages
for customers to order. This view considers electronic commerce and the use of the
Internet as merely improving business and communication, especially in business-to-
business transactions. Accordingly, issues in doing business on the Internet are mainly
organizational and operational ranging from security, competitive advantages in product
development and R&D, to efficiencies from automating purchasing functions, EDI, point
of sale information, and other inter-organizational transactions.
To many familiar with EDI, doing commerce on the Internet is not entirely advantageous
compared to traditional EDI. A clear tradeoff is made between secure but limited VANs
using traditional EDI and an insecure but far more flexible network with messaging and
remote login possibilities using the Internet. For example, Chevron Corp. of San
Francisco pays over $1,200 each time it sends an EDI report to the U.S. government via a
private VAN. In comparison, it pays about $2,000 per month for unlimited access to the
Internet (Radosevich 1996). However, many consider the Internet to be inferior to EDI
because of the perceived lack of security and reliability, even though they adjusting their
EDI strategies to include the Internet. Already, Internet-oriented EDI applications, such as
EDI/Open and Templar by Premonos Corp. (http://www.premonos.com), have reduced
EDI prices and afforded small and medium size companies to take advantage of
electronic transactions.
However, many interactions between sellers and buyers happen before they are ready to
exchange orders and bills. A somewhat broader view of electronic commerce includes
these interactions between businesses and consumers. Consumer services and product
announcements have been routinely released to the Internet by computer companies for
many years. And increasingly, firms are gearing up for Internet advertising and
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The Economics of Electronic Commerce
marketing. Going even further down the digital road, electronic shops and malls are
springing up that offer electronic versions of catalog shopping where consumers can
search and order products using Web browsers, bypassing traditional paper- and phone-
based merchandizing. Organizations devoted to commercial uses of the Internet such as
CommerceNet (http://ww.commerce.net) and government agencies such as the National
Telecommunications and Information Administration (NTIA) (http://www.ntia.doc.gov)
have encouraged business presence on the Internet and doing business electronically. As
recently as September, 1996, Yahoo's list of online malls shows over 700 shops
(http://www.yahoo. com/text/Business_and_Economy/Companies/Shopping_Centers/
Online_Malls) and Open Market's Commercial Sites Index shows 41,731 listings of
commercial Web sites in October 1996 (http://www.directory.net/dir/statitics.html).
Electronic Commerce of Digital Products
Despite the broadening view on electronic commerce, the commercial Internet is still seen
primarily as a new medium of communication, i.e. an open and interactive version of
magazines, television, and telephone. As an efficient communications medium, the
Internet can be used to facilitate marketing, advertising, ordering and customer service
functions of the business organizations, lessoning their dependence on traditional media.
With the development of digital currency in the offing, many aspects of payment clearing
procedures will also change significantly, particularly in terms of per-transaction cost and
speed. Such changes in marketing, payment and customer service will affect the markets
for both physical and digital products—for example an online furniture dealer as well as
an electronic magazine distributor. However, even more fundamental changes will
accompany the online sale of digital products since they, unlike physical products, can be
both produced and delivered over the network transforming the very tenets of the
manufacturing and distribution functions.
This business of digital products is radically advanced from conventional electronic
commerce areas, and requires further developments in communications infrastructure,
electronic payment systems, appropriate laws regarding copyright and sales taxes, liability
and consumer protection laws and so on. It is no longer doing the same business
electronically, but instead demands new business models and processes to take full
advantage of the enabling technologies in the multimedia industry. We call this fully
digital business as the core of electronic commerce to distinguish it from conventional
electronic commerce areas.
Figure 1.3 shows the difference between the core of electronic commerce and
conventional electronic areas. A market is decomposed into three components: players (or
agents), products and processes. Market players are sellers, buyers, intermediaries and
other third parties such as governments and consumer advocacy groups. Products are the
commodities being exchanged. The interactions between market agents regarding
products and other market activities are processes, which include product selection,
production, market research, searches, ordering, payment, delivery and consumption.
These three components of a market may be either physical (i.e. off-line) or digital (i.e.
online). The horizontal axis in Figure 1.3 represents whether market players are digital or
© 2003 Choi, Stahl & Whinston 1-12
The Economics of Electronic Commerce
physical. For example, a Web store is digital; a physical store is physical. Online
shoppers are digital; shoppers in a mall are physical. Similarly, the vertical axis represents
the degree to which a product is digitized. For example, a printed newspaper is physical,
while its online version is digital. CD-ROMs are in-between since their contents are
digital products but packaged in physical products. Finally, the third axis shows whether a
process is digital. Visiting a store is a physical process, while searching on the Web is a
digital process.
The traditional commerce—the lower left cube in the figure—is where all three
components are physical. In contrast, these components are all digital at the core of
electronic commerce, where not only production but also delivery, payment and
consumption—i.e. reading online or processing by a computer program—occur online.
The remaining white areas are part of conventional electronic commerce, where some of
the components are digital. For example, products may be physical—e.g. automobiles—
but marketing and payment may be conducted online; products may be digital—e.g.
online database—but payments could be made via checks, or buyers may be reading
print-outs instead of screen outputs. The growing use of digital—i.e. online—processes
for business-to-business transactions and consumer marketing is evident in the figure,
where electronic commerce dominates the traditional market.
Figure 1.3: Electronic commerce areas
The core of
Electronic commerce electronic commerce
areas
Virtual product
.
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Digital Traditional
irt
commerce
V
product Digital
process
Physical Physical
product process
Virtual player
Physical
Digital
agent
agent
Most of current electronic commerce applications and issues fall within the white areas of
Figure 1.3, dealing with one aspect on a particular axis—for example, setting up a Web
store, content digitization, electronic payments, online marketing and so on. Later
© 2003 Choi, Stahl & Whinston 1-13
The Economics of Electronic Commerce
chapters in this book also tackle these issues one by one and our audience is not limited to
digital product sellers. However, in each chapter, we make every effort to analyze an
issue in a broader context that includes all three components of a market. Therefore,
product digitization (of the product axis) is discussed in connection with online
consumption and digital marketing (of the process axis) and the role of Web store sales
representatives (of the player axis).
The core of electronic commerce represents the future of electronic commerce, where
market activities from production to consumption occur online bypassing all paper-based
transactions and traditional communications media. The Internet becomes more than
merely an alternative communication medium, but a microcosm, or an electronic version,
of physical markets with characteristics that are fundamentally different from physical
markets. This digital world of business, where market institutions, agents and products
are becoming "virtual" and native to the Internet, is also at the core of electronic
commerce economics.
The main difference between the digital world of business and the traditional physical
business world stems from the very nature of digitized products, which we discuss in
Chapter 2. However, there are many reasons why consumers too will behave differently
in a networked market. For example, access to product information via the network using
sophisticated computer programs will certainly affect the way consumers compare prices.
In turn, efficient shopping will affect product choices, pricing strategies, and competitive
efforts among sellers. Business organizations and relationships will also be affected as
spatial and temporal limitations of the market are removed and replaced by different
considerations of costs, efficiencies and the mode of interaction on a network. In other
words, the market environment enabled by the open distributed Internet resembles no
other physical market. The physical distance and geographical topology of a market are
replaced with network architecture and preference-based market territories. Thus, our
objective is to investigate the economic aspects of this newly emerging market of
electronic commerce by applying standard economic tools and by evaluating qualitative
differences in economic efficiencies and organizational changes.
Our analysis of electronic commerce market is timelier than you may think. The scope of
digital products, and correspondingly the scope of electronic commerce, will be much
wider than we imagine today—and much sooner. While digitized information products
are only a small portion of Internet-traded goods today, suitable online payment systems,
especially for small value items, will spur an explosive growth in digital products trading.
In the immediate future, CD-ROM and disk-based sales will be conducted online as the
transmission speed bottleneck is removed. And digital products are not limited to
information or "infotainment" products. All paper-based products, e.g. posters, calendars,
and all sorts of tickets, can be converted into or replaced by digital counterparts. So can
all other products made of graphics, images, and sound as well. Even some products
representing value may take a digital form as in digital currency and electronic checks,
stocks and bonds. Some purely physical products are made into smart products that allow
digital interface for monitoring and control—e.g. smart cars, smart boilers and home
security systems. Users will be able to interact with these products via email, exchange
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The Economics of Electronic Commerce
personal settings online, or download trouble-shooting programs. Essentially, all types of
business services and processes have the potential to become digital products exchanged
on a digital network, expanding the core of electronic commerce (see Figure 1.4).
Whether directly through their own business or through the business of their competitors,
the producers of both digital and physical products will be affected by the trends in
electronic commerce.
Figure 1.4: The growth of electronic commerce areas
The core of
electronic commerce
Virtual product
ss
ce
ro
lp
ua
irt
V
Digital
product
Digital
process
Physical
product Physical process
Physical
Virtual player
Digital
agent
agent
Commercial Potential of the Internet
Businesses need to place electronic commerce within the context of broader uses of the
Internet than the traditional commercial framework. As a market, electronic commerce
impacts not only marketing but also production and consumption. Information collected
through Web stores is used to customize products, to forecast future demand and to
formulate business strategies. Consumers not only order and pay for products online but
also search for product information, reveal their preferences, negotiate with sellers,
exchange information about products and firms, and use products online by filtering,
processing, and linking them with other computer programs. Likewise, supply chain
relationship among businesses and competitive strategies need to aim at increasing the
overall market efficiency, not just transactional efficiency.
The Internet can certainly be used as an alternative marketing channel, selling existing
products online, but the future of electronic commerce will be guided by innovative
digital products and services that will emerge in the electronic marketplace. But from
© 2003 Choi, Stahl & Whinston 1-15
