3 Electronic Market System Framework
3.1 The Institutional View on Electronic Markets
3.1.1 Economic Environment
3.1.1.2 Characteristics of the Agents
In chapter 2.1.2.2 the characteristics of the agents were described as the agents’ decision-making behavior. In the microeconomic framework the agents are supposed to act in the mechanism such that their utility drawn from the resource allocation is maximized. The utility is expressed by two factors: risk attitude and by preferences over resources (see 2.1.2.2). The utility formulization thereby implicitly assumes the following:
(1) preferences are only dependent on resources, (2) social factors are absent,
(3) preferences are stable,
(4) agents are present from the outset of the resource allocation process.
Assumption (1) suggests that preferences of the agents are only dependent on resources. This, however, widely ignores that taking part in a mechanism may also affect utility.
Assumption (2) claims that social aspects do not play a role in the decision-making behavior.
Apparently, the social life of the agent such as friendships or other relationships also affect the decision-making behavior.
Assumption (3) sketches a static character of the microeconomic framework, since prefer-ences are not changing over time. It is rather obvious that the extension towards an EMS framework must drop this assumption.
Assumption (4) rules out any dynamic elements in the microeconomic system. Agents are present from the beginning of the resource allocation process. When the factor time is intro-duced agents may enter the resource allocation process late.
In summary, assumption (1) and (2) prevent that agents can have other arguments in their utility function than the pure resource allocation. Assumption (3) and (4) impose a static char-acter of the resource allocation process. In the following the assumptions will be subsequently dropped.
3.1.1.2.1 Preferences over Mechanisms
The microeconomic system framework models the preferences as a function of the conse-quences, i.e. allocation and payment, of a mechanism. The consequences are further defined in terms of the outcomes. This, in turn, implies that preferences are not affected by events and activities associated with the participation in a mechanism. The difference between those two sources of utility might be confusing. Thus, two examples are given to pinpoint those two sources in more detail:
Example 3.1-3:Upstairs markets
Recall the block-trading example from Example 2.1-18. Block-traders favor crossing net-works to usual continuous trading systems (cf. Pagano 1989). The conclusion that this epitomizes the fact that agents value the usage of mechanism differently, depends solely
on the mechanism is simply wrong. The reason why block-traders choose this mechanism is totally output-driven. Due to the detrimental effect of continuous double auction, they do not use it. Accordingly, the classical mechanism theory model is sufficient to mirror this step.
Example 3.1-4: C2C Internet auction
A different example is reported about a famous Internet auction-house. Within bidding frenzies such overbidding can occasionally reach ridiculous heights. For instance, a com-puter cable worth $9 available in any store was sold for $50 (Cohen. 1999). Unlike the previous example, utility cannot only be drawn through the consequences. The outcome of this mechanism is highly inefficient, as it results in a drastically negative utility for the buyer. Obviously, the winning agent derives utility not only from the allocation (which was negative) but also from the participation in the mechanism.
Accordingly, not only the allocation of resources but also the thrill in participating in the mechanism contributes to an individual utility. As noted, classical mechanism design theory implicitly ignores mechanism-oriented determinants, since the utility function only comprises outcomes as arguments. Or stated differently, it takes the mechanism as an exchange of
“meaningless messages” (Glazer and Rubinstein 1998, 159). However, messages are not meaningless at all: Suppose for example, there are two agents, one buyer and one seller with corresponding reserve prices vb and vs, respectively. The designer wants to implement a social choice function, which attains that the good is transferred from the seller to the buyer as long as vb > vs. Mechanism Design theory suggests that “take-it-or-leave-it” would be appropriate in such a situation. This rational, down-to-earth view, does not account for the idiosyncratic factors concerning the mechanism. Participating in a mechanism can itself influence the indi-vidual utility. In this respect the interpretation of meaningless messages is incorrect. Rather are the messages, offers, counteroffers, or accepts. An offer may mean something totally dif-ferent to difdif-ferent people. In our example the seller could set his take-it-or-leave-it price at slightly less than the buyer’s reservation price vb. This offer could – although it leaves some value on the table for the buyer – insult the buyer. Because of these emotions the buyer opts for the “leave it” option, which leaves him with zero utility. Accordingly, “ignoring mecha-nism-related motives may yield misleading results.” (Glazer and Rubinstein 1998, 159)
Remark 3.1-5: Implementation with agents that have preferences over the mechanism
The idea of preferences over mechanisms is not completely new in mechanism theory. In the Glazer and Rubinstein model, for example, preferences are also dependent on the mechanism. Basically, they sketch a voting scenario where the agents provide recommen-dations as messages. As an innovation, the model prescribes that the agents are concerned about how their recommendations end up in the final decision: apparently, agents wish to see their recommendations be reflected by the implemented social choice function. This introduces a feedback between the mechanism and the equilibrium behavior of the agents.
Interestingly, Glazer and Rubinstein demonstrate that implementation becomes possible by the introduction of preferences over the mechanism that were previously impossible (Glazer and Rubinstein 1998; Jackson 2001). From an implementation theory point of view, modeling preferences over the mechanism will become an interesting issue.89
89 Nonetheless, the author is not aware of any other model than the presented Glazer-Rubinstein model that also incorporates a feedback between equilibrium behavior and mechanism.
As a conclusion, the EMS framework also incorporates preferences over mechanisms in its description of the economic environment. Since the mechanism itself can exert positive or negative impact on individual utility, it must be made explicit.
3.1.1.2.2 Embeddedness
One of the most persistent issues within economic sociology has been the criticism concern-ing the modelconcern-ing strategies of human behavior. Traditionally economics proceeds from “the notion of homo economicus acting in a world with full information, independent decision making, polypolistic competition, transitivity, and fixed preferences” (Beckert 2003, 769).
Sociologists commonly agree that the observed economic decision making in the real world does not match with these assumptions. Accordingly, sociologists have come up with a rival approach that may explain economic processes. It was Granovetter who revitalized the em-beddedness approach, which has over the last fifteen years served as the crucial counter-concept used by economic sociologists (Granovetter 1985; Beckert 2003).
“The revival of economic sociology in North America has catapulted Mark Granovetter’s 1985 article into prominence as its programmatic text and the embeddedness approach as its primary framework (Swedberg 1991). Consciously departing from the old economic sociology of Talcott Parsons and his colleagues, the proximate theoretical inspiration of the embedded-ness approach is Karl Polanyi’s work, especially his collaborative book Trade and Market in the Early Empires: »The human economy […] is embedded and enmeshed in institutions, economic and noneconomic« (Polanyi, Arensberg et al. 1957, 250)” (Lie 1997, 349).
Basically the key assumption of the embeddedness approach is that social networks – resting upon friendship, trusts or goodwill – sustain economic actions. Economic actions such as ne-gotiating or trading are embedded in networks of interpersonal relations. Four kinds of em-beddedness are usually distinguished: cognitive, cultural, structural, and political embedded-ness (Dequech 2003).
• Cognitive embeddedness basically refers to the concept of bounded rationality, as it ad-dresses the limitations of economic reasoning due to the structures of mental processes (Zukin and DiMaggio 1990; Dequech 2003). Hence, decision making of an agent depends on (or is embedded in) his mental processes.
• Structural embeddedness refers to the social relations that are essential to the market proc-ess. Any agent is involved in network of relations. Clearly, this so-called relational beddedness affects the behavior of the agents but is not the issue of this type of em-beddedness. What is meant by structural embeddedness addresses the aspect that not only the personal relations matter, but also the structure of the aggregated network of relations.
In other words, the relationship between economic agents cannot be validly decomposed into multiple atomistic bilateral relationships, as the overall network of social relation-ships influences the agents’ behavior (Granovetter 1985; Simsek, Lubatkin et al. 2003).
Granovetter summarizes structural embeddedness as the “contextualization of (economic) exchange in patterns of ongoing interpersonal relations” (Granovetter 1985; Dacin, Ven-tresca et al. 1999, 319).
• Economic actions are not only embedded in the network of ties but also in the political and legal framework of the country. Political embeddedness refers to the political context and the manner in which economic institions and decisions are shaped. Also the political and legal framework of the economy is designed embedded in a social environment. Both the political and the legal frameworks also sustain economic action (Jacobson, Lenway et al. 1993).
• Cultural embeddedness is concerned with the shared collective understandings of the society in shaping economic strategies and goals. As culture – understood as a system of believes, values, and symbols – provides the categories and thus the meanings in order to engage in economic actions, it affects individual behavior (Beckert 2003). Thus, cul-tural embeddedness as part of the economic environment stresses a constitutive form of culture.90
Overall, embeddedness emphasizes the fact that the agents are indissolubly connected with their social surrounding. Their decisions take also place within and with respect to this social surrounding. Apparently, embeddedness is not a rival theory to the prevailing economic the-ory. On the contrary, “embeddedness arguments take economic activity seriously but look beyond the rhetoric of intentionality and efficiency and make a strong commitment towards understanding relational aspects of organizations” (Dacin, Ventresca et al. 1999, 320-321).
This allows the integration of the concept of embeddedness into the electronic market system framework as an additional external variable, which affects agent behavior and consequently the outcome of an electronic market (Beckert 2003). This may surprise on the first view as embeddedness was often cited as a rival theory. Nonetheless embeddedness cannot constitute a rival approach at all, as it does currently not provide a theory, which can explain the forma-tion of strategy. Embeddedness thus argues on a different conceptual level, being part of the economic environment (Beckert 2003).
3.1.1.2.3 Instable Preferences
The founder of the microeconomic system framework already hinted at the possibility that preferences can change (Smith 1982). The microeconomic system framework principally is capable of modeling those learning processes. However, classical mechanism theory literature abstains from incorporating changes in preferences. As electronic markets are inherently as-sociated with dynamic environments, it is essential to incorporate changes in preferences.
Altering preferences can happen either on a short or on a long scale, i.e. during the messaging process or between different resource allocation processes:
Changing preferences during the messaging process
If it is assumed that the resources are not remaining the same during the messaging process, preferences concerning the modified resource characteristics can also fluctuate. For example, perishable goods such as flowers are gradually fading and, hence, loosing value for the agents.
Even the risk of loosing value suffices to value a resource at a later time less than the same resource at an earlier time, i.e. the preference for immediate preferences are higher valued than delayed preferences. In those cases preferences can be conceived as a function of time.
In many cases preferences are assumed to decrease over time. Preference discounting has been coined to reflect uncertainty or anticipated decreases in the preferences of delayed con-sumption.91 In this context factors that may induce preference discounting on a short scale are for instance changes in the probability or, alternatively, changes in the preference function. As time passes by, the probability that future consequences occur naturally changes.92 Also the
90 Culture will also play a role in the depiction of institutions. Under the term “social norms” aspects of culture will also be discussed. Different to the constitutive form of culture the section about “social norm” emphasizes a regulatory form. Regulatory form points at the changed level of analysis. Culture does not give meaning to the concepts but constrain the agents’ behavior. As such “social norms” are enlisted in the chapter about institutions (Dequech 2003).
91 Elsewhere, discounting is also used to reflect the assumption that agents have care less about future util-ity than about current utilutil-ity.
92 This bears the problem that the common discounted utility model representation has no explicit mean to account for changes in probability. Frederick thus concludes that in the case of changing probabilities,
preference function can change over time if the individual value for some resources change.
As before, the benefit that can be drawn out of consuming resources depends on levels of re-cent consumption: Water is being valued higher when thirsty (Frederick 1999; Frederick, Loewenstein et al. 2002).93
Beside those economic arguments also other disciplines contribute to explaining changing preferences. For example, in social psychology, two major theories have been emerged to explain changing preferences during the messaging process94:
• Dissonance theory asserts that agents try to minimize cognitive dissonances (Festinger 1957; Bowles 1998). Cognitive dissonances term a state of psychological discomfort aroused by conflicting preferences95. During the messaging process the agents are sup-posed to submit messages, e.g. offers. Selecting one offer out of the variety of possible of-fers can create a dissonance, since choosing an offer forfeits attractive features of another.
This state of cognitive dissonances is resolved by valuing the non-selected offer less at-tractive and the selected more atat-tractive than before (Akerlof and Dickens 1982; Bender-sky and Curhan 2003).
• Alternatively, self-perception theory assumes that the agents are unsure about their prefer-ences. Based upon their own behavior the agents infer – comparable with a neutral ob-server – their preferences. This means the agents make a choice during the messaging process and take this choice subsequently as a kind of evidence concerning their prefer-ences: If an agent submitted a specific message he must appreciate it (Bem 1967; Bender-sky and Curhan 2003).
Those preference changes during the messaging process are difficult to capture. These phe-nomena are an exception to standard preference theory. As there are only few approaches in economic theory that can cope with these intra-mechanism preference changes, this issue is at this point not further elaborated.
Changing preferences between different resource allocation processes
The inter-mechanism change of preferences reflects the changes in preferences mostly on the long scale. It can either refer to mechanism-oriented or allocation-oriented preferences96. The change of allocation-oriented preferences is straightforward to explain. Firstly, as before, the preference may change if one or more resources are allocated to an agent. Then, satisfied
the probabilities of future events and those for current consequences must be separately represented (Frederick 1999).
93 In this context, Rachlin argues that diminishing marginal utility is derivative of time preference. That is marginal utility diminishes because consumption of the marginal unit must be increasingly delayed. For example the first apple is valued more than the tenth as consumption of the tenth apple is delayed. Thus, Rachlin concludes that satiation alone cannot explain diminishing marginal utility because consumption could be sufficiently postponed to avoid satiation, with no loss in value if the discount rate was zero.
Nonetheless as Matthews pointed out that this argument cannot account for all forms of diminishing marginal utility. The standard example is that the second teaspoon of sugar may improve the taste of a glass of iced tea less than the first teaspoon, although it does not delay its consumption (Rachlin 1992;
Frederick 1999).
94 Here, only preferences concerning allocations are observed, as the emphasis is on changes during the participation in a specified mechanism. Note that preferences over mechanisms are relevant before the mechanism is selected.
95 Dissonance theory usually takes conflicting beliefs, attitudes or action as a reason for cognitive disso-nance (Festinger 1957). At this point the psychological term is translated into the economic language.
96 For simplification reasons preferences without explanation are treated as preferences over allocation, whereas mechanism-oriented preferences are shown separately.
mand reduces the need for a resource and thus reducing the residual demand.97 Secondly, a resource may be valued less than before due to the time elapsed. This devaluation can be rea-soned by various reasons: perishable resources, expired contracts, a positive time preference rate, etc. Again, allocation-oriented preferences are time-dependent.
Remark 3.1-6: Dynamic Mechanism Design
Dynamic mechanism design accounts for the changing preferences by distinguishing two cases of time-dependent preferences (1) constant types (2) changing types of the agents. In (1) the type of the agents remains the same, only the allocation at time t is discounted. In (2) the characteristics of an agent, represented by its type is altering. Interestingly, dy-namic mechanism design demonstrates that in a more period setting with changing prefer-ences where the agents can commit intertemporally, the optimal dynamic allocation equals the replica of the optimal static allocations over all periods. This would suggest that a static formulization is sufficient. However, if renegotiation among the resources is possi-ble dynamic mechanism design does not boil down to the static one (Dewatripont 1989;
Fudenberg and Tirole 2000). An introduction about the discussion of dynamic mechanism design can be found at (Baron and Besanko 1984; Fudenberg and Tirole 2000; Ishiguro 2003).
Instable – in particular time-dependent – preferences will have an impact on the resource allo-cation process. For example, when analyzing the revenue maximizing mechanism for elec-tronic markets, the dynamic nature of the environment is an important factor that needs to be considered. The previous discussion about the agents’ preferences is envisioned to discover current shortcomings of the problem formulation. As aforementioned, there are only few re-search papers dedicated to the dynamics of the environment (for example Gallien 2002), but currently there is hardly anything known about the robustness of static mechanism design results in dynamic settings.
Nonetheless, as previously mentioned the EMS framework simply requires a certain degree of dynamic environment. As such, the inclusion of changing preferences – either on a short or long scale – is necessary to accommodate this dynamism.
3.1.1.2.4 Dynamic Arrival
Commonly, mechanism theory assumes that all agents are taking part in the resource alloca-tion process from the beginning of the process. As such, those models are static in a way that they ignore the process through which bidders arrive to the market (Gallien 2002). Dynamic arrival relaxes the assumption of idle agents that are waiting for the market to start. Instead agents may arrive stochastically (Wang 1996).