4 Towards a Structured Market Engineering
4.3 A Design Process Model for Market Engineering
4.3.2 Stage 1 – Environmental Analysis
4.3.2.1 Environment Definition
The central intuition of the environment definition phase is to pinpoint the environment for which subsequently the electronic market service is offered. The environment definition is clearly a marketing action. To systematize the phase more thoroughly, the environment defi-nition is divided into three subsequent activities:
1) Market Definition, 2) Market Segmentation, and 3) Market Targeting.
Firstly, the relevant market is being defined. In other words, the market firm is carving out the arena in which it is going to compete for business (Fennell and Allenby 2003a). The market definition thus comprises information about the potential market participants, their geographi-cal positions, their specific needs, and so forth. In short, the market definition157 characterizes
157 The terms market definition, segmentation, and targeting have been established in marketing for a long time. As such, these terms are also used in this book, although the definition of the term “market” is not
the demand-side for the electronic market service that is eventually determined by the defini-tion of the trading object.
Secondly – having defined the relevant market – the market firm divides the defined market into several segments. The division into segments is intended to disaggregate total demand into smaller pieces of demand. The smaller pieces of demand are ideally of homogenous na-ture such that it is easier to fine-tune the electronic market service to the needs of this market segment (Smith 1956; Fennell and Allenby 2003a).
Thirdly, the market segments are evaluated against each other. As a result, the target market consisting of one or more market segments is selected (Hlavacek and Reddy 1986).
Market Participants Transaction Object
Preferences
Consumer Goods Industrial Goods
Sectors
Industrial Firms Retail Firms
Private Customers Government
Chemicals
Electronics
Clothing Machinery and Tools
Market Definition
Selected Segment
Figure 20: Environmental Definition
The intuition behind those three steps can be visualized by the means of the “socio-economic environment cube” (cf. Figure 20). The cube depicts the space of all conceivable environ-ments by the three dimensions trading objects, market participants and their demands and needs (Budimir, Holtmann et al. 2001). For example, the environment (i.e. demand and sup-ply situation) for electronics is different than for chemicals. Inside the segments – depicted by the mini-cubes – the preferences, i.e. the specific needs, are assumed to be homogeneous.158 Depending on how the market is defined, the segments may either exhibit heterogeneous preferences or may not exist. For example, when the slice is made over the transaction object or the participants, it is obvious that the needs and desires are different: The needs concerning an electronic market for wastewater may be different than for stocks. Alternatively, when the slice is made over the preferences, then – per definition – needs and demands are alike for all electronic trading venue. However, it may happen that the cube is representing no agent. Via market segmentation the plane is divided into several segments. The market firm then selects
exactly corresponding with the institutional definition given here. What marketing literature addresses with the term “market” is the environment, whereas the institutions are left out.
158 The granularity of the cubes depends on the referring analyst.
the desired target group with homogeneous demand, which reflects the identification of a mini-cube.
4.3.2.1.1 Market Definition
In market engineering the market definition is of eminent importance, as it describes the envi-ronment in which the market firm chooses to engage in (Brandt 1966; Fennell and Allenby 2003b). As such, the market definition provides the starting point for all analysis and planning activities concerning the trading, business and media rules – it is thus the foremost activity of market engineering.
Principally, there are various criteria that could be used to define the relevant market. For ex-ample, in the marketing literature usually geographical or product-oriented definitions are proposed. Geographical definitions, e.g. the European market, correspond to specific envi-ronments – in our example the “European” environment. Agents that live outside the specified region are not part of the environment and are consequently left out. Stated as a product mar-ket the marmar-ket definition determines the environment, which consists of all firms and offer-ings that offer comparable products. Those criteria can, obviously, be combined for a more precise market definition (Fennell and Allenby 2003b; Fennell and Allenby 2003a). As an environment is defined over the three dimensions being products, participants, and prefer-ences, there are the following strategies to perform the market definition:
(i) Market definition over the trading object definition
Commonly, in market engineering the trading object definition reasons the market definition.
Any market definition corresponds to a specific environment, but this correspondence is ini-tially unknown. The less specified the market definition is the more complex will be the cor-responding environment. Defining the trading object is, however, a difficult endeavor “select-ing the commodities which will be traded is often the most difficult part of the design process.
Sometimes a resource allocation problem has an obvious breakdown into commodities. Other times there are many ways to slice the resources into commodities, with no clearly superior treatment” (Wellman and Wurman 1998, 119-120).
(ii) Market definition over the participants
Alternatively, the market definition can be determined by selecting potential participant groups. In other words, the market firm chooses a promising participant group and attains thereby the market definition. For example, the market firm may choose banks as their target customer groups. In many cases the selection of the participant group is too broad to be of any help. For example, the definition may comprise participants to be women between 20 and 25;
the corresponding markets are unknown, as the information about the environment does not suffice to identify a market ad-hoc. As such, the market definition is often supplemented with a (more or less specific) definition of the trading object (i.e. blended market definition).
(iii) Market definition over the preferences
Thirdly, the market definition can be performed over the preferences. In other words, partici-pants with equal needs and desires concerning the electronic market service are used for the market definition. This may be a relevant strategy for market firms who already have estab-lished a running electronic market and want to penetrate in a market with the same preference profile. But again trading object definitions often enriches market definitions over preferences (i.e. blended market definition).
(iv) Blended market definition
Lastly a combination of the above strategies is also possible.
Comprising, most market definitions comprise the trading object definition either in a clear way e.g. stocks or generically. For the market definition it is to note that it is definitely of ad-vantage if the market firm has deep knowledge about the industry for which it intends to set up an electronic market service (Sawhney 1999a). In those cases the market firm has at least a rough idea about the real resource allocation problem and can appropriately react. On the other hand, it is also appealing to establish electronic market services for other unknown or even non-existent domains. For example, markets with innovative trading objects such as emission certificates may offer wide opportunities. It is, however, difficult to analyze the cor-responding environment, as a “market” may not exist. Alternatively those markets with inno-vative trading objects such as wastewater or water can already exist but are (natural) monopo-lies (Beecher 2000; Seidenstat 2000).159 Setting up electronic markets services to foster com-petition must not take the needs of the incumbent monopolist but also those of future entrants into consideration. As future entrants may not be aware of their needs, the premise of “make what customers want to buy” is extremely difficult to implement.
The market definition is certainly a decision task. The decision should be supported by discur-sive methods. However, as traditional marketing frequently omits this activity (which is as-tonishing, since marketing deals with markets but neither define them!) (Fennell and Allenby 2003b; Fennell and Allenby 2003a), it is referred to the methods that are used for segmenta-tion market research analysis methods (Baker 2001; Dolan and Ayland 2001).
In summary, market definition plays a primary role in this early stage of the market engineer-ing process. By explicitly imposengineer-ing boundaries on the socio-economic environment it pro-vides the context for succeeding activities. Market segmentation for example, simply requires an explicit definition of the underlying market.
4.3.2.1.2 Market Segmentation
The market definition only sketches a rough picture about the market, which the market firm intends to serve. Market segmentation divides the defined market into several segments. Mar-keting literature regards market segmentation as the key decision area (Wind 1978; Dibb 1999). The term market segmentation was coined by Wendell Smith’s influential article, which introduced the concept of segmentation that “[…] is based upon developments on the demand side of the market and represents a rational and more precise adjustment of product and marketing effort to consumer or users requirements” (Smith 1956, 5). In other words, the fundamental benefit of market segmentation is that it allows the firm to tailor their marketing program to the needs of the customer segment (Nagle and Holden 1995; Kotler 1997; Dibb 1999).160
159 Legal barriers in many times protect those natural monopolies. Setting up electronic market services in those markets, thus, requires beforehand liberalization. Those legal issues are, however, not covered.
160 Particularly pricing is more effective if tailored to specific market segments. An easy example may illus-trate this: A pricing sillus-trategy with only a single tariff bears an inefficient compromise, since customers with lower preferences may be excluded from buying the good if their willingness to pay is below this single tariff, while customers with higher preferences can attain a positive rent because their willingness to pay is above the tariff (Nagle and Holden 1995). By pricing over segments instead the group with the lower preferences can be served with a lower tariff while the group with the higher preferences can be charged at a higher tariff. Hence offering segmented pricing virtually diminishes the need for inefficient compromises and improves both sale and profit. Pricing is, however, not that easy for example because the individual membership to the market segments is not observable (Wilson 1992; Nagle and Holden 1995).
Basically the concept of market segmentation is intuitively simple, albeit its implementation is not. Unfortunately, there is no generally accepted approach to market segmenting (Beane and Ennis 1987). Table 6 summarizes the segmentation forms that are commonly suggested in literature (cf. Kotler and Armstrong 1998).161
Segmentation Techniques Description
Geographic Segmentation Descriptors for segmentation are geographic details of the customers, such as regions or countries.
Demographic Segmentation Using demographic descriptors (e.g. gender, age, and so forth) is the most preva-lent form of market segmentation. This segmentation theory has limitations when the segments do not clearly exist (Beane and Ennis 1987).
Psychographic
Segmenta-tion Psychographic segmentation is concerned with less conspicuous characteristics of the customers focusing on social descriptors such as way of living or lifestyle.
Those characteristics are difficult to operationalize; psychographic segmentation strives for the definition of clear quantitative measures to describe the lifestyle,
“[…] Psychographic research can be defined as quantitative research intended to place consumers on psychological – as distinguished from demographic dimen-sions” (Wells 1975, 197). Psychographic segmentation is commonly combined with demographic descriptors.
Behavioral Segmentation Behavioral segmentation involves behavior-centric descriptors such as purchase occasion, benefits sought, degree of usage etc. In other words, customers are seg-mented on the basis of knowledge about the product, attitude, or response to the product (Beane and Ennis 1987).
Benefit Segmentation Segmenting with respect to perceived value or benefit is denoted as benefit seg-mentation (Haley 1995). The underlying premise of benefit segseg-mentation is that the type of the benefit gives rise to the true market segments. Identifying market segments requires the development of an understanding of the customers’ re-quirements. Experience with this segmentation strategy has shown that the bene-fits sought by the customers can much more accurately describe the customer behavior than demographic strategies can do (Elliott and Glynn 1998).
Table 6: Segmentation Forms
These segmentation techniques are heavily discussed in general marketing literature, not so in the service literature, as Elliott and Glynn notice “The treatment of the central concept of market segmentation in the services literature is noticeably a lightweight” (Elliott and Glynn 1998, 40). Hitherto researchers tend to briefly touch market segmentation and focus on subse-quent activities such as targeting and positioning. If covered at all, mostly demographic or geographic variables are employed for segmentation. Taking into account that the customer is also co-producer of the service, it appears to be disappointing that market segmentation does not deserve a more thorough treatment in the service literature.
In market engineering it is principally possible to segment the defined markets using any of the five techniques given in Table 6. However, geographic, psychographic and behavioral segmentations have severe drawbacks that argue against their application. The inherent ubiq-uity of electronic markets can make a geographic segmentation in many times meaningless.
Psychographic and behavioral techniques tend to be more appropriate for firms that offer goods instead of services. As such, market engineering typically relies on demographical or benefit segmentation:
161 Literature also distinguishes a normative theory of segmentation that strives for optimal choices of seg-ments. Models have been rarely implemented and are frequently ignored by marketing literature pointing at their inherent problems concerning its operationazability (Wind 1978).
• Demographic Segmentation
The intuition behind the demographical segmentation is that certain customer groups have somewhat more homogeneous needs. For example, in financial trading retail investors have different needs than institutional investors. Nonetheless can the differences between customers of the same group still be significant. Demographic (and also geographic) seg-mentation techniques alone are apparently with respect to market engineering insufficient.
Customers are not “using” the electronic market service because they belong to a certain demographic group that shares comparable habits. Instead, they use the electronic market service because it creates value for them. For example, buyers appreciate reverse auctions as these auctions create value for them in a way that the buy prices are gradually lowered due to the competition on the seller side. In this rather general example customers con-sume this electronic market service because of its perceived benefit.
• Benefit Segmentation
Thus, for market engineering it appears to be promising to make use of benefit-oriented segmentation as well. Possible descriptors or requirements are for instance fast execution of offers, market impact, liquidity, amount of information disseminated, speed of informa-tion disseminainforma-tion, and so forth (NYSE 2000; Budimir, Holtmann et al. 2001). Using benefit segmentation for customer retention is fairly straightforward if enough data about the customers is available to extract those needs. For market firms the segmentation of customers that already take part in ongoing electronic markets it is presumably easy to gather those data. However, this is different in situations where no ongoing (electronic) markets exist. In those cases the market firm has mainly to rely on demographical data. In this case it is, nevertheless, advisable to obtain more information about the benefits from potential customers.
Example 4.3-1: Traditional versus benefit segmenting
In financial markets it is usually distinguished between private and institutional investors.
Broadly speaking institutional investors are characterized by the fact that they trade huge amounts of securities in a professional manner. Private investors are typically less in-formed and trade smaller packages of securities. If a market firm would traditionally seg-ment into private and institutional investors the segseg-mentation is of limited use, as the groups are still extremely heterogeneous. The so-called heavy traders are, for example, a sub-group of private investors who resemble in their trading behavior more institutional than private investors. A pure demographical segmentation is thus not decisive enough.
Segmenting after their trading motive appears to be a better way. Heavy traders are, for example, interested in accruing profit following a buying low and selling high strategy. As such, they are concerned about fast execution and real time information dissemination.
This brief example shows that customer needs are more appropriate criteria to reasonably segment markets.
In summary, the activity of market segmentation divides the environment that corresponds to the market definition into smaller parts according to some descriptors. In Figure 20 the doted lattice upon the cube schematically represents the result of the segmentation activity.
4.3.2.1.3 Market Targeting
Once identified, the potential segments must be evaluated concerning their validity and their relative attractiveness. Subsequently, the most attractive market segments are selected; this activity is usually dubbed market targeting (Hlavacek and Reddy 1986; Dibb 1999). The first step in market targeting is to check whether the market segments are considered qualifying.
The qualification of market segments is usually regarded as being valid, if the criteria com-piled in Table 7 – originally presented by Kotler – are satisfied (Kotler 1997).
Criteria Description
Measurability Measurability is concerned with the measurability of the size of the market seg-ment. This of course assumes that the market segment actually does exist (Beane and Ennis 1987).
Accessibility A qualifying market segment must be accessible for the market firm.
Substantiality The market segment must be sufficiently large and profitable
Actionability Actionability checks whether the market segment can be effectively reached by marketing programmes.
Table 7: Criteria for Market Targeting
Additionally marketing literature also includes segment stability also as qualifying criteria.
Only if the market segments will exist in that form for some time in the future, the market segments are promising for actions to be taken (Dibb 1999). As a matter of fact, many market segments satisfy those criteria and thus qualify for market segmentation. In other words, the qualification criteria are necessary but not sufficient conditions for service. The identification of the market segments that are potentially being served depends on the assessment of the market segments’ attractiveness.
Unfortunately, marketing literature has been aiming at the evaluation of the different segmen-tation methods rather than aiming at the evaluation of the segments itself (Sarabia 1996). At-tempts to assess the segments attractiveness guiding the targeting process can be roughly dis-tinguished into three groups:
1. Profit-oriented methods
The first group of methods seeks to trace (potential) sales revenues to market segments and relate these revenues to marketing costs that are necessary to exploit those revenues (Beik and Buzby 1973). The resulting profit gauge may, however, not be a comprehensive measure for attractiveness.
2. Multi-criteria methods
The second group of methods can be subscribed as multi-dimensional measures, as they not only contain a single measure such as profit but also other criteria such as segment stability, relative responsive rates and segment size into account (McCann 1974; Sarabia 1996). The relevance of those multi-dimensional measures is, however, diminished by their static nature.
3. Dynamic methods
The third group comprises all measures, which are not myopic in a sense that they are not only concerned with current but also with future value. For a market firm the customers of a market segment are not merely regarded as isolated transactions with only current value;
rather are these customers representing a revenue stream of potential future value. Analo-gous to the financial concept of the net present value satisfies the need of gauging the market segments’ value over time. This move from static to dynamic thinking also im-plements a long-term relationship-building behavior of the market firm (Grönroos 1994;
Elliott and Glynn 1998).
As holistic market engineering (design & operation) is principally interested in sustaining success, the methods pertaining to the third group (i.e. dynamic methods) are – due to their dynamic nature – suggested as relevant method for the assessment of market segments.
Having identified substantially attractive segments, the further task of the market firm is to select the most appropriate segments. In fact, this selection constitutes the overall
market-targeting task. The primary challenge of market market-targeting is to obtain a balanced customer portfolio (Elliott and Glynn 1998) . The underlying intuition of a balanced customer portfolio lies in the observation that not all customer relationships are worth keeping. Some customers may no longer fit under the current strategy of the market firm due to changes in their behav-ior and correspondingly in their needs. This may occur because the maintenance costs of these relationships exceed the revenues they generate. Now the goal of a market firm is to obtain a balanced customer portfolio, i.e. an optimal mixture of customers that promises sufficient current profit, adequate future profits and also decent growth perspectives. The selection of the market segment is intended to exactly attain such a balanced customer portfolio.
Finally, once the targeted market segments have been identified the environment definition phase closes initiating the requirement analysis phase.