3 Electronic Market System Framework
3.2 The Organizational View on Electronic Markets
3.2.1 The Market Firm
When the institutional view on electronic markets was depicted, the existence of a market firm was merely postulated. This postulation is now relaxed, emphasizing the organizational view on electronic markets. Firstly, the relationship between institutions and organizations are illustrated. It follows that some institutions require organizational support to be effective (chapter 3.2.1.1). Secondly, the institution of electronic markets exemplifies such institutions that need an organization. Due to the uncertainties and risks associated with the provision of electronic markets this organization will be a firm (chapter 3.2.1.2).
3.2.1.1 Institutions and Organizations
According to the well-known definition of Milgrom and Roberts are economic organizations
“[…] created entities within and through which people interact to reach individual and col-lective economic goals” (Milgrom and Roberts 1992, 19).119 Organizations are “more or less permanent combinations of production factors” (Kasper 2002, 38) such as labor and capital in pursuit of economic goals. Formal organizations are those organizations, which glue networks of agents to an entity with independent legal identity together. Examples of formal organiza-tions are corporaorganiza-tions, unions, partnerships etc. The formation of organizaorganiza-tions, i.e. the gluing together of agents requires either implicit or explicit institutions. Institutions and organiza-tions are often confounded. The reason may stem from the fact that certain instituorganiza-tions can only survive if maintained within a (formal) organization (Loehman and Kilgour 1998;
Kasper 2002): That is, organizations give backing and substance to institutions.
Hitherto, the coordination-mechanism market was analyzed by referring to their institutions.
Markets, nonetheless, also constitute an organization. In essence markets can be understood as humanly created entities, which aim at providing a facility for trading that “minimizes” the transaction costs. The institution determines the allocation and the corresponding outcomes, whereas the organization defines the relationship between buyers and sellers.
From at least medieval time, it was common in Europe to found markets as (formal) organiza-tions for trading. For example, in finance and international trade very early examples of or-ganized markets have been emerged (Greif 1993; Kroszner 1999). The reason why (formal) organizations are introduced stems from the fact that these organizations can tremendously reduce the costs that adhere to trading with strangers. A comparison will illustrate this ability.
119 In organization literature the term organization often also refers to the process of creating entities.
• Unorganized Trade
In cases, where there is no organization, agents that are willing to trade have to identify their potential transaction partners. Identification requires double coincidence of supply and demand such that a transaction can take place. The potential trade is exacerbated by the fact that potential partner are strangers. This implies that information about their reli-ability, credit-worthiness, promptness, and honesty, as well as information about the quali-ties of the goods is missing. Acquiring information about the agents and their offers and demands creates costs, which are basically transaction costs. Comprising, unorganized trade resembles trade-by-barter (Telser and Higinbotham 1977).
• Organized Trade
Organizations can streamline this trade-by-barter by introducing a standardized medium of exchange, i.e. the transaction product. The standardization of the transaction product al-lows trading without knowing the identities of the corresponding parties. Comparable with the introduction of money, the standardization of transaction product permits its inter-changeability. As all participating agents are forced to a common understanding concern-ing the transaction product, it is irrelevant from whom the product originally comes from (Telser and Higinbotham 1977). This practice enhances the liquidity and fungibility of those products among the participants (Kroszner 1999).
Furthermore, an organization can firstly design a meaningful code of business and can also monitor its compliance. A meaningful code of business refers to the trading rules, which can streamline coordination of the resources and simultaneously reduce information costs. As a matter of fact, the organization can impose those trading rules and, moreover, enforce them (Kasper 2002).
Hitherto, it was implicitly assumed that the agents in transaction comply with their obliga-tions. However, there is still the risk of default. An (formal) organization can alleviate this risk. As the participating agents may prefer to deal with someone with whom they have regular business and who has a reputation to lose, the formal organization can intermedi-ate between the parties in transaction. Instead of dealing directly with the counter party, they can clinch their deal with the formal organization of the market: the seller receives a payment incurs a liability to market organization, whereas the buyer incurs a payment but receives an asset (i.e. the transaction product) from the market organization. Failure to comply can be legally enforce by filing suits. Furthermore, the (formal) organization can ban those violators form the market. As the (formal) organization can realize economies of scale in the enforcement, they can reduce the transaction costs. However, it is not nec-essary that the formal organization actively takes part in the trade; instead intermediation can be confined to convey information about the potential counter parties.
On the one hand, the facilitation of trade reduces costs, on the other hand, it incurs costs which the formal organization has to pay (Telser and Higinbotham 1977; Kasper 2002).
Comprising, the introduction of organizations entails substantial advantages concerning standardization of the transaction product and process as well as their enforcement, incurs, however, also costs, which can be substantial as well.
Whether a market organization evolves depends on the net effect of cost reduction and crea-tion of such an organizacrea-tion. If the cost reduccrea-tions outweigh the cost creacrea-tion, as it is the case in financial markets, organizations will eventually emerge.
3.2.1.2 The Organization of Electronic Markets
Now the question arises whether electronic markets are organized? In essence, electronic markets evidently give rise to organizations. Electronic markets embody institutions that are necessarily being planned or designed. Imposing and monitoring institutions requires some sort of authority that is either above or outside the group of agents the institution regulates
(Simon 1991, 39). Designing institutions is, thus, always associated with the appointment of distinguished agents that receive their authority by creating an organization. In most of the cases the organization will be formal, as the organization gets more weight when it can inde-pendently act as a legal entity.
Hitherto it was assumed that there exists a formal organization – called market firm. But where does this market firm come from? This becomes critical, as it is not self-evident that an electronic market emerges. Having relaxed the “free-lunch assumption”, facilitation and en-forcement of trade creates costs for setting up the trading infrastructure, operating and con-trolling the trading process. Setting up the trading infrastructure in turn means investing in the appropriate hardware, acquire the necessary trading software and distributing it to the partici-pating agents. In short, operating an electronic market requires specific investments. These investments are, nevertheless, obligatory to go into service.
The claim here is that the creation of formal organizations for electronic markets requires ei-ther cooperative or entrepreneurial spirit. If neiei-ther of those spirits is present, electronic mar-kets will not emerge, as the associated costs and risks take their toll.
• Cooperative spirit
A major advantage of formal organizations in markets is to coordinate behavior by prom-ulgating standards such as the transaction product definition and the trading rules, which helps the agents to form better expectations about the behavior of the environment, includ-ing the other agents (Simon 1991). By doinclud-ing so, transaction costs among the agents can be substantially reduced. This section is labeled cooperative spirit, which hints at the origin of the formal organization: The participating agents may together constitute a kind of ring that takes responsibility of setting up an electronic market. By charging fees from the ring members the costs that are incurred by setting up and operating can be recouped. Such membership organizations are frequently vulnerable to free riding. Free riding is possible if agents can benefit from the organization without paying for it. For example, if agents that are not members of the ring can participate in the market process, they enjoy the benefits without being chargeable. In those cases the participation rules can be an effec-tive tool to force participation – those agents unwilling to pay for the organization are ex-cluded from the process.
Example 3.2-1: The Chicago Board of Trade
For example, the Chicago Board of Trade (CBOT) was initially founded in 1848 as a vol-untary membership organization. In 1850 the CBOT started with trying to promulgate standard definition of grain as a trading products. Having achieved the adoption of the standards in 1856, the main focus of the board was to encourage adherence to the new standards. Cheating was mainly enforced by the expulsion from trading. As trading in grain was almost centralized over the board, this threat was credible (Kroszner 1999).
Basically, the formal organization can be manifested by a legal firm or by a cartel of members. A cartel of members is still a cooperation, which strives for streamlining the market process by simultaneous full coverage of costs. The formal organization is in that case basically a not-for-profit organization (Pirrong 2000). In the case of a legal firm, pro-vision and operation of the electronic market are backed up by a legal enterprise. As long as the firm belongs to same members, it is likely that this joint venture still seeks for cost
coverage as maxim.120 Once the ownership is altered, the firm exhibits more entrepreneu-rial instead of cooperative spirit, reflecting profit maximization goals.
• Entrepreneurial spirit
In the second case, the formal organization is build up by an entrepreneur. Inspired by the aspiration for profit combined with the personal innovation power, the entrepreneur gives rise to a firm. As there is a demand for establishing an electronic market, the supply of a trading venue appears to be germane to extract profit. This would, however, only entail that the trading venue is provided not necessarily that a firm is founded.
In the tradition of Coase, it is referenced to the Knightian uncertainty argument: The in-tention the entrepreneur has in mind is to a great extent shadowy due to the high uncer-tainty involved with the endeavor. As the entrepreneur cannot provide the service of mar-ket operation alone, he must coordinate the activities that are necessary. However, due to the shadowy forecast what activities exactly the task of providing and operating requires the centralization of deciding and control within a firm is inevitable (Coase 1937; Coase 1988; Foss and Foss 1999).
“In the first place, goods are produced for a market, on the basis of entirely impersonal prediction of wants, not for satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers’ wants. In the second place, the work of forecasting and at the same time a large part of the technological direc-tion and control of producdirec-tion are still further concentrated upon a very narrow class of producers, and we meet with a new economic functionary, the entrepreneur. […] When uncertainty is present and the task of deciding what to do and how to do it takes the as-cendancy over that of execution the internal organization of the productive groups is no longer a matter of indifference or a mechanical detail. Centralization of this deciding and controlling function is imperative; a process of “cephalization” […] is inevitable […]”
(see Knight (1933) qtd. in Coase 1988).
There is another possibility why an electronic market is established. An industrial firm producing some kind of goods, may want to introduce an electronic market as an addi-tional channel of distribution. In those biased markets (recall chapter 3.1.1.1) it is rather dubious whether all market participants can realize the benefits of an organized trading venue. Instead the market firm is suspected to exert market power on the participants and thus extract rents from the buyers. Conversely, the market firm can also establish the elec-tronic market as a channel for procurement. But again, the market firm as buyer is sus-pected to exert market power on the sellers.
In general, novelties are introduced by firms for profit reasons and are tested in the market process. The same applies to the provision and operation of electronic markets: an entre-preneur, denoted as market firm, scent out an attractive niche for which he intends to pro-vide an electronic trading venue. Whether this trading venue will ever yield the envisioned profit depends on how successful the electronic market is on the “market for markets”.
The main idea of this section is to demonstrate that the electronic market is not merely the provision and operation of an institution, but also “as the other side of the coin” an entrepre-neurial or – at least – cooperative activity. Entrepreentrepre-neurial and cooperative activities – under the roof of a formal organization – also have in common that they fill market deficiencies
120 In electronic markets the dawn of mutualized “cartels of members” is nearing. As the marginal costs of an additional member has sharply decreased – due to information technology - to zero. Thus, charging fees for a membership is in a contestable market (for markets) economically untenable (Steil 2002).
(Leibenstein 1968). Schumpeter once coined the term of an innovative entrepreneur who con-jectures potential of profit by introducing either new goods or services or by superior produc-tion technologies or organizaproduc-tional structures (Shane 2001). Nonetheless as entrepreneurial activities are devoted to profit maximization, cooperative activities also seek to fill the market deficiencies but for some mutually agreed-on goals. As before, the formal organization in charge of the electronic market will be called – regardless of their goals – market firm. Where the distinction is necessary, it will be explicitly annotated in the following.