3 Electronic Market System Framework
3.2 The Organizational View on Electronic Markets
3.2.3 The Strategic Positioning of the Market Firm
The customers of the service – the market participants – are the primary factor that determines the quality of the market process. Basically, the market firm can train their customers con-cerning how to use the electronic market adequately. Frequently, stock exchanges offer train-ing programs for traders as complementary service.
In summary, a market firm is a service company that provides the electronic markets for elec-tronic market services. As any other service company market firms cannot determine the qual-ity of their service. By carefully designing the provision of electronic markets, the market firm can nonetheless indirectly affect the quality of their service.
ronment) coordination creates transaction costs. As transaction costs reduce the gains from trade, they reduce individual utility and on the society level social welfare.
By offering the electronic market service, which basically consists of rules and their enforce-ment, transaction costs can be decreased. The rationale lies in the better predictability of trad-ers’ actions. Thus, activities that insures against opportunistic behavior, which are generally costly, can be omitted as the institution of the electronic market will forbid or sanction this detrimental opportunistic behavior. From this perspective, the electronic market service is designed for reducing transaction costs. Coase emphasizes the transaction cost decreasing impact of institutions:
“Economists observing the regulations of the exchanges often assume that they are an attempt to exercise monopoly power and aim to restrain competition. They ignore, or at any rate fail to emphasize an alternative explanation for these regulations: that they exist to reduce trans-action costs and therefore to increase to volume of trade” (Coase 1988, 9).
The cooperative mission of the electronic market paraphrases a not-for-profit firm. This view on the mission of electronic markets typically reflects the neo-institutional paradigm.
Entrepreneurial Mission
The electronic market service can, furthermore, be offered as an instrument to extract profits.
The service is provided only if the participating agents pay fees (recall chapter 3.1.2.3.5).
Those fees are for the participants, however, part of the transaction costs that occur on trade.
When the transaction costs rise, previously profitable trades turns to detrimental ones and thus are left undone. The demand curve for this service is hence not inelastic – an increase in the fees reduces demanded quantity of services. Conceiving the market firm as a service company allows the application of the neoclassical price theory.
The neoclassical price theory investigates the firm’s price setting behavior in dependency of the competitive situation. In the model of perfect competition (infinite number of supplier of a good) the firm faces a vertical demand curve, which entails that the individual firm cannot charge more than the competitive equilibrium price. Owing to the profit maximization as-sumption the price equals the marginal costs. This implies that the firms in perfect competi-tion cannot attain supernormal profits.129
In the model of the monopoly (one supplier of a good) the demand curve – or at least a part of it – is decreasing. In this setting the monopolist can set the price above the marginal costs.130 Because the demand schedule is not vertical demand will shrink but not vanish. Optimality requires the price to be higher than the marginal costs resulting in a decrease in the quantity demanded. In other words, the monopolists raises the price by reducing quantity such that only those agents are served, who are willing to pay not only the marginal costs for this good but also an additional monopoly rent. The magnitude of the monopoly rent depends on the monopolist’s market power to exclusively occupy the supply side. Comprising, the monopo-list can realize supernormal profits.
As the monopoly model reflects the optimum for firms, they try to establish a situation, in which they face a partially decreasing demand curve. Gutenberg dubbed this situation an ac-quisitory potential. Firms will thus seek to establish such a situation by for instance product differentiation either by physical attributes or by advertisement.
129 For those unfamiliar with the classical price theory it is referred to standard microeconomic textbooks (Kreps 1990; Varian 1992).
130 This implicitly assumes that no price discrimination is possible (Wilson 1992).
Assuming the market firm to be a neoclassical firm, the market firm strives for market power in the service segment. By providing different service prerequisites the market firm can dif-ferentiate their service from the others. Recall in this context, that the service procedure com-prises the description how the service is performed via the institutional rules in particular the trading rules. Service differentiation creates a new sub-segment, which displays an acquisitory potential. In those cases the market firm can charge prices for the service that are higher than the marginal costs.
The struggle for market power has another reason that was previously not covered. The mar-ginal costs associated with the service are almost zero – the reason stems from the fact that those costs are mainly costs of information technology. Accordingly, a situation comparable with perfect competition is impossible. The reason is that the profit maximizing condition requires the price equaling the marginal costs. As the marginal costs are zero, the price cannot be higher than zero leaving the market firms with no revenues at all. Since recouping the ini-tial investments is impossible, the market firms make a loss. Market firms facing such a situa-tion, consequently have to differentiate their services or to discriminate prices to earn money with the provision of the service (Varian 2000).
The entrepreneurial mission of the electronic market stands for a for-profit firm. This view on the mission of electronic markets typically reflects the neoclassical paradigm.
Empirically the traditional organization as “cartel of members” exhibiting cooperative mis-sion in its purest form – where the members finance the trading venue through a fixed mem-bership fee – has been vanishing. For example, stock exchanges that were previously organ-ized as a cooperative club have recently turned to profit-oriented firms reflecting the entrepre-neurial mission. The German Stock exchange, Deutsche Boerse, is the prototype for this shift.
The reason for this creeping extinction of cooperative vehicles lies in the electronification of the market process, which has made these organization forms economically untenable (Steil 2002). The marginal costs of an additional member to participate have dropped to zero. In fierce competition the possible levies that can be charged for access must also drop to zero.
The rationale is straightforward: Competing market firms may offer the electronic market service with lower access levies as their competitors attracting additional participants. The other competitors have likewise an incentive to undercut the prevailing lowest access levy. At the end of this process these access levies converge to zero. Access levies are just another expression for membership fees. Comprising, membership fees are economically infeasible facing competition among market firms. Accruing funds for financing the investment and operation is possible only via transaction-based fees. Eliminating membership in favor of transaction-based fees entails that the participating agents are more treated like a customer of a firm than members of a club. As the electronic market service is a “a valuable proprietary product not costlessly replicable by traders, it is feasible for the owner to operate it, and sell access to it, as a normal for-profit commercial enterprise” (Steil 2002, 3). Apparently, this theoretical argument bolsters the empirical observation.
The discussion of the mission has revealed that profit-maximizing firms may prevail. Thus, in the following, market firms are regarded as profit-maximizing firms: Although one have to keep in mind that also cooperative spirit may influence the strategic mission, it is, nonethe-less, the entrepreneurial spirit that prevails.
3.2.3.2 Product Program
Principally, market firms are not confined to the product electronic market service. Espe-cially, when market firms strive for maximizing profit, it is reasonable to assume that they
diversify their product program. The product program of the market firms can, however, have a deep impact on the electronic market service. Suppose the product program suggests the market firm to become an active player in the market process. That is, the market firm can use the electronic market as an additional distribution or procurement channel. Then, the rules of the game may change, as the circumstances of the electronic market have changed.
To account for the changes in the circumstances stemming from the product program, Kaplan and Sawhney suggest in their influential paper a distinction of electronic markets into neutral and biased electronic markets. Their reasoning is appealing, as they argue that the aims of the market firm totally differ in those two cases, incurring different problems (Kaplan and Sawh-ney 2000).
• Neutral electronic markets
In neutral electronic markets the market firm does not actively take part in the market process. Instead the market firm maintains a fair, unbiased market process. The pivotal question for electronic markets is attracting as many buyers and sellers on the platform such that the critical mass can be surpassed. Critical mass is a term from the network eco-nomics; it states the minimum size of a network that can be sustained (Shapiro and Varian 1999; Shy 2001). As markets are “network goods”, the concept of critical mass can also be applied to electronic markets. Since neutral electronic markets do not bring per-se in-fluential buyers and sellers with them, they somehow have to attract and lock-in key trad-ers (Raisch 2001).
• Biased electronic markets
In biased electronic markets the market firm actively takes part in the market process.
That is, the market firm uses the own market venue as a different distribution or procure-ment channel. By acting as buyer or seller, the electronic market already starts with a po-tential trader. The size of the market does not completely rely on the participation decision of others, as the operator itself has some market power. But exactly this market power marks the basic problems of biased market venues. Potential partner could distrust the market firm who unites market as well as operational power.
From the lessons learnt of business-to-business markets, it becomes clear, that the participants prefer neutral electronic markets. However, experiences also revealed that neutral electronic markets have rarely surpassed the critical liquidity. For example, the global food exchange Efdex struggled with the acquisition of sufficient participants, which eventually forced Efdex to shut their electronic market down.
Biased electronic markets have advantages there, but are suspected to systematically disad-vantage other market participants. For example, the Dell eMarketplace was designed as a venue for trading computer hardware. Although the electronic market admitted not only Dell as seller, the potential participants always distrusted the tight connection between the market firm and the producer Dell. As a consequence Dell eMarketplace also had to close the elec-tronic market.131
3.2.3.3 Impact of Strategic Positioning on Electronic Markets
Obviously, the strategic positioning of the market firm affects the electronic market in two ways: Firstly, in the design of the (extended) institution and, secondly, on the behavior.
If the market firm’s mission is cooperative, then the electronic market intends to reduce the transaction-cost as much as possible. As such, the electronic market is designed to efficiently
131 More examples of unsuccessful electronic market endeavors can be seen on the dot.com graveyard (http://www.b2business.net/Startups/Graveyard/).
allocate the resources, which resembles the classical mechanism design problem. Only the costs for operating the electronic market are charged from the participants. On the other hand, the market firm may strive for maximizing its profit. Then, the market firm will probably skim off the transaction cost savings. As aforementioned, market firms will eventually adopt the later model.
Secondly, when the market firm is also market participant it is very likely that the institution is designed in a way to match the own needs. For example, if the market firm is also buyer, the trading rules may strive for forcing the prices down by some sort of reverse auction. The interweavement between market firm and participating agent directly affects agent behavior.
For example, the lack of trust in the electronic market may prevent the wide adoption of the biased electronic market.
Although there are some arguments favoring biased electronic markets (e.g. liquidity, industry knowledge, etc.), the trust argument inevitably favors neutral electronic markets. As such, this book primarily concentrates on profit-maximizing neutral electronic markets.