Ecommerce

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.

The Economics of Electronic Commerce © 2003. Choi, Stahl & Whinston P-1 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. The Economics of Electronic Commerce © 2003. Choi, Stahl & Whinston P-2 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 The Economics of Electronic Commerce © 2003. Choi, Stahl & Whinston P-3 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 The Economics of Electronic Commerce © 2003. Choi, Stahl & Whinston P-4 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. The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-1 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 The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-1 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 The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-2 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 The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-3 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 The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-4 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 The Economics of Electronic Commerce © 2003 Choi, Stahl & Whinston 1-5 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.