I n t e r n e t E c o n o m i c s

Internet-based electronic marketplaces leverage

information technology to match buyers and sellers with increased
effectiveness and lower transaction costs, leading to more
efficient, “friction-free” markets.

The Emerging Role of

Electronic Marketplaces
on the Internet
Markets play a central role in the economy, facilitating the
Yannis Bakos exchange of information, goods, services, and payments. In the
process, they create economic value for buyers, sellers, market
intermediaries, and for society at large. Recent years have seen a dramatic increase in the role of
information technology in markets, both in traditional markets, and in the emergence of elec-
tronic marketplaces, such as the multitude of Internet-based online auctions.
Functions of a Market
Matching buyers and sellers
Markets (electronic or otherwise) have three main • Determination of product offerings
functions, summarized in Table 1: matching buy- - Product features offered by sellers
ers and sellers; facilitating the exchange of infor- - Aggregation of different products
• Search (of buyers for sellers and of sellers for buyers)
mation, goods, services and payments associated - Price and product information
with market transactions; and providing an insti- - Matching seller offerings with buyer preferences
• Price discovery
tutional infrastructure, such as a legal and regula- - Process and outcome in determination of prices
tory framework, that enables the efficient
functioning of the market. Facilitation of transactions
• Logistics
In a modern economy, the first two functions - Delivery of information, good, or service to buyer
are provided by intermediaries, while the institu- • Settlement
tional infrastructure is typically the province of - Transfer of payment to seller
• Trust
governments. Internet-based electronic market- - Credit system, reputations, rating agencies like Consumer
places leverage information technology to perform Reports and Better Business Bureaus
these functions with increased effectiveness and Institutional infrastucture
reduced transaction costs, resulting in more effi- • Legal
cient, “friction-free” markets. - Commercial code, contract law, dispute resolution,
intellectual property protection
Matching Buyers and Sellers. Markets “clear” • Regulatory
by matching demand and supply. This process of - Rules and regulations, monitoring, enforcement
matching buyers’ demand with sellers’ product
offerings has three main components: determining Table 1. Functions of a market

COMMUNICATIONS OF THE ACM August 1998/Vol. 41, No. 8 35

 Establishing a dialogue and a sense of community among
customers can create value by enabling the sharing of experiences,
problems and solutions, but also allows the collection of
important information about individual consumers.

product offerings, search, and price discovery. The behav- For instance, some financial markets use one or more
ior of buyers, sellers, and intermediaries is motivated of the several types of auctions to determine prices,
by their desire to maximize their private utility. such as the “call market” auction at the opening of a
When markets function well, this also leads to an trading day at the New York Stock Exchange, when
efficient allocation of productive resources. Viewed bids are accepted up to a certain time and exchange
this way, markets are the engine and steering system occurs when the market opens. This is the first price
of our economy. that is communicated via the stock market ticker to
Markets provide sellers with information about the market at large, kicking off a day of “continuous
demand that allows them to employ economic inputs market” trading. Other markets, such as the tradi-
such as capital, technology and labor, and develop tional automobile dealership, employ negotiation
products with characteristics that match the needs of between buyers and sellers until a price is reached. In
buyers. Sellers determine a schedule of product offer- still other markets, such as the typical department
ings that they expect will maximize their profits store, merchants make firm offers that customers can
based on: either take or leave.
Facilitation of Transactions. The matching func-
• information about buyer demand; tion of a market establishes a bilateral relationship
• the cost of inputs; between a buyer and a seller. After a transaction is
• the available technology for production and dis- agreed upon, the product sold must be transported to
tribution of the information, goods and services the buyer (logistics), and payment must be transferred
purchased by the buyers; and, to the seller (settlement). Markets typically incorpo-
• the transaction costs of administering production, rate mechanisms for logistics and settlement: when a
distribution, and payment. travel agent uses an airline reservations system to
book a flight, the system will generate the itinerary
Buyers select their purchases from the available and the ticket, and will process a credit card payment.
product offerings after considering factors such as Furthermore, market transactions require the estab-
price and product characteristics. In obtaining and lishment of a certain level of trust, which protects
processing this information, buyers face search costs. buyers, sellers and intermediaries from the oppor-
These costs include the opportunity cost of time spent tunistic behavior of other market participants. For
searching, as well as associated expenditures such as instance, this trust role may include banks issuing let-
driving, telephone calls, computer fees, magazine sub- ters of credit, credit reporting bureaus, or rating agen-
scriptions, etc. Typically, sellers exploit these search cies such as Consumer Reports and Better Business
costs by raising their prices, and thus enjoy higher Bureaus, which keep track of product information and
profits. Similarly sellers may face search costs in locat- seller reputations, and thus discourage opportunistic
ing qualified buyers for their products, such as market behavior. Finally, markets provide the physical infra-
research, advertising and sales calls. structure that allows transactions between the buyers
A key function of markets in our economic system and the sellers to take place. This includes real assets
is price discovery, which is the process of determining such as physical structures and trading floors, com-
the prices at which demand and supply “clear” and puters and communication networks, and transporta-
trade occurs. For certain markets, such as financial tion systems.
markets, this is their primary function. Markets can Institutional Infrastructure. The institutional
employ a number of mechanisms for price discovery. infrastructure specifies the laws, rules and regulations

36 August 1998/Vol. 41, No. 8 COMMUNICATIONS OF THE ACM

that govern market transactions, such as issues related
• Purchasing a new home
to contract law, dispute resolution, and intellectual - Research city and neighborhood
property protection, and provides mechanisms for - Find a house
their enforcement. In addition, the dynamics of elec- - Inspections, title research, appraisals, contracts
- Get a mortgage
tronic markets may raise certain antitrust issues. For - Moving services
example, there are large economies of scale in distrib- - Decorators, furniture, etc.
• Planning a vacation
ution, as a single online retailer or intermediary can - Research destination
serve a very large market. There are also potential - Arrange accommodations and travel
demand-side economies of scale in payment mecha- - Purchase maps, books, information
- Check out weather, items to take
nisms and software. These may lead to a winner-take- • Purchasing a car
all market structure [1] with one or a few firms - Research make and model
- Select a dealer
dominating the market. - Get a loan or arrange a lease
- Purchase insurance
How the Internet Affects Markets
Electronic marketplaces, especially Internet-based Table 2. Components of consumer processes and
markets, are having a major impact on the roles of transaction/distribution cost
markets discussed previously [2, 12].
Product Offerings. Two major emerging trends The ultimate objective is to provide customized ser-
distinguish products in electronic marketplaces from vices according to individual preferences, whether
their traditional counterparts: increased personalization expressed or inferred. Increased selling effectiveness
and customization of product offerings, and the aggregation comes from being able to design appropriate prod-
and disaggregation of information-based product components ucts to address the needs of individual consumers,
to match customer needs and to support new pricing and from being able to identify the moment when a
strategies. customer’s purchasing decision is most likely to
Electronic marketplaces support personalization occur and to be prepared for that moment, one step
and customization in two ways: ahead of the competition.
When determining their product mix, sellers
• Consumer tracking technology allows the identi- must decide which product components or features
fication of individual buyers; information about will be included in each product offering. For exam-
these buyers, such as relevant demographics, con- ple, the developer of an operating system must
sumer profiles, or comparison with the known decide which features to implement, and whether
preferences of similar consumers, can be used to they will be marketed and priced individually or in
discover or estimate their specific preferences. a single bundle. These decisions are driven by the
• Information-rich products lend themselves to relative cost of different product bundles, which
cost-effective customization; for instance, deliver- includes the following types of costs:
ing an electronic newspaper tailored to the inter-
ests of an individual reader need not be more • Production cost: the cost of producing additional
costly than delivering the same copy to all units for inclusion in the bundle, including stor-
subscribers. age, processing, and communications costs
incurred in the process.
Current personalization and customization technolo- • Transaction and distribution cost: the cost of dis-
gies use either rule-based systems like Broadvision tributing a bundle of goods and administering
(www.broadvision.com) that draw upon sets of the related transactions, such as arranging for
expert rules, or collaborative filtering systems like payment.
the Firefly Network (www.firefly.net) that utilize the • Binding cost: the cost of binding the component
feedback and experiences of consumers with a profile goods together for distribution as a bundle, such
of likes and dislikes similar to the targeted buyer. as formatting changes necessary to include news
This allows the practice of “one-to-one market- stories from wire services in a newspaper bundle.
ing,” which is based on understanding individual • Menu cost: the cost of administering multiple
consumers. For instance, establishing a dialogue and prices. If a mixed bundling strategy is pursued,
a sense of community among customers can create where the available components are offered in dif-
value by enabling the sharing of experiences, prob- ferent combinations, then a set of n goods may
lems and solutions, but also allows the collection of require as many as 2n prices (one for each subset
important information about individual consumers. of one or more goods).

COMMUNICATIONS OF THE ACM August 1998/Vol. 41, No. 8 37

 Consumer Reports, and recommendations from friends.
She would then agree on price, order the vehicle, and
c take delivery through a car dealer, arrange financing
Marginal production,
distribution, and through a bank, and purchase insurance from an
transactions are high insurance company. By dramatically lowering the
Marginal Costs
enough to make both
bundled and unbundled transaction, distribution and binding costs, the
Unbundled
sales dominate sales unprofitable Internet has allowed intermediaries such as Auto-by-
bundling Tel (www.auto-by-tel.com) or Microsoft’s Carpoint
Mean
Valu- (www.carpoint.com) to offer all of these products
ation
Bundling is more and services, with the exception of an actual test
c0 profitable than drive.
unbundled sales
Similar intermediaries are emerging in other
Distribution Costs d areas, such as the Travelocity (www.travelocity.com)
and Microsoft’s Expedia (www.expedia.com) travel
Figure 1. Phase diagram for bundling and unbundling services aggregators, or Microsoft’s Boardwalk Web
strategies as a function of marginal cost site that will aggregate products and services related
to real estate transactions.
The Case of Information Goods. Digital infor-
mation goods, such as news articles, digital images
Internet marketplaces are changing the constraints or music, allow perfect copies to be created and dis-
imposed by these costs and thus are fostering new tributed almost without cost via the Internet. The
types of intermediaries that create value by aggre- Internet is thus precipitating a dramatic reduction
gating services and products that traditionally were in the marginal costs of production and distribution
offered by separate industries. For instance, Table 2 for these goods, while micropayment technologies
shows the components of three processes that gener- are reducing the transaction costs for their commer-
ate value for consumers. In traditional markets, these cial exchange. Bakos and Brynjolfsson [6] point out
components are provided by separate industries. A that this creates new opportunities for repackaging
consumer in the market for a new car might select a content through strategies such as bundling, site
make and model based on the experience collected licensing, subscriptions, rentals, differential pricing
from test drives, research from auto magazines and and per-use fees. All of these schemes can be thought

Figure 2. ComputerESP price comparison engine

38 August 1998/Vol. 41, No. 8 COMMUNICATIONS OF THE ACM

of as either aggregating or disaggregating informa- match their needs.
tion goods along some dimension. For instance, Several Internet-based technologies assist buyers’
aggregation can take place across products, as when searching: multimedia, high bandwidth, and rating
software programs are bundled for sale in a software sites provide more product information. Search
suite or when access to various content of an online engines help buyers identify appropriate seller offer-
service is provided for a fixed fee. Aggregation can ings. The search engines can be hierarchical directories
also take place across consumers, as with the provi- (like Yahoo!), generic tools (like AltaVista in early
sion of a site license to multiple users for a fixed fee, 1998), or specialized tools that work best in the con-
or over time, as with subscriptions. text of specific markets (such as Pricewatch and
Many information goods have been bundled solely ComputerESP for computers and peripherals, or
to save on transaction, distribution and menu costs, Expedia and Travelocity for airline tickets and other
yet these costs are much lower on the Internet. Thus travel products). Intelligent agents such as Bargain-
software and other types of content may be increas- finder (bf.cstar.ac.com/bf) or Jango (www.jango.com)
ingly disaggregated and metered, as on-demand soft- have been developed to scout the Web and compare
ware applets or as individual news stories and stock product offerings by price or features on the behalf of
quotes. Independent of the cost considerations men- the buyers. These technologies keep lowering buyers’
tioned previously, Bakos and Brynjolfsson [6] show search costs. The lower search costs enable new mar-
that aggregation of large numbers of information kets to emerge. For example, low buyer search costs
goods can be a powerful strategy that results in and global reach allowed Onsale.com
higher profits for sellers as well as a socially desirable (www.onsale.com) to create markets in goods like
wider distribution of the goods. This is due to the secondhand cameras; otherwise the search costs
ability of aggregation to change the shape of the would be too high to enable potential buyers and
demand curve faced by the sellers to one that is eas- sellers to find each other in a conventional market.
ier to exploit. Several other intermediaries are emerging to facili-
Aggregation can be a surprisingly profitable strat- tate the process of matching buyers and sellers.
egy when marginal production costs are low and con- Among many others they include Yahoo!, Price-
sumers are homogeneous. Bakos and Brynjolfsson’s watch, Netbot’s Jango, and several other search
analysis provides a framework to understand the engines, Web directories and shopping agents. They
emergence of intermediaries that aggregate online also include providers for product information (e.g.,
content, such as America Online and Yahoo!, as well CNet, trade magazines), recommendations and per-
as the increasing use of subscription pricing in the sonalization (e.g., Firefly Network), and information
sale of information goods by companies such as about sellers such as Bizrate.
Netscape, Dow-Jones, or Reuters. Figure 1 graphi- Price Discovery. Electronic marketplaces enable
cally summarizes this discussion and depicts the new types of price discovery to be employed in dif-
impact of marginal cost c and distribution/transac- ferent markets. For example, some airlines auction
tion cost d on the desirability of bundling large num- last-minute unsold seats to the highest bidders, and
bers of information goods. Web-based auctions at Onsale.com have created for
Search. Electronic marketplaces lower the buyers’ consumer goods markets that function like the finan-
cost to obtain information about the price and prod- cial markets. Intermediaries such as Priceline
uct features of seller offerings as well as the sellers’ cost (www.priceline.com) allow buyers to specify product
to communicate information about their prices and requirements and the amount they’re willing to pay,
product characteristics. For instance, a buyer in the and then make corresponding offers to the partici-
market for a 400MHz Pentium II microprocessor can pating sellers, reversing the traditional functioning
easily compare the prices of different sellers by using a of retail markets. Finally, agents such as Kasbah
specialized search engine like Pricewatch (www.price- (ecommerce.media.mit.edu/kasbah) and Tête-à-Tête
watch.com) or ComputerESP (www.computeresp. (ecommerce.media.mit.edu/tete-a-tete) that can
com), as shown in Figure 2. Similarly, links to manu- negotiate purchases on behalf of buyers and sellers,
facturers’ Web sites can be used to obtain detailed may restructure the price discovery process in Inter-
information about the product features of different net marketplaces [11].
laptop computers. By lowering buyers’ search costs, The ability to customize products, combined with
electronic markets increase economic efficiency. Not the ability of sellers to access substantial information
only do buyers incur lower costs even after considering about prospective buyers, such as demographics,
more product offerings, they also benefit from being preferences and past shopping behavior, is greatly
able to identify and purchase products that better improving sellers’ ability to price discriminate—that

COMMUNICATIONS OF THE ACM August 1998/Vol. 41, No. 8 39

is, to charge different prices for different buyers. UPS are emerging as major Internet intermediaries,
Price discrimination is a powerful tool that allows because of their logistics expertise and their
sellers to increase their profits, and reduces the con- economies of scale in distribution.
sumer surplus enjoyed by buyers. On the other hand, Electronic payment systems will further lower
price discrimination enables sellers to service buyers transaction costs in Internet marketplaces, and
who would otherwise be priced out of the market, an micropayment systems will lower the cost of small
outcome that increases economic efficiency. transactions, enabling new pricing strategies such as
These new types of price discovery, such as the the metering of software use. As face-to-face market-
ability of buyers to make offers and the ability to places are replaced by electronic ones, there is
conduct electronic negotiations between buyer and increasing need to protect market participants from
seller agents, are changing the “microstructure” of opportunistic behavior. Technologies such as public
consumer markets. Finance theory has shown that key cryptography can provide security and authenti-
market microstructure affects both the efficiency of cation of transactions, while intermediaries like
markets and the bargaining power of their partici- Bizrate (www.bizrate.com) will use information
pants. The increasing importance of electronic com- from consumers to keep track of merchants’ reputa-
merce emphasizes the need to carry this
type of research analysis to electronic mar-
Mark-
ketplaces. It is unclear who the beneficia- up As search costs fall from very high to
moderate, new markets emerge, and
ries of this process will be. The ability to both sellers and buyers benefit.
r However, if search costs continue to fall,
implement different price discovery mech-
market prices fall and sellers are made
anisms may result in more efficient mar- worse off, while buyers benefit from the
kets, thus benefiting buyers and hurting r/2 lower prices and their improved ability
to find products that fit their needs.
inefficient sellers. As menu costs decrease,
sellers will move away from fixed pricing,
and more prices will become negotiable buyer
[7]. While savvy buyers may benefit, the 0 search
ability to negotiate prices may not be r 2/4t r 2/t cost
market breakdown
pleasant or result in a good deal, as many
visitors to auto dealerships have discov-
ered. Furthermore, when sellers are better informed, Figure 3. The impact of buyer search costs in a differentiated
they are likely to increase their profits by charging market
different prices to different buyers. Economic theory
predicts that buyers with more bargaining power, tions. Credit bureaus and credit card companies will
typically the more affluent ones, will fare better in provide credit information or guarantee payment for
this situation. consumers. Finally, intermediaries like Verisign
Facilitation. The cost of logistics—the process of (www.verisign.com) are emerging as “certificate
transporting products from the seller to the buyer— authorities” that match legal identities to the pos-
has been estimated at more than 10% of the GNP session of cryptographic keys—a public key infra-
[8]. Electronic marketplaces improve information structure.
sharing between buyers and sellers, helping lower
the cost of logistics and promoting quick, just-in- Internet Marketplaces and Competition
time deliveries and reduced inventories. The distrib- Impact of Lower Search Costs. The ability of Inter-
ution of information goods such as newspapers, net marketplaces to reduce search costs for price and
music, videos and software, is likely to be com- product information may significantly affect compe-
pletely transformed, as the information infrastruc- tition. Bakos [4, 5] shows that lower buyer search
ture will replace physical distribution systems. costs in electronic marketplaces promote price com-
Sellers in Internet marketplaces are typically respon- petition among sellers. This effect will be most dra-
sible for delivery to their customers, and increasingly matic in commodity markets, where intensive price
contract with third-party providers for direct deliv- competition can eliminate all seller profits. It will
ery from the manufacturer to the final consumer, also be significant in markets where products are dif-
reducing costs and time-to-delivery. Thus, direct ferentiated, reducing the monopoly power enjoyed
sellers like Dell Computer are squeezing out tradi- by sellers, and leading to lower prices and seller prof-
tional intermediaries such as wholesalers and dis- its. Figure 3 shows the equilibrium prices for a dif-
tributors, while delivery providers such as FedEx and ferentiated good with zero marginal cost, which

40 August 1998/Vol. 41, No. 8 COMMUNICATIONS OF THE ACM

 The dynamics of friction-free markets are not attractive for sellers
that had previously depended on geography or customer ignorance to
insulate them from the low-cost sellers in the market.

consumers value at r and has a degree of differentia- vices. Internet marketplaces could provide price cut-
tion t. As search costs fall from very high to moder- ters with the means to reach a larger fraction of the
ate, new markets emerge, and both sellers and buyers buyers, and thus undermine the monopolistic nature
benefit. However, if search costs continue to fall, of these markets.
sellers are made worse off since buyers can more eas- While there is much speculation about the effect
ily find the lowest-cost seller, while buyers benefit that electronic marketplaces have on prices, thus far
from the lower prices and their improved ability to there has been little systematic analysis. One
find products that fit their needs. exploratory study by Bailey and Brynjolfsson [3] did
The dynamics of friction-free markets are not not find much evidence that prices on the Internet
attractive for sellers that had previously depended on were lower than prices for the same goods sold via
geography or customer ignorance to insulate them traditional retail channels. Their analysis was based
from the low-cost sellers in the market. As geogra- on data from 52 Internet and conventional retailers
phy becomes less important, new sources of product for 337 distinct titles of books, music compact discs,
differentiation, such as customized features or service and software. Bailey and Brynjolfsson provide several
or innovation, will become more important, at least possible explanations for their unexpected findings,
for those sellers who don’t have the lowest cost of including the possibility that searching on the Inter-
production. Also, like an arms race in which both net during the sample period was not as easy as is
sides develop increasingly powerful weapons, sellers sometimes assumed, that the demographics of the
can exploit the reduction in menu costs to compen- typical Internet user encouraged a higher price equi-
sate for the lower search costs in electronic market- librium, that many of the Internet retailers were still
places. Specifically, sellers can make it difficult to experimenting with pricing strategies, and that
compare the price of alternative product offerings, Internet retailers were differentiating their products
and they can attempt to collect information about (for example, via delivery options or customized rec-
buyers that allows more effective price discrimina- ommendations). Clearly, more empirical research is
tion. Airlines, for example, have implemented needed in this area.
extremely complicated and ever-changing fare struc- Increasing Differentiation and Lowering the
tures, flight restrictions, and ticket availability, Cost of Product Information. A higher degree of
sometimes offering hundreds of fares for travel product differentiation leads to an increase in seller
between certain pairs of destinations. profits, which may partially or completely offset the
It is also interesting to note that when informa- decrease caused by lower search costs. Sellers in elec-
tional inefficiencies prevail, a large number of sellers tronic markets will thus want increasingly to differ-
does not necessarily result in a competitive and effi- entiate their products, possibly utilizing the
cient market. If search costs are high, individual sell- personalization and customization technologies dis-
ers do not have a strong incentive to lower their cussed earlier.
prices because few buyers would discover them. As Buyers in a differentiated market face two types of
the number of sellers increases, it becomes more dif- search costs: the cost of obtaining price information
ficult for buyers to locate discounters, and thus the and the cost of obtaining information about the
market may become more monopolistic as the num- product characteristics of a seller’s offering. If sellers
ber of sellers increases! This behavior is likely in cer- can control the type of electronic market introduced,
tain markets with little or no advertising, such as they should favor a system emphasizing product
some markets for professional legal and medical ser- information rather than price-shopping.

COMMUNICATIONS OF THE ACM August 1998/Vol. 41, No. 8 41

 A key variable for such a system is the cost of tained as electronic intermediaries gain a significant
product information relative to the cost of price market share. Instead, the physical experience com-
information about the product. For instance, an ponent might be unbundled to a physical interme-
electronic marketplace designed to promote price- diary. Auto-by-Tel, for example, may pay a fee to the
shopping makes it easy to compare price informa- intermediary where the test drive took place, a ser-
tion, but might still require a higher-cost inquiry vice that could be provided by a traditional dealer-
(such as a visit) to obtain detailed product informa- ship, but also by a specialized showroom or a car
tion. For example, a buyer looking for a computer rental company.
monitor on the Internet can easily compare prices Internet-based electronic marketplaces are still at
from a large number of sellers, but then must obtain a formative stage, and it is hard to fully predict their
and evaluate the monitors’ specifications, assess the impact on the structure of markets. However it is
sellers’ reputations and return policies, and ideally becoming clear that they will promote greater eco-
locate a display model at a showroom or at a col- nomic efficiency, and help sustain economic growth.
league’s office. In the process, they are creating major transforma-
By contrast, an electronic marketplace can be tions, full of strategic opportunities for intermedi-
designed to promote competition based on product aries ready to compete by adding value for buyers
features. For example, high-quality multimedia and sellers rather than by exploiting information
product descriptions in standardized formats could asymmetries. c
help identify product offerings matching the buy-
er’s preferences, while price information could be References
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physical deliveries and payments, providing trust
relationships and ensuring the integrity of the Yannis Bakos (bakos@stern.nyu.edu; www.stern.nyu.edu/~bakos)
markets. will be joining the Stern School of Business at New York
Presently, Internet-based electronic intermedi- University as an associate professor of Management.
aries often “freeload” on traditional intermediaries
Permission to make digital or hard copies of all or part of this work for personal or class-
for various reasons, such as the physical experience room use is granted without fee provided that copies are not made or distributed for
that is still important in several markets before a profit or commercial advantage and that copies bear this notice and the full citation on
the first page. To copy otherwise, to republish, to post on servers or to redistribute to
buyer can select an appropriate product offering. For lists, requires prior specific permission and/or a fee.
example, car buyers may test drive a vehicle at a tra-
ditional dealer, and subsequently purchase it
through Auto-by-Tel. This clearly cannot be sus- © 1998 ACM 0002-0782/98/0800 $5.00

42 August 1998/Vol. 41, No. 8 COMMUNICATIONS OF THE ACM