MISQ 1999 - Grover - Six Myths of Information and Markets

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Six Myths of Information and Markets: Information Technology Networks, Electronic

Commerce, and the Battle for Consumer SurplusAuthor(s): Varun Grover and Pradipkumar RamanlalSource: MIS Quarterly, Vol. 23, No. 4 (Dec., 1999), pp. 465-495Published by: Management Information Systems Research Center, University of MinnesotaStable URL: http://www.jstor.org/stable/249486

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Grover& Ramanlal/SixMythsof Informationnd Markets

SIXMYTHSOF INFORMATIONND MARKETS:INFORMATION ECHNOLOGYNETWORKS,ELECTRONICOMMERCE,AND THE BATTLE ORCONSUMERSURPLUS1By: VarunGroverManagement Science DepartmentCollege of Business AdministrationUniversity of South CarolinaColumbia, SC 29208U.S.A.

[email protected] of FinanceCollege of Business AdministrationUniversity of Central FloridaOrlando, [email protected]

AbstractThe infusion of powerful information networksinto business environments is beginning to havea profound impact on the nature of governancebetween buyers and sellers in the marketplace.Most articles in this area emphasize the benefitsto the consumer side of the equation due toreduced coordination, search, and transactionalcosts. This article presents a broader view ofinformation and markets by elucidating innova-tive ways that sellers can survive in intenselycompetitive markets. The article is framed in

Allen Lee was the acceptingsenior editor for thispaper.

terms of six myths and counter-myths of infor-mation technology and effective markets. Themyths provide a conventional view of howincreased customization and outsourcing, openarchitectures, a larger customer base, and lowprice guarantees will benefit the buyer. Thecounter-myths illustrate that it is altogether fea-sible for IT to enable supplier strategies thatextract consumer surplus. For instance, supplierscould use IT to price discriminate by tailoringproduct offerings and charging buyers as muchas they are willing to pay. They could also seg-ment markets making comparative shopping dif-ficult, thus avoiding the competitive equilibri-um. Also, suppliers could focus on the creationof networks that lock in customers or followaggressive pricing strategies that deter pricecompetition.Both the myths and counter-myths are presentedand examined in a polemical format using sim-ple, fundamental economic arguments. We hopeto provide provocative new avenues for dis-course in this area by recognizing the complexi-iy of interactions between buyers and suppliersin a highly networked environment.Keywords: Electronic markets, networked mar-kets, myths of markets,economic theory, sell-er strategies, buyer strategies, electronic com-

merceISRL Categories: AM02, BA01, CA10, GA01,HA0702

MISQuarterlyVol.23 No. 4, pp. 465-495/December1999 465

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IntroductionA classic example of informationtechnology thatcreated strategic advantage is the ASAPsystem atAmerican Hospital Supply Corporation (AHSC).This interorganizational system allowed hospitalsto order their supplies directly through personalcomputers or mainframes linked directly toAHSC's mainframes. Customized informationflow through this proprietary network createdswitching costs for the buyer hospital, therebyproviding AHSC with monopolistic power. In1985, AHSC was purchased by Baxter Travenol,which partnered with General ElectricInformationServices to create a hospital supplymarketplace. Successive generations of ASAPcreated a more distributed market-based modelthat today involves many hospital suppliers(competitors of the old AHSC) and buyersinvolved in an end-to-end electronic commerceinfrastructure or the hospital industry.This evo-lution is not unlike changes in other industries.For instance, American Airline's SABREsystem,once a source of monopolistic rents for theprovider, is now an independent profit centerthat facilitates an unbiased electronic market(Applegate 1995).The rationale behind these consistent patternscan be found in increased industry competition,reduced technology costs, and increased inter-connectivity of technology through open archi-tectures. Ifwe complement these trends with therecent explosion of almost ubiquitous infrastruc-tures like the Internet, it is possible to argue fordistributed market structures and consequentlymore effective markets. Indeed, such reasoningcan be found through the lens of transaction costeconomics, where information technologydecreases coordination costs between buyersand sellers,2 making market structures moreviable (Malone et al. 1987). The power ofInternettechnologies to match buyers and sell-ers, share information, reduce search costs, andcompare complex products has been argued toalleviate market imperfections, resulting in moreeffective markets (Bakos 1991 a).

2Theterms "sellers"and "suppliers" re used inter-changeablyn this document.

While hardevidence for such a definitive rendtowardmarketshas been limited at best, somelongitudinalobservations indicate survival ofmonopolisticpositions,despite significant nfu-sion of information technology (Hess andKemerer 994; Lee1998). However,no study oour knowledgehas had the luxuryof observingpatterns f evolutionon the Internet, technolo-gy that involves a quantumleap in its reach,openness,and impact(Quelch and Klein1996;Widdifieldand Grover1995). Morover,he ges-tationperiodforevolution of puremarket truc-turesis unknown,while the argumentsorthesestructures emainvociferousand reasonable.Inthis paperwe seek to providea broaderviewof information nd markets.We do so by fram-ing conventionalargumentson how the freeflow of information n Internet-like nfrastruc-tures should favor buyers, thereby improvingmarketeffectiveness.We then presentplausiblecounter-argumentso illustratepossible supplierstrategies hat are now viable. With the neweconomics of information,hese strategiesmayindeedimpedemarket ffectiveness.Weexpandcurrenthinkingby providingargumentsor andagainst marketeffectiveness, presented in theform of "myths"and "counter-myths." heydraw extensivelyfrom fundamentaleconomicprinciples.Economicexamplesare also provid-ed for illustrative urposesand not as a substi-tute for empiricalresearch. It is important onote thatthese alternative rguments nd exam-ples do not follow deterministically s the onlypossibledeductionsand conclusions fromexist-ing economic theory but representaltogetherfeasible strategies that economic actors canenact. The intent here is simple:we wish to beprovocative in impressing upon readers thecomplexityof interactions n networked con-texts, and the need to broaden the scope ofinvestigationwhen examiningmarketeffective-ness on the Internet.Thefollowingsectionsprovidebackgroundntofundamental conomic theoryof effectivemar-kets, he roleof informationechnology,andgen-eral assumptions hat are made in subsequentdiscussion.Examplesand economic argumentsfor each mythand counter-myth f informationand markets ollow this. The final two sectionsdiscussthe implications ndconclusions.

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Grover& Ramanlal/SixMythsof InformationndMarkets

MicroeconomicTheoryofEffectiveMarketsA fundamental, comprehensive representationofa market is the aggregate demand curve (seeFigure 1). It specifies the consumers' reservationprice, i.e., the maximum amount they are willingto pay for each successive unit of the product. Inpractice, consumers pay only the market price,which depends on the degree of competitionbetween suppliers and their ability to price dis-criminate between consumers. The differencebetween the reservation price and the marketprice (summed across all customers) is the con-sumer surplus.Marketeffectiveness may be char-acterized in terms of the division of this surplusbetween consumers and suppliers, where moreeffective markets are characterized as those thatbenefit the consumer (see Varian1984).In markets where suppliers face perfect competi-tion, the equilibrium price will be the minimuma supplier is willing to accept, equal to the mar-ginal cost of producing the product. Pricingabove the marginal cost will drive a consumerfrom one supplier to another who offers a lowerprice. Under perfect competition, consumer sur-plus takes on its maximum possible value. Theentire surplusaccrues to consumers (given by thearea under the demand curve but above theequilibrium price POin Figure 1). Thus, marketsare most effective when perfect competitionholds.

Incontrast,markets releasteffectiveunderper-fect price discrimination. If suppliers can assesstheircustomer's eservation riceandare abletosegmentmarkets,ach customer ouldthenfacea differentmarketprice equalto the reservationprice. By charging he maximumamountthateach customer s willingto pay alongthe entiredemandcurve,suppliersextract otal consumersurplus,herebymakingmarketseasteffective.This perspectiveof marketsdescribesthe twoextremesof a spectrum: erfectpricediscrimina-tion,wheresuppliers xtracthe entireconsumersurplusand markets re leasteffective;and per-fect competition,wheremarketsare mosteffec-tive becausethe surplusn itsentiretyaccrues oconsumers.Giventhe realityof opposingmotivesof suppli-ers and consumers,however,most markets allbetween these two extremes. The conflictingforcesatplaywill determinehe eventualmarketstructure. For example, commoditizationenhances product substitutibilityand lowersearch costs permit comparative shopping,which results in more effective markets.Conversely,informationasymmetriesbetweensuppliersand customersand cost differentialsbetween them for acquiring nformationaboutproductsand pricesresult n less effectivemar-kets.In he latter ase, someof the consumer ur-pluswill be expropriatedromcustomersas sup-pliersset pricesbasedon decisions madewithinthe corporatehierarchy ather han as a conse-

In perfect competitionPO= marginal cost of product

QOQuantity

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Value toConsumer(P1)P rice

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quence of market forces. This situation sustainsitself when there are inhibitors to pure competi-tion, which presupposes that buyers can cost-lessly search for alternative suppliers and com-pare product offerings.Our premise of the market'seffectiveness reflectsthis continuum where effective markets, whichwork in favor of the consumer, are contrastedwith ineffective markets, which work in favor ofthe supplier. The remainder of this paper willdraw upon these concepts, which relate marketeffectiveness to the distributionof consumer sur-plus in discussing the myths of the impact ofinformationtechnology on market structures.

ITand EffectiveMarketsThe worldwide web of computer networks andelectronic information services allow a large,growing number of suppliers to interact with alarge, growing number of buyers. Transactionrevenue on the Internet is estimated at over $2billion, and it is just beginning to enter a phase ofrapid growth. ForresterResearch, a Cambridge,Massachusetts, based research organization,forecasts annual online sales in 2000 willapproach $7 billion. The U.S. telecommunica-tions deregulation bill, the growth in multimediaservices, the availability of intelligent searchagents, and the investments in widening band-width are just some of the trends that bode wellfor electronic commerce.Conventional thinking would suggest that thesetrends point us in the direction of greater com-petitiveness and more effective markets, wherethe free flow of information permits buyers tosearch competing sellers, thereby forcing thecompetitive equilibrium. Presumably, sellers areless able to sustain monopolistic positions. Fouraspects of this argument that suggest movementtoward price competition are:1. ITreduces transaction costs: If IT reduces the

buyers'costs associated with conducting mar-ketplace transactions, namely, searching forsuppliers, information seeking, and negotiat-ing contracts, then comparative shopping isfeasible and the supplier's ability to generatemonopolistic rents is reduced. Conversely, if

coordination osts are high, buyers may notincurthe searchcosts to uncovercompetingsuppliers, allowing suppliers to increaseprices recognizing hat buyerswould ratherpaythe higherpricethan incuran expensivesearch.Inthis case, lowering priceswill notincreasethe supplier'sprofitabilitybecauseadditionalbuyerswould not be attracted ueto restrictive earch costs. Therefore,priceschargedwould be higherthan those underpure competition,resulting n less effectivemarkets.As these costs decreasethroughIT,these excess profitsare eventuallycompetedaway (Bakos1991a, 1991b; GurbaxaniandWhang1991).

2. ITreduces perceived complexity of products:If IT allows buyers to search and comparecomplex products by providing informationina manner that is easy to interpret, the buyerperceives less complexity and can changesuppliers based on this information. Thisresults in more effective markets (Malone etal., 1987). In other words, informationreduces uncertainty for the buyer regardingthe value of complex products, thereby reduc-ing the suppliers' ability to capitalize on thisinformation asymmetry and generate higherrents.

3. IT reduces asset specificity: If ITallows prod-ucts to be recast into alternative uses (i.e.,reducing assets specificity) by changing someof their informationattributesat minimal cost,then a broader range of consumers willreceivemore"customized"roducts Maloneet al. 1987).However,nowconsumers annotbe charged a premiumfor customization,because alternativesuppliers could gatherinformationnddo the samecustomization tvirtuallyno cost. Inotherwords,customiza-tionbecomesa commodity ervice hat s sub-ject to marketorces,resultingn bettervaluefor the consumer and more effective markets(Bakos 1991b).

4. IT increases free information flow. If ITallows buyers to become more informedabout suppliers in the marketplace and theirproduct offerings, and suppliers can accessinformationon the needs of buyers, the basisforgeneration of excess profitsis reduced. Itis



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a well-knownprincipleof economic theorythat in competitive marketswith efficient,free,andcompleteflow of information,ellersreceive no excess returnbeyondthe cost ofcapital employed (Varian1984). The buyerand seller both understandhe value of theproductasperceivedbythe otherparty,here-by reducing opportunisticbehavior.Simplemicroeconomicmodels of perfectcompeti-tionassume hatbuyers an costlesslyacquireinformation boutpricesresultingn a singlemarketprice. While unrealisticat one time,today's electronic markets are makingthisassumptionncreasingly ealistic.Insummary,onventionalwisdomand econom-ic theorywould suggestthat ITreducesmarketimperfections nd allows more players o com-pete in cyberspace,thereby resulting n moreeffectivemarkets.While it maybe prematureoobserve heseeffects nevery industry, iventhatthe gestationperiodmightnotyetbe completed,anecdotalevidence existsof a growingnumberof Internet-basedmarketmechanisms hat haveresulted n lowerprices.Basedon the arguments

presentedabove, andsupport roma numberofacademicandindustry bservers,we canexpectthis trend o continue.Therefore,he corepropo-sitionthat follows fromthese arguments an bestatedas follows:Increasing pervasiveness of information technol-ogy and information on ubiquitous global net-works (the Internet)will continue to increase theeffectiveness of markets.We now turn to the counter-arguments.Interestingly,he enactment of such counter-argumentsallswithin he "feasible pace"of thesame microeconomictheorythat allows us tomakethe case for effective markets. n framingthese alternative iews as "myths,"we hopefullyopen up a moreencompassing iew of informa-tion and markets hat recognizesthe opposingmotives of buyersand sellersand the potentialimpactof these motiveson the natureof marketstructureshatresult.The following six general tenets hold for allmyths n the subsequentanalysis:1. Theunit cost of IT-based rocessing, torage,and communication s becoming infinitesi-

mally small, althoughnot necessarilyat thesame rate orbuyersand sellers.2. Information, electively applied, can repre-sent two sides of the same coin, i.e., it caneitherclarifyor distortperceptions.The latteris oftennot considered.

3. ITcapitalizations asymmetricalmongsup-pliers and individual consumers, therebyresulting in informationasymmetry whichexistsdespitedeclinesin ITcosts).Ingeneral,supplier irmsare stillbettercapitalized hanindividualconsumers,which meansthatwemightbe able to distinguish etween hequal-ityof informationbtainedbyeach party.

4. All partiesworkin their own respectiveself-interests,which may not be consistentwithcreating an effective market.In particular,suppliersmightbe more interestedn usingITto sustainmonopolisticpositions.5. Differentconsumers could value the sameinformation ifferently. hiscreatesa problemin allowingmarket orcesto assessthe "true"valueof information.6. The market tructurevolves towardan equi-librium state rather han being one that isspecifieda priori.However, he market truc-ture is a variable nfluencedby IT.These twoparts of the tenet are intricately related.Specifically,hestateofequilibriumsdynam-ic; andthisdynamic s influencedby IT.The key question is: How do sellers survive inintensely competitive markets on IT networkswith low coordination costs that seem to favorbuyers?Low costs makecomparative hoppingsimple and force sellers to compete based onprice.Sellersdreadprice competition,however,because the resulting quilibriumeadsto theirmakingsmallor zero profits.The trick orsellersto survive in such a "hostile" nvironment s touse the veryresourcehatgave riseto theirprob-lems, namely,contemporary nd powerful ow-cost IT.The mythsbelow illustrate hat it is altogetherfeasible for ITto enable supplierstrategies hatextractconsumer urplus.For nstance, upplierscould use ITto price discriminateby tailoringproductofferingsand chargingbuyersas much



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as they are willing to pay. They could also seg-ment markets making comparative shopping dif-ficult, thus avoiding the competitive equilibri-um. Also, suppliers could focus on the creationof networks that lock in customers or followaggressive pricing strategies that deter pricecompetition.These supplier strategies are presented below inthe form of myths and counter-myths. Note that:(1) while we devote more space to discussion ofthe non-conventional counter-myths, it reflectsour desire to address their limited exposure inthe literature rather than their imminence, and(2) the economic examples used are for illustra-tive purposes only, to express potential devia-tions from effective markets in tangible mone-tary terms.

Six Mythsof Informationand MarketsMyth # 1: Product customization,enabled by IT networks, would benefitbuyersCounter-myth #1: Productcustomization, enabled by IT networks,could allow sellers to exploit buyersA General Perspective on Myth andCounter-myth #1Arguments for the myth follow fairly conven-tional thinking. Many suppliers operating in net-worked environments attempt to capture infor-mation on buyers. Buyers often provide theirinformation in the hope that they will benefit bygetting a product tailored to their needs. ShopKomaintains such information in a 400 gigabytedata warehouse and makes this informationavailable for potential target marketing viabrowsers on the Internet. Similarly, House ofSeagram uses a database on 10 million adultswho consume spirits to build brand loyalty aswell as targetconsumers of rival products. It canbe reasonably expected that in a highly compet-itive environment, this customization, if valu-able to the customer and if based on informa-tion technology, can and will be replicated by a

number of suppliers. This would keep the priceof such a service down. We can observe thisoutcome on the Web where hundreds of finan-cial service sites exist (e.g., Stockpoint) thatallow any client to enter their personal stockportfolio, track it in real time, and use variousoptions for organizing the data. Today, this ser-vice is often given away free. Buyers seem to begetting customized service for an extremely lowprice.However, we propose there is an alternative per-spective (counter-myth). Suppliers using power-ful computers and comprehensive databasescould exploit smaller and smaller marketniches,by making inferences about an individual buyer'sflexibility on product and price, propensity toshop around, etc. Indoing so, they could inhibitcompetition and charge higher prices in thesemarket niches.An emerging tool to facilitate this exploitation isIBM'snet. Mining solution, which uses sophisti-cated computer algorithms to transformsite-visitinformation into detailed customer reports(McCune 1997). Netscape's cookie technologyis remarkable in that it stores information ontransactions and web pages visited by users ontheir own machines, providing an integratedprofile of the customer for suppliers (Hagel andRayport 1997). Companies like the GartnerGroup and Lexis-Nexis can sell customizedreports or information to different customers,even charging different prices to different cus-tomers if they can infer the customer's willing-ness to pay. Similarly, Kurzweil AppliedIntelligence uses a versioning strategy by sellingseven different versions of its voice recognitionsoftware, each with different features turned offand on and priced based on how different cus-tomers value the products (Shapiro and Varian1998). With such superior information obtain-able by suppliers, buyers may end up payingmore for customized products that may cost vir-tually nothing to create. Buyers may be willingto pay more to forego the difficulty of shoppingaround for highly customized products. This isparticularly true for individual consumers thatrely on generic search engines and relativelylow ITsophistication.Growth in database marketing, relationship mar-keting, data warehousing, and data mining epit-



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Grover& Ramanlal/SixMythsof InformationndMarkets

omize this trend. In fact, the Meta Groupesti-matesthat the datawarehousingmarket rewasmuch as 40%in 1998 with 85%of manufactur-ers and retailersbelieving that they will havelarge integrateddata analysis capabilities inplace bythe year2000 (BusinessWeek1997).An Economic Perspective on Myth andCounter-myth #1Myth:Themythpresumeshatif sellersuse IT ogather nformationn buyers, heycan "narrow-cast" or tailor offeringsto differentbuyersorbuyer segments. The customized productincreases he buyer'sreservation rice.The lowcost of entryinto cyberspace,however,permitsmultiple suppliers o collect and processbuyerinformation,o customizetheirofferings.Buyerscan searchout these alternative uppliersandchoose the supplier that provides the bestvalue/price radeoff.Thus,while the reservationprice increases, the competitive equilibriumholds, ensuring he increasedconsumersurplusaccrues o the buyer.This marketworks n favorof the buyerand is thereforemore effective.Counter-myth:nterestingly,he enactmentof analternative scenario can also be examinedthroughhe economic lens.The aboveargumentis sound, provided hat the cost of informationaccess for both the buyerand seller decreasesproportionately.f so, the competitiveequilibri-ummaybe sustainable.Theequilibriummaybeunstable,however,becausethe slightest ostdif-ferential between buyers and sellers may beleveraged o a bigadvantagegiventhatthe costsof information atheringare minimal.Suppliers(i.e., firms) n generalare in a betterpositiontoleverage nformationsymmetry,s theyarelarg-er andhaveeconomies of scale in gathering ndanalyzing buyer information.Buyers(i.e., indi-viduals),on the otherhand,mustresort o publicsearchengines and their own processing nfra-structureo locate andcomparesuppliers.Consider a supplierwho collects informationabout customersover the Internet.The supplierwould like to use this informationo extractanyconsumersurplus.A self-interested ustomer isawareofthis. Thecustomer sneverthelesswillingtodivulge nformation iththepromise fobtain-ingacustomizedproduct.Thesuppliern urnusesthis nformationo make nferences bout hecus-

tomer'sreservationprice. By customizingprod-ucts for customers with different reservationprices, hesupplier aneffectively xtract urplus-es alongthe entiredemandcurve,as longas thepriceexceedsthesupplier'smarginalost.Thistar-get marketing everses he traditional pproachwheresuppliersdivulgeinformationbout hem-selves(specifically, riceandproductnformation)andcustomers omparativehop o obtain hesur-plus. Competition n the market or customizedproducts hatpresumably ould shift he surplusfrom ellers o buyers s inhibited or wo reasons:(1)sellerssegmentmarketshroughproduct us-tomizationand(2)buyersare imited n theirabil-ity to assess price/value radeoffsacrossmarketsegments due to differentialIT capitalizationbetweenbuyersand sellers.Inotherwords,whilesellerswithvery ow costs of customizationouldpresumablyompete,individualbuyers acepro-portionately igher earch osts, hereby educingthe incentiveosearch utalternativeellers.Thus,lowerIT ostsforsellersrelativeo buyers, venasbothsetsofcostsapproach ero,providean effec-tive meansbywhichsuppliersanexpropriateur-plusfromcustomers.Apositiveexternality f the supplier's rofitmax-imizationobjectiveis the increasedmarket ize.With nformation boutcustomers, uppliers anbroaden he marketby providinga customizedproduct o consumers,albeit at pricesclose tothe maximumhey arewillingto pay.Whyis this marketnot to the benefitof the con-sumer? The customer gives up informationexpectinga return rom hesuppliern the formofbetterserviceor customization.While this out-come mayindeedoccur,the supplier s now in abetterpositionto use the informationo extractsurplus rom to charge every customer n everysegment beyondthat which was possibleunderperfectcompetition.This follows because of theseller'sabilityto segmentmarkets hroughcus-tomization, hereby mpeding ompetitiveorces.The maximumamountthatconsumerswill payforcustomizationorrespondso thelimiting aseof perfectpricediscrimination, hereconsumersarecharged he maximumprice they arewillingto pay for a product,in which case all surplusaccrues to the supplier.This is not an effectivemarketbecause value derivedfromthe efficientuse of ITaccrues o supplierssee Figure ).



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Suppliers

Suppliers use ITto collect and processinformation on buyersand infer reservationprice.

BuyersluL I( 1 tiIYI ROlE d I[U 11(s]mul I k i

Economic ExampleConsider the way Intuit versions its popularfinancial software product Quicken. If Intuitchose to market a single version of its product tothe largest number of consumers, it may consid-er one with only the most popular features liketrackingpersonal expenses, online bill payments,and links to financial websites. Lesssophisticatedconsumers who wish to pay bills the traditionalway, via mail, will be unwilling to pay for theonline billing feature and therefore may foregopurchasing the product. More sophisticated con-sumers who want complex and detailed invest-ment advice, which the product does not offer,may also forego purchasing it. The problem withoffering a single version of the product is that itfails to discriminate between customers. Offeringmultiple versions overcomes this problem andpermits Intuitto price discriminate between con-sumers and extract surplus in the process as thefollowing numerical example illustrates.Suppose the optimal single version of the finan-cial software product has five features and ispriced at $10 per feature for a total of $50. Andsuppose it costs $8 per feature on average to pro-duce the software for a total of $40. Thus a sur-plus of $2 per feature accrues to the supplier.Potential customers are of two types: those whoprefer more features whom we refer to as the

"high" type, and those who preferfewer featureswhom we refer to as the "low" type. We assumethe high type is not only more affluent (i.e., ableto pay more) but also has a higher reservationprice (i.e., willing to pay more) and desire a moresophisticated product (i.e., with a largernumberof features).Conversely, the low type is less afflu-ent, has a lower reservation price, and prefersfewer features.Suppose the high type's reservation price is $11per feature with a desire for seven features. Andsuppose the low type's reservationprice is $9 perfeature with a preference for three features. Thesupplier has no knowledge of these reservationprices and customization preferences. Thus, theoriginal product with five features was intendedto strike a balance. The high type likes the pricebut not the customization; the low type likes nei-ther. Thus, only the high type will potentially beattracted to the offer with probability less than 1.Now suppose the supplier uses data mining soft-ware on the Internet to obtain information onconsumers' income levels and personal prefer-ences and infers the reservation prices and cus-tomization preferences of the two types. As aresult, two versions are marketed:a base versionwith three features priced at $27 ($9 per feature)and an advanced version with seven featurespriced at $77 ($11 per feature). Indeed theseprices are comparable to Intuit's base and top-

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line versions of Quicken. Now both types willlikely be drawn to Intuit'sofferings.Customization serves not only to identify thoseconsumers with higher reservation prices fromwhom surpluses can be expropriated, but alsofacilitates market segmentation necessary toexploit the surpluses along the entire demandcurve. This follows because the high and lowtypes reveal their identities by the choices theymake. Knowing that only the high type willchoose the advanced version permits the suppli-er to extract the consumer surplus of $3 per fea-ture from that customer. Correspondingly, thesurplus of $1 per feature is obtained from thecustomer that chooses the base version. This per-sists because the two markets for the high andlow types are segmented. Lack of features keepsthe high type from choosing the base version,and the smaller reservation price keeps the lowtype from choosing the advanced version.Byofferingtwo versions, notonly does the marketsize increase, butthe supplieris able to draw moreof the surplus on a per-featurebasis. The marketsize increases because boththe high and lowtypesaresatisfied when previouslyneitherwas. The sur-plus on a per-featurebasisthat the supplierextractsis $2.40 ($3 per feature for the advanced versionwith seven features and $1 perfeature forthe baseversion with three featuresfora weighted averageof $2.40 perfeature, up from$2.00 perfeatureforthe single-version case). Using buyer information,the supplier has successfully price-discriminatedalong the demand curve. While both customertypes aresatisfied and the market sexpanded, sur-plus is moved away from consumers, renderingmarkets less effective.Myth #2: Increased outsourcing,enabled by IT networks, would lowerprices and benefit buyersCounter-myth#2: Increasedoutsourcing, enabled by ITnetworks,could reinforce the seller's monopoly bysustaininghigher pricesA General Perspective on Myth andCounter-myth#2The myth is based on the argument that wewould expect outsourcing, coordinated by IT

networks, to reduce the supplier's productioncost. These lower costs for suppliers should trans-late into lower prices for consumers if competi-tion prevails. Thus, outsourcing product compo-nents to specialized manufacturerscould poten-tially result in more effective markets.Conversely, failure to outsource may result in lesseffective markets. For example, if GM manufac-tured its own tires, we would likely have moreexpensive cars.In discussing the counter-myth, however, weshould recognize that complex products or spe-cialized components that are outsourced areunlikely to be produced by a large number ofsuppliers. Thus, the market for outsourced prod-ucts may indeed be less competitive as firms usea common supplier or set of suppliers. Oneexample is Massachusetts General Hospital's useof "teleradiology"as a means to remotely accessthe diagnostic skills of medical experts. Inessence, traditional radiology is reengineeredinto two parts: an in-house task of a radiologytechnician coupled with the remote service of aradiology expert. As hospitals increasingly com-pete (e.g., with HMOs), the remote service,which requires complex and specialized skills,are shared by multiple hospitals, reducing com-petitiveness along this dimension (Apte andMason 1995). Similarly,UPS integrates its deliv-ery service as part of product sales by its corpo-rate clients, providing a single sale-and-deliverypackage. As competing corporate clientsincreasingly adopt similar arrangements withUPS, competition among these corporationswith respect to the product component of thepackage persists, but competition with respect toshipping services is reduced giving UPS marketpower along this dimension (Computerworld1997).The noncompetitive impact of outsourced prod-ucts is apparent in the computer industryas well.Computer assemblers like Dell compete aggres-sively on all components and services exceptIntel'schips, which hold a monopolistic power inthe industry.While Intel decreases prices regu-larly for chips with aging technology, its cutting-edge chips command a premium suggesting mar-ket power. Infact, Intel'skey strategyhas been tocommoditize complementary products likechipsets and motherboards to stimulate demand

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for its core product, the microprocessor (Shapiroand Varian 1999). Yet another interesting exam-ple is the airline industry. What appears to befierce competition among large numbers ofonline travel agents essentially boils down tocompetition among a few large airlines. Most ofthese airlines control the value chain and aremaking money at the cost of on-line agencies(Davis 1999).We emphasize that increased outsourcing,enabled by information technology, could rein-force the seller's monopoly. The ability ofmonopolies to sustain higher prices is wellknown. The focus here is to illustrate the abilityof IT to accentuate this effect. Monopolies withstrong pricing power but low marketpenetrationcan be less profitable than monopolies with lesspricing power but greater market penetrationfacilitated by IT. And while vertical integrationcan increase monopolistic power, the outcomecould be less desirable if it comes as the expenseof market penetration.Summarizing, even though ITreduces coordina-tion costs between firmsgiving rise to the poten-tial benefits of outsourcing, the reduced costscould also make monopolistic supply chains andhigher prices easier to sustain. This is particular-ly true in the case of complex and specializedcomponents that are common among the prod-ucts of competing firms.An Economic Perspective on MythandCounter-myth#2Myth: Transaction Cost Economics is an impor-tant theoretical frameworkthat has been used tostudy the decision to outsource. The firm'sdeci-sion to outsource is usually thought to depend onthe total cost of producing as opposed to procur-ing a given component. It is often true that thegiven component can be obtained at a lower costfrom independent outside suppliers who enjoyeconomies of scale and scope in specialized pro-duction. However, the resulting market gover-nance calls for locating and monitoring a reliablesupplier,which could involve significanttransac-tion costs. Alternatively, the firm could producethe component in-house through an organiza-tional hierarchy, thereby saving on transactioncosts but at the expense of higher productioncosts. ITcan alter the balance of these tradeoffs

by lowering transaction costs, thereby favoringmarkets (outsourcing) to hierarchies (Williamson1975, 1979). As large global networks make out-sourcing increasingly viable, marketgovernancein lieu of hierarchical organizations will result inlower overall costs (Evans and Wurster 1997).With increased competition among suppliers, thebenefit of lower costs will be passed on to theconsumer.Counter-myth: However, economic argumentsoffer another possibility. While it may be costeffective for firms to rely on forms of marketgov-ernance for product components, a limit to thenumber of suppliers that the industrycan sustainmay exist. Each marginal supplier who enters theindustry incurs an expense in real assets as wellas in transactional relationships. Moreover, theincrease in suppliers reduces the volume of trans-actions per relationship, thereby increasing thecost per transaction. As a result, successive sup-pliers contemplating entry into the industryfaceincreasingly larger relationship hurdles. Thesehurdles are reduced to the extent that the indus-try expands and can therefore support additionalsuppliers.In contrast, fewer relationships permit the firmand the supplier to invest in asset-specificresources, i.e., resources allocated to the rela-tionship. Suppliers benefit in terms of beingassured of a market for the components theyprovide. Firmsbenefit in terms of reduced mon-itoring costs. But fewer suppliers of a compo-nent reduce competition, which increases theirability to extract consumer surplus via the firmfrom the end customer. The surplus is thendivided between the supplier and the firmaccording to their relative market powers, there-by making markets less effective. Suppliers willenter the industry only if the derived consumersurplus exceeds the hurdle to overcome rela-tionship costs. This has been referredto as the"move-to-the-middle" hypotheses (Clemons1993).As IT costs approach zero, and outsourcingbecomes prevalent, it is reasonable to expect thatspecialization would result in a core set of sup-pliers, particularly for complex idiosyncraticproducts. Within this core set, a single suppliercould well exist for each component thatthe firmoutsources. The firm would package the various



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Grover&Ramanlal/SixMythsof InformationndMarkets

components into a product for sale to the cus-tomer. While several firms could be competingamongst themselves for the customer, this wouldexert no competitive force on the few individualsuppliers to yield any consumer surplusthat theycould derive from the individual componentsthey provide.In summary, the core suppliers could derivesupranormal rents from their monopolistic posi-tion on each component provided. Thus, as ITcosts approach zero, the market governance(outsourcing) structure that results for complexidiosyncratic components permits suppliers toretain excessive consumer surplus, thereby mak-ing markets less effective.As can be seen in Figure3, the market structureis determined by the complexity of product com-ponents. This contrasts to the marketstructureinFigure2, which is driven by customization.Economic ExampleHere it is interestingto consider the role of Intelin the computer hardware industry. If computermanufacturers such as Dell and Compaq, whocompete intensely in the market for personalcomputers, were to develop their own micro-processor units, it would probably result in moreexpensive computers. Thus, the microprocessor,which is a complex and idiosyncratic compo-nent, is outsourced to Intel. While competitionbetween Dell and Compaq has resulted in lower

prices and lower marginsforcomputers, Intel hassustained higher prices and marginsfor its micro-processors. And while consumers are pleasedwith the lower prices for computers, it is oftenoverlooked that these prices could be lower stillif not for Intel's market power as the followingexample illustrates.The two computer manufacturers,labeled A andB, sell computers composed of two types of com-ponents: generic disk drives, memory, modems,and multimedia peripherals (labeled x), and theunique microprocessor (labeled y). Multiplemanufacturers enjoy economies of scale for xbecause the components are simple. In contrast,y is complex and idiosyncratic and relationshipscost are high, and therefore in equilibrium it iscost effective for only one supplier, labeled C, toproduce this component.Suppose the marginalcosts of the components xand y are $900 and $100, respectively. Then themarginalcost of the computer, that firmsA and Bsell, is $1,000. At that price, surpluses accrue toconsumers. Now suppose firms A and B as wellas supplier C attempt to obtain some of the sur-plus by raising prices. Supplier C raises the priceof component y to $600, to obtain a surplus of$500 (given its marginal cost of $100). FirmsAand B price the computer at $2,000, also for asurplus of $500 (given their marginal costs are$1,500: $900 for x and $600 for y). The questionarises: are these prices sustainable in equilibri-

Sup p liers

rlnihly corn pe titive marketplace. Co m petition is onal dim ensions of product except com ponents providjin the monopolistic supply chain.

Custom ers

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um, and what economic forces are at play thatwill influence them?Firms A and B will be unable to maintain thecomputer's price at $2,000 because of competi-tive forces. Price competition will force each firmto lower price successively until price equalsmarginal cost at $1,500, reducing their surplusesto zero. On the other hand, there are no compet-itive forces that will cause supplier C to reducethe price it charges firmsA and B for componenty, thereby keeping its surplus of $500. Neither Anor B can credibly pressure C to lower its price(say, by threatening to not produce the productcomposed of x and y) because if B withdrewfrom the market, its market share would be cap-tured by A.In this example, ITmight keep transaction costsrelated to outsourcing down. However, the ben-efits that accrue to consumers are reducedowing to the surplus captured by the monopolistin the supply chain. This capture followsbecause component y is not competitive in thefinal product. By raising price, supplier C affectsthe cost structureof both firms A and B equally.Unless they have the latitude to absorb it intothe cost structure of other components, bothfirms have to pass the cost down to the con-sumer. In other words, supplier C is absorbingconsumer surplus from the end customers. FirmsA and B, however, are competing on all otherdimensions of the product except component y(where they have no differentiation). Ironically,casual observers of the end product see the mar-ket as highly competitive.

Myth #3: Open IT network architectureslower prices and benefit buyers asdependence on supplier hierarchies isreducedCounter-myth #3: Open IT networkarchitectures could be exploited bysuppliers to create captive buyernetworks that can sustain higher pricesA General Perspective on Myth andCounter-myth #3The myth implies that as IT architecturesbecome more open ala Internet and TCP/IP

standards, companies have greater difficultysustaining hierarchical positions with respect totheir customers based on technology protocolsand interfaces. This is unlike many widelyreported strategic systems of the 1980s, whereproprietary links (e.g., American HospitalSupply's ASAP System) were established(Johnston and Vitale 1988; Porter and Millar1985) to increase switching costs for buyersand force dependence relationships. Openarchitectures make such dependence relation-ships difficult to sustain because a buyer caneasily search and switch to an alternative sup-plier. We can therefore expect more compari-son shopping by buyers ultimately forcing sup-pliers to lower prices.However, the counter-myth is based on argu-ments contrary to conventional wisdom. Asnetworks become IT intensive and both buyersand sellers gain better access to information,we can expect differential IT capitalizationbetween buyers and sellers to tilt the balanceof power. Larger suppliers are likely to be in abetter position to package information productsas well as information about products and ser-vices in a manner that makes it difficult forconsumers to assess their value for compara-tive purposes. Difficulty in assessing tradeoffsbetween the product's price and the value itaffords would inevitably impede competition.This is abundantly apparent on the Web,where suppliers have successfully created sub-nets or private access areas in which "special"consumers can obtain membership by paying afee or providing personal information. Oncemembership is obtained, the subnet affordsconsumers certain privileges such as specialproduct discounts and improved customer ser-vice. For instance, ESPN's Sports Zone allowsmembers to obtain inside information andreports on their favorite teams that are notavailable outside the subnet. In fact, the con-sumer is part of a captive buyer networkbecause there is a time, information, and pos-sibly financial cost to exiting the subnet andregistering for another one to compare prod-ucts. Moreover, assessing the subnet's valueprior to entry is often difficult.Other examples include traditional businesseslinking up to Internet Malls, which include a



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collection of online storefronts, each offeringdifferent products, accessible through a singleInternet site. Many products are a result ofpartnerships between firms. Consumers couldbe hard pressed to make price comparisons ofindividual products due to bundling acrossproducts and even companies within the mallsite (Wreden 1997b). Similarly, Reuters bundlescommodity style news items and data servicesto meet the specific needs of clients in waysthat allow charging higher prices. News col-lection by Reuters from multiple sources isfacilitated by low-cost and open IT networkarchitectures. However, the products are bun-dled in ways that make it difficult to compareprices and features across comparative offer-ings by competitors. Thus, suppliers haveeffectively created captive buyer networks orhierarchies and can consequently charge high-er prices.An Economic Perspective on Myth andCounter-myth #3Myth: With open standards and declining searchcosts, customers need not depend on a singlesource of supply. This is particularly true forinformation-intensive products and services,which can be delivered through information net-works, as customers can easily search andacquire competitive products. It thereforebecomes difficult for the supplier to generatemonopolistic rents and extract consumer surplusbased on a relationship involving switchingcosts.Counter-myth: While it is true that companieswould find it difficult to sustain hierarchiesbased on idiosyncratic protocols, higher ITcap-italization could allow supplier firms to deliber-ately provide selective product information totargeted customers in ways that can inhibitproduct comparison. If product comparison isobscured, consumers have no frame of referenceto assess the competitive price. They will tend toresort to their reservation price for making deci-sions. Information-intensiveproducts in particu-lar allow the ease of "bundling" components,making it difficult, if not impossible, for con-sumers to compare products and make choicesbased on price. Thus, firms avoid the competi-tive outcome.

One way firms can extract consumer surplusalong the demand curve is by successively addingcomponents (e.g., upgrades) to the base productand correspondingly increasing its price byamounts that exceed the marginal cost of add-ons. This strategy targets jointly those customerswho have the resources to pay the higher price aswell asthose who have a higherreservationprice.Both are necessary for suppliers to extract surplussuccessfully. Consumers with higher reservationprices are willing to pay proportionatelymore forthe upgrades because the surpluses they derivefrom the base product are sufficient to offset thepremium they pay for the extras. In this manner,suppliers can extract surplus based on the maxi-mum price a customer is willing to pay rather hanthe minimum price a supplier is willing to accept.This is in contrast to the competitive outcome,where products are comparable and supplierswill lower prices (i.e., give away consumer sur-plus) to capture a larger consumer base. Here,consumers cannot compare individual productsor prices directly because they are bundled, andthey must assess price/value tradeoffs based ontheir reservationprice.As ITcosts become arbitrarily mall, firms are notlimited to successive upgrades alone. Instead,bundles of every perceived combination of com-ponent products can be offered. Comparativeshopping across bundles could then becomesimpossible, and the reservation price is the onlybasis on which choices can be made. In short,informationselectively applied can impede com-parative shopping by consumers, and suppliershave a vested interest in using omniscient IT forthis purpose. Indeed, some of the suppliers andbundles may altogether ignore consumers withsmaller reservation prices in an effort to obtainthe surplus from those who are willing to paymore. In contrast to Figure 4, traditional eco-nomic theory suggests that suppliers competebased on price, thereby promoting product com-parison across suppliers. The outcome thatresults in which surpluses accrue to consumers isclearly undesirable to suppliers. Indeed, fromthesupplier's vantage, the use of IT to avoid thecompetitive outcome is key.Economic ExampleTo see how open architectures can sustaincaptive networks, consider how information



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Suppliers

Buyers are forced tmake decisions onproductsbased on reservatiorather than market

Suppliers use IT tobundle productssuch a way that buyersannot easily com parehem. This puts themin an advantageousposition to choosestomers who value thebundles higherupplier cant / choose to/ ignore buyers \/ with lower \ \n price reservationt forces.

Buyers0 m - S S@~ A - -

services providers like Bloomberg and Zacksoperate. Both service providers couple publicinformation available on open architectureswith proprietary information on their networksto create information products that customersvalue. For example, the public informationcorresponds to accounting data of publiclytraded firms, and the proprietary informationcorresponds to the synthesis of analyst recom-mendations for stock performance. The twotypes of information are then combined in aconvenient format and made available via theWeb on a subscription basis ranging from sev-eral hundred to several thousand dollars peryear. Other examples include Visual Numerics'use of the open-architecture Fortran and C++programming languages together with its pro-prietary graphics and user interface software tocreate packaged products for programmersthatcommand premium prices. The followingexample illustrates how these types of informa-tion may be combined to extract surplus fromconsumers.Suppose there are two suppliers, labeled A andB, of informationproducts and each supplier hasa proprietycomponent, labeled x and z, respec-tively. SupplierA'sproprietyinformationx can bethought of as Zacks' recommendation for stockperformance, and supplier B's propriety informa-tion can be thought of as nonpublic informationof security prices available on Blumberg's infor-mation-services network. Both these types of pro-priety information are potentially valuable totradersof financial securities. A third informationcomponent, labeled y, is available to both sup-pliers via open architectures.This common infor-

mation includes the accounting data of publiclytraded firms. Thus, supplier A can bundle com-ponents x and y, while supplier B can bundlecomponents y and z. The bundled informationproducts are then made available to two cus-tomers, labeled 1 and 2.Assume consumer 1's reservation prices for thethree components, x, y, and z, are $5, $5, andzero, respectively; and consumers 2's reservationprices are zero, $5 and $5, respectively. Inotherwords, consumer 1 values Zacks' proprietaryinformation and the common accounting data,and consumer 2 values Blumberg's proprietaryinformation and the common accounting data.These reservation prices may represent themonthly subscription rates that customers arewilling to pay for on-line access. Assume that themarginal cost to the information-serviceproviders of each component is $2.SupplierA bundles x and y, while supplier B bun-dles y and z, the marginal cost of each bundlebeing $4. Both products are priced at $10. Dueto the bundling, customers 1 and 2 will find itdif-ficult to compare the products that suppliers Aand B provide, thereby excluding comparativeshopping based on price (see Table 1).Under this scenario, customer 1 purchases fromsupplier A and customer 2 from supplier Bbecause in each case market price does notexceed the reservation price. In contrast, 1 willnot purchase from B and neither will 2 from A,because in these cases market prices exceedreservation prices. Each supplier obtains con-sumer surplus equal to $6 (market price of $10less the marginalcost of $4).



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u;:;~~~II IIIIi;';a iSao1 sI I1 ;aJ11SI IMANXM. p. -p. * 1----~~~~~~~~~~Supplier A(Bundles x and y) Supplier B(Bundles y and z)Customer 1 2 1 2Reservation Prices $10 $5 $5 $10MarketPrice $10 $10Marginal Cost $4 $4

Forthe competitive equilibrium to hold (at leastfor component y, which is generic), suppliersmust have incentives to lower prices with thepotential to increase sales and profits. However,neither supplier has an incentive to lower theprice below $10 because neither can draw theother's customer until the price hits $5. If onesupplier lowers the price to $5, while both cus-tomers would be attracted,the consumer surpluswhich that supplier is able to extract would bereduced from $6 to $2 (marketprice, $5, less themarginal cost, $4, times the number of cus-tomers, 2). Thus, price competition is futile tosuppliers.Unbundling the products proves fruitless to sup-pliers as well. Suppliers A and B can charge amaximum of $5 forcomponents x and z (equal tothe reservation prices), respectively, while themarket price for component y is $2 (equal tomarginalcost) given direct competition betweenA and B in that market. Thus, unbundlingreduces each supplier's surplus from $6 to $3. Itis evident from this example that suppliers canuse the pricing power of the unique components(x and z) to extract from consumer's surplus onthe generic component (y).The competitive equilibrium is also inhibited inthe individual markets that suppliersA and B cre-ate. This follows because low ITcosts encourageproliferation of new markets (i.e., structuringofnew bundles) ratherthan entry into old markets(i.e., competition with suppliers of existing bun-dles). The former permits extracting surplus fromconsumers. Conversely, consumers derive sur-plus in the latter.It is apparent that the market is being segment-ed where supplier A captures customer 1 onlyand supplier B customer 2 only. Each supplier

findsit unprofitableo capture he othersuppli-er's customer.In turn, customers 1 and 2 arepayingthe maximumprice they are willing topay.In a competitive ituation n the absenceofbundling,at leastcomponenty would be com-parabledirectlyacrosssuppliers,allowingcon-sumers to make decisions based on price.Notice that it is not the uniquenessof compo-nenty but rather ts bundlingwith componentsx and z thatpermits uppliers o extractsurplusfrom consumerswho have a high reservationprice for an otherwise generic product.Thushighlynetworked nvironments an reducemar-keteffectiveness.Myth #4: Linking multiple marketcenters using IT networks would resultin consolidated markets that benefit thebuyerCounter-myth #4: Linking multiplemarket centers using IT networks couldresult in fragmented markets thatbenefit the supplierA General Perspective on Myth andCounter-myth #4The unprecedentedgrowthof today's informa-tion networkss allowingthe interconnection fdiversemarkets.For instance,what were onceproprietarynetworks like American Airline'sSABREor EDI industry platforms are nowbecoming a part of the integrated networkmilieu.Themythis basedon the argumenthatintegratingmarket enters of buyersand suppli-ers with IT links can increasethe size of theoverall market, hereby improving he choicesand pricesforcustomers.


I


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The counter-myth however, implies that the ITconnections themselves may not improve thenature of markets. Suppliers, driven by profitmotives, may not be fully open in disclosingvaluable information on the network when itmay be used instead to gain strategic advan-tage. An example is the recently implementedlinkages between the New York Stock Exchangeand the Mexican Bolsa facilitated by AmericanDepository Receipts (ADR)for cross-listed secu-rities. Mexican firms are permitted to list theirstocks on the NYSE. Since trading of thesestocks occurs on both exchanges, there is infor-mation flow between the markets. The objec-tives are for the NYSEto generate trading com-missions and for the Mexican Bolsa to becomea more liquid market. While some improve-ment results from IT linkages, the marketsremain fragmented in many respects as seen intrading cost and trading volume differencesacross the two trading centers (Domowitz et al.1996). In. short, IT linkages do not fully inte-grate the markets.Similarly, the electronic integration of majorsecurity tradingcenters as mandated by Congressin 1975 has yet to be successful. Largerexchanges demonstrate unwillingness to fullyreveal information in the expectation that theymay profit from withholding it (Blume andGoldstein 1997; Groveret al. 1999). Inthe Fall of1998, the Pacific Stock Exchange implementedan intranet-basedtrading system called Optimarkthat lets investors buy or sell in large volumeswithout telegraphing their moves to other traders,which helps keep the market from movingagainst the investors trading these large quanti-ties. These examples illustratethat network link-ages alone are not sufficient to render benefits toconsumers if the supplier's incentive to profitfrom private information precludes making itfreely available on the network.While the previous examples pertain to securi-ties markets, important inferences can be drawnfor information and product markets. Untilrecently, the concept of consolidated marketsapplied mainly to securities exchanges for thefollowing reasons: financial securities are stan-dardized commodities and information sharingacross financial markets was mandated byCongress and facilitated by electronic networksestablished by stock exchanges. With the advent

of the Internet, the trading environment forinformation and products now more closelyresembles the trading environment for financialsecurities. The question is, what have welearned from securities markets that will tell ushow networks of product and information mar-kets will evolve?Despite the passage of congressional mandatesfor securities markets as far back as 1975, theimpact of electronic linkages on the market'sstructure has only recently come to light. Webelieve a wait-and-see approach to the evolutionof information markets on the Internet couldprove costly since we believe it can significantlyinfluence the balance of power between suppli-ers and consumers. Intuitionsuggests that on theWeb, larger shopping sites (markets) could bereluctant to reveal full information becausesmaller sites could pre-empt their pricing.Therefore, despite the network linkages, theincentive to profit from information as opposedto freely revealing it may inhibit customers fromgetting all the benefits of integrated markets.An Economic Perspective on Myth andCounter-myth #4Myth: If multiple markets are linked through ITnetworks so that buyers and sellers at differenttrading locations can access product and priceinformationacross markets,then the broadermar-ket would be more effective, benefiting the con-sumer. Thisfollows because (1)the increased sizeof the combined market and (2) the efficiency ofinformation flows across trading centers wouldalleviate potential inefficiencies in the individualtradinglocales, permittingcomparative shopping,thereby making it more difficult for suppliers toextract consumer surplus. Inshort, a broader baseof buyers and a broader base of sellers wouldresult in more effective markets.Counter-myth: The above reasoning underesti-mates the self-motivated incentives of suppliersin the individual market centers. Suppliers wishto maximize the surplus they can obtain fromconsumers. They might do this by inhibitingvaluable information flows from their market tothe other. For example, obtaining informationfrom other markets but not revealing informationto those same markets creates the potential togenerate larger profits (e.g., Madhavan 1995). If



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Grover&Ramanlal/SixMythsof InformationndMarkets

Suppliers

Suppliers

M arket Structure 1

B uyers

M arket Structure 2

Market segmentationis sustained despite ITconnections across twoglobal markets due to themarket structure favorableto each segment

B uyers

g[e ll -IaL'il'AInmx.U gIaIIISELi1 i:tiu '4LAIEIsuppliers in both markets pursue this strategy(and they have the incentive to do so), the mar-kets would remain fragmented because tradinginformation(e.g., price and quantity) in one mar-ket, though relevant, is unavailable to the other.Suppliers in the individual marketsface reducedcompetition. Therefore, they are in a better posi-tion to expropriate surplus from their customers.In other words, these information-inhibitioneffects reinforcethe conduct of business betweensellers and buyers in their respective markets. Ifmarkets have no incentive to share information,the ITnetwork provides little or no help in mak-ing markets more effective. Market effectivenessimproves only through creation of the incentiveto share information and/or change the structureof the two markets(see Figure5).Economic ExampleFor this case, it is useful to consider securitiesmarkets.We provide a numerical example illus-

trating how the incentive to collect but notdivulge informationcan lead to marketfragmen-tation, thereby creating the opportunity for sup-pliers to obtain surplus from consumers.The effect of information sharing (or the lackthereof) across markets can be seen by examin-ing the interaction of largertrading centers (e.g.,the New York Stock Exchange) with the smallerregional exchanges (e.g., Cincinnati) (see Blumeand Goldstein 1997). The Securities ActAmendment of 1975 has resulted in the imple-mentation of IT linkages across these marketswith the goal of sharingtrading information(e.g.,prices and quantities of securities traded) for thepotential benefit of customers.Consider two markets,A and B, connected by IT.(see Table 2).The larger trading center, market A, benefitsfrom economies of scale. Security dealers at

.0 - . - .S~~~~tllMarket A (larger) Market B (smaller)

Stock Value $10 (Known to A) Unknown to BAsk and Bid Prices $10 1/2 - $9 1/2 $10 1/2 - $9 1/2Transaction Prices $10 1/4 - $9 3/4 $10 1/2 - $9 1/2Surplus Extracted $0.25 per trade $0.50 per trade

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this location collect information about thestock's value ($10) when setting ask (price atwhich the dealer sells) and bid (priceat whichthe dealerbuys) quotes ($10 1/2 - $9 1/2). Thenetworkallows the smaller radingcenter,mar-ket B, to free ride on information ollected inthe largermarket. While the stock's value isunknown to marketB, it matches the quotes$10 1/2 - $9 1/2 using the available IT link-ages. Of course, A expects B to free ride andtherefore sets wide bid-ask spreads in anattempt o obscure information bout the secu-rity'strue value (Blumeand Goldstein 1997).The wider spread makes it more difficult toascertainthe true value of the securityand atthe same time offers inferior radingterms tocustomers (i.e., higher ask price, lower bidprice). In response,B draws customersfromAby payingbrokerage irms a small commissionfor directingorders to B and promisingthemprices as good as those posted in the largermarket o that conflictof interest ssues do notarise(Easley t al. 1996). But are customersget-ting the best pricegiven the dealer'sstrategy nmarketA?Clearly,hidinginformation bout thetrue value of the security benefits dealers inboth markets but customers in neither.Thus,the unwillingness o share information ecauseof self-motivatedncentives results n fragment-ed markets.As a consequence, more surpluscan be extracted romconsumers, herebymak-ing markets ess effective. This outcome holdsdespite the presence of low cost IT linkages.Clearly, ndividual ncentivesmust be addressedbeforemarkets an be more effective.

Myth #5: Expanding the customerbase for a product using IT networkswould result in greater benefits tobuyersCounter-Myth #5: Expanding theCustomer Base for a Product Using ITNetworks Could Allow Suppliers toExploit BuyersA General Perspective on Myth andCounter-myth #5As the consumerbase of productsexpands,themythsuggests hateach consumerderivesinher-

ent benefits arisingfrom the numberof otherconsumersusing he sameproduct.Forexample,the benefitderived romusingMicrosoft'sOfficeSuite is not justthat it permitsword processingand spreadsheetanalysis,but that it also facili-tatesinteraction etween usersof the sameprod-uct. Thesize of the benefitdependson the num-ber of users. The Internet llows softwarecom-paniesto quicklybuilda customerbase by giv-ing softwareaway free of cost. The more con-sumersusingthe software,he greater heircom-patibility n exchanginginformationrelatedtothe software,andthe more the relatedsoftwaresupport.For nstance,Real Networks s buildinga largeinstalledbase for its streamingechnolo-gy, with more than 26 million users as of July1998, by distributingts softwarefree over theInternet.With the size of this installed baseincreasing,video streamingon the Internethasbecome prevalent.Anotherplausible consequence (counter-myth)of a largecustomerbase, however, s the suppli-er'sability o leverage tsmarketpowerby charg-ing higherprices.Forexample,AOLaggressivelybuilds its customer bases by enticing potentialcustomerswith offersof "free"hours,with theexpectationof charginghigher prices for prod-ucts sold via its Internetite once customersarelocked in. HP takes advantageof its installedbase in inkjetprinters y charginga premiumorits cartridgesGames1998). Microsofteveragesitsexistingcustomerbaseby marketing ubscrip-tion-basedsoftware hrough he Web. Similarly,Windows '98 and MS Office'97 mightwell bepriced highersimplybecause customerscannotswitcheasilyto competingproducts or two rea-sons: the cost of learning o use an alternativeproductand forfeiture f the advantagesassoci-ated with a network of customers. In fact,Microsoft's ecent attempt o build a customerbaseforitsbrowser oftwareby bundling t withthe operating ystemhas been challengedbytheJusticeDepartment,which has recognizedthemarketpower associatedwith an installedcus-tomerbase.On the Web, McGraw-HillProfessionalBookGrouphasitscatalogof over9,000 businessandtechnical books on-line. It is receiving over200,000 hits/monthwith a 30%annualgrowth nthis number.Experimentingwith a try-before-you-buy echnology hatallowsreaderso down-



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load chapters/materialsrom books (based onIBM'sCryptolopetechnology for copyrightedmaterialover the Internet) nd exchange ideas,McGraw-Hills successfullybuildinga networkof customers oritsproduct Wreden1997b).An Economic Perspective on Myth andCounter-myth #5Myth:In the absence of market ragmentation(myth4), a largercustomer base for a specificproduct increases collective buying power.Moreover,ow ITcostsenhancecustomeraccessto thisproduct. fa producthasa broadermarket,it is more ikely o be soldthrougha market truc-turerather hana relationship ierarchy. urther,morecustomers ranslates nto intangiblebene-fits forthe consumer uch as service andsupportinfrastructure,nformal informationexchangeson the product, hirdparty raining,and greaterconfidencein vendor.All suggestaccrualof sur-plusto consumers.Counter-myth: snoted,the argument resentedabove can be framed n termsof networkexter-nality Katz ndShapiro1985).Simply tated, heutilitythat a consumer derives from a productdependson the numberof otherusers hat areinthe same product network (BrynjolfssonandKemerer 996). IT acilitatesnetwork xternalitysimply by enabling networks,particularly orproductsthat are complex. Complex productsrequirespecialized service and service infra-structure,tandardizedeatures hatenable wideusage, interconnectionwith other productsandproductmodules,and otherfeatures hat createthe potential or a largecustomerbase.Companies ften invest nestablishing networkby standardizing productand creatinga largecustomerbase for its use (e.g., by giving awayfree software).Such a strategycalls for earlyinvestmentswith no immediate payoffs. Thebenefit hatconsumersderive frombeing partofthe network an be conceivedas a sourceof con-sumersurplus.Moreover, he surplus ncreaseswiththe network's ize at littlecostto the suppli-er. Thekeyissuethatarises s the divisionof thissurplusbetweenthe consumerandsupplier.Thedivisionof the surplus s drivenby two fac-tors,marketpowerandexit costs, bothof whichworkto the supplier'sadvantage.Marketpowerarisesbecause the network nherently aisesbar-

riers to entry by competing suppliers. Exit costsarise for customers who wish to switch to a com-peting product and therefore incur loss of theproduct's use as well as loss of the accompany-ing externality.As a result, suppliers can charge aprice above their marginal cost permitting thetransfer of surplus from buyers to sellers.Exit costs influence comparative shoppingamong alternative products. Suppose a customerusing a software product contemplates not pur-chasing the upgrade in favor of a competingproduct. By switching from the current productto a competing one, the customer (1) saves anamount equal to the price of the upgrade; (2)loses the value of the corresponding networkexternality;(3) incurs search and start-upcosts tobenefit from the externality of the competingproduct;and (4) incurs the cost of purchasingthealternative product. Costs due to (2) and (3) rep-resent hurdles to price-based comparative shop-ping between the two competing products.Unless the alternative product is lower in priceby an amount that is sufficient to compensate forthe hurdles imposed by (2) and (3), the buyer willnot switch.Suppliers can therefore hold the consumer basecaptive, charging a price well above marginalcost by an amount equal to the reservation priceof the network externality. In doing so, supplierscan extract significant amounts of surplus fromconsumers. While it could be argued that this isa returnon the investment for building networkexternalities, note that the amount of investmenthas no bearing on the amount of surplusthat canbe extracted. In the absence of competitiveforces, the latteramount can be significantly larg-er than the former,in which case marketsare lesseffective (see Figure 6).Economic ExampleConsider two suppliers, A and B, who marketcompeting products but where only supplier Abenefits from network externalities (see Table 3).Suppliers face equal marginal costs of $10.Therefore, in a purely competitive market, theequilibrium price should be $10, with all sur-plus accruing to customers. However, supplier Abuilds a large customer base with product sup-port infrastructure resulting in product confi-dence and user connectivity that customersvalue at $5, i.e., supplier A has established a



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Suppliers

[siI l ll IEmIU5TiL Ai K S E 4.?~ mIeii . k 1 s III i ltl I Anetwork externality worth $5 per customer. Ofcourse, establishing this network is not withoutcost; the cost of financing this network is partofsupplier A's marginal cost. Supplier A cancharge as much as $15 (marginal cost plus net-work externality) without fear of losing cus-tomers to supplier B. Indeed, by charging $14,supplier A can run supplier B out of businessbecause for the latter supplier to draw cus-tomers, he or she must lower price to $9, whichis below the marginal cost.Here, the $5 consumer surplus (i.e., the excessof market price above marginal cost) goes tosupplier A! This outcome manifests price dis-crimination, where the supplier can charge theconsumer what he is willing to pay and isindicative of an ineffective market. Notice thatthis result holds regardless of what supplier Amay have invested in the network externality. Inother words, there are not competitive forcesthat draw a relation between the cost of theexternality and the consumer surplus that isderived.Clearly, today's IT tools and distribution infra-structure make it easier to establish externalityfor products, particularly information-intensiveand software-based products. The captive cus-tomer base that results allows suppliers to cap-ture monopolistic rents, thereby making itmore difficult for competitors to compete with-

out the externality. The short-run implicationfor suppliers is clear. They should invest inbuilding an externality to render the marketineffective.

Myth #6: A low-price guarantee bysuppliers in environments enabled by ITnetworks would result in markets thatbenefit the buyerCounter-myth #6: A low-price guaranteeby suppliers in environments enabled byIT networks could result in price fixingand higher prices for the buyerA General Perspective on Myth andCounter-myth #6The myth follows conventional thinking and pre-sumes that in networked environments like theInternet, customers can easily gather copiousinformation across products and make informedchoices on price and quality issues. Supplierscan nevertheless retain customers in this highlycompetitive environment by offering low-priceguarantees, as is typical among physical storeslike WalMart and Sears. In essence, the supplieroffers to match the lowest price in the marketthatthe customer is able to identify. Customers com-



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U0M- Om irM igw 1S1 - 1

Supplier AMarginalCost $10 $10Reservation Price of $5 0Network ExternalityMarket Price $15 $10

pare prices by suppliers of comparable productson the network. They then buy the product at thelowest offered price from that supplier offeringthe low-price guarantee. Clearly,the matching ofprices by suppliers seems to encourage pricecompetition to the benefit of customers.Alternatively, the counter-myth is based on therealistic premise that highly networked environ-ments also allow suppliers to track their com-petitors' prices. Such tracking could cause reluc-tance on the partof suppliersto lower prices. Thereason is because lower prices may not have theintended effect of attractingadditional customersif competitors are known to offer the low-priceguarantee. Indeed, the supplier that lowers pricescould even lose customers to other suppliers pro-viding the guarantee. This could have the effectof price fixing, ratherthan competitive pricing.One set of businesses that can collect competi-tors' price data is the airline industry.The AirlineTariffPublishing Company (ATPCO)sends infor-mation electronically about fare changes to itssubscribers, which means that every airline getsa near realtime look at what its competitors aredoing. Airlines aretherefore in a position to guar-antee low fares, being fully cognizant of theircompetitors' pricing information (Wreden1997a). Similarly,NASDAQ is a network of com-puterswhere multiple securitydealers can set bidand ask quotes on a specific stock. Each dealer'squotes are instantaneously available to all otherdealers. Moreover, it is common practice fordealers to offer the low-price guarantee.Customers can go to any dealer or broker (whohas an agreement with a dealer for the guarantee)and purchase the stock at the best price the mar-ket offers. Inboth the airlinecase as well as NAS-DAQ, the evidence suggests that this practice hasincreased rather than decreased prices (Huangand Stoll 1996).

An Economic Perspective on Myth andCounter-myth #6Myth: If we assume that search costs approachzero with pervasive and powerful IT,then com-parative shopping for simple products shouldforce the competitive equilibrium. This is espe-cially true if suppliers offer a "low price guaran-tee," i.e., offer to match the lowest price of anysupplier in the industry. Consumers can thensearch easily for the lowest price in the industryand be assured of that price from their supplier.To attract customers, suppliers would have tocompete vigorously based on price, movingprice rapidly to equal marginal cost, whichresults in the competitive outcome where all sur-pluses accrue to the consumer.Counter-myth: The above argument is intuitivelyappealing, and low price guarantees can influ-ence consumer behavior. In highly networkedenvironments, however, the negligible searchcosts might work as well, if not better, in favor ofsuppliers. We can assume in networked environ-ments that customers and suppliers know theprices offered by all competing suppliers in themarket. If the suppliers charge different prices,customers would migrateto the supplier with thelowest one. This creates the incentive for eachsupplier to lower price in an effort to attract cus-tomers. Inthis scenario, the competitive equilib-rium holds.However, if all suppliers offer the low-priceguarantee, customers will be indifferent towhere they shop. They can go to any supplierand get the lowest price in the market.Competing based on price becomes ineffectivebecause no additional customers can be drawnto a supplier if that supplier lowers price(unlike the competitive environment). This situ-ation holds because, in effect, all suppliers


Supplier B


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Suppliers networked with ITso that all suppliers knoweach others' prices. There is Su liersNO incentive for suppliers tolower price because anothersupplier would get the sale. /Can set monopolistic pricesthrough price fixing and gaincustomer surplusIF A

Every Supplier offersbuyers the lowest priceguarantee.l"~

Buyers can go toany supplier to getlowest price

*o0 * Buyers

0 * * S 0

lower their prices simultaneously. This simulta-neous movement of prices can have a perverseimpact on competition because it not onlyremoves the incentive to lower prices, but itactually creates an incentive to raise them. Forthe same reason that no customers can begained by lowering prices, raising them will notlose customers. Moreover, if the supplier withthe lowest offer in the market raised his price,all suppliers would benefit as a result (seeexample below).In effect, price matching enables price fixing,where the price at which trade occurs bears norelationship to costs. Lowering prices wouldyield no benefit, but it could invoke retributionfrom other suppliers because the price andidentity of all suppliers is known, whereas rais-ing prices would benefit suppliers (see Figure7).Economic ExampleAssume three suppliers, A, B, and C, sell an iden-tical product, which has a marginal cost of $1.Suppose they price the product at $7, $6, and $5,respectively. In a non-networked environment,they could sustain these prices and generatemonopoly rents due to high search costs for theconsumer. Ifthey all offer a low-price guarantee,they could still obtain monopoly rents as it iscostly for the consumer to search the lowestprice.

Under highly networked environments, however,the consumer knows the price of each supplier,and suppliers know the prices of their competi-tors. Suppose initially that only B and C offer thelow-price guarantee. There is no incentive for Cto lower the price below his/her initial level of $5because no additional customers can be drawnsince B offers a low-price guarantee. In contrast,C has an incentive to raise his/her price to thelevel of $6 posted by B because doing so willincrease per-unit profitswithout losing customersto B. In that case, both B and C will make largeprofits (tradingwith the same customer base at ahigher price). Of course, no customer will tradewith A at $7.For A to attract customers, he/she must eitherlower price from $7 to $6 or offer the low-priceguarantee. Suppose the latter is adopted. Both Band C will lose customers to A. While B and Ccannot get these customers back by loweringprice, they can nevertheless increase profits byraising price to the level of $7 posted by A (again,trading with the same customer base at a higherprice).This illustrates that with low price guarantees,suppliers have no incentive to lower prices. Incontrast, they have an incentive to raise prices.Thus, consumer surplus is absorbed by the sup-plier, while consumers have the perception thatthey are getting the lowest price.



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This myth is interestingbecause the implicit pricefixing is difficult to identify by simply observingthe market. Clearly, price matching impedescompetition and renders markets less effective.Only after several in-depth comparative studiesof the bid-ask spread on the NYSEvs. NASDAQwas the above problem revealed (see, e.g.,Christie and Schultz 1994; Godek 1996).Now, NASDAQ is revising its tradingrules to per-mit individual investors (trading certain stocksonly) to compete based on price with dealers vialimit orders that are observable to the public(NASD Press Release 1995). In other words,while dealers may implicitly agree among them-selves to fix prices by matching to the detrimentof individual investors, these investors couldavoid the inferiorprices offered by dealers if theycould trade among themselves directly. Thisdirect trading is facilitated by investors submit-ting limit orders that are observable to otherinvestors. In this environment, dealers cannotaffordto offer inferiorterms without the potentialfor losing customers who trade among them-selves directly and therefore are forced to com-pete based on price. Thus, the ability of low-price guarantees to fix prices is reduced,although not eliminated.

ImplicationsThe basic message of this paper is simple. Wepropose that with the pervasiveness of openarchitectures and electronic commerce, bothconsumers and suppliers can and will leverage ITto their advantage. While conventional wisdomtends to emphasize reduced coordination costfor consumers in the evolution toward marketstructures,suppliers can be equally aggressive inusing the same IT to maintain monopolies.Unlike the strategic systems of the 1980s, thesestrategies need not be based on idiosyncraticprotocols tying buyers to suppliers, but are possi-ble in an environment of high and open connec-tivity. Therefore,this paper hopefully alerts acad-emics and practitionersto the altogether feasiblestrategiesthat can be enacted by firms in the pre-sent and future. While we devote more space tothe counter-myths enacted from the suppliers'vantagepoint rather than more conventional

thinking, his does not reflecttheir inevitability.Rather,he equilibrium utcome in any marketwould be the result of a complex interplaybetweenthe vestedinterests f participants.Forces Working in Favor of SuppliersImplicit n our discussionof counter-mythsrethreefactorsmotivating uppliers o enactthesestrategies:1. Increases in the set of feasible strategies:While ITby itselfis neutral, ts ubiquityandflexibilityallows suppliers o manipulateorwithhold information n ways that increasethe coordination ostsof the usually esscap-italizedconsumer.Thepossibility o manipu-late information low using IT dramaticallyincreases the opportunityset of potentialstrategieshatsuppliers an adopt.2. Unique cost structure of informationprod-ucts:Typicalnformationroducts equire ig-nificantup-front apitaloutlaysfor informa-tion gatheringorsoftwaredevelopment).Themarginal ost of distribution r replication fthesedigitalassets s (almost) ero. Under hescenarioof intensiveprice competition, hecompetitiveequilibriumbased on traditionaleconomic theorywould yield priceequal tomarginal ost at zero. Clearly hisoutcome isveryundesirable orsuppliers.Therefore,heyhave every incentiveto engage in strategiesthatprevent t fromoccurring.3. Difficulty n definingthe long run: Itcan bereasonably argued that supplier strategies,such as those described in this papermightnot be sustainablenthe longrun,givenmar-ketforces. For nstance,anylimiton informa-tion available to customers might createopportunitiesfor intermediaries hat worktowardcorrectingt. Theproblem s definingthe long run n a rapidly hanging echnolog-ical environment.We w

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MISQ 1999 - Grover - Six Myths of Information and Markets