International Entrepreneurship and Management Journal

ISSN: 1757-1938 SJR : 0.847 SNIP : 1.89948

THE IMPACT OF IT ON MARKET INFORMATION AND TRANSPARENCY: A UNIFIED THEORETICAL FRAMEWORK

Nelson F. Granados Doctoral Program  Alok Gupta Professor Robert J. Kauffman Director, MIS Research Center, and Professor and Chair 

Information and Decision Sciences Carlson School of Management, University of Minnesota Minneapolis, MN 55455 {ngranados, agupta, rkauffman}@csom.umn.edu 

ABSTRACT

 With the advent of the Internet, we have seen existing markets transform and new ones emerge. In this paper, we contribute to the understanding of this phenomenon by developing a unified theory about the role that IT plays in affecting market information, transparency and market structure. In particular, we introduce a new theoretical framework which uncovers the process and the forces that, together with IT, facilitate or inhibit the emerging dominance of transparent electronic markets. Transparent electronic markets offer unbiased, complete, and accurate market information. Our effort to develop a unified theoretical framework begins with a thorough assessment of the prior literature. It also uses an inductive approach involving the case study method, in which we contrast and compare the forces that have led the air travel and financial securities markets to become increasingly transparent. Building on the electronic markets and electronic hierarchies research of Malone, Yates and Benjamin [1987], our findings suggest that IT alone does not explain a move to transparent electronic markets. Instead, we argue that enhanced electronic representation of products, and competitive and institutional forces have also played an important role in the process by which most sellers have come to favor transparent markets. Keywords: Economic theory, electronic commerce, electronic markets and hierarchies, market design theory, market structure, market transparency, theory-building research, unified theoretical framework.  I. INTRODUCTION The electronic markets hypothesis (EMH) posits that IT reduces coordination costs between suppliers and buyers, leading to the dominance of market-based forms of economic activity [Malone et al., 1987]. The primary drivers of this move are advanced ITs such as the Internet, which provide a platform that reduces information search costs. The EMH predicts that, in this technological environment, biased electronic markets will emerge as suppliers take advantage of IT to lock in buyers. However, unbiased electronic markets will gradually dominate, where all products and suppliers can be evaluated by buyers to make well-informed decisions. Unbiased markets generally benefit buyers because they are better able to discern the product that best fits their needs. On the other hand, this very benefit to buyers may be a threat to sellers, as they forego the benefits of information asymmetries. Consequently, some industries which were expected to move to unbiased electronic markets have not done so. Possible explanations include the move-to-the-middle hypothesis [Clemons et al., 1993] and the risk-augmented transaction cost theory [Kauffman and Mohtadi, 2004], which uncover the incentives of market participants to implement biases. Nevertheless, many firms deliberately compete for buyers with market information. So far, theories of the impact of IT on market structure explain rather specific outcomes. At one extreme, there are theories such as the EMH that predict a move to unbiased electronic markets. On the other hand, there are theories that explain why biased markets and other quasi-market forms may prevail. However, both outcomes are observed in the real world, and it appears that the strategic choices of firms can affect these outcomes. For example, although many online travel agencies have embraced the Internet to offer products and prices from most airlines [Granados et al., 2005], a similar move which would be expected in the mortgage industry has not occurred—at least not to the same extent [Hess and Kemerer, 1994]. With the advent of the Internet, the long-term outcome of the mortgage industry’s structure is still uncertain, and it will depend on technical implementation choices of firms in the industry [Wigand et al., 2005]. 1 Our objective is to examine the variations in market outcomes as firms use IT to compete for consumers with market information and provide theoretical explanations for these variations. We start by integrating existing arguments from different theories about why specific market outcomes may prevail. In particular, we use Malone et al.’s [1987] and other authors’ numerous arguments about the conditions under which unbiased electronic markets are preferred to biased electronic markets. 1 However, we also use arguments from theories that explain why biased markets may prevail. In other words, while we use existing theory on hierarchies and markets as a theoretical foundation, we focus on the different dimensions of market transformation triggered by IT, once market-based forms are in place. In addition, we observe that firms have used IT to devise complex strategies to manipulate information that affect more than just the level of bias of their market mechanisms. A more complete characterization of the possible strategies is related to the concept of market transparency, which includes the accuracy and completeness of market information, in addition to the level of bias. Therefore, there is an opportunity to extend the theoretical foundations of the impact of IT on market structure, based on real-world observations from recent years, as the evolution of electronic markets is fueled by the Internet. In this paper, we examine how IT interacts with other forces to facilitate or inhibit a move to transparent electronic markets, and set the stage for future research on other forms of advanced market organization. We use a case research strategy, which is appropriate to answer “how” questions [Benbasat et al., 1987] and uncover process knowledge. In particular, we build theory to answer the following research questions: • To what extent do we observe a move to transparent markets in different sectors? • What are the factors and theoretical bases that explain differences in market structure in the presence of IT?

 of how IT shapes a market’s structure: electronic markets and hierarchies theory and market design theory. ELECTRONIC MARKETS AND HIERARCHIES Theories about the impact of IT on organizational forms are rooted in transaction cost economics. Coase [1937], in his discussion of the boundary of the firm, suggested that the flow of materials will occur within a firm to the extent that the respective transaction costs are lower than in the price mechanisms of markets. More generally, firms (or hierarchies) and markets are two polar forms of economic activity, while contractual arrangements between firms fall along a continuum from firms to markets, such as electronic integration, long-term contracts, and joint ventures [Zaheer and Venkatraman, 1994]. Building on transaction cost economics, the electronic market hypothesis (EMH) of Malone et al. [1987] predicts that IT will lead to higher use of market transactions in the conduct of economic activity. IT reduces market coordination costs, such as the cost of searching for suppliers, establishing contracts, and buying supplies in the spot market. The EMH also predicts that moves to market-based forms of organization will be gradual; they will not occur all at once. Malone et al. [1987] state that the first stage will involve movement from electronic hierarchies to biased electronic markets. In this stage, suppliers benefit from implementing systems that conceal or distort information about competitors. In the second stage, competitive and legal forces lead to the adoption of unbiased electronic markets, where all options for trading are made available. Finally, in the third stage, the proliferation of information in unbiased markets leads to personalized markets, with functionality that allows buyers to filter the options available for trading. In this manner, Malone et al. [1987] and other researchers identified the potential impact that IT can have on the informational structure of markets. It is fair to say that the overall predictions of Malone et al.’s [1987] work were remarkably on target in some industries. One example that especially rings true 4 is the air travel industry, which involves their predictions about unbiased and personalized markets. “In these cases, a final stage may be the development of electronic markets that provide personalized decision aids to help individual buyers select from the alternatives available, what we call personalized markets bold added for emphasis]. For example, at least one such system has been developed for airline reservations … Using this system, travel agencies and corporate travel departments can receive information about available flights with each flight automatically ranked on a scale from 1 to 100. The rankings take into account ‘fares, departure times, and even the value of an executive’s time.’ … It is easy to imagine even more sophisticated systems that use artificial intelligence (AI) techniques to screen advertising messages and product descriptions according to precisely the criteria that are important to a given buyer … Air travelers, for instance, might specify rules with which their own automated buyers’ agents [bold again added for emphasis] could compare a wide range of possible flights and select the ones that best match that particular traveler’s preferences. A fairly simple set of such rules could, in many cases, do a better job of matching travelers’ preferences than all but the most conscientious and knowledgeable travel agents. [pp. 492-493] Despite these theoretical predictions, real world observations point out that IT innovations have not necessarily led to market-based forms of organization in other industries. Hess and Kemerer [1994] analyzed mortgage markets, for example. They suggest that the EMH may need to be reframed because it does not clearly explain the lack of electronic market organization in the industry. With the the Internet, however, industry-wide efforts emerged to implement vertical XML-based IS standards to improve mortgage processing, data exchange and information transparency long the supply chain [Wigand et al., 2005]. Though one could argue that the industry is now more electronic market-like than when Hess and Kemerer examined it, on a relative basis the move to unbiased mortgage markets has not occurred to the extent that it has in air travel markets.  Alternative theories have emerged to explain these industry structure outcomes, which we label quasi-market theories. These theories suggest that IT also reduces coordination costs of rather hierarchical contractual arrangements, so relationships with a few suppliers may prevail. Clemons et al. [1993] proposed a move-to-the-middle hypothesis. They recognize that IT may not only impact the transaction costs of market coordination, but also the transaction costs of 5 long-term business relationships, such as monitoring product quality or safe-guarding relationship-specific investments. By reducing product complexity and asset specificity, IT reduces the transaction costs of long-term relationships, so buyers may prefer explicit coordination with a few suppliers over the purchase of supplies in the spot market. 2 Wang and Seidman [1995] suggest that, due to negative externalities, it may be optimal for fewer suppliers to join an electronic data interchange system. More recently, Kauffman and Mohtadi [2004] proposed a risk-augmented transaction cost theory that is aimed at explaining the market structure effects of demand and supply shocks, such as sudden inventory build-up due to a recession or the loss of a key supplier. They showed that the possibility of shocks impacting large buyers’ procurement may lead them to safeguard their profits through vertical or biased relationships, rather than pursuing trade in a market setting. Moreover, the EMH has not effectively explained the fall in the number of suppliers that occurred in the auto industry in the 1990s [Cusumano and Takeishi, 1991]. Bakos and Brynjolfsson [1993] proposed an interpretation based on the theory of incomplete contracts, which posits that not all desired aspects of a trading relationship are contractible. So buyers may limit the number of suppliers to maintain supplier incentives to make non-contractible investments such as quality, responsiveness, and innovation. Hence, the equilibrium number of suppliers may decrease in the presence of IT. Summary With the advent of e-commerce technologies and the Internet, we have observed the emergence of new markets and the proliferation of existing ones. Theoretically, this phenomenon can be partially explained with the EMH, which suggests that IT will reduce coordination costs across firms, leading to proportionally higher market-based forms of economic activity. On the other hand, quasi-market theories help explain why biased markets may prevail. When subject to transaction risks such as opportunism, asset-specific sunk costs, and

 Table 1. Market Design Dimensions and Impact of IT M ARKET DESIGN DIMENSIONS DESCRIPTION IMPACT OF IT Informational Features Market Transparency  Availability and accessibility of market information. Increases potential for complete, accurate, and unbiased market information Price Discovery Process by which market prices are established Enables innovative and dynamic mechanisms Trading Protocols Transaction process and rules Increases flexibility to set trading rules Degree of Automation Efficiency Speed and cost of transactions Increases efficiency Reach Frequency of transactions and geographical reach Increases reach potential Reliance on Intermediaries Degree of intermediation Enables electronic intermediation and direct trading Source: Adapted from Madhavan [2000] incomplete or distorted. For example, Hotwire is an online travel agency that offers last-minute fares for multiple airline, showing a low level of bias. However, it does not show the airline or itinerary until after purchase, so we characterize it as an opaque market mechanism. E-commerce technologies increase the potential for market transparency. In turn, sellers strategically decide whether to capitalize on this potential in two ways. First, they can make choices regarding the information to be disclosed to buyers through their market mechanism, such as their own Internet portal or an electronic exchange in which they have decision-making power. Second, they can make strategic decisions to trade in a market based on its information disclosure rules. Large market participants often avoid trading in electronic markets that require broad identity disclosure because it provides signals about their cost structure [Zhu, 2004] or their motivation to trade [Clemons and Weber, 1990; Madhavan, 2000]. But buyers generally prefer market transparency. This is because they can better ascertain their product valuation and select the best product and supplier.

 at the best price. Market transparency benefits buyers in three ways. (See Figure 1.) First, search costs decrease as more information is made available at no additional cost. For example, through the Internet, major online travel agents (OTAs) such as Orbitz, Travelocity, and Expedia now provide immediate and inexpensive access to tables with multiple combinations of air carriers, flight itineraries, and ticket prices. By purchasing a ticket via these OTAs, consumers can evaluate multiple alternatives and act as their own travel agents. Value increase Decrease in search costs Notes: Buyer Surplus A = Buyer surplus without transparency Buyer Surplus B = Buyer surplus with transparency CONTRIBUTION OF Value Price MARKET TRANSPARENCY Buyer Surplus A Price decrease Buyer Surplus B Figure 1. Contribution of Market Transparency to Buyer Surplus Second, the value of a purchase increases if the consumer discerns product characteristics of existing alternatives with higher precision, resulting in more accurate product valuation [Hasbrouck, 1995]. In financial markets, for example, Internet brokerage firms are able to provide instantaneous and detailed information about a stock, which enables a more accurate valuation by the investor. Third, information may become available that allows a consumer to transact at a lower price for a given product. Stigler [1961] showed that a lower price may result if search costs are reduced such that a lower market price is discovered. However, there are some situations in which buyers may prefer less market transparency. For example, in business-to-business markets, high-demand 10

 buyers may express concerns about sharing too much information about thedemand forecasts, lest an electronically linked supplier will exploit that information and turn prices against them [Kauffman and Mohtadi, 2005]Price discovery, the process by which market prices are established, iir . s anocess s. nd ic market design [An rs, et l nge. Pros, saction ange ther important aspect of market design. Price discovery involves the proby which latent demand and supply result in realized market prices and trade volumes [Madhavan, 2000]. In some markets, by obtaining details about the trading process, buyers and sellers are able to discover their reservation priceFor example, in financial markets transaction history provides clues about demand and supply pressures, which influence the prices at which buyers asellers are willing to transact [Pagano and Roell, 1996].  Auction theory is related to price discovery in electronandalingam et al., 2005]. Electronic market mechanisms such as doubleauctions have a dynamic price discovery process: every bid by buyers, selleor intermediaries is a signal to determine transaction prices. Other market mechanisms, such as posted prices, are more static. ITs such as the Internenable the creation of novel and dynamic mechanisms, increasing the potentiafor price discovery. In turn, sellers make choices regarding market designs alonga continuum from static to dynamic market mechanisms. For example, Internet-based electronic auctions of airline tickets have enabled markets for distressed inventory of seats close to flight departures [Klein and Loebbecke, 2003]. Trading protocols represent the rules of trading and transactional exchatocols are often the result of ongoing business practices and transactional norms. They may reflect government regulations to ensure fair trading practicemarket participation fees and other fixed transaction costs for the market participants. Advanced ITs enable innovative and flexible definition of tranprotocols. For example, the practice of 24-hour electronic trading in financial markets is now possible thanks to Internet technologies. On the Internet, a change in trading rules may require a small, immediate, and inexpensive chin a Web site’s design that will become rapidly available to all participants

IT and Market Design Trade-offs tures of market design influence market per  e 2001]. or nuser, of ch that the lonop a III. WITHIN-CASE ANALYSIS: AIR TRAVEL The robustness of its ability to explain diff Together, these informational feaformance. However, there are trade-offs to be made, because changing a market’s design in one dimension may affect it in another [Levecq and Weber,2002]. In the market transparency dimension, suppliers and intermediaries arecommonly faced with the trade-off between the benefits of a more transparent market to attract buyers and the losses that may be incurred by releasing privatinformation. Though market transparency increases demand by attracting buyers, it may put seller profit at risk due to better informed buyers [Porter,In the price discovery dimension, sellers face the decision to post fixed prices egotiate. While negotiation allows effective price discovery, there are information and negotiation costs that may deter buyers [Riley and Zeckha1983]. There is also a trade-off between selecting a fixed price versus an auctionmechanism. While an electronic auction may attract buyers through effective price discovery, it may also hurt seller revenues as buyers enjoy higher levels price transparency. Therefore, market design decisions that buyers, sellers, and intermediaries make depend on the evaluation of these trade-offs. We contend that IT transforms these market design trade-offs, sug-term expected aggregate outcome of sellers’ market design decisions will change. In the next section, we examine this process for air travel and financial securities, which have gone through significant IT-driven changes in the dimension of market transparency. Based on these mini-cases, we develtheoretical framework of the impact of IT on market structure.  AND FINANCIAL SECURITIES a theoretical model is largely based onerent kinds of outcomes that are observed for a given phenomenon. We seek to explain the extent to which transparent electronic market mechanisms prevail across industries. Some industries make it to that point sooner, while others arrive later (and possibly not at all). Thus, since our goal is to develop an