Communications of the ACM

Communications of the ACM

Electronic Markets Hypothesis Redux: Where Are We Now?

By Bonnie C. Glassberg
Communications of the ACM, February 2007, Vol. 50 No. 2, Pages 51-55
10.1145/1216016.1216020
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It has been almost 20 years since Malone, Yates, and Benjamin [7] developed their seminal paper on the impact of information technology (IT) on the choice to coordinate economic activity predominantly via electronic markets as opposed to electronic hierarchies. This theory is now commonly referred to as the electronic markets hypothesis (or the EMH). As electronic interconnections have developed at a phenomenal rate during the intervening decades, many of the propositions of this theory have been shown to be remarkably prophetic. For example, there are many electronic markets online, and the main drivers appear to be advances in IT and ease of use, particularly the Web. For example, in the travel industry there is a vibrant, unbiased aggregate electronic market that provides personalized decision aids to ticket buyers.

However, there have been several studies that either did not support the theory's propositions or criticized the theory. The purpose of this article is to review and critique the EMH in light of the evolution and application of IT to coordinate economic activity. If the EMH is valid, solid evidence of the shifts it predicts toward the use of electronic markets rather than electronic hierarchies might be visible in various industry sectors by now, with similar trends in both business-to-consumer (B2C) and business-to-business (B2B) exchanges. We also examine lessons gleaned from the academic and business worlds, which shed new light on a more complex set of factors affecting sourcing decisions than Malone et al. envisioned.

The basic premise of EMH involves the overall shift toward the use of electronic markets rather than hierarchies to coordinate economic activity. Malone [7] credits the falling cost of coordination (using IT) for this shift. Coordination cost covers activities such as gathering information, negotiating contracts, scheduling, tracking financial flows, and protecting against the risk of "opportunistic" behavior. These additional costs include expenses associated with purchasing from multiple vendors instead of conducting business as a hierarchical relationship (that is, with a sole supplier). In the presence of advances in IT, however, these additional coordination costs can be dramatically decreased (without a concomitant increase in the production costs), thereby making the market structure a viable alternative to a hierarchical relationship. In addition to coordination costs, EMH postulates that a move to "the market" is enhanced because IT will lower the complexity of product description and reduce asset specificity. In this context, asset specificity refers to the degree to which a product or service has characteristics that make it suitable for only a small group of potential buyers.

A recent review of the Social Sciences Citation Index revealed that the EMH has been cited in more than 300 publications, many of which are academic journals. It appears that many of these citations presume that the theory's propositions are valid. However, few studies have tested it. While there is some empirical evidence that the premises of the EMH may apply to B2C commerce [3, 8], the theory depends heavily on transaction cost theory to explain firm behavior. In the B2B arena, firms may not ultimately benefit by solely seeking to lower transaction costs through market forces. Trust, service, delivery scheduling, and switching costs are just some of the issues that may cause firms to be reluctant to rely on electronic markets [5].

Obviously, any theory that is both heavily cited and frequently criticized by academicians makes an important contribution to the dialogue that enhances our understanding of the impact of IT on economic structures. Furthermore, the EMH is valuable for informing business strategists because it can be used both to understand several historical changes in U.S. economic structures and to predict how changes in IT will continue to impact e-commerce in specific industries [7]. The authors of this article reviewed, critiqued, and tested the EMH in a variety of economic sectors [4, 8]. Perhaps our fresh look at the EMH from a scholarly and practitioner perspective will help to explain both the appeal and the controversy of such a well-known theory.

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EMH Critique

The EMH does not distinguish between the B2C and B2B economic segments. Although some strategic management researchers (for example, [9]) argue that there is no significant distinction in success factors between B2C and B2B e-commerce, our research has uncovered some differences in these sectors. Thus, we believe that such a distinction is valuable and necessary to understand the underlying factors in each sector, and we have framed our discussion accordingly. Here, we discuss both sectors.

B2C. For many consumer products and services, the Internet supports electronic markets. For example, eBay, Priceline, and LendingTree allow consumers to quickly find many potential suppliers for both goods and services. The Internet allows individuals to search for mortgage products, make lender comparisons, and apply for a loan online [8]. Thus, the EMH's prediction that IT can reduce coordination cost, leading to the greater use of electronic markets, is generally supported in B2C commerce. Similarly, IT has reduced the complexity of product descriptions in the music [3], home mortgage, and residential real estate industries [8]. Searchable real estate property listings are now an online standard, and advice about navigating through the complex purchase process is provided. On the other hand, these two factors (complexity of product description and coordination cost) are actually closely associated, and having them both in a model that predicts the development of electronic markets seems redundant. More complex descriptions require more coordination when one is trying to make comparisons among competing suppliers, and the effect of IT will be similar for each factor. A home buyer, for example, can obtain standardized information online (in the form of listings), which reduces the complexity of this product's description. At the same time the buyer can query the standardized information to reduce the search space by eliminating homes that meet certain criteria; thus coordination costs are simultaneously reduced by the same IT.

The results of studies of EMH [3, 8] in four industries (home mortgages, residential real estate, financial services, and retail music), suggest that asset specificity is also not a significant factor in the creation of these electronic markets. Although electronic markets did develop, there was no evidence that IT lowered specificity of the product characteristics. Moreover, there are some consumer products where asset specificity is inherently high (for example, collectibles sold on eBay and residential real estate) and other products where asset specificity is inherently low (for example, financial products, such as mortgages and music); when both scenarios develop significant electronic markets, the direction of the potential mediating effect of asset specificity is obviously unclear. Hence, it appears that asset specificity may not be a significant factor in the development of electronic markets across these industries.

In addition to the factors already discussed, the EMH predicts the evolution of electronic markets from biased to unbiased markets, and from unbiased to personalized markets. For consumers, making personal travel arrangements is commonplace, and service providers, such as Travelocity and Orbitz, provide customized (that is, personalized) interfaces. In an interesting development, two major airlines, Northwest and American, announced they would begin charging customers service fees for tickets purchased through their reservation offices and at airport locations. It seems they are losing money every time someone comes up to the airport desk to buy a ticket [11]. Thus it appears that electronic markets in this industry will continue to be the norm.

In summary, we argue for a refined B2C EMH model that de-emphasizes complexity of product description and asset specificity as factors that mediate IT's effect on the choice between electronic markets and electronic hierarchies.

Others, such as Lee and Clark [5], have discussed additional factors that may be important for the model. Regarding the e-commerce literature associated with the choice between electronic hierarchies versus electronic markets as alternative industry structures, they conclude there are two major dimensions to consider. One of these dimensions is concerned with a choice between hierarchies, networks, or markets. The other dimension relates to the firm boundary issue—whether a firm should internally produce or outsource a product or service.

Obviously the make-or-buy (the firm boundaries) question is not applicable for almost all consumer products and services because "making" is simply not a viable option as most consumers have neither the resources nor the wherewithal to create their own products or services. Moreover, it is difficult to conceive of many products and services procured by consumers via long-term hierarchical relationships (which are usually governed by a contract in a B2B scenario). Thus the choice for the dependent variable in the EMH model (that is, the predominant transaction mechanism) with regard to B2C can often be simplified to a dichotomy between non-electronic markets and electronic markets (rather than between electronic hierarchies and electronic markets).

Given that advances in IT have permeated the procurement process for consumers (for example, the Internet), one would expect to find electronic markets developing for almost all consumer products and services. We argue that such markets are indeed being developed on the Internet. The business strategies of firms in the consumer products value chains need to foster the development of these markets with more technological innovations that reduce coordination costs.

But what other factors might be important? New trends, supported by empirical research [8], suggest that:

• There should be a distinction between the influence of IT on buyers' coordination costs (the premise of the EMH) and on suppliers' coordination costs, both of which can be reduced by IT and lead to more electronic markets;
• Industries with higher variability of prices and product availability are likely to depend more on electronic market coordination;
• The less complex the procurement process, the more likely transactions will be made via an electronic market; and,
• The standardization of product ratings or product formats (for example, having consistent formats for comparisons) and the emergence of standardized processes is likely to lead to more use of electronic market coordination.

Finally, the EMH implies that individual consumers are rational actors, seeking the lowest-cost alternative. Because the Internet reduces information asymmetry, consumers are likely to use electronic markets as a method for comparison shopping (for example, to gather prices, detailed product information, and features). But that does not imply that the consumer will purchase directly from this electronic market. Transaction security, access to service, the ability to see and touch the product, and brand loyalty are just some of the reasons why many consumers ultimately go to a local store to buy a product they researched on the Internet.

B2B. Firms are looking establish exchange structures to streamline their business processes and enhance their competitive edge. Malone [7] suggested that IT would help reduce the complexity of product description and asset specificity, thus lowering search cost and coordination cost. If this were so, more firms would turn to electronic markets as a way to gain that competitive edge. While there are many online B2B markets now, their use has not grown as quickly as anticipated [12]. Here, we discuss four major reasons why B2B markets may not have developed in certain circumstances.

First, the criteria used to make the governance decision cover a wide range of issues. Some firms are concerned with cost, but others now require much more of their trading partners in terms of quality, timing, flexibility, customization, and responsiveness [1, 12]. Although price, volume, and delivery dates can be spelled out in advance, other items are more difficult to delineate and enforce in contracts. Over time, relationships once dependent on contractual obligations can evolve into deeper understanding via non-contractible issues (for example, quality, security, responsiveness). When the requirements of the exchange are difficult to spell out and enforce, firms should opt for hierarchical or cooperative exchange structures [2, 10, 12]. This allows the firm to reduce operations risk and opportunism risk, and also minimizes switching costs.

Second, the way firms make decisions regarding governance structure is much more complex than that presented by Malone et al. and must be looked at from an international as well as historical perspective. U.S. companies are obsessed with profit maximization and short-term financial objectives. Asian firms, on the other hand, have taken a humanistic view of economic exchanges by focusing on the development of long-term relationships. Frequent interaction builds confidence and sets up a dialogue for further collaboration. If a relationship is going well, what incentive is there to change it?

Third, the types of linkages occurring on the continuum between the invisible hand of the market and the visible hand of a hierarchy are viable new economic exchange structures, such as consortiums and cooperative ventures, which must be considered [2, 6]. Smaller firms tend to specialize in a particular product, process, or niche. These centers of competence and innovation benefit from forming alliances with other firms where each can add value to the relationship. Cooperation allows firms to share cost and risk, reduce the learning curve, and gain synergies as each contributes its core competency. These links also provide new sources of industry intelligence. Developing a network of relationships increases a firm's information collection efficiency, thus helping it become aware of threats and opportunities more quickly. The focus is thus based on the relationship, rather than the transaction.

Finally, theories from reference disciplines other than information systems and transaction cost economics must be considered in understanding the decision-making process. Research in such areas as strategy, management, and organizational behavior can shed new light on the needs firms have, as well as the role of organizational memory (the effects of prior dealings), and other relevant costs.

Although simple models can often be very useful, the EMH model is generally rather parsimonious, considering the many other factors that may affect market structure. Cost is only one factor that drives firms to choose one market structure over another, and the cost will vary depending on perceived risk, the volume of transactions, and the relative power of the participants. Additionally, components such as frequency of the exchange, complexity of the transaction, the risk of opportunism, switching cost, firm reputation, managerial skill, and economic conditions may play a more prominent role in the exchange decision [4]. The frequency of the firms' interactions and the success or failure of initial transactions will affect attitudes toward one another and toward the risks involved [1]. In short, continued relationships build trust, momentum, and a strong desire to maintain the status quo.

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Toward a New Model of Governance Structure

Table 1 summarizes key elements, dimensions, and issues that form the basis of the EMH in B2B environments. Additional criteria, discussed earlier, that should be considered in a new model of governance structure are outlined for comparison. Note that EMH relies on transaction cost economics and information systems as reference disciplines and only pure hierarchies and markets are considered. Economic models are limiting in that they look at snapshots, where only a single point in time is considered relevant. A new model should consider adopting key learnings from studies in strategy, management, and organizational behavior and must include new forms of organizational linkages, such as alliances and consortiums. The environment that firms operate in is dynamic, and both current and prior exchanges (such as transactions and communications) are important.

When parties do not trust one another or have little experience upon which to assess compliance, they must guard against the risk of opportunism, thereby incurring costs for monitoring, bonding, and residual loss (cost to the principal due to misalignment of goals). Utilizing an online market as a strategy each time for procurement can result in working with new exchange partners every transaction. This alternative may be preferred when the need for procuring goods and services first arises and the buyer has had no prior dealings with potential suppliers. In the long run, however, continuous monitoring expenses can add up. Substantial investment can also occur in the process of adapting to the routines, methods, and operations of the exchange partner. This adaptation process favors continuance of the existing relationship, as repeated transactions build trust [10].

Buyers and sellers who may be sensitive to price should be aware that electronic markets are not necessarily a low-cost alternative as a search mechanism. Market providers can not only impose significant switching costs on their participants but hookup may entail a sizable investment in hardware, software, and employee training. In addition, buyers will be analyzing sellers they have likely never dealt with before. Information available in the electronic market may not reveal the size of the firm or its reputation. See Table 2 for a summary of factors that companies may consider when choosing a governance structure.

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Conclusion

Individuals and firms alike are looking for solutions to their sourcing problems. Both must find partners and make appropriate choices in governance structures. These choices include not only electronic hierarchies and electronic markets; in addition, firms can undertake cooperative ventures. With consumer-to-consumer (C2C) and B2C exchanges, the cost of the transaction is more likely to be an important issue. With B2B commerce, the decision-making process cannot rely on cost alone.

Information technology improves the ability to store, transmit and process ever-larger amounts of data. IT will also continue to play a critical role not only in providing the links between firms, but also in establishing and maintaining the Web of contacts between firms. While IT is an enabler, helping firms to reach their goals, it is corporate strategy that provides the vision, objectives, and principles that guide decision making. To compete, firms must learn how manage relationships, not just transactions.

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