Electronic Commerce
An Experiment in Efficiency
The development of the Internet as a legitimate medium for business interactions has dramatically altered the nature of commerce throughout the world. Originally spawned as an alternative tool of communication in the event of a nuclear war, the Internet has undergone tremendous growth since its inception in 1969. The unforeseen outcome of this defensive scheme turned technological innovation has redefined our narrow perception of commerce; it has driven the winds of change through the very bastions of conventional business strategy. Thus far, electronic commerce has lowered the barriers to entry by reducing spatial and temporal limitations, redistributing resources from ineffective intermediaries to active escrow agents who validate the authenticity of goods, expanded the markets to stimulate the influx of new firms, creating the competition that will benefit both consumers and producers, and has ultimately produced the foundations for a more efficient market.
Whether these ambitious claims can be fully realized remains to be seen. Many obstacles still lie in the road to the success of electronic commerce. Fundamental problems with the overloaded infrastructure pose the greatest threat to the continued growth of the Internet. As the size of the network increases, congestion and bandwidth bottlenecks drag the pace of transmission to a halt. The potential security issues associated with the nature of an open network also serve to discourage potential consumers. And without the direct validation of certain tangible goods, consumers have more reason to revert to traditional means of trade. In addition to these issues regarding the technicalities of commerce via the Internet, uncertainties about legalities such as copyright laws and taxes loom over the expansion of this business alternative. But despite these pessimistic factors, electronic commerce has exploded within the past year and has revolutionized the way businesses utilize their resources and the way in which they approach the market. As the dawn of a new millenium rapidly approaches, electronic commerce has transformed the world of business and has emerged as a viable model of a perfectly competitive market.
The strategic and often serendipitous decisions made by the creators of the Internet regarding the free and open structure of the network proved to be among the most crucial factors in the success of electronic commerce in its present nascent stage. To be sure, the Internet was not designed to be a global information highway. Quite to the contrary, it was created through an initiative of the United States Department of Defense, designed as a closed network of electronic communication for military and government agencies. With this purpose in mind, the primary goal for the infrastructure of the network was not to make information easily accessible, but instead to survive in the case of nuclear war.
Leonard Kleinrock at MIT published the first paper on packet switching theory and demonstrated the feasibility of communications using packets rather than circuits which turned out to be a major step along the path towards computer networking.1 Initially, ARPA-net2, the predecessor of the Internet, consisted of just four nodes that connected research laboratories at the University of California-Los Angeles, Stanford University, the University of California-Santa Barbara, and the University of Utah. The role of universities in developing this networking technology was extremely instrumental in the initial growth of the Internet.
From this modest beginning, the network already demonstrated the defining characteristics of a multi-nodal, decentralized system, distinguishing it from all other available systems of communication. To assure reliability of message transmission, all nodes were connected by more than one path. If one connection failed, the message would be dispatched via another route. And to keep the network secure from disruption or attack, which was an important military concern, this network was designed so that there would be no centralized control.3 An unintentional byproduct of this decentralization was that the system could grow easily, since there was no central node that would have had to be periodically upgraded. The National Science Foundation recognized the advantage of an interconnected network and funded the development of the wide area network which later became the backbone of the Internet.4 The NSF had decided that in order to keep the U.S. competitive in scientific research, it needed to extend network access to every science and engineering researcher.5 This close partnership between government and academic centers has done much to shape the Internet into the ubiquitous source of shared information and burgeoning source of electronic commerce that it has today become.
Even as a marketplace pressed repeatedly to the forefront of American news media, electronic commerce continues to elude precise definition. It encompasses such a wide range of practices that despite its growing presence, it retains an amorphous identity. As on scholar has put it, electronic commerce, in its broadest sense, "refers to the use of electronic means and technologies to conduct commerce, including within-business, business-to-business, and business-to-consumer interactions."6 From the outset, this burgeoning virtual marketplace has staked its existence on the success of electronic means to expedite commercial transactions and to improve efficiencies in business organizations and processes.7 In a way, and perhaps unknowingly, cyberspace companies are taking part in a global economic experiment to increase market efficiency by lowering transaction costs, a reduction that benefits both producers and consumers.
The transition of companies into virtual businesses eliminates many of the constraints that confront a firm in the physical world. Restraints such as distance and time become obsolete as web storefronts offer continuous customer service and support just a mouseclick away. This advantage becomes increasingly important as consumers realize the convenience of shopping at their own leisure. This incentive might be the factor that entices the consumer to switch to on-line transactions. The very nature of the Internet as a communications tool also allows it to serve as an expedient conduit between the customer and supplier, allowing easy feedback and thus streamlining commercial interactions. Free from the constraining costs of geographical distance and operational hours, electronic commerce enables producers to appeal to a larger market, an advantage that will likely increase their margin of profit.
In addition to providing this opportunity to increase profit, the Internet also behaves as the "Great Equalizer." The virtual existence of companies on the Internet makes it difficult to distinguish physical differences in their size. Both large and small firms are capable of impressing potential customers without the large investment in capital needed to maintain a dominant physical presence over a neighboring competitor. For a few thousand dollars, on-line storefront software packages offer potential businesses an accounting and database management system with sufficient catalog and storefront features. Products that run under Windows and Unix cost between $1000 and $10,000.8 Compared to the estimated investment of hundreds of thousands of dollars required to purchase and furnish an establishment in the physical world, these costs would seem almost inconsequential.
In the world of electronic commerce, physical appearance does not always reveal information about the size, and thus the relative market position, of a store.9 This equalizing effect gives leverage to smaller firms entering the market and allows for the lower barrier to entry associated with the electronic marketplace. Although established firms might still command a decent share of the market with their reputation, the initial cost and the risks of investing in a new venture are significantly reduced.
The lower barrier to entry is consequently reflected in the present market trend of direct sales, a development which facilitates the entry of these small, specialized firms. As the rate of direct sales continues to increase, consumers are demanding more products reflective of their own preferences. Product differentiation is becoming more prevalent in the electronic marketplace. The novelty of made-to-order items is capturing a larger crowd and has enabled small businesses to carve their own niche. Dell Inc., a computer manufacturer, began as a minor competitor in the computer industry and now has grown to become the most profitable producer of customized computers in the world. Smaller firms that specialize in producing a certain product are gaining ground on larger firms that mass produce a large quantity of homogeneous products. By encouraging an environment conducive to the entrance of new businesses, electronic commerce sparks the spirit of entrepreneurship that ultimately leads to a more competitive market.
While the Internet has certainly lowered the barrier to entry, establishing a virtual business still requires sufficient financial means and business expertise. A recent study produced by the OECD summarizes these concerns:
"Often, the major part of this investment is not direct capital costs, but the associated costs of implementing and maintaining new systems and acquiring new technological and organisational competencies. For small and medium-sized enterprises, these costs can take up a proportionally larger share of available investment capital than for large firms."10
The exponential gains recently achieved by companies like Yahoo! and Amazon.com have clearly resuscitated the ageless myth of immediate and effortless success.11 In reality, however, the process of physically organizing, designing, and operating a business on the Internet demands time and resources regardless of its virtual nature. The effective management of an online business demands knowledge, effort, creativity, and available credit, just as any retail business.12 Moreover, the established wisdom of traditional business methods must now be reevaluated and refocused to take advantage of certain inherent strengths of the Internet. Within the virtual marketplace, time and space have almost no meaning; the opportunities afforded by instantaneous communication allow for the retrieval of the most current information possible, helping firms in both their short and long run decision making.
Its ability to offer more efficient and lower cost distribution systems makes the Internet attractive as a vehicle for electronic commerce. In terms of transaction management, many of the separate intermediary hurdles that normally hinder the ease and efficiency of commercial transactions can be automated electronically and, as a result, side-stepped..13 History has demonstrated that changes in the distribution of goods and services can create substantial business opportunities. These technologies have had revolutionary implications on the structure of organizations. They flatten hierarchies and eliminate levels of middle managers.14 The postal mail-order and the Sears Catalog in the late 1800's, as well as the telephone mail-order in the 1970's, altered many business strategies and created a new market for mail-order companies.15 These industries exploited each new advancement in technology to increase their profits and expand their markets.
Today, a new breed of business firms with similar goals aims to capitalize on the Internet as the prominent medium through which to distribute their goods. Electronic commerce software applications are designed to increase responsiveness and accountability, while allowing business structures to retain a certain amount of flexibility.16 Direct distribution channels using these software applications certainly appear to be the most efficient method of conducting business; increasing transactional efficiency by reducing the cost of intermediaries should always yield higher profits.17 In non-electronic commerce, the steps in a purchasing transaction can include such things as locating products, evaluating their characteristics, comparing and negotiating prices, ordering and invoicing, and arranging means of payment and delivery. Each of these steps incurs costs which, for the most part, have tended to increase as a function of distance and time.18 Electronic commerce supports sophisticated design and manufacturing concepts, like concurrent engineering, that improve the coordination of these transactions to reduce the costs of information exchange.19
Basic economic tenets hold that for a firm or a market to be efficient, production costs as well as transaction costs must be minimized. In physical markets, the cost of selling to consumers is usually lowered by using intermediaries. Retail stores often manage the inventory better and provide superior service than do the suppliers. Even mail and phone-order companies, like J. Crew Inc., use retail stores to re-enforce their presence in the catalog market. But in the unique field of electronic commerce, many businesses exist only on the Internet. The nature of this "virtual" existence has led some authors to question the very necessity of intermediaries.
"with consumers distributed widely throughout the network, the intermediary's cost of selling to consumers might be as large as the cost of producer-to-buyer delivery. In other words, the gain from retailing and distribution is not so apparent in the non-spatial environment of the Internet."20
This situation might imply that there really is no role for an intermediary in electronic commerce. On the contrary, the traditional dispersory role of the intermediary for business firms in physical markets simply evolves into other agents that facilitate transactions in the virtual world.
With all the excitement surrounding the growth of the Internet, the inherent vulnerabilities of this information infrastructure are frequently overlooked. Stripped of all its elaborate multi-media applications, the core of the Internet reveals a bare database of information. But it is this information that forms the critical foundation of all interactions in electronic commerce. The success of an electronic market must depend on the quality and availability of information. When market agents lack proper information, the market is plagued with inefficiency and, in extreme cases, may fail to function at all. Put simply, consumers may hesitate to purchase a product of unknown quality.21 The intangible nature of the products offered over the Internet does not allow the possibility of the direct inspection that consumers value so highly. In some cases, standardization protocols for products like books and compact discs reduces the need to examine the product before purchasing and also acts as a mechanism for quality assurance. But for many other products, (say clothing or flowers, for example) the inability to handle and inspect the goods in question, combined with a natural skepticism about the reputation of the company involved, may act as a deterrent in purchasing decisions. The global scope of the virtual marketplace blurs the distinction between domestic and foreign businesses and provides all firms with an open portal to consumers worldwide. While this creates extensive business opportunities, it also provides suspect firms with the possibility to exploit unwary consumers. So without the assurance of reputation and without physical validation of a product, quality uncertainty becomes the prime issue regarding electronic commerce.
In a competitive market, perfect information leads to maximum efficiency because the consumers and producers are able to settle at a price that increases the surplus for both parties by bringing the price level to the equilibrium price. The virtual marketplace offers many more companies accurate price information and, as a result, limits excessive profits, enhances competitiveness, and helps to curb inflation.22 Information is essential in making markets work well. In electronic commerce, the responsibility of quality assurance and information distribution must be assumed by either the producer, in the form of advertisements, or by a third party. Because an objective evaluation of a product often involves a comparison with competing products, a third party is often preferred by the sellers and buyers.23 Public third parties such as government agencies or consumer advocacy groups offer this service without charge. In 1993, NSF funded a project to put the Securities and Exchange Commission's EDGAR filings of publicly owned companies on the Internet. This website now contains detailed financial information on thousands of companies.24 Unfortunately, public third parties are restrained by the limited resources that are characteristic of public goods. These services, like most organizations that supply public goods, generally receive inadequate funds because of high costs and public apathy towards providing the revenue for these public goods.
Thus, the responsibility for distributing the information intended to encourage consumers to engage in electronic commerce must ultimately fall on the private sector and on the individuals themselves. The expansion of the Internet has led to the development of many programs and applications that assist consumers in locating the information that they seeks. At the same time, specialized advertising companies have emerged to help businesses target certain consumers for their products. All of these services have supplanted the role of the distributor as a critical intermediary for firms and have facilitated the dissemination of essential information to the consumer.
In gathering information, search engines enable the consumer to perform sequential and simultaneous searches through the vast amount of data available on the Internet. There is little opportunity cost associated with this method aside from that of one's time and energy. Although this alternative may not be the most efficient, the consumer's willingness to pay is much less than the utility of the information. Consequently, the minimal cost borne by consumers in performing the search themselves yields the best result for the consumer. Also, several companies have created guides to help users navigate the Internet, even if they do not know quite where they want to go. These guides turn profit by selling advertising slots displayed on screen with the guide's index.25 But with the features of network technology, consumers may not even need to probe for information. Navigation through the Internet leaves a trace of data that reveals certain demographic information about the users. Virtual businesses utilize this data to target consumers that most resemble potential buyers. With the help of on-line advertising companies, firms hope to provide the right information to the right consumer at the right time, efficiently dispersing information to the benefit of better informed consumers. Such a strategy also benefits the firm financially, allowing it to target individuals with a higher demand for its products.
Directed advertising utilizes resources with greater efficiency than traditional broadcast advertising. The difficulty, however, is to reconcile the potential inconsistencies caused by a medium that resembles a broadcast in its reach, but also possesses the targetability and measurability of a direct marketing medium.26 Other limitations concerning on-line advertisements involve its inability to evoke emotion for products, like diapers and detergents, that would otherwise be indistinguishable from each other. Many companies are now combining conventional advertising awareness with media technology to produce interactive banners that effectively entice consumers. These companies strive to consolidate the virtues of brand advertising with the measurable efficiencies of direct response.27 Such strategies attempt to reduce wasteful advertising and distribute available resources more practically. Advertising and search processes complement each other and are essential in relieving part of the uncertainty surrounding product quality and in establishing a firm's presence in the virtual market.
Although the role of the intermediary in electronic commerce may appear jeopardized by the impact of direct sales, the lack of product validation and means of appraisal introduce a fundamental problem that must be reconciled with the introduction of new intermediaries. The electronic marketplace necessitates the intervention of third party escrow agents such as consumer agencies or advertisers to insure the quality of a certain firm's product by distributing vital information about it. This information will lead to price discovery by both producers and consumers which, in turn, will lower prices to a competitive level and benefit both parties. Furthermore, most manufacturers do not understand consumers well enough to deal with them directly.28 Because of these vulnerabilities and inefficiencies associated with an un-intermediated market, intermediaries remain a vital part of electronic commerce.
The tremendous opportunities for growth fueled by the Internet have influenced cyberspace companies and traditional businesses alike. In the emerging marketplace of electronic commerce, products can be developed and launched at relatively low costs to producers. Potential customers and investors can be more efficiently targeted. Markets can be quickly identified and accurately tested. No other marketplace can boast such instant links between producers and their customers.29 As the number of Internet users continues to increase, virtual firms must reevaluate their marketing and advertising strategies, ultimately refocusing their efforts to exploit the opportunities afforded by such remarkable growth.30
This impending expansion, however, will certainly strain the existing infrastructure Internet. The number of computers linked to the Internet has increased from a mere 562 in 1983 to its first million in mid-1992 to the approximately 16,146,000 machines connected worldwide in 1997.31 Such remarkable growth will not persist if its survival hinges upon the present infrastructure.
"As the number of users multiplies, the number of paths leading to the Internet renders communications among its patchwork of component networks increasingly less straightforward. Meanwhile, the aging backbones ? both the switches and the mix of T1 and T3 lines ? prove a less and less capable conduit for the traffic crushing through them. . ."32
Besides the congestion factor, the primary lack of the network bandwidth through which message transmission occurs threatens the further development of innovative applications for electronic commerce. One possible solution to this dilemma would be to deploy fiber-optic cable instead of the twisted-pair copper phone wire used by most consumers. But while this innovation will eventually result in a much greater bandwidth, phone companies claim it will take at least three decades to implement too long for businesses looking to exploit the Internet now.33 While other alternatives exist and may temporarily relieve the problem, the strained infrastructure continues to become more and more congested. How businesses coordinate the traffic flow of potential consumers will be an important factor in determining the success and market efficiency of electronic commerce.
The open nature of the Internet infrastructure also exposes its vulnerability as an insecure network. Extensive resources and energy are being devoted to developing secure technology to make large-scale commerce on the Internet feasible. The major elements of security required for electronic commerce include: the authentication of individuals and companies so that both can trust that the parties they are dealing with are who they claim to be, the encryption of documents so that sensitive information cannot be decoded even if the messages are intercepted, and digital signatures that verify the integrity of the documents so that both parties can trust that documents have not been altered in transit.34
The appropriate network security solution for a particular company depends on its needs and the level of risk the enterprise is willing to assume.35 Most firms now adopt innovative firewall technologies to protect themselves against loss and the corruption of information by unsolicited agents.36 In addition, the security issue has prompted the creation of an entire industry dedicated to electronic vigilance. Internet security firms behave as escrow agents in ensuring the deliverance of a product to the consumer. Again, the role of an intermediary proves to be indispensable.
With the majority of attention focused on the potential benefits of electronic commerce, the controversial issues regarding the external governance of this lucrative and boundless institution lurk in the shadow of its own success. An international infrastructure such as the Internet will ultimately require that countries come up with some sort of policy addressing many of the details that are now taken for granted.37
The wealth of information on the network has raised a great deal of concern about intellectual property rights. Ideally, copyright laws and trade regulations are mechanisms that attempt to balance and protect private and social interests. But the transitory nature of electronic commerce proves to be a great obstacle to establishing clear legal definitions. It is difficult to contain the electronic marketplace within geographically defined trade areas and frontier-based regulatory and administrative regimes.38
Instead, a market-oriented economic approach should be applied towards the problem of protecting copyrights in the digital world. Authorities should be concerned with the distribution of copyrighted material only if it affects the market size of the copyrighted work. The implementation of strict, unrealistic regulations cannot possibly rival the pace of copyright infringement on the Internet and could possibly have an adverse affect and threaten the future of electronic commerce. In general, economic principles show that government ordinances tend to create gratuitous deadweight loss which reduces the efficiency of any market.39 While revenue opportunities do exist, copyright enforcement is only symbolic. Making products insensitive to reproduction and resale is an alternative to the vexing problem of securing digital copyright.40 By allowing the market to respond to violations of copyright standards, the responsibility is delegated into the hands of those in the digital community who are most capable of handling these legal infractions.
Despite these structural and legislative roadblocks, electronic commerce has achieved unprecedented success in the past few years. The novelty
of purchasing goods over the Internet now appeals to a variety of demographic groups and the electronic marketplace serves as an indiscriminate medium for interactions that cross social and ethnic barriers. Fourth-quarter holiday sales in 1998 demonstrate the potential of the Internet in catering to a retail mass market. Led by first-time buyers and, surprisingly, consumers in the over-50 age group, on-line spending grew an average of nearly 200 percent.41 Although computer hardware and software still command the largest share of products sold on-line, travel, books, music, toys, and entertainment comprise the categories that have experienced the greatest growth rate since 1997with an estimated 290 percent increase in sales.42 A Commerce Department study indicates that the information technology sector will provide approximately 8.2 percent of 1998's total GDP.43 These figures are staggering and the continued development of the Internet as a viable market for goods ensures that this recent trend will continue.
The successful transformation of a military network into a vast commercial market has proven the ingenuity of entrepreneurship in exploiting technology. From its meager beginnings as a scientific experiment, the Internet now embraces the global community with its ubiquitous reach and provides tremendous opportunities for economic growth through communication. Possessing an ever-expanding global reach, the Internet may well become the primary platform for international contact.44 As the medium for electronic commerce, it has facilitated the enormous growth of the virtual marketplace and presently furnishes us with an experimental stage to further realize the economic efficiency of a competitive market. In effect, electronic commerce has reduced the spatial and temporal limitations of the market by lowering barriers to entry, introducing new intermediaries to fill the diminishing role of the retailer, and redistributing resources. Through these initiatives, electronic commerce has created a new standard of market efficiency. The benefits of exploiting this great opportunity cannot be emphasized enough; the costs of remaining rooted in the physical market may well be the demise of many companies. Although many issues concerning congestion, security, and regulations may dampen the potential of electronic commerce, the road ahead is wide open, with electronic commerce as the vehicle that will take businesses into the next millenium.
Footnotes
1 John E. Young, Global Network: Computers in a Sustainable Society (Washington, D.C.: Worldwatch Institute, 1993), 26.
A packet switching system permits multiple pairs of computers to communicate across a shared network with minimal delay because it divides each conversation into small packets and arranges for the computers that share a network to take turns sending packets. All data is transferred in packets. The receiving machine reassembles the original message from the separated packets that arrive from another machine.
2 A creation of the Advanced Research Projects Agency of the Department of Defense. Because of the high cost of resources in the 1960's (a computer with 200 kilobytes of memory cost approximately 2 million dollars in 1965), the government funded this project to allow users at various sites to share access to these expensive computers (Lane and Summerhill, Internet Primer, 2).
3 Douglas E. Comer, The Internet Book: Everything You Need To Know About Computer Networking and How the Internet Works (New Jersey: Prentice-Hall, Inc., 1997), 57.
4 Backbones are high-speed central networks which are equivalents the interstate highway system. Although the network is distributed, there are certain hierarchical features. The backbones deliver the information to mid-level networks and then to lower-level networks until it finally reaches its destination (LaQuey, The Internet Companion, 26).
5 Comer, The Internet Book, 67.
6 Choi, Stahl, and Whinston, The Economics of Electronic Commerce, 13.
7 Choi, Stahl, and Whinston, The Economics of Electronic Commerce, 15.
8 Nelson King, "Open for Business," Internet World, October 1997, 78.
9 Choi, Stahl, and Whinston, The Economics of Electronic Commerce, 464.
10 Electronic Commerce: Opportunities and Challenges for Government (France: OECD Publications, 1997), 46.
11 King, "Open for Business", 77.
12 King, "Open for Business", 78.
13 Electronic Commerce: Opportunities and Challenges for Govern