Graduate School of Business The University of Texas at Austin

COMMERCE ON THE INTERNET: WHAT'S HOLDING IT UP?

Process innovations enabled by the Internet -- such as intranet applications, open EDI, and on-line marketing --promise immense benefits to firms and organizations. However, consumer-oriented businesses involving digital as well as physical products lag far behind lofty predictions. While others deal with technologies, laws, and business models to cope with peculiarities of the Internet, we would like to discuss a more fundamental aspect of the Internet as a market infrastructure.

The cause of many issues and uncertainty about commercial uses of the Internet lies in the Internet's beginning as a publicly funded, noncommercial network, which has resulted in the absence of market-determined, economic prices for network usage and for network-delivered contents. Legal and technological measures will certainly help sort which uses of the new medium are acceptable or desirable. But so far as we advocate industry initiatives and market-oriented solutions, a critical need is to grasp the implications of having, or not having, economically efficient prices for both network connection and contents.

Market Implications of Internet Pricing

Limited resources are best allocated through market prices that reflect costs of production, consumption values, and opportunity costs of alternative uses. The Internet as a communication network does not have such "market prices" even though it differs little from telephone networks. Thus, the price one pays for Internet connection seldom corresponds to the actual cost or value of connection (for Internet pricing, see http://cism.bus.utexas.edu/res/wp.html). Instead, flat-rate pricing practices further distort resource allocation; often encouraging congestion as evidenced in last year's America Online episode. Government policies such as the access charge exemption for Internet service providers by the Federal Communications Commission also create different prices for the same service using the same network infrastructure (e.g. Internet telephony). While lowered prices might be welcome, such benefits should come from efficient pricing and competition to assure economic health in the long run.

Finding efficient prices for the Internet is difficult since a typical Internet connection involves such diverse networks as local telephone networks, long distance fiber and satellite networks, and private wired as well as cable and wireless networks. Another factor is the legacy of the old NSFNET, giving an impression that the Internet is essentially "free." The Internet is certainly not free; various organizations pay their share of the cost, but these shares are not allocated efficiently.

As a by-product of inefficient connection pricing, contents distributed over the network have no economic prices. In such an environment, an advertisement for an on-line flower shop competes with a critical medical database for delivery, and the former often wins. Indiscriminate spamming (unsolicited bulk e-mail) on the Internet is primarily due to the lack of proper prices for delivery and contents. Because there is no agreed-upon market price or a way to pay and collect such payments, the Internet culture often relies on unenforceable moral standards (such as netiquettes) or threats of lawsuits.

Spamming can be countered by technological means, such as filtering software; by legislation; or by a market mechanism. Some bills propose to ban spamming, equating e-mails with faxes. A simpler approach may be to establish a system of legal on-line identity similar to driver's license numbers. Most troublesome spammers use unreturnable e-mail addresses, effectively avoiding backlash. With legally required and unique on-line addresses, much spamming can be discouraged. Still, a market-oriented approach is to promote technologies and payment mechanisms to allow efficient exchanges of all knowledge-based products, including advertisements. Similarly, Web-casting, like spamming, distributes contents without considering effective prices for network usage. These broadcast-based models appear reasonable only if we ignore economic prices.

Another "price-less" information product is identifiable consumer information. Protecting consumer privacy becomes extremely difficult when technologies are so advanced that the consumer's every move can be recorded and analyzed. Withholding identifiable information or regulating the use of such information may be one solution. Various cryptographic and technological means to hide information are another. However, an active market for consumer information is essential; it allows products to be personalized, an essential nature of using information. An efficient market with established ownership rights over consumer information would allow, not limit, trading such a product. Many retail firms, on-line search services, and free e-mail providers are indeed in the business of commoditizing consumer information, albeit without encouraging consumer participation. Electronic commerce offers an opportunity to improve this imperfect information brokerage through market processes without an added burden of legal intervention.

Subscription, Bundling, and Micropayment

As flat-rate charges for connection potentially increase network congestion, subscription and bundling practices reduce consumer choices and introduce inefficiency. Some argue that subscription and bundling, popular for physical products, will also be preferred in electronic commerce. Consumers are content with bundled cable channels, packaged newspapers and magazines, they argue. In this vein, digital coins and microtransactions will be unnecessary as bills will be aggregated.

However, equally significant is the general trend toward unbundling apparent even in physical markets (e.g., cable tiering, specialized magazines and journals). More options mean more choices for consumers, and it increases profits as well. Giving consumers more choices requires a payment system flexible enough to bill for small or occasional purchases. Whether it's digital cash or smart money stored in smart cards, micropayment systems are essential in supporting need-based information trading in the Digital Age. Its alternative is wasted resources (like unwanted newspaper sections) or lowered quality (like broadcast messages catering to the lowest common denominator).

A more elemental issue regarding microtransactions stems from different visions about the future of information trading. Can anyone become an information seller in the Digital Age? If so, selling bits of information and knowledge becomes impractical, if not impossible, without micropayments. On the other hand, large players in software and entertainment industries don't see the Internet and electronic commerce as a "revolutionary new market," dismissing millions of individual Web pages as useless junk. Some even predict that the wired and wireless information infrastructure will be used to sell entertainment and advertising rather than information and knowledge-based products. In this vision, the Internet is another telemarketing channel or a fancy television, and the need for micropayments is often dismissed.

This illustrates those choices in payment systems, technologies, and policies critically depend on the way we view the future of electronic commerce. The global information infrastructure opens up a whole new market where the behavior of firms and consumers change so radically that existing policies and business practices don't seem to apply any longer. Nevertheless, our understanding of the nature of digital products and their uses is often influenced by what we know from physical markets. We need to pay more attention to the peculiarities and possibilities of the new electronic marketplace.

Can the "Invisible Hand" Take Care of the Market?

We are witnessing a wholly new type of market with far-reaching implications from production to consumption. Electronic commerce activities include not only on-line advertising and ordering but also consumer searches, digital production processes, intermediation and distribution, payment, product delivery, and consumption. In short, the electronic marketplace is a virtual version of physical markets. As knowledge-based products become the mainstays of our economy, digital markets and electronic commerce will account for more of global economic activities than physical counterparts. People will still buy clothes and automobiles, but on-line custom tailors will offer better-fitting suits based on 3-D scanning. Smart automobiles equipped with smart cards will accept digital files for tune-ups, diagnosis and repair, travel directions and registration. Smart houses and smart appliances will be controlled via e-mails while you are vacationing. The list of digital products and services in the electronic marketplace will grow exponentially as the way we use knowledge and information evolves.

Will this electronic marketplace be an improvement over physical markets? On the one hand, it may represent the most competitive and efficient market because the numbers of producers and buyers are large, transaction costs are minimized, and information about products and prices is plentiful. For such an efficient market to work, external interventions such as taxation and regulation should be avoided.

On the other hand, peculiarities of digital products may result in market dominance by a few firms. For example, the economies of scale, standardization, and network effects all favor one software program over others, resulting in de facto monopolization. Should governments intervene to promote competition? What forms of market intervention will be effective? Requiring competing standards reduces efficiency, and it may punish good products and businesses. Regulation would not work when firms are not natural monopolies and face free entry. Breaking up vertically integrated firms may eliminate the ground for anti-competitive behaviors, but how should market boundaries be drawn?

Despite its potential, electronic commerce may fizzle rather than sizzle if some of these issues are not resolved. Unfortunately, there are no facts and empirical data for the electronic market on which to base one's analysis. But theoretical exercises can help formulate business models and policy choices since the electronic marketplace, despite its differences, is still a market for which standard economics can be used. Clearly, governments, industries, and academic researchers have roles to play in mapping out strategies for the 21st century.

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Soon-Yong Choi (soon@mail.utexas.edu), Dale O. Stahl (stahl@eco.utexas.edu) and Andrew B. Whinston (abw@uts.cc.utexas.edu) are co-authors of The Economics of Electronic Commerce (Macmillan Technical Publishing, 1997). For more information regarding economics and electronic commerce, contact Andrew B. Whinston (abw@uts.cc.utexas.edu), Director, The Center for Research in Electronic Commerce, Graduate School of Business, University of Texas-Austin (http://cism.bus.utexas.edu). Telephone: 512-471-8879.