The Economics of Electronic Commerce

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The Economics of Electronic Commerce

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This book is written in the belief that the tenets and teachings of economics are vital to an insightful analysis of the broad spectrum of issues affecting commercial uses of the Internet and the next-generation information infrastructure. Our digital future is being decided on the Internet, where prototypical products and services have been test-driven by an odd collection of individuals. Just a few years ago, commercial uses of this somewhat chaotic and decentralized network of networks seemed highly unrealistic. Today, while the government and large corporations are grappling with proposals on how to build the national information infrastructure, major components of......

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4. The Economics of Electronic Commerce advanced topics and terms. In addition, we include examples whenever possible to make our discussion more concrete and specific. The online references to these and other related sites and documents found at the end of each chapter will allow readers to further explore these and other examples on their own. Acknowledgments This book is a result of collaboration among the authors but many thanks are due to our colleagues who provided us with interesting materials, read the manuscript and made invaluable suggestions. For their help, we would like to thank John Allison, Valerie Bencivenga, Scott Freeman, Mark Lemley, R. Preston McAfee, David Sibley and Bruce Smith as well as anonymous reviewers. Alok Gupta's collaboration for the section on the infrastructure pricing is specially acknowledged. Susan Kutor suffered most while reading and correcting often incomplete chapters, and we are indebted to her for her suggestions and corrections. We'd also like to thank our editor Thomas Stone, who tirelessly worked to make this project perfected, and Amy Lewis, Tim Micheli and the staff at Macmillan Technical Publishing. Finally, we would like to acknowledge financial support from the Information Technology and Organizations program at the National Science Foundation and the program managers, Drs. Su Shing Chen and Les Gasser, and the support from the Information Technology Program of the State of Texas. © 2003. Choi, Stahl & Whinston P-4
5. The Economics of Electronic Commerce Chapter One: Electronic Commerce and the Internet 1.1. Developments in Inter-networking _____________________________________ 1 Distributed and Networked Computing _________________________________ 2 Open Network ______________________________________________________ 3 Two-way Communications and the Web ________________________________ 7 1.2. What Is Electronic Commerce? _______________________________________ 9 Electronic Commerce Examples _______________________________________ 9 Electronic Commerce as a Communications Network ____________________ 11 Electronic Commerce of Digital Products_______________________________ 12 Commercial Potential of the Internet __________________________________ 15 1.3. Market Characteristics of Electronic Commerce_________________________ 16 Current Commercial Uses of the Internet_______________________________ 17 User Characteristics ________________________________________________ 19 Competition and Market Organization_________________________________ 20 Business Organization and Virtual Firms ______________________________ 22 Legal Environment _________________________________________________ 23 1.4. Current Issues in Electronic Commerce _______________________________ 25 Contents and Quality _______________________________________________ 26 Copyrights vs. Users Rights __________________________________________ 28 Interactive Advertising and the Use of Consumer Information _____________ 30 Internet Intermediaries______________________________________________ 32 Security and Privacy of Internet Transactions___________________________ 33 Pricing Strategies for Digital Products _________________________________ 34 Online Taxation, Regulation and Other Legal Issues _____________________ 35 1.5. Summary ________________________________________________________ 36 References___________________________________________________________ 37 Suggested Readings and Notes __________________________________________ 38 Internet Resources ____________________________________________________ 39 © 2003 Choi, Stahl & Whinston 1-1
6. The Economics of Electronic Commerce Chapter One: Electronic Commerce and the Internet Our objective in this and the next two chapters is to provide you with a framework for understanding the economic impact of the new business medium by defining electronic commerce and the nature of digital products. Opinions regarding the future shape of the Internet and electronic commerce may vary widely, but consensus reigns that commercial uses of the Internet will have an immense effect on businesses, governments, and consumers. The question is, "In exactly what areas and in what ways will they be affected?" A shared definition of electronic commerce is the first step toward presenting the answers. In this chapter, we discuss the characteristics of computing environments that have made the Internet the infrastructure for electronic commerce. In Section 1.1, we present an overview of how computing and networking environments have evolved into the Internet. Our objective is to highlight differences between the Internet and previous computing and communications environments in order to give a clearer understanding of the importance of the Internet as a commercial medium. In section 1.2, we review commercial and non-commercial uses of computing and communication technologies, and define what electronic commerce is within the context of changing technologies. It will be evident that conventional distinctions between commercial and non-commercial uses of the Internet are no longer valid. In Section 1.3, we discuss the market characteristics of electronic commerce, pointing out the differences from traditional physical product markets as well as issues arising from the novice nature of electronic commerce. To wrap up our introduction in Section 1.4, we introduce readers to key issues in electronic commerce and look at how economic analysis may help to resolve many uncertainties. While these snapshots put the issues in perspective, later chapters will deal with each in depth. 1.1. Developments in Inter-networking The Internet is a network of networks. Each network is comprised of computers connected by wire- or wireless medium such as radio signals that enable component computers to "talk" to each other. Once computers are networked, files on one computer can be accessed from any other computer on the network; messages can be exchanged, and limited resources such as printers can be shared. Large or small, each network is owned and managed by a company or a single group with the exception of the Internet. The Internet is not owned or managed by any single entity although its component networks are independent units managed and usually paid for by the network's owners. (We discuss in detail the Internet technology and infrastructure in Chapter 3, Section 3.6; in this chapter, we focus on general characteristics of the Internet as a market infrastructure). Computers on these component networks become a part of the larger © 2003 Choi, Stahl & Whinston 1-1
10. The Economics of Electronic Commerce duplicating traditional seller-to-buyer market relationship, yielding up a whole new area of economic research. The Internet with such advantages, however, has a series of potential problems. While the openness of the TCP/IP protocol suite is the reason why the Internet is growing so fast, it also poses a serious problem as a commercial medium due to the fundamental lack of security measures in the TCP/IP (Bhimani 1996). Compared to private VANs, the Internet has many weaknesses in this respect. Messages can easily be wiretapped and eavesdropped during transmission. The messages could then be altered and sent to another party. Because of this, the receiving party cannot be assured of the identity of the original sender. Challenges exist to meeting many essential security requirements for computer transactions: confidentiality, authentication, data integrity, and nonrepudiation. How serious are these security problems when the Internet is used for commerce? After all, access control for any computer on the Internet can be achieved by using access passwords, firewalls, or by simply disconnecting from the network when not in use. In general, only those files designated for sharing by owners can be transferred. To secure confidential and authenticated messages, encryption and digital signature technologies are already being adopted that provide content level security. Such security measures are applied to each message being transmitted just as a secure envelope with a tamper- resistant seal protects a message within. Alternatively, the transfer medium may be secured such as the communication line itself. The next generation Internet protocols will incorporate security measures on TCP/IP layers thereby securing the transfer conduit itself (Hinden 1996) In short, with adequate access control and content security via encryption, today's Internet offers a rather robust, albeit imperfect, security. While the level of performance guarantee for the Internet is lower than that for private networks, the chance for a catastrophic failure is lower for the Internet compared to a private network which is controlled and administered by a central authority. A message traveling on the Internet will be re-routed if a part of the Internet fails. At the same time, an eavesdropping on the Internet is neither targeted nor specific as in the case of private networks. Since private networks carry designated information over the same network, the result of a security breach will be more severe than on the Internet where packets of message travel in mixed jumbles. When the next generation of Internet standard is implemented along with content level encryption, the security of the Internet may become a concern in mostly isolated instances. While security and reliability will significantly increase in the next generation Internet, its ever-increasing traffic due to multimedia, real-time and broadcasting applications may not result in any noticeable improvement in terms of network congestion. More efficient compression technologies, faster modems and larger pipelines will certainly increase the absolute size of the Internet bandwidth. However, cheaper and more abundant integrated circuits and powerful microprocessors have been overwhelmed by concurrent, or often outpacing, increases in the demand for computational power. Similarly, congestion may become a more critical issue in electronic commerce than network security problems that have worried many prospective online marketers. © 2003 Choi, Stahl & Whinston 1-5
11. The Economics of Electronic Commerce Sidebar: Who controls the Internet? From its beginning in 1969 as ARPAnet (after Advanced Research Projects Agency of the U.S. Defense Department), connections to the Internet have been based on open standards to provide flexibility and robustness in order to maintain communications capability even under a catastrophic disaster or a serious system failure in some of the network's component computers. As the Internet grew into a network of networks, no single computer or network acted as a central authority. However, as in other social organizations, there are certain groups whose opinions matter. At the top of these groups is the Internet Society or ISOC (http://info.isoc.org/ index.html), shown in Figure 1.1. The Internet Society is a volunteer membership organization which appoints the Internet Architecture Board, or the IAB (http://www.iab.org/iab/). The IAB is responsible for maintaining interoperable standards for communications as well as Internet addressing. Figure 1.1: The Internet Society home page The Internet Engineering Task Force or IETF (http://www.ietf.cnri.reston.va.us/) is another volunteer organization that sets up working groups to deal with operational and short-term technical problems. Anyone can participate in these working groups. Their reports are recommendations for voluntary adoption or may be sent to the IAB for more official treatment. As a participant and a user of the Internet, any network needs to follow © 2003 Choi, Stahl & Whinston 1-6
14. The Economics of Electronic Commerce Figure 1.2: Types of data sent over the NSFNET backbone FTP Telnet Usenet irc Gopher email Web 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jun-93 Dec-93 Jun-94 Dec-94 Mar-95 Source: Data from http://www.mit.edu:8001/people/mkgray/net/web-growth- summary.html. 1.2. What Is Electronic Commerce? In this section, we define what electronic commerce is. This is not as simple as it sounds, since electronic commerce is a fast-moving target. The definition is ever changing and expanding to include more and more sectors of the economy as the influence of electronic communications extends. A conventional definition emphasizes technological aspects in an attempt to provide a lasting concept. As the following sections illustrate, we prefer to stress the economic aspects and define electronic commerce as a new market offering a new type of commodity, i.e. digital products, through digital processes. Sellers of physical products are affected as well by digital processes—e.g. online ordering, market research and payment settlement—and are part of this new market. Electronic Commerce Examples Technology is transforming many aspects of business and market activities. In its broadest sense, electronic commerce refers to the use of electronic means and technologies to conduct commerce—including within-business, business-to-business and business-to-consumer interactions. The enabling technologies, of course, are also used for non-commercial activities such as entertainment, communication, filing and paying taxes, managing personal finance, research and education, which may still include the services of online companies. As a result, it is somewhat difficult—and sometimes arbitrary—to © 2003 Choi, Stahl & Whinston 1-9
16. The Economics of Electronic Commerce and countless other business activities. More important than the mere number of areas being affected by electronic commerce is the fact that these activities can be integrated into a holistic business process. Thus, all the areas mentioned above are not really a separate application but rather one aspect of the whole electronic commerce process. For example, inventory and supply management is tied to production as well as to the demand data collected from consumers ordering via Web stores. In short, the business potential of electronic commerce is the ability to innovate and integrate business and market processes. The most obvious and immediate use is achieving transactional efficiency. Electronic Commerce as a Communications Network At the core of traditional electronic commerce is the use of electronic means to expedite commercial transactions and improve efficiencies in business processes and organizations. In this vein, electronic commerce on the Internet means online ordering and payments. The narrowest definition of what electronic commerce is holds that electronic commerce on the Internet is a networked electronic data interchange (EDI) with a more flexible messaging system. Traditional EDI is limited to signals that only computers can read and that correspond to information on electronic forms used in standard business transactions such as ordering, invoicing and shipping. An open EDI using the Internet means that EDI messages may be sent and received via email. In the next level of sophistication, EDI can use electronic forms made available on Web pages for customers to order. This view considers electronic commerce and the use of the Internet as merely improving business and communication, especially in business-to- business transactions. Accordingly, issues in doing business on the Internet are mainly organizational and operational ranging from security, competitive advantages in product development and R&D, to efficiencies from automating purchasing functions, EDI, point of sale information, and other inter-organizational transactions. To many familiar with EDI, doing commerce on the Internet is not entirely advantageous compared to traditional EDI. A clear tradeoff is made between secure but limited VANs using traditional EDI and an insecure but far more flexible network with messaging and remote login possibilities using the Internet. For example, Chevron Corp. of San Francisco pays over $1,200 each time it sends an EDI report to the U.S. government via a private VAN. In comparison, it pays about$2,000 per month for unlimited access to the Internet (Radosevich 1996). However, many consider the Internet to be inferior to EDI because of the perceived lack of security and reliability, even though they adjusting their EDI strategies to include the Internet. Already, Internet-oriented EDI applications, such as EDI/Open and Templar by Premonos Corp. (http://www.premonos.com), have reduced EDI prices and afforded small and medium size companies to take advantage of electronic transactions. However, many interactions between sellers and buyers happen before they are ready to exchange orders and bills. A somewhat broader view of electronic commerce includes these interactions between businesses and consumers. Consumer services and product announcements have been routinely released to the Internet by computer companies for many years. And increasingly, firms are gearing up for Internet advertising and © 2003 Choi, Stahl & Whinston 1-11