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Deutsche Bank Research conomics Microeconomic aspects of the internet economy According to the official statistics, there are few indications of a new economy developing in ”old” Europe. Other data and surveys show that business models based on the internet are rapidly making inroads in the economy. The spread of the internet is resulting in a strong reduction of transaction costs, which in a developed economy account for roughly 50% of total costs. In the production of IT goods even positive economies of scale, i.e. falling average costs, are apparent. Thus sales growth becomes the decisive competition parameter. This is leading to massive price competition. However, in the long term the intensity of competition for information goods may decline as a result of oligopolistic market structures. In spite of this, the internet and e-commerce have the effect of a fitness programme for the overall economy and will contribute to contain cyclical price risks in the coming year. The internet is increasingly penetrating the developed economies. In the USA and the UK, and now also in Germany, roughly half of all companies have their own website. Over 10% of all companies use the internet for distribution. True, the proportion of households with internet access is roughly three times as high in the USA (close to 35%) as, for example, in Germany, but growth rates are enormous here as well. It is often argued that, with the spread of the internet, economic laws and mechanisms which functioned in the past are no longer valid. In most areas, the effects of the internet are only beginning to make themselves felt, and they are in addition being masked in major industrialised countries by other factors, such as globalisation, the introduction of the euro or budget consolidation. It is therefore almost impossible at this stage to analyse the implications of the internet with the help of macro variables. The following article will thus analyse the effects in the microeconomic area, e.g. changes in cost and company structures, the change in competition parameters, and the consequences for market structures. Falling production costs for information goods In analysing production costs a distinction has to be made between ”classical” goods and services, and information goods. For classical goods, such as cars, marginal costs in a given production function describe the well-known U shape, i.e. the costs for an additional unit initially fall as a result of learning effects and improved capacity utilisation, but begin to rise again from a certain output quantity. This development is the result of the variable costs (dependent on output), which rise strongly when optimal capacity utilisation is exceeded (due to overtime, higher maintenance costs etc.). The cost curve in the production of information goods is completely different. Such goods exist in, or can be translated into, binary form, i.e. they are computer readable. This means it is possible to reproduce the product – or the data – almost for free. In other words, variable costs and marginal costs are close to zero. Thus the average cost of the product falls with each additional copy. However, information goods have a very high share of fixed costs, i.e. the costs of the initial production of a computer programme, a film or a music CD. This cost structure results in economies of scale. Sales growth and market share thus become decisive competition parameters – especially as distribution costs for digital goods, which can in part be sold as download directly via the internet, are minimal and thus do not lead to capacity problems in either production or distribution. 2 Economics E-commerce infrastructure: corporate sector %of companies Intranet DE Internet GB US Website 0 10 20 30 40 50 60 E-commerce infrastructure: private households %of population Cellular phone DE GB Internet US Personal PC 0 10 20 30 40 50 60 Traditional goods: average & marginal cost 160 Marginal cost 140 120 100 Average variable cost Average cost 80 60 40 Average fixed cost 20 Units 1 2 0 3 4 5 6 7 8 9 10 Deutsche Bank Research conomics Network effects and demand creation It is the prospects for economies of scale which make growth the make-or-break criterion for providers of information goods. And when it comes to demand creation, massive economies of scale are generated by network effects. Quasi standards are increasingly emerging, especially for computer programs (e.g. office packages, internet browsers, programming languages). After a provider has managed to establish a product as a standard, e.g. Microsoft with the operating system Windows, the use of a rival product gives rise to high costs (incompatibility, training costs), known as lock-in costs. In addition, it becomes increasingly attractive for newcomers to decide in favour of the existing standard. A similar effect occurs with electronic trading platforms or electronic marketplaces. With each additional participant, the benefit for existing participants increases. From a certain level of usage, these network effects develop dynamics of their own which lead to exponential demand growth. For this reason companies will endeavour to exceed this ”tipping point” and make correspondingly strong marketing efforts. Early market entry substantially increases the chances of reaching the tipping point, a phenomenon which is called first-mover advantage. Massive investment in marketing and sales promotion are among the chief reasons why many well-known internet companies are still not making a profit despite rocketing sales. Amazon.com, for example, recorded a roughly 170% year-on-year sales increase in 1999, while operating losses soared by 345%. Information goods: average cost 300 250 200 150 100 50 Units 0 1 2 4 5 6 7 8 9 10 Tipping point Tipping point Significance Production costs for material goods Demand It will also be possible to make substantial cost savings in the production of material goods, even though marginal costs for a given production function will continue to show the classical U shape despite the internet. In addition, the production process will become more flexible, so that a standard assumption of microeconomic theory – that the production function is fixed at least in the short term – has to be increasingly called into question. The internet has almost per definition the effect of reducing transaction costs. Transaction costs consist of the costs for gathering and processing information as well as the costs for concluding, monitoring and implementing contracts. In developed economies transaction costs probably have a GDP share of slightly around 50%. As the application of internet technology is relatively cheap, many processes in information-gathering and analysis can be automated. A large number of individual studies – mainly for the USA – point to considerable savings potential in this regard. • 3 Date of B2B online integration (German medium size companies) Don’t know 18% 2002 13% 2000 52% 2001 17% Selling and customer service Savings potential is most apparent with regard to selling space. Certainly, the costs for the creation and maintenance of an ecommerce website can range between several thousand dollars and hundreds of millions (the online broker E*Trade puts the costs of its website at USD 485 m). If, however, it is taken into consideration that the expenditure for a website can in an extreme case replace a complete chain of stores with several thousands of shops and, in addition, that the website is open around the clock, even amounts of this magnitude appear in a rather different light. Furthermore, an online-shop also leads to a marked reduction in personnel costs. For example, sales per employee at Amazon.com amount to roughly USD 267,000, compared with USD 103,000 at Economics Date of e-business model implementation (German medium-size companies) Don’t know 19% 2002 6% 2000 54% 2001 21% 3 Deutsche Bank Research conomics Barnes and Nobel, a traditional book shop. However, employees in e-commerce are better trained and get correspondingly higher salaries, so that the savings in personnel costs are limited. There is further savings potential in the handling of orders. Detailed product information on the website makes it possible to provide the customer with full information without the costs of a traditional sales talk. Car dealers speak about costs of roughly USD 25 for an ecommerce transaction compared with several hundred dollars for a traditional sales talk. An internet-backed interface makes it possible for the dealer to check the internal consistency of the order, order confirmation and settlement. By introducing e-commerce, the network equipment company Cisco has been able to reduce the error rate in order processing to 2% from roughly 25%. Products and services are becoming increasingly complex and therefore require more intensive advice. In many companies customer service costs and after-sales services account for up to 10% of total costs. Online manuals and expert-system-backed advice offer considerable savings potential in this regard. Cisco estimates that its phone calls in this area have been reduced by roughly ¼ million per month, which has led to cost savings of above USD 500 m. • Worldwide Supply Procurement % Distribution 100 90 80 70 60 50 40 30 20 10 97 98 99 00 01 02 03 * Share of new applications by small companies Purchasing and stocks World-wide there are now probably close to 1,000 internet marketplaces where goods and services are offered to producers in a certain sector. Although many are unlikely to survive, some large industry-specific marketplaces will emerge. The operators of Covisint, a joint purchasing platform of Ford, GM, DaimlerChrysler, Renault/Nissan and Toyota expect an annual purchase volume of USD 500 bn to be settled via their platform. There are similar group purchasing platforms in retail trade (GlobalNetXchange.com) or in the European construction sector (b2build.com), etc. According to tests in the USA, savings of 10 to 50% can even be made on purchases of low-value goods, such as office material, where processing costs are sometimes higher than the value of the order. Furthermore, it has in many cases been possible to shorten the order cycle substantially. More efficient purchasing automatically leads to a reduction in inventories and thus lowers costs in this area. Further savings potential results from networking with downstream areas of the value-added chain, which makes it possible to forecast demand more accurately. Taken to the extreme, this leads to a built-to-order business model, as used by the computer producer Dell, for example. Purchased components are in Dell’s stocks for no more than eight days. Savings on stock-keeping should be particularly large for perishable goods, products which rapidly become outdated technologically or are subject to fashion, as well as for goods subject to a continuing price decline, such as computers. • Distribution With e-commerce reducing other cost components, transport costs are playing an increasingly important role in the choice of production location for traditional goods. However, e-commerce methods can lead to considerable cost savings in this area as well (e.g. through improved fleet management in the transparent sector). There are almost no transport costs for digital goods (see table). 4 Internet-based applications* Economics E-commerce impact on distribution costs USD per transaction Traditional Airline ticket Banking 8.00 1.08 Telephone Internet Savings % Source: OECD Bill payment 2.22-3.32 Term life ins. pol. 400-700 0.54 Software distrib. 15.00 5.00 1.00 0.13 0.65-1.10 200-350 87 89 71-67 50 0.20-0.50 97-99 Deutsche Bank Research conomics Forecasts for international e-commerce sales in 2003 range between USD 1,244 bn and 4,600 bn, which would correspond to between roughly 3% and 12% of GDP. This makes it clear that forecasts on potential cost savings through the use of e-commerce are subject to considerable uncertainty. According to company estimates, cost savings as a result of B2B e-commerce will range between 2 and 40% depending on the sector. Forecasts of cost savings of close to 5% in the entire economy over the next few years thus seem realistic. This would mean that transaction costs in the overall economy can be cut by 10%. E-commerce worldwide 10 9 8 7 6 5 4 3 2 1 0 Transaction costs: market versus company 4000 % USD bn 3000 Share of GDP (left) It is widely expected that companies will become smaller due to the internet-related decline in transaction costs, since it will become easier to acquire services that do not belong to the company’s core competencies on the market. As sharing and coordinating information will become easier, new forms of organisation will emerge. In the extreme, firms and individuals will collaborate on certain projects and cease their cooperation once the project is completed. As the internet makes it possible to pass on real-time information on sales and production within the whole chain of production, the best functions to outsource are those in which a company interfaces with its environment. There are already corporate structures (so-called ”virtual firms”) which have outsourced nearly all functions, e.g. development, production, sales and invoicing, with the company only assuring the coordination of the outsourced functions. 2500 2000 1500 Sales (right) 1000 500 0 1999 Transaction costs also determine whether an economic transaction is carried out directly in the market or within a company. Market contracts are always replaced by transactions within the company if this leads to cost savings. This kind of substitution takes place until organisation costs within the company equal transaction costs in the market. According to Coase, who developed this approach in 1937, organisational costs increase disproportionately from a certain company size. Furthermore, as the size of an organisation increases, efficient remuneration based on the marginal product of the respective work becomes impossible. This creates incentives for dodging and inefficiencies, which reduce the productivity of the whole company; avoiding them creates transaction costs again (costs of performance control). 3500 2000 2001 2002 2003 E-commerce: penetration by product 1999 Financial brokerage Hard & software Books Event tickets Consumer electronics US Music, videos Europe Travel Toys Apparel Home, garden Food, Wine % of sales 0 2 4 6 8 10 12 14 16 However, the use of the internet will not only reduce the transaction costs resulting from a company’s interaction with its environment, but also internal organisational costs. Owing to the improved processing and dissemination of information, project-oriented forms of organisation within companies are likely to increasingly question hierarchical structures – and thus the role of middle management within the companies. Overall, the cost-cutting effect of the internet will likely be reinforced by changes in the institutional framework. In the corporate sector the rising competitive pressure, which is partly an effect of the internet, and the management’s stronger focus on shareholder value will probably lead to a reduction in internal organisational costs. At the same time the number of company start-ups whose products make it possible to better exploit the advantages of the internet will likely grow thanks to a more liquid capital market and a bigger supply of venture capital. Economics 5 Deutsche Bank Research conomics Competition parameters in e-commerce • Brand acceptance plays a more important role Due to the network effects and economies of scale described above, rapid sales growth is crucial for long-term success in e-commerce. However, the fact that companies from all over the world compete on the internet makes it increasingly difficult for the individual company to establish itself and gain sufficient visibility. As there is no personal contact between business partners on the internet, confidence is an important factor. This can at least temporarily give established traditional companies a considerable competitive advantage over new companies that only do business on the net. Moreover, and this is particularly valid for B2C business, where it is largely impossible to examine a product before buying, well-known suppliers with a good reputation will likely have a considerable competitive edge. On the other hand, initially pursuing a two-track ”bricks-and-clicks” sales strategy generates higher costs; in addition, e-commerce will likely cannibalise traditional sales channels. B2B- versus B2C-turnover in Europe 1999 Business-toConsumer 31% • Information about the customer is capital E-commerce can help to individualise customer relations. At the same time, the internet permits bidirectional communication since e-commerce businesses can directly observe visitors to their sites (by registering the clickstream). Moreover, e-commerce firms can ask visitors to their sites to fill in a registration form, which usually includes questions about the customer’s social and economic background. Getting and processing information about customers becomes an important factor in competition. Firms can inform their customers individually of updates or complementary products, and products can be specially assembled according to the customer’s interests (e.g. online newspapers or investment recommendations by banks). The current behaviour of the individual online customer can be compared with the behavioural patterns of typified customer groups, and service can be adapted accordingly. A simple example is Amazon.com’s book recommendations: buyers of a book learn which other books the customers bought who also bought the first book. However, this strategy has its limits, as the following example shows. Amazon.com has started to sell do-it-yourself tools and equipment on its website. Buyers of a drill were informed that other buyers of the same drill had also purchased the DVDs of the Hollywood films ”Apocalypse Now” and ”Titanic”.... Detailed knowledge about customer preferences is an important asset for ecommerce firms. It makes a firm an interesting cooperation partner for other companies since this information can be used to cross-sell other products (e.g. by advertisements on the respective site). • E-commerce share of total sales (German medium-size companies) 80 nearly 0% below 10% 10-25% 25-below 50% 50%and above % 70 60 50 40 30 20 10 0 1998 1999 2000 until 2005 Pricing policy: new flexibility The production-cost curves for information goods described above explain why prices for almost homogeneous information goods usually slide during the expansion phase of the market. If a company attracts customers by undercutting the prices of its competitors, the rise in sales will likely more than compensate the lower profits per unit sold. However, e-commerce will also change the pricing policy for traditional goods and services. For example, the high transaction costs of an auction are massively reduced by the internet. Therefore, even products with a relatively low value, such as unsold plane tickets, can be auctioned off online. Thanks to their individualised customer relationships e-commerce businesses can 6 Business-to-Business 69% Economics First-mover advantage causes price war on markets for IT goods Deutsche Bank Research conomics also offer individualised prices. For example, if the company knows a customer to be price-sensitive (e.g. because he bought the paperback edition or took advantage of special offers and rebates), it can vary the price accordingly. • While price changes entail considerable menu costs in traditional businesses (new price tags, printing new price lists etc.), the internet makes it possible to change prices at any time without major costs. Together with a prudent inventory management, early price cuts can help to avoid that articles remain unsold. Moreover, if sales are high enough, prices can be changed with the aim of testing out the price elasticity of demand. E-commerce is thus fundamentally different from traditional mail-order business. Menue costs of price changes are declining dramatically Companies’ ability to change prices frequently will create considerable problems for official price statistics. At the moment there are no comprehensive price comparisons for products sold both on the internet and through traditional channels. Earlier studies came to the result that prices were even slightly higher in B2C business than in traditional business. One reason for this could be that internet users tend to have an above-average income so that they are price-sensitive only to a limited extent – at least in the case of relatively low-value products. Moreover, besides shopping, this group probably wants to experiment with the internet (forerunner effect). However, as the internet spreads further, competition will likely force companies to pass on a large part of their cost savings to the consumer. In more recent comparisons the internet prices are usually lower. Pricing policy can be individualised Acting in real time: new qualities needed Due to the first-mover advantage and rising economies of scale, the speed with which innovations are incorporated in business models will be even more important in e-commerce than in the traditional economy. Traditional business strategies aim first at gaining a dominant position on a regional market, which is then used as a basis for further expansion. However, on the internet such strategies have limited prospects as competition is global. Since companies are permanently in contact with their customers, suppliers etc., they find themselves forced to react more quickly and more flexibly to changes. For example, an internet company loses its credibility if it does not reply to an e-mail within 24 hours. This will have an effect on organisational structures (see above), and on the qualities required of employees. Market structure: more or less competition? With the internet the economy will take a large step towards the ideal of full competition (high number of suppliers and buyers, complete information, no transaction costs). Competition for traditional goods and services will indeed increase. Production chains will disintegrate and obstacles to market entry become smaller. In many cases the world market will be the relevant market. Price transparency will increase thanks to price agents (shopbots), i.e. intelligent search programs which automatically pick the cheapest offer from a range of internet suppliers. If companies succeed in creating an individualised customer relationship, this should reduce the competitive advantage of local suppliers. While we will probably soon see a consolidation in industry-specific internet marketplaces, this is more likely to intensify Economics Market share: browser Other Netscape Worldwide Microsoft 7 Deutsche Bank Research conomics competition in the remaining marketplaces. However, a different speed in adopting e-commerce can considerably change the competitiveness of established companies. The specific conditions in pure internet business could also lead to less competition. Rising economies of scale and the huge costs of establishing a brand name favour oligopolistic market structures with only a small number of sellers. This consolidation trend is already evident in the case of internet search engines. The first-mover advantage is impressively supported by the international success (market share) of American internet companies, such as Yahoo!, eBay or Amazon.com. Positive networking effects due to standardisation can have a similar effect, if companies are using proprietary standards. The monopolylike situation of Microsoft in operating systems and office applications is a warning example. In such cases competition can lead to a marked price decline at first, but after a consolidation phase prices might even rise again. Market share: operating systems Macintosh Other Worldwide Windows E-commerce: a fitness programme for the economy Overall, e-commerce has not yet reached the tipping point, particularly not in the B2C area. However, there is hardly a company now which is not directly or indirectly affected. E-commerce is certainly still in the experimental phase, i.e. it is not clear yet which solutions and structures will eventually become established. As the ”Neuer Markt” quotations in Germany show, companies’ prospects of success are changing almost daily, inevitably bringing some huge disappointments. However, ecommerce should eventually lead to massive savings in transaction costs and thus enhance the economy’s flexibility. In many sectors competition is bound to increase so that most of the cost savings will likely be passed on to consumers. Therefore inflation should be lower in the foreseeable future than in earlier economic cycles. Stefan Schneider, +49 69 910-31790 ([email protected]) Bibliography: OECD, “A new economy?: The Changing Role of Innovation and Information Technology in Growth”, 2000 OECD, “Economic Outlook”, 2000 OECD, “OECD Information Technology Outlook, 2000 Beck, Hanno and Prinz, Aloys, “Ökonomie des Internet”, 1999 Kelly, Kevin, “New Rules for the New Economy”, 1999 Quah, Danny T., “The Weightless Economy in Growth”, 1999 Richter, R. und Furnbotn, E., „Neue Institutionenökonomik - Eine Einführung und kritische Würdigung“, 1996 Shapiro, C., “Information Rules”, 1999 Smith, Michael D., “Understanding Digital Markets: Review and Assessment”, 1999 © 2000. Publisher: Deutsche Bank AG, DB Research, D-60272 Frankfurt am Main, Federal Republic of Germany, editor and publisher, all rights reserved. When quoting please cite „Deutsche Bank Research“. The information contained in this publication is derived from carefully selected public sources we believe are reasonable. We do not guarantee its accuracy or completeness, and nothing in this report shall be construed to be a representation of such a guarantee. Any opinions expressed reflect the current judgement of the author, and do not necessarily reflect the opinion of Deutsche Bank AG or any of its subsidiaries and affiliates. The opinions presented are subject to change without notice. Neither Deutsche Bank AG nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this document or its contents. Deutsche Bank Securities Inc. has accepted responsibility for the distribution of this report in the United States under applicable requirements. Deutsche Bank AG London and Morgan Grenfell & Co., Limited, both being regulated by the Securities and Futures Authority, have respectively, as designated, accepted responsibility for the distribution of this report in the United Kingdom under applicable requirements. Printed by: HST Offsetdruck GmbH, Dieburg. ISSN 1438-9185 8 Economics