Download Microeconomic aspects of the inter- net economy

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economic laws and mechanisms which functioned in the past are no
longer valid.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%
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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).
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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
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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“.
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Economics