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Market and Firm Two Sides of a Coin5

Carsten Holtmann and Dirk Neumann University of Karlsruhe carsten.holtmann@iw.uni-karlsruhe.de dirk.neumann@iw.uni-karlsruhe.de

Abstract
Electronic markets are not just evolving they are designed. As such providing electronic trading venues is an entrepreneurial activity. The institutional approach followed here introduces a market operator as an economic player. As the entrepreneur charges fees for his service of operating an electronic market, the transaction cost savings incurred by information technology are essentially fully shifted to the market participants. As such the momentum predicted by the Electronic Market Hypothesis is limited in practice. The paper addresses this gap by deriving a conceptual framework, which reconciles the classical view on electronic markets with the entrepreneurial view.

Introduction

Although economists claim to study the working of the market, in modern economic theory the market itself has an even more shadowy role than the firm. [] In the modern textbook, the analysis deals with the determination of market prices, but discussion of the market itself has entirely disappeared [Coase 1988] In their famous Electronic Market Hypothesis (EMH) Malone, Yates et al. predicted that coordination in general will shift from hierarchical to market coordination as information technology is more extensively used [Malone et al. 1987]. The reason for this shift stems from the overall

This material is based upon work supported by the Alexander-von-Humboldt foundation, the Federal Ministry of Education and Research, and the Social Sciences and Humanities Research Council of Canada.

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reduction of transaction costs. Interestingly enough, this shift has empirically not yet been observed. Obviously, markets work better in theory than in practice. One reason is that in theory electronic markets are frequently reduced to resource allocation mechanisms. In this case, the contorting effects induced by the market operator, that acts as an economic player in a socioeconomic system are by assumption neglected. From a more practical point of view, an electronic market is not merely an abstract allocation mechanism, but rather the provision of facilities for resource allocation by an entrepreneur. The provision of these facilities constitutes a service, which is basically the entrepreneurs product.6 The provision of those trading services comprises the choice of an attractive business segment, which hallmarks the firms basic problem: which services to produce and in what quantities [Spulber 1999]. But what makes a business segment attractive? Attractiveness mainly stems from the potential agents who may want to enter the business segment. Apparently, the problem for whom particular goods are produced becomes an important factor of success. Furthermore, the notion of the problem how and to which costs to produce is important. The production costs of the entrepreneur have to be compensated by fees charged for the trading services. The price for the trading service marks the amount of the (explicit) transaction costs each market participant has to face. The question to which price the services are sold completes the set of relevant problems the operator has to solve. Electronic trading systems reduce the production costs an entrepreneur faces when providing the resource allocation facility to others. But, only if those cost savings are passed over to the market participants, their transaction costs decrease. The potential extent of declines in the market participants transaction costs is marked through technology advancement. The realized extent depends on the market operators decision to hand over cost reductions. This decision is typically influenced by the industry structure and the competition he faces. Hence, the momentum of the EMH is limited due to the impact of a (profit-oriented) market operator. The traditional view on markets as resource allocation mechanisms needs amendments to work for electronic markets. Accordingly, this paper provides two major extension of the microeconomic system framework (see chapter 2), namely (i) the inclusion of the market operator as an actor on the market for market services, and, (ii) the introduction of the infrastructure and the business structure of electronic markets, which comprise the production technology as well as the relevant aspects of the market operators business model. First, we start with some methodological considerations about frameworks. Subsequently, we present the microeconomic system framework in brief, which will be the starting point for our extensions. These extensions presents an industry and a firm view on markets by introducing a profit-oriented market operator. Having pointed at the similarities to ordinary service providers, the challenges of Market Engineering and their peculiarities are illustrated. The paper concludes with summary and further research.

Throughout the paper the terms product and service are regarded as synonyms.

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Methodological Issues

Before the microeconomic system framework is presented, it is useful to discuss the notion of a economic framework in distinction to economic models. This more methodological debate highlights the properties a good framework must provide and how it can be used. Generally, there are many ways to build theory that advances both knowledge and practice. On a broad level, literature identifies two feasible approaches, models and frameworks [Porter 1991]. Models, on the one hand, usually make use of mathematical formalism. For tractability reasons the models impose more or less strict restrictions. This abstraction confines the degree of complexity of the real world problem and thus isolated specific effects. Accordingly, restricting the model to some key variables whose interactions are examined in depth provides clear conclusions. These conclusions are, however, very sensitive to the underlying assumptions and the applied equilibrium concept. Porter thus concludes, that the normative significance of each model depends on the fit between its assumptions and reality [Porter 1991]. The sensitiveness does not diminish the value of models, taking into account that the real value of models lies in developing intuition [Mcafee/Mcmillan 1996]. Frameworks, on the other hand, seek to capture much of the complexity of the real world by encompassing several variables. Note, that a framework identifies and structures the relevant variables. Furthermore, it also reveals the interactions between the variables. As such, the theory inherent in a framework is contained by the choice of the variables, their organization, their interactions and finally the relationship among the variables. Unlike models, frameworks often cannot decisively determine all the interactions among the variables. Sometimes frameworks are offended because their inherent complexity makes it pretty difficult to falsify the stated arguments. Nonetheless, frameworks grant the researcher a comprehensive overview over the problem domain, the concepts, i.e. the variables, and their relationship. Frameworks and models are not necessarily contradicting each other. Rather are these approaches complementary: Models, on the one hand, can explore the concise interaction among a limited number of variables taken out of the framework. By using formal logic, even subtle effects can be isolated and studied. Frameworks, on the other hand, present a more comprehensive view on the problem domain and hence demonstrate which important variables were omitted in the various models. As such, frameworks incite the development of formal models. The benefit of frameworks in general is threefold: Identification of the key parameters It is supposed to explain, either graphically or in narrative form, the main things to be studied the key parameters, constructs or variables and the presumed interaction among them [Miles/Huberman 1994]. Clarification of the chain of causality The framework clarifies the chain of causality between the parameters, constructs or variables. Comprehensive Overview The framework is supposed to present a comprehensive overview about the various theory streams of the studied field. The depiction of the sometimes contradicting views in literature may help to recognize the nature of the effects and the underlying assumptions. More accentuated, the framework ideally provides the comprehensive range of the field, such that it allows connecting the sub-problems with the entire topic.

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Electronic Market Framework

The view presented here is motivated by Coase. Identifying markets and hierarchies to be alternative (extreme) coordination mechanisms in 1937 [Coase 1937], he perceives in 1988: [] the provision of markets is an entrepreneurial activity [] [Coase 1988]. The electronic market is conceived to be the product (or service) of a firm called market operator. In this understanding market and firm are two sides of the same coin. The microeconomic system framework (see Figure 1) appears to be a good starting point for detailed analysis of electronic markets since it provides a comprehensive, generic description of any conceivable resource allocation process. This basic framework developed by Mechanism Design theorists Smith illustrates that any resource allocation process relies on a very few well accepted concepts: At heart, it distinguishes between the economic environment and the institution which together form the microeconomic system [Smith 1982, Smith 2002]7. The environment determines demand and supply situation for a set of resources, which is exogenously given. Within the boundaries of the institutional rules the participating agents formulate their needs in terms of an order language the institution provides. Subsequently, the institution also determines the outcome of the market process, which basically means the concrete assignment of the resources. Individual behavior is hence affected by the institution, which delimits personal actions and the information and incentive structure of the system. How exactly the agents behave is subject to a behavior theory, e.g. utility maximization. The choice and transfer rule determine the outcomes, i.e. resource allocation and the corresponding payments. Subsequently, the performance of the system is calculated by evaluating the outcomes with respect to the environment.
Outcomes
(efficiency, price volatility) (allocations, prices)

Performance

Agent Behavior
(based on dispersed private information given the institution)

Institution
(language of market, rules of communication and of contract, procedural stucture)

Economic Environment
(agent preferences, cost, resources, knowledge)

Fig. 1: Microeconomic System Framework [Smith 2002] In order to generalize this framework in a way that it can also capture electronic markets, two major extensions are necessary, which will be presented in the following. 3.1 Extension 1

Electronic markets are operated by (profit-maximizing) firms rather than a benevolent, fictitious mechanism. In the microeconomic system framework the resource allocation process is defined by a mechanism. Basically, a mechanism is a mathematical function, which takes the strategies of the agents as inputs and renders the allocation and corresponding payments as outputs [Jackson 2002]. This mathematical formulation can be interpreted as follows. The resource allocation process is regulated by a benevolent auctioneer. The trading rules are common knowledge, so
7

Extending the work of Hurwicz [1973].

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the only thing agents have to do is to submit their strategy schedule. Since the allocation is free of charge the fictitious auctioneer maximizes the utility of the society. In electronic markets the assumption of a benevolent, fictitious auctioneer is no longer maintainable. Instead a firm called market operator is supposed to assume the responsibilities of the fictitious auctioneer. Unlike the auctioneer, the market operator controls the market process for profit reasons or at least for cost recovery. In addition, the market operator also undertakes other entrepreneurial tasks, i.e., investments in the infrastructure [Di Noia 1999]. The basic chain of causalities of microeconomic system framework, however, still holds even in this adapted setting. Surely, the concepts need some amendments to cope with the varied set of assumptions. The amended framework is illustrated in Figure 2 where the left panel depicts extension 1 and the right extension 2. The economic environment does not only comprise factors that determine demand and supply, it also contains factors that determine the behavior of the market operator. Suppose the market operator is partly owned by a group of investors. Their interests and demands (the corporate governance) affect the business policy of the market operator. Accordingly, the economic environment is redefined as basic conditions and refers to all factors that are outside the control of the market operator. The term market operator disguises the fact that the firm is an institution as well. Contracts among the interested groups of the firm basically constitute the firm. Those institutional rights affect the conduct of the firm. The managers conduct their entrepreneurial activities based upon their contracts. Analogous to industrial firms, market operators are exposed to competition. Accordingly, the operators are forced to offer the best service portfolio to the lowest possible fees if they want to remain active in the fierce competition [Porter 1980, Di Noia 1999]. In summary, beside the institution firm the decisions of the management are also dependent on the competitors in the market for markets. Taking institutions and competitors together yields the market structure. Conduct of the firm denotes all entrepreneurial activities of the economic actor (advertisement, research and development, etc.). The outcome of those activities is measured by the firms profit or other more specific measures (e.g. return on investment, return on capital employed, etc.) and is interpreted as its performance. The extension of the microeconomic system to electronic markets describes the shift from a resource allocation view to an industry view. The industry view depicted in the left panel of Figure 2 sketches the market structure-conduct-performance framework known from industrial organization [Mason 1939, Bain 1968]. 3.2 Extension 2

The product of an electronic market is the provision and the enforcement of institutional rules. These rules not only comprise microstructure rules but also those concerning the infrastructure and business structure. The service a market operator provides pertains to the design of the institutional rules. The microstructure simply denotes the trading rules. As electronic markets are basically information systems designing electronic markets is consequently also a software engineering task. The electronic market must be embedded in a balanced business structure; since the electronic market is the product a market operator wants to earn money with. This product mainly embodies a resource allocation process extended by business and infrastructure restrictions. Assuming that the operator can specify the transaction product, i.e., the resource that is to be allocated, it

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is not any more a full subset of the economic environment. The reason is straightforward: taking into consideration that the market operator can actively design via standardization the transaction product, it is not any more completely exogenously given. In the sequel the trading services a market operator produces will be illustrated in greater detail. The three main questions what to provide, how to provide and how much to charge guide this illustration. Each question refers to a special perspective concerning the market structure, namely, microstructure, infrastructure, and business structure. These perspectives reflecting various theory streams correspond to different views on the phenomenon electronic market. As such each perspective give rise to different sets of parameters of the market structure. The depiction of all these structural parameters is neither possible today, nor will it be possible in the future. However, dividing the whole structure into disjunctive subsets may help to overcome the restrictions of a single theory stream. Firstly, partial-analyses in the isolated perspectives are still possible and valuable as they develop intuition. Secondly, total-analyses based on the electronic market framework can help to come up with better and thus more practical predictions. Once markets are conceived in their totality, theory and practice will not diverge any more. What to provide Microstructure The microstructure perspective is concerned with the definition of the institution specifying the trading protocol. Ever since the establishment of a separate discipline, Economics has been dealing with markets. However, traditional theory abstracts from the specific market mechanism. Most of its models assume perfect information, which basically means that participants have all available information. Long before the Nobel price winners Stiglitz, Akerlof and Spence had started working on asymmetric information, Hayek already emphasized that the market process can communicate dispersed information which allows a better resource allocation [Hayek 1945]. The classical metaphor of the Walrasian Auctioneer assuming perfect information is inadequate to explicitly explain the precise functioning of a market. New approaches therefore address these shortcomings by incorporating aspects such as the working of institutions concerning risk and information allocation. Institutions in general can be conceived as humanly devised constraints imposed on human interaction [North 1987]. These constraints can be either formal or informal. Formal constraints denote strict norms, codes, laws or similar rules, whereas informal constraints are (more or less) self-imposed codes of conduct. Both types of constraints govern the interaction among the humans that deal with each other in an institutional setting. Stated differently, the institutions expose the property rights an agent is granted in the interaction process. Property rights pertain in this context to the communication process and not as usual to commodities. This rather unfamiliar view is easy to understand if the right to speak, the right to demand the resource, or the right to demand transfer payments are conceived as private property. Those private properties are defined and constituted by the institution [Smith 1982]. Institutions are frequently specified as consisting of four kinds of rules [Smith 1982, Wurman/Wellman/Walsh 1998, Parkes 2001, Jackson 2002]: Language the way offers can be specified Choice Rule determining who gets what Transfer Rule determining who pays what Adjustment Rules determining the flow of the market process RSEEM 2003 84

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Although not explicitly stated, alternative approaches characterizing institutional rules pretty much identify somewhat similar rules [Ostrom 1998, Gomber 2000, Strbel/Weinhardt 2003]. As previously mentioned the design of the institutional rules defines the service of the market operator. Nonetheless, those rules must also be implemented in an adequate infrastructure to make the service provision possible. How to provide - Infrastructure The infrastructure is concerned with the production technology the operator uses. In electronic markets this is primarily a question of how to use information technology. Firstly, existing trading rules (microstructure) can be purely translated into an information system. The first electronic stock exchanges, for example, just implemented the rules of the existing floor exchanges. The arguments for this electronification usually comprise efficiency aspects: Trading processes can be performed faster and at lower costs. Furthermore, electronic markets do not require participants to be located at a certain floor to participate in the market, remote membership is possible. The potential regional range of the market becomes almost unlimited. Secondly, information systems can also be used to design new markets, as IT facilitates the establishment of more complex trading methods that have desirable properties. In contrast to electronification, this is often referred to as electronization. For example mechanisms that allocate a product to the participant who values it most (economic efficiency) do exist in theory. With the help of information technology such complex auctions, in this case the Generalized Vickrey Auction [Varian 1995, Ausubel/Milgrom 2002], can be practically computed. In this respect, the area of computational Mechanism Design aims at developing mechanisms that embody desirable economic properties (e.g. strategy proofness, efficiency, revenue maximization) without incurring their disadvantages (e.g. computational tractability, information requirements) [Nisan/Ronen 2001, Bichler et al. 2002, Conitzer/Sandholm 2002]. The choice of the production technology is clearly a software engineering activity. But it naturally comprises hardware aspects, too. Security and integration issues also play a pivotal role in the operation of the electronic market. Operating targets in the choice for the best production technology also comprehend issues such as standardization, flexibility, and interoperability with other systems, e.g., markets or ERP (enterprise resource planning) systems. The better the market is integrated with the firms and customers information system landscape, the greater are the efficiency gains that can be achieved. Overall, detailed studies how exactly the infrastructure affects the behavior of the market participants are currently missing. Only general results measuring the user adoption of information systems are available, but need adjustment to market settings [Chau 2001]. Nonetheless, infrastructure design is not only a software engineering but also a Market Engineering activity. How much to charge Business Structure The business structure is primarily concerned with the cost and revenue aspects of the service provision. Both depend on the overall strategy as well as the corporate governance of the firm. Non-profit and for-profit organizations mark extreme points. Traditional non-electronic markets such as floor stock exchanges were often established as non-profit organizations (registered associations). Interest groups co-operated in building an institution that typically minimized their trading fees to reduce the coordination costs. As a consequence of this registered association, all members together were responsible for the compa RSEEM 2003 85

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nies decisions and strategies, and also, for the market structure. This shared responsibility results in an institution that is characterized by balanced interests of the members [Hansmann 1996, Di Noia 1999]. In recent years registered associations have increasingly lost in importance as operators of markets [Domowitz/Steil 1999, Lee 2000]. Many stock exchanges have, for instance, been altered from registered associations to private firms [Di Noia 1998], new players have been founded as private firms. No longer similar interests of members but heterogeneous interests of shareholders and customers have to be regarded, when the strategy of the markets operator shifts from cost recovery to profit-maximization. Special problems appear between customers with and without ownership of the market, as the latter may have the power to prey the former. Therefore, the challenge in the business design lies in the sound balancing of shareholders and non-shareholder interests. Especially the fee structure can be a very smooth setscrew to tune participants behavior by conceding privileges to selected groups or activities (e.g. liquidity provision).
Extension I: The market operator as an entrepreneur within an inductry
Outcome

Extension 2: The market as the product of an entrepreneur


Outcome

Conduct

Behavior of market participants

Performance of the operator/ the industry

Trading Services
Microstructure Infrastructure Businessstructure

Market Operator

Competitors

Transaction Product Basic Conditions (e.g., interests and demands of share- and stakeholders, legal environment...) Economics Environment (e.g., interests and demands of market participants, legal environment...)

Figure 2: Electronic Market Framework Figure 2 summarizes the extensions of the traditional resource allocation mechanism framework. Principally, the key parameters Environment, Institution, Behavior, Outcome, and Performance and their chain of causality remain relevant, albeit the parameters need refinement and specification: In the industry perspective this leads to a description, which resembles the StructureConduct-Performance Theory. This is not really a surprising finding, as markets are explicitly treated as firms. If the firm market operator is closer observed, it becomes obvious, that the provision of market services is its primary product. As such the microstructure defines the ser RSEEM 2003 86

Performance of the marekt

Structure

Market Structure

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vice, the infrastructure offers the medium for its provision, and the business structure primarily determines the revenue sources. Apparently, the similarities between the market operator and any other typical service providers allow applying several theory streams of Economics and Management Science. Nonetheless, comprehensive amendments have to be performed, as the service definition, the center of the Market Engineering task, is very cumbersome, as the following section will demonstrate.

The Design of the Market as a Product

Market design is a highly complex task, even in its traditional understanding as microstructure design [Neumann et al. 2002]. Firstly, there is no perfect mechanism in a sense that there is no mechanism that attains an excellent market performance independent of the underlying environment, viz. the traded goods [Wellman/Wurman 1998]. Secondly, market mechanisms favor one group on the expense of others [O' Hara 1997]. Thirdly, details matter [Ockenfels/Roth 2002]. Only slight changes in the rules can totally sway the behavior of the agents. Fourthly, the design space is amazingly huge, making design a challenging and time consuming task [Wurman/Wellman/Walsh 1998]. In a Market Engineering understood as the process of consciously designing all of the three perspectives [Weinhardt/Holtmann/Neumann 2003] sense, the definition of the market operators product is even more complex as it requires not only designing the parameters of the microstructure but of all of the three structure perspectives. Gluing all three structural elements together can result in a closed, sound concept that is likely to be successful in the competition. Contradictions between the design areas can, on the contrary, result in the overall failure of a market. Consequently, it is the interdependencies among the design areas that are critical factors to success. All those three perspectives influence the behavior of the market participants. Suppose the following example: The participants will change their bidding behavior if no longer open but sealed bids (microstructure) are allowed, or, if face-to-face interaction is replaced with computer front-ends (infrastructure), or if transaction fees are increased (business structure). The complexity of Market Engineering tremendously rises as the perspectives are closely intertwined. For example the renown C2C auction system eBay provides a proxy bidding procedure which resembles a Vickrey Auction [Ockenfels/Roth 2002]. This electronic market gives rise for a phenomenon called sniping. Snipping basically denotes late bidding behavior of the participants. In traditional non-electronic auctions sniping was not a factor; once electronic media is introduced the behavior swayed. Sniping, however, leads to distortionary effects. From a microstructure perspective it decreases the information feedback of the mechanisms and turns the last minutes of the auction from an open bidding process into a closed. From an infrastructure perspective, sniping is undesired, because of the high amount of communication within the short period right before the end of the auction. Service providers cannot store their products and have therefore to align their capacities to peak loads. This is, however, from a business and infrastructure point of view highly undesirable, as it would require high-performance infrastructures, which may be extremely expensive. If the operator will mend the defected auction, he has to remedy the distortionary effect of the change in the infrastructure by a change in the trading rules. In the eBay example changing the stopping rule can prohibit sniping. Amazon offers a completely equal auction as eBay but the stopping rule. The institution states a soft stopping rule: Whenever a new bid is placed, the

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auction time is automatically prolonged. As a result bidding behavior is much more evenly distributed over time [Ockenfels/Roth 2002]. If the engineer will adjust the defected auction, he can also remove the disturbing incentives by altering the business rules. For example the stock exchange EURONEXT charges a higher fee for each order entered during the two minutes preceding market close. This makes late bidding more costly which may outweigh the incentive to do so. This example may demonstrate the complexity of the design task and hence creates a challenge for future research.

Conclusion

The present paper extends the traditional understanding of an electronic market. Instead of perceiving the market as a coordination mechanism, the market is defined as a product of a firm, which acts within the industry of market operators. The provision and enforcement of institutional rules for resource allocation is thus an entrepreneurial activity. Accordingly, we suggest adding two more perspectives to the analysis of electronic markets. This inclusion entails that three interdependent sets of rules, each representing a different perspective, constitute the institution electronic market. Institutional rules ranging form the market microstructure over their realization by the means of information technology to the pricing affect the strategic behavior of the participants in the market and, consequently, the market outcome. The traditional understanding of market performance thus also needs refining in a way that it can capture all three perspectives, not only the market microstructure. The integration of the different perspectives into a conceptual framework aims at providing a comprehensive overview that illustrates the key variables and their interdependencies. As such it can help to formulate more realistic models, which eventually may result in better predictions. Consequently, the true potentials of electronic markets become more obvious if markets are not assumed to be merely virtual mechanisms but products of economic entities. Hitherto, scientific literature conceiving markets as firms is still in its infancy. Accordingly a deep pool of related research papers is missing [Schwartz 1995, Di Noia 1999, Lee 2000]. Nonetheless, the interpretation of markets as a firms product may strengthen the application of (general) business administration literature on electronic markets. Where applicable, it has to be adjusted to the special aspects of market operators. Electronic markets are not only evolving they are also designed. However, currently there is no coherent design tool available that accounts for all three perspectives. Accordingly, further research has to be done in the development of appropriate design tools. Communication can be the key factor connecting all three perspectives. This reflects Hayeks classical view on markets as communication system, the information technology view as inter-organizational information system and the business view as revenue source. By the emphasis on communication, it is possible to retain the classical resource allocation framework as the basis for the electronic market framework. A resource allocation system is nothing more than a communication process, which is governed, monitored and enforced by institutional rules [Smith 2002]. Communication and its restrictions can obviously be captured by a communication model. The demand for a coherent modeling of the integrated view can presumably be satisfied by communication modeling approaches provided by the discipline of computer science. Tools such as AUML, i.e. agent-oriented UML [Bauer/Mller/Odell 2001], appear to be promising to adequately model markets in their totality.

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To make the statement the market is a marvel [Hayek in Williamson 1985] come true for electronic markets, too, it needs to overcome the perception of the electronic market as a mystery.

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