E-Business - Transaction Cost Notes

E-Business - Transaction Cost

Course Objectives

• Define "E-business".
• Understand transaction costs and the Internet.
  • What is transaction cost?
  • Why does the Internet transform some industries but not others?
• Analyze channel conflict.
• Analyze disruptive technologies.
• Analyze online architectures.
• Analyze Network Effects.
• Analyze search engines.
• Analyze cryptography and secure payments.
• Synthesize a website using “Joomla CMS”.
• Evaluate the synthesized website.

Transaction Cost and the Internet

• Why the Internet transforms certain industries while in others it doesn't.
• Understand transaction cost.

Transaction Cost

• Transaction cost is the cost associated with making an economic exchange.
• Not the direct price you pay.
• If transaction costs are too high, no economic exchange will take place.

Factors Contributing to Transaction Costs

• Difficulty in searching for and finding items.
• Lack of trust in sellers, especially in overseas markets.

Nobel Prize and Transaction Cost

• Ronald Coase: "Price is not the only issue in the market."
• Price discovery is a cost.

Types of Transaction Cost

• Formalized by Ronald Coase.
  • Visibility cost.
  • Bargaining (Negotiation) cost.
  • Policing and enforcement cost.

Visibility Cost

• Associated with determining:
  • Whether the required good is available.
  • Where it is available.
  • Its price.
• Search and information cost involves time and energy.

Bargaining Cost

• Associated with negotiation about:
  • Price.
  • Delivery way.
  • Delivery date.
• Required to come to an appropriate agreement with the other party.

Bargaining Cost & Information Asymmetry

• Bargaining costs arise because of information asymmetry.
• If two people have the same information, bargaining cannot take place.
• If a seller or buyer has more information, they can negotiate.

Policing and Enforcement Costs

• Associated with trust issues.
  • Assurance that the product will perform as promised.
  • Responsibility if it doesn't perform as promised.
  • Ability to return to the seller for repairs, etc.
• If you do not trust a seller, you will probably not buy it.

Assumptions

• Why do these costs occur?
  • Because of the architecture of the market.
  • Because of the structure of the market.

Assumption #1: Bounded Rationality

• People’s cognitive abilities are limited.
  • Limited memory.
  • Limited cognitive processing power.

Assumption #2: Information Asymmetry

• Bargaining is a function of how much information buyers or sellers have.
• Typically, sellers have more information.
• Only then you have bargaining.
• Example: buying a used car; the salesman has more information.

Assumption #3: Opportunism

• Human behavior which makes information asymmetry harmful.
  • Self-interest.
  • Taking advantage of others.
• People may not be entirely honest and truthful about their intentions.
• People might attempt to take advantage of unexpected circumstances that give them the chance to exploit the other party.

Why Transaction Costs are Important

• Transaction costs cannot be eliminated, only minimized.
• They form a source of inefficiency.
• If transaction costs are very high:
  • Develop a solution for reducing the transaction costs.
  • Examples: people who negotiate on your behalf, intermediaries who tell the best price for a small commission (e.g., www.skyscanner.net).

Aggregators

• Online intermediaries who tell the best price for a small commission.
• Aggregators essentially arise in industries where the products are generally similar.
• If you don't have many different players, aggregators add no value because they do not reduce enough of the costs.
• The cost was low in the first place.
• Have nothing to compare or aggregate if the products are very different.

Aggregators: Example of Google News

• Takes news items from different newspapers and puts them all in one place.
• You don't have to go to different sources.
• The news is essentially the same across different newspapers.

Transaction Cost and the Internet

• Google allows a more efficient search, reducing the visibility cost.
• Amazon allows price discovery, reducing visibility cost.
• eBay provides trust information, reducing policies and enforcement cost.
• The Internet is a universal tool that enables reduction in all aspects of transaction costs.

Internet's Impact

• Internet reduces transaction cost.
• Internet is successful and value-add.
• People are willing to pay for a reduction in transaction costs.
• The Internet has been the greatest tool for search, connection, and discovery.

Internet Business Models

• Transaction cost might be the basis of some of the most successful Internet business models.
• The Internet reduces transaction costs.
• To find new start-up opportunities:
  • Find an industry in which there is very high friction.
  • Reduce that particular friction.

Industry Transformation

• Certain industries are getting transformed by the Internet because of the fact that they have very high transaction costs.
• The Internet allows a reduction in those transaction costs.

E-bay Business Model Analyze

• eBay sells hard to find items whose transaction cost is extremely high.

Physical vs Online Stores

• “Physical stores are becoming like showrooms for online retailers”.

Example of Airline Industries/ Airtravel

• Airline industry has transformed dramatically.
• Travel agents have almost all been replaced by online sites.
• Online sites made a difference in this industry.

Power of Transaction Costs

• The transaction cost has a predictive power.
• News business is changing.
• To predict what's going to be happening in the newspaper industry, just look at some trends.
  • The newspaper industry is consolidating.
  • Many newspapers have gone out of business.
  • The number of players is dramatically shrinking.
  • Newspapers are not making money.
  • Will aggregators still make sense?

Transaction Costs Framework

• Transaction costs offer an exploratory framework to understand how different industries will get impacted.
• Look at rise and fall in transaction cost.
• Look at whether that industry is right for transformation, or the Internet won't make that much of a difference in that particular industry.

In Summary

• Transaction cost: The cost incurred in making an economic exchange, not the direct price you pay.
• 3 categories:
  • Visibility cost: Search and information cost.
  • Bargaining cost: Negotiation.
  • Policing and enforcement cost: Trust issues problem.
• The internet is a complete tool that enables reduction in all aspects of transaction costs.
• Transaction costs have a predictive power for the future of online industries.