eCommerce Economics

David VanHoose

• Publisher: Routledge
• Year: 2011
• ISBN:
  9781136821806
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This second edition of eCommerce Economics addresses the economic issues associated with using computer-mediated electronic networks, such as the Internet, as mechanisms for transferring ownership of or rights to use goods and services. After studying this book, students will recognize problems that arise in the electronic marketplace, such as how to gauge the competitive environment, what products to offer, how to market those products, and how to price those products. They also will understand the conceptual tools required to evaluate the proper scope of public policies relating to electronic commerce.

Core topics covered in the book include the underpinning of electronic commerce and the application of basic economic principles, including the theories of perfect and imperfect competition, to the electronic marketplace. Building on this foundation, the book discusses virtual products, network industries, and business strategies and conduct. Additional key topics include Internet advertising, intellectual property rights in a digital environment, regulatory issues in electronic markets, public sector issues, online banking and finance, digital cash, international electronic trade, and the implications of e-commerce for aggregate economic activity.

Unit II Information, Advertising, And Innovation in the electronic marketplace

DOI: 10.4324/9780203830369-6

Searching for information in electronic markets

DOI: 10.4324/9780203830369-7

FUNDAMENTAL ISSUES

1. What is asymmetric information, and what types of problems can it generate?
2. What is the lemons problem, and what are some possible solutions?
3. Why can a firm gain from providing more information, and how does a firm determine how much information to provide to consumers?
4. How does a consumer determine the best price of a product and how much product price and quality information to acquire?
5. What makes a market efficient, and how efficient is the electronic marketplace?

E-Commerce Today

You probably have a relative or a friend who seems to derive great pleasure from shopping. Recent research suggests that much of the enjoyment that such people gain from the act of shopping can be traced to the chemical dopamine, which in the human brain generates feelings of satisfaction. A person’s brain releases dopamine when the individual experiences something novel or enjoyable, such as purchasing a new item from an online seller. Researchers have monitored how much dopamine is released into people’s minds as they shop by strapping onto their hands portable electroencephalogram monitors and having them engage in online shopping. By tracking amounts of dopamine observed in people’s brains, researchers have measured what they believe to be the pleasure that people receive from the online shopping experience.

Some researchers contend that the immediate satisfaction that some people experience from shopping leads them to buy items that they later wish they had not purchased. Such “impulse buying,” these researchers conclude, is particularly likely to occur when people shop online—in particular in the case of goods and services about which people possess limited information regarding quality.

Not all shoppers are quick to buy on impulse. Many consumers engage in labor-intensive information searches before deciding whether goods and services possess sufficiently desirable qualities to justify purchasing at posted prices. Your own experience undoubtedly has taught you, however, that not all information you receive is reliable information. All of us have heard rumors, confronted opinions masquerading as facts, and encountered overblown claims of “high quality.” This means that a rational consumer should not rely on information received from all available sources.

In addition, from time to time you have probably found yourself in a state of “information overload.” Sometimes so much information, even conflicting information, is available from so many different sources that it can become difficult simply to recollect and recall the information you have obtained.

Furthermore, you probably have experienced situations in which few information sources are readily available. Sometimes this information can be costly to obtain.

Consumers typically face all three types of informational difficulties—the potential for information to be unreliable, to be difficult to process, or to be hard to find. In this chapter, you will learn about how these information-related problems can arise in the electronic marketplace and about how consumers make choices in light of incomplete information.

Imperfect Information about Product Quality

Asymmetric information: Information possessed by one party in a transaction but unavailable to another party.

Adverse selection: A situation in which a number of the products offered for sale in a market are those with the worst quality or in which many of the those who offer to purchase a product have bad characteristics.

Moral hazard: The potential for either the buyer or seller of a product to exhibit undesirable behavior after arranging or completing an exchange.

Consumers often encounter a lack of knowledge about how much quality varies among products of different firms. This is the problem of asymmetric information, in which one party to a transaction possesses information that is not available to the other party. Two types of problems can arise as a result from asymmetric information. One is adverse selection, in which many or perhaps all of the products offered in the marketplace are those with the worst quality or in which at least some of the producers or consumers who offer to sell or buy a product are those possessing undesirable characteristics. Another is moral hazard, which is the possibility that either the buyer or seller may engage in undesirable behavior after arranging or completing a transaction. (See the box Policymaking Online: Some Consumers Unexpectedly Arrange for Their Friends to Be Tagged by Tagged.com.)

POLICYMAKING ONLINE: SOME CONSUMERS UNEXPECTEDLY ARRANGE FOR THEIR FRIENDS TO BE TAGGED BY TAGGED.COM

Recently, Tagged.com, a social networking site, included as part of its user registration agreement an option in which the registering user of the site consented to permit the company to contact people in their e-mail address books. People in these address books then received e-mails stating that the consenting users “sent you photos on Tagged.” The e-mails invited recipients to click on a link which, in turn, required them to register with Tagged.com to view the photos. To induce e-mail recipients to register, the e-mail suggested that if the recipients failed to respond, their friends “may think you said no.” Any recipients opting to register confronted the same option to grant the company the right to contact people in their own e-mail address books.

A problem was that many registrants complained that during the registration process it was easy for them to overlook or misunderstand the nature of their consent to permit Tagged.com to send e-mails to those in their address books. As a consequence, even though Tagged.com was fully informed about the nature of the permission registrants granted when providing their consent, the registrants themselves were not completely informed. Indeed, about 2,000 registrants complained that Tagged.com had effectively “stolen” information from their address boxes, which the company used to try to round up yet more registrants from among their friends and other e-mail correspondents. Furthermore, the attorney general of New York charged that Tagged.com’s utilization of registrants’ address books for the purpose of transmitting e-mail messages purporting to have been sent by the registrants themselves amounted to fraud. The company contended that all that had happened was a misunderstanding by the users, to whom it apologized and for whom it provided assistance in resetting the terms of their registrations.

Ultimately, whether simple user confusion or fraudulent activities were involved was settled through the legal process. The one fact that is certain is that the issues confronted by Tagged.com and a number of its users arose from asymmetric information.

For critical analysis: In your view, do problems arising from Tagged.com’s registration process and the company’s utilization of e-mail address books appear to have been related to adverse selection or moral hazard? Explain your reasoning.

Incomplete information about the quality of a firm’s product or its service gives rise to these asymmetric-information problems, which have the potential to hinder the smooth functioning of the electronic marketplace. Let’s consider how.

Adverse selection and the market for “lemons”

The colloquial “lemon” is a product with undesirable features that limit its usefulness. A recently purchased used car that exhibits persistent engine problems is a classic example.

Adverse selection in C2C auctions

Used cars are not the only goods that can turn out to be lemons. Suppose that a college student who is an aspiring amateur astronomer, but who has a limited budget, decides to shop for a backyard telescope at C2C auction sites. The student knows enough about astronomy to realize that a software-guided telescope equipped with a clock drive is essential to serious amateur astronomy. Software points the telescope at a desired object, and a clock motor powers gears that move the body of the telescope along its mount as the earth rotates on its axis, so that the image of a planet, star, or other astronomical object will remain centered in the eyepiece.

Thus, the student searches online auction sites for telescopes that have this and other desirable features. After finding a software-guided telescope with a clock drive plus several other desirable features, the student offers what seems to be a relatively low price of $800 for the telescope and is pleased when the bid wins. The student arranges payment and receives the telescope from a delivery service. Soon, however, the student discovers that the telescope’s clock drive makes a subdued, but audible, grinding noise. One gear seems to move only grudgingly, and the image of the student’s favorite object persistently drifts out of the field of vision as the earth turns on its axis. The clock drive with the used telescope, it turns out, will require expensive repair work, or perhaps replacement.

This student is a victim of the adverse selection problem. Because people have incomplete information about products such as telescopes, they can overvalue bad products while undervaluing good products.

Adverse selection: bad products driving out good products

Suppose that potential buyers of used telescopes at C2C auction sites believe that half the used telescopes in the market are lemons (such as the one purchased by the student in our example), which they value at $400. They believe that the other half of used telescopes of a given quality for serious amateur astronomical observing have a value of $1,200. This means that the average value assessment of a randomly selected used telescope offered for sale at a C2C auction site by a typical consumer equals (½ × $400) + (½ × $1,200) = $200 + $600 = $800. Consequently, a buyer is willing to pay $400 more than the assessed value of a lemon telescope because there is a 50–50 chance that the telescope might be a good one. At the same time, a buyer is only willing to pay $400 less than the assessed value of a good-quality telescope because of the even chance that it might turn out to be a lemon.

Now suppose that all potential sellers of used telescopes understand that this situation governs the market. An owner of a used telescope in good condition realizes that typical buyers will be willing to offer only $800 for the telescope, even though its inherent value is $1,200. An owner of a high-quality telescope is thereby much less likely to offer it for sale at a C2C auction site. In contrast, a person who owns a used telescope that barely functions and thereby has an inherent value of only $400 is pleased to sell it for $800. This means that relatively few people with good used telescopes are likely to offer them for sale at C2C auction sites, while many people with low-quality telescopes are likely to do so.

Eventually, potential used-telescope buyers may begin to recognize that the probability of finding a good used telescope for sale on a C2C auction site is as high as the probability of having a meteor land in their backyards. That is, their belief that a good used telescope will be offered for sale may drop close to zero. If so, the market price of a used telescope will drop to $400, the assessed price of a low-quality telescope, because only lemon telescopes will trade in this electronic marketplace. In this case, the likely presence of bad used telescopes drives high-quality used telescopes from Internet auction sites.

1. What is asymmetric information, and what types of problems can it generate? Asymmetric information exists when one party to an eco...

Table of contents

• Cover Page
• Half Title Page
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of illustrations
• Preface to the second edition
• Unit I Electronic Commerce—Markets and Prices
• Unit II Information, Advertising, and Innovation in the Electronic Marketplace
• Unit III Policy Implications of Electronic Commerce
• Unit IV Internet Trade, Electronic Money and Banking, and the Economy
• Glossary
• Index