Page 52 - Electronic Commerce

Introduction to Electronic Commerce

barter. Most economists agree that markets are strong and effective mechanisms for
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allocating scarce resources. Thus, one would expect most business transactions to occur
within markets. However, much business activity today occurs within large hierarchical
business organizations, which economists generally refer to as firms, or companies.
Most hierarchical organizations are headed by a top-level president or chief operating
officer. Reporting to the president are a number of executives who, in turn, have a larger
number of middle managers who report to them, and so on. An organization can have a
relatively flat hierarchy, in which there are only a few levels of management, or it can
have many reporting levels. In either case, the bottom level includes the largest number of
employees and is usually made up of production workers or service providers. Thus, the
hierarchical organization always has a pyramid-shaped structure.
These large firms often conduct many different business activities entirely within the
organizational structure of the firm and participate in markets only for purchasing raw
materials and selling finished products. If markets are indeed highly effective mechanisms
for allocating scarce resources, these large corporations should participate in markets at
every stage of their production and value-generation processes. The late Nobel laureate
Ronald Coase wrote an essay in 1937 in which he questioned why individuals who
engaged in commerce often created firms to organize their activities. He was particularly
interested in the hierarchical structure of these business organizations. Coase concluded
that transaction costs were the main motivation for moving economic activity from
markets to hierarchically structured firms.

Transaction Costs
Transaction costs are the total of all costs that a buyer and seller incur as they gather
information and negotiate a purchase-and-sale transaction. Although brokerage fees and
sales commissions can be a part of transaction costs, the cost of information search and
acquisition is often far larger. Another significant component of transaction costs can be
the investment a seller makes in equipment or in the hiring of skilled employees to supply
the product or service to the buyer.
To understand better how transaction costs occur in markets, consider the following
example: A sweater dealer could obtain sweaters by engaging in market transactions with
a number of independent sweater knitters. Each knitter could sell sweaters to one or
several dealers. Transaction costs incurred by the dealer would include the costs of
identifying the independent knitters, visiting them to negotiate the purchase price,
arranging for delivery of the sweaters, and inspecting the sweaters on arrival. The knitters
would also incur costs, such as the purchase of knitting supplies. Because individual
knitters could not know whether any sweater dealer would ever buy sweaters from them,
the investments they make to enter the sweater-knitting business have an uncertain yield.
This risk is a significant transaction cost for the knitters.
After purchasing the sweaters, sweater dealers take them to a different market in
which sweater dealers meet and do business with the retail shops that sell sweaters to the
consumer. The dealers can learn which colors, patterns, and styles are in demand from
price and quantity negotiations with the retail shops in this market. The sweater dealers
can then use that information to negotiate price and other terms in the knitters’ market.
A diagram of this set of markets appears in Figure 1-6.

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