With the Internet, the relation between the consumer and retailers will change dramatically. Customization will mean that retail businesses in electronic markets will need information about the preferences of consumers to alter products competitively. Consumers, in turn, will invest time and energy in establishing relations with certain retailers; retailers will collect and process consumer-derived information easily and cheaply using information technology. The economic literature on transaction costs suggests that, as a result, consumers may become locked into certain relationships with retailers. Consumers may ultimately become dependent subcontractors to retailers.

Contents

Introduction
Consumers as Subcontractors
Suppliers (Intermediaries) vs. Consumers
Some Concluding Remarks

Introduction

Many scholars have argued that Internet or electronic markets will be different markets from the markets we are all very familiar with. It is now also established that emerging electronic markets will not resemble the perfect markets of economic theory. Internet markets will not have an infinite number of producers selling their wares to large numbers of consumers without being able to influence prices, profit margins will not dwindle, intermediaries between producers and consumers will continue to exist (Dolfsma, 1998).

In this article, I propose to use a well-known economic theory to further our understanding about how consumers and the intermediaries (or suppliers) selling to them interact on electronic markets. The economic theory I have in mind derives from the literature on Industrial Organization, where relations between firms that are under contract to produce parts of a final product and firms that have assigned these contract are studied. This is literature that has developed after Ronald Coase's seminal article first appeared in 1937. In this article, Coase asks what determines the limits of the firm - where does the market end and where does hierarchy start, and why. Oliver Williamson (e.g. 1975) has stepped into Coase's footsteps; both have received a Nobel Prize for their research.

If consumers can be perceived of as subcontractors, what insights does that yield? I will argue that consumers are likely to become locked into positions where they find themselves more dependent on suppliers (producers, but more likely intermediaries) than the other way around. At the same time, however, suppliers are limited in the extent to which they can wield their market power since demand will become more volatile in electronic markets. If appropriate, I will refer to the market for music products, which is exemplary for how electronic markets will develop (cf. The Economist, 1997).

Consumers as Subcontractors

In emerging electronic markets consumers are flooded with information that they need to filter and qualify. Intermediaries are in a much better position to perform these tasks better and more efficient than consumers themselves. Not only will they be able to exploit economies of scale and scope in gathering and interpreting information on the Internet, but they will be able to strike deals with upstream suppliers to consider their products and bring them to the attention of consumers. Intermediaries' position will depend on their reputation in both the market where they buy products (information, usually) from suppliers, and where they sell to final consumers. Consumers in their turn, will appreciate the selection of information done for them by these intermediaries and will be willing to pay for these services.

With the use of the preferences that consumers reveal by their implicitly or explicitly stated choices, the intermediaries that form the last chain before the consumers are able to construct detailed consumer profiles. Answers to questions, as well as clicking behavior, are valuable resources that intermediaries can use to customize their products as well as their sales efforts. Since contemporary hardware and software become increasingly sophisticated, information gathering and subsequent profiling on the basis of that can be automated to a significant degree. Consumers' profiles that intermediaries are able to construct may become increasingly focused on single individuals.

As consumers are, as such, increasingly involved in the production process itself - especially in the design and marketing aspects of it (if one can still legitimately distinguish between these aspects in cases such as these) - one may for that reason perceive of them as subcontractors to the intermediaries or suppliers with which the "consumers" deal.

Consumers and intermediaries may both benefit from these developments in electronic markets. Consumers because they can save time searching for the products they want and will even be offered items they might like but had not considered or known about until then, of a kind and quality that meets their preferences to higher degrees. Intermediaries will particularly benefit, however (Dolfsma, 1998). They are crucial gatekeepers, control an important funnel of attention (c.f. Crane, 1992). It will be difficult for upstream suppliers to go around this bottleneck and reach consumers directly or establish their own intermediary. Intermediaries that have established a reputation have an advantage over new entrants in that they have already established links with (potential) consumers. Such links can work to the benefit of both consumers and intermediaries.

Given that digital products can easily be reproduced and transmuted, and do not deteriorate if used or copied (Whinston et al., 1997), customization of them is progressing and will continue to do so in the future. Consumers, however, need to convey information about themselves in order to secure these benefits of customization. Information may be conveyed by their behavior as they move from Web site to Web site, it may be revealed by the speed with which they make these moves, and it may be explicitly given by consumers to intermediaries in response to questions posed. However this information is conveyed, it means much more investment in terms of time and money on the part of consumers than on the part of intermediaries. Intermediaries will do much of the information gathering and classifying by the use of special software. The possibly extensive databases that are thus constructed can subsequently be used to fine tune marketing efforts and offer customers products that will meet their preferences in better ways. As a bonus, intermediaries may also offer to their "clients" or customers related products in which some interest may have been expressed.

Suppliers (Intermediaries) vs. Consumers

Since the cost of investing in a market relation between intermediary and consumer is much higher for the latter than for the former, and it is consequently unfavorable for a consumer to switch to another intermediary; the investments of consumers can be considered as what Williamson calls idiosyncratic investments. These investments are idiosyncratic, because when discontinuing the business relation in which investments were made and starting one with another intermediary means that the consumer has to enter into a process of providing implicit or explicit information about his preferences to this new partner afresh. In his conceptual framework, such investments make the party undertaking them dependent on the other party in the relation; the party is locked into a relation. This second party may then use the market power available to extract higher profits from the market.

Before making the investment, consumers may therefore need to be persuaded of the benefits they will reap from entering into such a relationship with an intermediary. Once this relationship has started, the sunk cost involved in the investments made will prevent either party to abandon it. If one party has invested more, and more in a way that is non-recoverable and cannot be used in relations with new business partners, this party will be in an unfavorable position.

Consumers generally are aware of their investment, and if they are not yet aware they will rapidly become aware of it; their knowledge does not stop them from participating in this sort of relationship. The potential benefits - in terms of decreased search costs and increased fulfillment of their needs - may convince them that it is beneficial to initiate a relationship with a particular intermediary. Consumers may also appreciate it when they are pointed to different but related products. In addition, intermediaries in this early and immature state of many electronic markets have started to compensate (potential) customers for their personal and unique information. This compensation takes the form of rebates or samples. In the case of information products that exist in a physical state - such as newspapers, magazines, and books - this process seems to have developed a great deal.

Who will benefit more from future developments in Internet markets is difficult to say, however. By no means are intermediaries necessarily the parties that are likely to gain most. And even if they are to gain more than consumers, that gain may not be at the expense of Internet shoppers. Total economic activity, I suggest, will expand due to developments in Internet markets. If it does, and if intermediaries take the bigger share of that market, the economic position of consumers need not deteriorate in absolute terms. Developments in electronic markets can increase the economic pie, as much as they can change the distribution of the pie itself.

Two countervailing forces are at play in Internet markets that set limits to the degree to which intermediaries can wield their market power. One is the fact that communities that form in the virtual world - for instance, in discussion groups - are not bound by geography. This means that the background and sources of information at the disposal of each member of the community will likely differ significantly more than in traditional, physical markets. For that reason, the likelihood that information will disperse in the network or community about alternative intermediaries to turn to, or about (alleged) abuses by the intermediary with whom community members now deal, is substantial. The market for music products is an example. As argued elsewhere at some length, the discussion lists about what used to be local music bands have a global membership (Dolfsma, 1999). Bands from New Zealand, for instance, are the focal point of discussion lists in which the members are for an substantial part based in the countries other than New Zealand. As a consequence, sales of recordings by these bands outside of New Zealand are quite remarkable.

A second tendency that will be observed as electronic markets develop and mature is an increased volatility in demand on these markets. New products altogether, or new variants of an existing products - and each may subsequently be customized - are likely to find their way to the market. These will partly be delivered by entrants on electronic markets in an attempt to establish a foothold in a particular market, but may also be launched by incumbents as a means of constructing barriers to entry and defend their own position on a market. Such practices by incumbents are already known for certain physical markets such as cereals, soaps, washing powders, and detergents (cf. Scherer and Ross, 1990) but will to some extent be copied by Internet markets in my view.

Whether or not incumbents will succeed in maintaining their possibly dominant positions in electronic markets depends on how responses to their behavior is perceived and acted upon in the different Internet communities that are relevant to these firms. Internet communities have extended possibilities to express, in terms originally described by economist Albert Hirschmann (1970), their voice, while their members may not always be able to exercise the exit option because they are locked into a relation with an intermediary that they themselves have invested in heavily. How this works out in terms of the absolute and relative numbers of customers who remain loyal to an intermediary and the products it brings to a market is not clear. The effect may be that the position of a firm that mediates between producers and consumers will become less secure than it is in physical markets, but that need not necessarily result in its position inevitably deteriorating. Entertainment industries provide examples of industries where a fundamental feature of business is an equivalently high degree of demand volatility. Still these industries tend to be dominated by a few large companies (see Vogel, 1998). Future developments will thus have to decide which of these tendencies will be stronger.

Some Concluding Remarks

In this article I have proposed to apply an economic theory from the literature of Industrial Organization to understand emerging relations between consumers and intermediaries (suppliers) on electronic markets. These relations will change because products exchanged on these markets are easy to reproduce and transmute, while at the same time they do not deteriorate in quality when used or copied. Customization, however, is predicated on consumers providing intermediaries with information about their preferences. The process in which such information is given, requires more investments on the part of consumers than on the part of intermediaries. Consumers may become dependent on (locked into) intermediaries due to these idiosyncratic investments, giving the latter the possibility to increase their profits. There are countervailing tendencies, however, which have to do with how communities on the Internet are organized. Whether intermediaries will increase their share of the economic pie in relative or absolute terms depends on how these tendencies balance out and on whether the development of electronic markets will increase the economic pie itself.

About the Authors

Wilfred Dolfsma is senior researcher at both the University of Twente and Erasmus University Rotterdam in the Netherlands. His research is on the effects of technological change on economic processes, and vice versa. In addition, consumption patterns and consumption theory are a significant part of his research. The author has studied economics and philosophy and has a Ph.D in economics from Erasmus University Rotterdam.
E-mail: dolfsma@fhk.eur.nl

References

Robert Coase, 1937. "The Nature of the Firm," Economica, volume 4, pp. 386-405.

Diana Crane, 1992. The Production of Culture: Media and the Urban Arts. Newbury Park, Calif.: Sage Publications.

Wilfred Dolfsma, 1999. "How Will the Music Industry Weather the Globalization Storm?" Paper presented at the Association for Evolutionary Economics (AFEE)/Allied Social Science Associations (ASSA) annual joint meeting, 3-5 January 1999, New York, N. Y.

Wilfred Dolfsma, 1998. "Internet: An Economist's Utopia?" Review of International Political Economy, volume 5, number 4, pp. 712-720.

The Economist, 1997. "Electronic Commerce - The search for the perfect market," 10 May, pp. 10 ff.

Albert O. Hirschman, 1970. Exit, Voice and Loyalty: Responses to Decline in Firms, Organization, and States. Cambridge, Mass.: Harvard University Press.

F. M. Scherer and David Ross, 1990. Industrial Market Structure and Economic Performance. 3rd edition. Boston: Houghton Mifflin.

H. L. Vogel, 1998. Entertainment Industry Economics. 4th edition. Cambridge: Cambridge University Press.

Andrew B. Whinston, Dale O. Stahl, and Soon-Yong Choi, 1997. The Economics of Electronic Commerce. Indianapolis, Ind. : Macmillan Technical Pub. ( table of contents).

Oliver E. Williamson, 1975. Markets and Hierarchies: Analysis and Antitrust Implications. New York: Free Press.

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