RiP Fixed Pricing: The Internet Is on Its Way to "Marketizing" Everything - price transparency online

Business Economics, April, 2000 by Sam Kinney

INTERNET BUSINESS-TO-BUSINESS AUCTIONS FOSTER TRANSPARENCY AND EFFICIENCY

The Internet has made business-to-business auction-based transactions a new force in markets. The result is to force some markets to be much more competitive, punishing firms that heretofore had been able to rely on imperfect information to mitigate inability to compete on cost and quality. It has also created a new type of Internet-based intermediary firm to set up auctions, qualify participants, and conduct the auctions. This article describes how seller-bidding reverse auctions are conducted, illustrates the cost savings that are possible for buyers, and discusses the implications of this new type of commerce.

It has been trumpeted as the triumph of the little guy. Internet connectivity promises to reduce knowledge workers to independent telecommuters, interacting in a virtual corporate environment. Never before could an enterprise be so small yet have such reach.

But the Internet hasn't just been a boon to the small independent operator. It has also awakened and amplified the power lurking within corporate giants, using technology to give them unprecedented purchasing power and control. Major corporations are using this power to compel their smaller suppliers to compete in Internet-enabled marketplaces, where price discovery is perfect and competition is truly Darwinian. These marketplaces, which use the Internet to hold auction-based negotiations, promise to create both opportunities and risks throughout the industrial economy.

The effect of these auction-based marketplaces will be to practically eliminate fixed pricing in many industrial and other business-to-business markets. Price lists and catalogs will become customer specific like never before. Prices will vary more frequently over time as the cost of renegotiation plummets.

While the Internet promises to reduce transaction costs, its effect on price transparency will in the end define the impact of business-to-business Internet commerce. Increased price transparency--the process of making inefficient markets more efficient--will send ripple effects through the economy. Invariably, increased price transparency means prices decline. The macroeconomic effects will be seen in continued deflationary pressures. The microeconomic effect will be seen in the adaptation of individual businesses.

Internet Marketplaces: The Right Technology for the Right Market Situation

Internet marketplaces are springing up literally by the hour. Some markets specialize in particular product categories. Others focus on helping buyers buy better. Others are sponsored by supplier advertising in order to assist certain suppliers sell more.

To understand the proliferation of Internet marketplaces, one has to begin by understanding the particular needs being addressed by each marketplace. These needs vary across a number of dimensions, and there is no "one-size-fits-all" marketplace solution because of this divergence of needs.

But some general principles are already apparent. First, Internet marketplaces that succeed are generally those sponsored by the more powerful player in a commercial setting. Where buyers have power, buyer-sponsored marketplaces succeed. Where the balance of power favors suppliers, supplier-sponsored versions succeed.

Second, the particular technology used in a marketplace depends on the characteristics of the products being sold. While there is some conceptual appeal to think that markets eventually evolve into the bid-ask markets common in financial instruments, many markets will not evolve that way. Some markets will evolve towards buyer-bidding auctions, where prices rise, while others will become seller-bidding reverse auctions, where prices decline. The characteristics of the three types of auction markets are summarized in Table 1.

Classical bid-ask neutral marketplaces are familiar because we use them every day in financial markets. Stock exchanges such as the NYSE and NASDAQ follow this classical format. Because there are many buyers and many sellers, market makers build order books in both directions--sell orders at high prices and buy orders at low prices. When you have perfectly standardized products and counterparty indifference (buyers do not care who the seller is), the bid-ask neutral marketplace is the correct market making technology. It is helpful to consider the massive infrastructure that exists behind the stock exchanges, infrastructure aimed at standardizing the "product" traded on the exchange. The SEC demands filings, Generally Accepted Accounting Principles (GAAP), audits, and legal opinions. It also manages a myriad of rules aimed at making shares completely standardized and giving all participants equal information.

Seller-bidding reverse auctions are less familiar, but they are fast becoming the end game for price setting in many industrial and other business products. Seller-bidding auctions work where market structures are one-sided, in this case where there is only one buyer. Whenever a product is custom-made to a buyer's specification, the resulting market structure is a single-buyer market. We would not expect custom-made products to trade on neutral bid-ask exchanges, because there is only one buyer to create the buy-side order book. Other product characteristics favoring seller-bidding reverse auctions include counter party preference. Industrial buyers typically select suppliers not exclusively based on price, so they exhibit a preference for certain suppliers over others, price being equal. As a result, they tend to demand that seller-bidding auctions be private affairs, open only to preselected supplier participants.