ELECTRONIC COMMERCE:ONLINE TRADING MARKETS AND AUCTIONS

ONLINE TRADING MARKETS AND AUCTIONS

Virtually all types of products are being sold through online auctions such as Onsale.com or eBay (see Figure 5). Firms and governments can implement sophisticated bidding and auction procedures for buying supplies and selling their products. Consumers can search and negotiate for best prices through auctions. By eliminating physical distance and simply increasing the number of products and trading partners available to individual bidders, online auctions offer opportunities unrealized in physical markets. Such a market arrangement, however, may produce price levels—and thus com- petitiveness and profit levels—that may be fundamentally different from physical markets. In this section, we present an overview of various types of auctions being implemented on the Internet and evaluate their effects on price levels, market competition, and overall economic gains and losses.

Types of Auctions

Auctions may be for a single object or a package of nonidentical items. Alternatively, auctions may be for multiple units where many units of a homogeneous, standardized good are to be sold, such as gold bullion in the auctions conducted by the International Monetary Fund and the U.S. Treasury in the 1970s and the weekly auctioning of securities by the Treasury.

Auctions discussed in this section are single auctions where either an item is offered for sale and the market consists of multiple buyers making bids to buy or an item is wanted and the market consists of multiple sellers making offers to sell. In either case, one side of the market consists of a single buyer or seller. Most online auctions are currently single auctions. On the other hand, multiple buyers and sellers may be making bids and offers simultaneously in a double auction. An example of a double auction is a stock trading pit. Because market clearing level of price may differ substan- tially between double and single auctions, we discuss double auctions in Section 7.5 below.

Auctions may also be classified according to the different institutional rules governing the exchange. These rules are important because they can affect bidding incentives and thus the type of items offered and the efficiency of an exchange. There are four primary types of auctions:

1. English auction. An English auction, also known as an ascending bid auction, customarily begins with the auctioneer soliciting a first bid from the crowd of would-be buyers or an- nouncing the seller’s reservation price. Any bid, once recognized by the auctioneer, becomes the standing bid, which cannot be withdrawn. Any new bid is admissible if and only if it is higher than the standing bid. The auction ends when the auctioneer is unable to call forth a

new higher bid, and the item is ‘‘knocked down’’ to the last bidder at a price equal to that amount bid. Examples include livestock auctions in the United States and wool auctions in Australia.

2. Dutch auction. Under this procedure, also known as a descending bid auction, the auctioneer begins at some price level thought to be somewhat higher than any buyer is willing to pay, and the price is decreased in decrements until the first buyer accepts by shouting ‘‘Mine!’’ The item is then awarded to that buyer at the price accepted. A Dutch auction is popular for produce and cut flowers in Holland, fish auctions, and tobacco. Price markdowns in department stores or consignment stores also resemble Dutch auctions.

3. First price auction. This is the common form of ‘‘sealed’’ or written bid auction, in which the highest bidder is awarded the item at a price equal to the amount bid. This procedure is thus called a sealed-bid first price auction. It is commonly used to sell off multiple units, such as short-term U.S. Treasury securities.

4. Second price auction. This is a sealed bid auction in which the highest bidder is awarded the item at a price equal to the bid of the second highest bidder. The procedure is not common, although it is used in stamp auctions. The multiple-unit extension of this second price sealed bid auction is called a competitive or uniform price auction. If five identical items are sold through a competitive price auction, for example, the five highest bidders will each win an item but all will pay the fifth-highest price.

The distinguishing feature of an auction market is the presence of bids and offers and the com- petitive means by which the final price is reached. A wide variety of online markets will qualify as an auction using this definition. Less than two years after eBay appeared on the Internet, revenues from online auctions have reached billions of dollars in the United States, projected to grow into tens of billions in a few years. Major online auctions are in consumer products such as computers, airline tickets, and collectibles, but a growing segment of the market covers business markets where excess supplies and inventories are being auctioned off.

B2B Trading Markets

Online auctions for business are an extension of supply chain applications of the Internet, by which firms seek parts and supplies from a large pool of potential business partners. The real-time interaction in these auctions differs significantly from contract-based supply relationships, which may be stable but often inefficient in terms of costs. A more flexible and responsive supply chain relationship is required as the manufacturing process itself becomes more flexible to meet changing demands in real time. Especially for digital products, the business relationship between suppliers and producers may be defined by the requirement for immediate delivery of needed components.

Currently, business-to-business auctions are mainly those that sell excess or surplus inventories. For example, FastParts (http: / / www.fastparts.com) and FairMarket (http: / / www.fairmarket.com) of- fer online auctions for surplus industrial goods, mainly desired by corporate purchasing departments. A significant impediment to widespread B2B auctions is the fact that online auctions allow only a single item to be exchanged at a time. However, corporate purchasing managers typically deal with thousands of items. This will require them to make and monitor bids in thousands of web pages simultaneously, each handling one item. A more efficient auction will allow them to place a bid on a combination of items. Unlike auctions organized around a single item or multiple units of a single item, the new market mechanism poses serious challenge in guaranteeing market clearance because it must be able to match these combinatorial bids and offers, unbundling and rebundling them (see Section 7.5.2).

Auctions in Consumer Markets

Auctions selling consumer goods are mainly found in used merchandise and collectibles markets. Both in Onsale.com and eBay, all types of consumer goods are offered by individuals for sale. Ordinarily these items would have been sold through classified advertisements in local newspapers or in various ‘‘for sale’’ newsgroups. Online innovations stem from the size of the potential audience and the real-time and interactive bidding process.

While online markets have an inherently larger reach than physical markets in terms of the number of participants the success of eBay and onsale.com is largely due to their allowing potential buyers and sellers an easy way to interact in real time. eBay, for example, is simply an automated classified ad. The list of products offered as well as those who buy and sell at eBay site resembles those found in the classified ad market. Want and for-sale ads are largely controlled by newspapers who generate as much as 30% of their total revenues from individual advertisers. Aware of the increasing threat posed by Internet-based classified ads, several newspapers experimented with online classified ad- vertising based on their print versions. Nevertheless, large-scale initiatives by newspapers have all but failed. Surprisingly, eBay has succeeded in the same product category.

While online classified ads offered by newspapers are nothing more than online versions of their print ads, eBay offers features that consumers find convenient. Classified ads provide buyers only with contact information for purchasing a product. The buyers must make telephone calls and ne- gotiate with the sellers. On eBay’s website, all these necessary processes are automated and made convenient. Sometimes the formula of successful online business is simply to maximize the inter- activity and real-time capabilities of the online medium itself.

Besides successful online versions of classified ads, another type of online auction deals with perishable goods, which need to be sold quickly. Excess airline tickets and surplus manufacturing products comprise the second type of products sold in online auction markets. For these products, the electronic marketplace offers the necessary global market reach and responsiveness.

Despite the growing interest in online auctions, the majority of consumer goods, except those discussed above, are not suitable for auctions. For these items, conventional selling such as posted price retailing will be more than adequate. Nevertheless, the flexibility offered by online trading may offer innovative market processes. For example, instead of searching for products and vendors by visiting sellers’ websites, a buyer may solicit offers from all potential sellers. This is a reverse auction, discussed below. Such a buying mechanism is so innovative that it has the potential to be used for almost all types of consumer goods.

Reverse Auctions

A reverse auction is where a buyer solicits offers from sellers by specifying terms of trade that include product specification, price, delivery schedule and so on. Once interested sellers are notified and assembled, they may compete by lowering their offers until one is accepted by the buyer. Al- ternatively, offers may be accepted as sealed bids until one is chosen. In this regard, a reverse auction is more akin to a buyer auction, commonly found in business procurement and government contract- ing.

But an online implementation of a reverse auction—e.g., Priceline.com—deals with more mun- dane varieties of consumer goods and services. At Priceline.com website (http: / / www.priceline.com), consumers can specify the maximum price they are willing to pay for airline tickets, hotel rooms, automobiles and home mortgage (see Figure 6). Then Priceline.com acts as a reverse auction market as it searches and finds a seller who has the good that matches the buyer’s requirements and is willing to provide the good or service at the specified terms.

Like classified ads, the reverse auction mechanism is commonly found in physical markets. For example, it is used to determine suppliers and contractors in large-scale projects. In some seller’s markets where products are perishable, sellers compete to unload their products before they become spoiled or unserviceable. Not surprisingly, Priceline.com’s main source of revenues is the airline industry, where unsold seats are perishable products that cannot be saved and resold at a later date.

As in the case of building contractors and bidders, the advantage of reverse auction hinges on the limited time span of certain products and services and the existence of competition among sellers. However, it is seldom used for manufactured consumption goods. An obvious logistical problem is that there are many more buyers than sellers. This will render reverse auctions almost impossible to handle. On the other hand, online markets may offer an opportunity for reverse auctions to be used more frequently, even for most consumer goods. In a sense, reverse auctions are a form of customer- pulled marketing and an ideal selling mechanism for the digital age.

Consumer-initiated, or pulled, searches may produce some potential vendors who have matching products for sale, but contacts have to be made separately from the search result. Online reverse auctions combine search process with direct contact and negotiation with the sellers. The prospect of using a reverse auction as an online business model depends on its ability to enable consumers to specify various aspects of the good or service they intend to purchase because individual preferences may not be matched by existing products and services. In such cases, interested sellers may engage in ex post manufacturing to satisfy customer requirements. Online searches, reverse auctions, and ex post manufacturing represent the continuing innovation of the digital economy to satisfy personalized needs.

Emerging Market Mechanisms

Auctions are typically used when sellers are uncertain about market demand but want to maximize selling prices. Conversely, buyers use auctions to obtain lowest prices for contracts and supplies. If this is the case, why would sellers use online auctions when they can obtain higher prices through posed-price selling? Revenues are maximized, because since traditional auctions usually involve one seller with multiple buyers or one buyer with multiple sellers. In each of these cases, the individual who sells an object or awards a contract is always better off as the number of bidders increases

(Wang 1993; Bulow and Klemperer 1996). However, if the auction consists of many sellers and buyers simultaneously, the result changes dramatically. Such an auction is called a double auction market.

Double Auction

In a typical auction, a single seller receives bids from multiple buyers or one buyer collects offers from multiple sellers. In a double auction, both multiple sellers and buyers submit bids and offers simultaneously, similar to trading in security markets. Multiple units of different products may be auctioned off at the same time.

A double auction closely resembles supply-and-demand interactions in physical markets. Because of this simple fact, a double auction results in a very different price level from single auctions, described above. In a single auction, the selling price may be far above the competitive level due to competition among the buyers. With many sellers and buyers, however, double auction markets tend to generate competitive outcomes. A double auction is simply an interactive form of market where both buyers and sellers are competitive.

Ideally, any effort to promote competitiveness should include expanding double auctions and similar market mechanisms in the digital economy because they offer an opportunity to raise eco- nomic efficiencies unsurpassed by any physical market organizations. For auctioneers, however, single auctions generate substantially more revenues than double auctions. Where will the incentives be for them to participate in such a competitive market? Both sellers and buyers will prefer single auctions. On the other hand, a variant type of double auction may present a unique opportunity in the digital marketplace. For example, when buyers are looking for a bundle of products and services, a double auction with many sellers and buyers is necessary to clear the market.

Bundle Trading

Bundle trading is an essential market mechanism when products are customized and buyer’s needs must be satisfied by many sellers. Customized and personalized products often consist of a collection of complementary goods and services. For example, a combination of airline tickets, hotel rooms, a rental car, meals, and amusement park admission tickets can be bundled as a packaged leisure product. Some products that are vertically related, such as a computer operating system and a web browser, may be provided by different vendors, requiring buyers to deal with multiple sellers.

While a purchase that involves multiple sellers may be carried out through a series of transactions or auctions, bundle trading offers a simplified and efficient solution. In addition, products and services are increasingly bundled and integrated rather than being sold as separate units. As a result, a different kind of problem arises, namely how to facilitate markets that allow convenient buying and selling of a wide range of products and services in one basket or transaction.

A technological solution to bundle trading is to provide an auction that allows buyers and sellers to trade any number of goods in any combination. For example, stock trading markets such as NYSE or Nasdaq are double auctions that clear individual assets one by one. On the other hand, investors usually hold their assets in a portfolio that consists of diverse assets, consistent with their investment objectives on the overall returns and values. Nevertheless, physical markets are unable to carry out unbundling and rebundling of assets offered and demanded in the market.

The networked environment on the Internet offers a possibility of allowing such portfolio-based transactions. In essence, the desired auction mechanism must unbundle and rebundle offers and bids presented by both sellers and buyers. A prototype of such a mechanism is a portfolio trading algorithm developed for the investment community (Fan et al. 1999; Srinivasan et al. 1999). Its basic setup, however, can extend into procurement process in manufacturing as well as bundle trading in physical products and personal services.

Alternatively, third-party intermediaries may provide an agent-based solution to trading bundles. Like a travel agent, an intermediary can assemble a package of products and services to match a customer’s need. Because of the increasing trend toward integrated products, intermediaries or agent- based service providers will play a greater role in the Internet economy.