BizAims

The answers to this question provide us with a preview to what we try to achieve in this FAQ: comparing the digital economy with the physical economy, and coming up with a better understanding of the new market. Business strategies must be based on a sound understanding of the market dynamics, for which we rely on standard economics. More in-depth discussion is presented in our book, "The Economics of Electronic Commerce".

Is the electronic marketplace a perfect, "friction-less" market? Will transaction costs become zero? Will the market be perfectly competitive, yielding lowest possible prices? Should the market be left alone to march toward those predictions?

On the surface, the electronic marketplace appears to be something of a perfect market, where there are numerous, worldwide sellers and buyers, who in turn have bountiful information about the market and products, and where no intermediaries are necessary. Such a market is very competitive and efficient (with no need to regulate or intervene arbitrarily).

However, closer looks indicate that consumer searches are not very efficient (due to the cost of having a complete, easily searchable database, and because sellers may not provide all information necessary). Although wholesalers and retail outlets may not be needed, other types of intermediaries appear to be essential for the electronic market to function adequately (e.g. certification authorities, electronic malls who guarantee product quality, mediators for bargaining and conflict resolution, etc.). All these brokers add transaction costs.

How about the often-heard "zero marginal cost" argument that digital products will be priced at zero (given out free) because their reproduction costs will be minimal?

The price will approach zero only if

(1) the marginal cost is really approaching zero and

(2) there is effective competition among sellers.

In short, the marginal cost of a digital product may be substantial. Even when it is close to zero, prices in a non-competitive market will be determined more by demand (or the buyer's willingness to pay) than by marginal cost. Unless we think all information and digital products are of no value, they will never be priced at zero by sellers with market power. (Giving out free products today does not mean that sellers are doing it because the costs are zero nor that they will continue to do so when they monopolize the market.)