24 September 2007

Will the internet increase monopolisation?

The internet has been enthusiastically proclaimed as a harbinger of greater competition. The work of Thomas Malone, among others, has predicted an 'electronic market' effect. The results of this are alleged to generate a highly competitive, rivalrous business world.

Prima facie, a reduction in transaction costs might be expected to facilitate marketisation of business-to-business (B2B) commerce and to reduce lock-in. The internet allows information to be both posted and accessed cheaply and easily, making it possible for companies to 'shop around'. In theory, this will make real attributes such as price and quality more important than advertising or reputation, giving small firms a better chance and increasing competition. Companies will find it easier to outsource, but will be less likely to form close integrated relationships with their suppliers, preferring to form casual, temporary relationships via the Web. This summarises the orthodox view of the effects of the internet on commerce.

It is often forgotten, however, that competition in Marshall's sense — i.e. rivalry between homogeneous firms — is an incidental by-product of capitalism. It depends crucially on it being efficient to have a particular activity carried on by a large number of firms rather than by a few. In the long run, this key condition may fail to hold. To consider the likely effects of the internet on market structure, we need to consider how improvements in information exchange will affect efficient firm scale and scope. This topic has not been explored in detail in either the economics or management literatures.

The issue of firm size is one of the key questions of industrial organisation. It is also one which has been linked since the early days of industrial economics with the issue of competition — Knight (1921), for example, argued that the force arising from the powerful desire to benefit from a monopoly position 'must be offset by an equally powerful one making for decreased efficiency.' The issue of efficient size more recently came back into attention, with some (e.g. Arthur 1996) arguing that decreasing returns to scale have ceased to be a relevant feature for many industries, and that in some we are seeing increasing returns.

The question of efficient scale determines concentration, and hence competition and static efficiency. The question of efficient scope affects how focused a firm is — i.e. how many ancillary activities it internalises — and therefore determines the boundaries of firms. The restructuring of business over the last fifteen years — outsourcing, globalisation, mergers — suggests that a change in conditions may have led to a change in what is efficient. A number of researchers (e.g. Malone, Yates and Benjamin 1987, Hammer 1999) have already observed and documented the link between outsourcing and B2B.

Each of the issues of scale, scope and overall firm size need to be considered. With regard to scale, when different companies operate in the same area of business, some duplication of costs is inevitable. Prima facie, therefore, there are potential efficiency gains (economies of scale) from expanding market share, or by simply integrating with rivals. In theory, one should always be able do at least as well by having two similar businesses under common ownership. Since firms tend not to expand without limit, however, there are clearly countervailing forces at work. These have usually been supposed to operate at the managerial level.

The issue of scope has received considerable attention through the work of Coase, Williamson and the property rights theorists (e.g. Grossman and Hart 1986). The key reason for internalising processes secondary to a business's core activity is generally agreed to be that of 'transaction costs' — the incidental costs of contracting with independent parties. Most recently, these costs have come to be identified principally with inefficiencies that arise ex post because contracts are incomplete and therefore not capable of providing ex ante protection against opportunism. As the incomplete contracts literature has emphasised, even a watertight contract will not always be honoured, and legal measures after the fact are expensive and can be ineffective. These theories would explain the current increase in outsourcing as due to improvement in contracts and a lessening of opportunistic behaviour. However, as Brynjolffsson (1993) has observed, empirical studies (e.g. Kanter 1989, Piore 1989) do not support this interpretation. I propose that other types of transaction cost are more important in answering this question, most notably losses arising from imperfect information exchange. Subject to some exceptions (e.g Radner 1996, Casson and Wadeson 1998), these have received relatively little attention to date as a source of transaction cost.

Finally, on the question of the overall size of a firm, it has generally been agreed that the management function typically yields decreasing returns to scale above a certain size, and that this is one of the main reasons why diseconomies of scale set in as firms expand market share. This may be due either to the fact that expanding firms require increasing spans of management, or to the information costs of communicating between different divisions in different locations. One way of interpreting these effects is by reference to bounded rationality — Williamson (1985), for example, summarises this view by arguing that effective expansion ceases when "bounds on cognitive competence" are reached.

Putting these three factors together yields a theory of optimum firm size and scope, which is a function of the trade-off between (a) production economies of scale which favour 'wide' firms, (b) savings in transaction costs from internalising ancillary functions which favour 'deep' firms, and (c) managerial diseconomies of size which favour smaller firms. Effects (a) and (b) each make firms want to expand — horizontally and vertically, respectively — while effect (c) restrains them from doing so. Thus, the need to keep managerial costs down can be achieved either by (i) reducing scale, which means economies of scale are lost and average production costs rise, or (ii) vertical disintegration, which increases transaction costs.

The motive for outsourcing is often said to be that it enables a business to concentrate on its key activity, or 'core competence'. Provided that outsourcing can be achieved with a relatively low resulting increase in transaction cost, it enables businesses to exploit economies of scale that would previously have been offset by managerial diseconomies. I argue that electronic information exchange (EIE) has had, and will continue to have, the effect of facilitating outsourcing in order to exploit economies of scale.

One consequence of this observation is that if transaction costs generally fall, there will be a tendency to switch away from (i) in favour of (ii). In other words, horizontal integration will take place at the expense of vertical integration: outsourcing facilitates mergers.

Little work has been done on explaining the recent trend for increased concentration as a result of horizontal mergers, although Chandler's work suggested that decentralisation is more feasible for the firm with greater lateral scope. Chandler (e.g. 1962) argued that functional scale economies are not great enough to make up for the diseconomies caused by the co-ordination problems inherent in functional structure, and that large firms can combine the most advantageous features of both if they undergo a structural shift into divisional management. General Motors and DuPont are pioneering examples of this. It would seem to be easier for horizontally integrated firms to undergo this shift without incurring inefficiency caused by communication errors than for vertically integrated firms.

One indirect consequence of the tendency of sectors to become monopolised as a result of increasing exploitation of scale economies is that bilateral trade (i.e. exclusive trade between two specific parties) becomes a more attractive option, simply because there is relatively little competition. This helps to explain why we are seeing increasing talk of buyer-supplier 'partnership', and related concepts increasingly featuring as key aspects of supply chain management. Corporations such as Bose practise hole-in-the-wall manufacturing: manufacturers make their products on site in Bose's factories and participate in the company's management meetings. Bose also pioneered 'JIT2', involving suppliers permanently on site, a practice that has spread widely since it was first introduced in the early nineties. Companies, rather than keeping their options open with a large supplier base, are cutting the numbers of their suppliers. Companies seem happy to be closely tied together, and are using e-business to build closer links with their suppliers.

Malone, Yates and Benjamin (1987, 1989) deny this effect in favour of the theory of increased marketisation. They predict that short-term buyer-supplier contracts, not partnership, is the principal effect of EIE — or at least of the form of it with most potential flexibility, the internet. It is true that in areas where homogeneous, irregular inputs are required, the use of web features like electronic auction is likely to lead to more static rivalry. By reducing search costs and rendering information accessible, the internet may indeed make a firm's search for a new supplier more market-like. However, it is important not to mistake a number of special cases for the whole picture. Overall, the evidence suggests increasing concentration and increased use of partnership. Companies appear to prefer partnership relationships where possible because they "improve quality and performance and [...] reduce costs" (Dussuage and Garrette 1999). Steinfield et al. (1998) find that electronic communications networks are being used more often than not as part of a strategy of tighter buyer-supplier relationships.

If e-business does not on balance increase marketisation, but rather encourages monopolisation and lock-in, we need to consider the effects on competition and static efficiency. I suggest that Malone et al's vision of the principal impact of e-business — internet-engendered markets giving easy access to a wide range of facts on different suppliers, benefiting industry and ultimately the consumer by keeping prices low and quality high — is flawed. Horizontal merger activity is likely to continue to feature at every level of business, further increasing concentration.

However, the conventional model of competition — several suppliers of the same product battling for the same customers — is likely to be increasingly replaced by more dynamic forms of competition in which one firm seeks to displace rivals by more efficiently matching customers' needs. Furthermore, potential competition, of the kind proposed by contestable market theorists (e.g. Baumol 1982), in which the behaviour of incumbent firms is constrained by the threat of entry, is likely to replace static rivalry. This will happen as entry barriers decline because firms increasingly focus on core competences and carry out smaller and smaller ranges of activities. A horizontally integrated, vertically disintegrated industry of the kind we have outlined maintains efficiency through fiercer potential competition. It is far easier for a rival to set up in competition with a flat, specialised market niche player than it is to set up a whole value chain in competition with a vertically integrated firm.

As Baumol, Panzar and Willig (1982) have argued, concentration of output need not be harmful so long as barriers to entry are low: the mere threat of competition can make a firm behave competitively. Microsoft, for example, has a near-monopoly in many areas of PC software but arguably remains innovative because its markets are contestable. Electronic information exchange lowers communication costs and thereby also helps to lower barriers to entry.

This is a summary of a paper I wrote in 2000. I have not had an opportunity to update it for any recent developments. A version of the full paper, including a simple numerical model, empirical data, and bibliography, is available here.


Lord Higham- Murray said...

...imperfect information exchange...

Some examples, please.

Fabian Tassano said...

Imperfect coordination between supplier and customer. E.g. wrong stock items are delivered because of misunderstanding; time schedule not agreed clearly enough leading to breakdown of logistics. EIE should reduce the costs and losses associated with this type of error - at least in theory.

Lord Higham-Johnson said...

Right but in aggregrate terms, is it a major issue?

Fabian Tassano said...

That's the theory. I visited some companies, e.g. ICI and BAE, where anecdotal evidence suggested that accurate information exchange was indeed an important issue.