Revisit the Debate on Intermediation, Disintermediation And

RESEARCHElectronic Markets Vol. 13 No 2

AbstractRevisit the Debate on Intermediation, The existing literature opposing disintermediation adopts a very realistic but broad Disintermediation and Reintermediation due definition of intermediary functions, making the outcome of their arguments obvious, i.e. to E-commerce intermediation will always exist in one form or another. Supporters of disintermediation take a more focused definition of an inter- RAVI SEN AND RUTH C. KING mediary, i.e. an economic player that buys from the seller and sells to the buyer and reduces their transaction costs of trading by doing so. It is difficult to reconcile the debate from these opposite ends because of the lack of a common definition of intermediaries. In this paper we have used the definition adopted by supporters of disintermediation to show that disintermediation due to web-based e-commerce is never a possibility. The paper uses a two-stage extensive form game with simultaneous moves in the first stage to analyse the effect of web-based INTRODUCTION e-commerce on intermediated offline channel structures. The model is solved for the Nash Web-based electronic commerce equilibrium. Depending on the relation (e-commerce) is leading to consid- between the mark-up of existing offline erable changes in industry value intermediaries and the discomfort cost chains by changing the economics (associated with online channel structures) and structure of distribution channels of buyers, the game has two equilibria–one (e.g. Benjamin and Wigand 1995b; in which the manufacturer continues Evans and Wurster 1997). These to sell through an intermediated offline changes in distribution structures are channel structure, and the second in which of particular interest to the interme- the manufacturer sells through a combina- diaries that operated in traditional tion of direct-online-channel structure and channels. The web-enabled distribu- DOI: 10.1080/1019678032000067181 intermediated-online and intermediated-offline tion structure may result in the demise channel structures.

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 of the existing intermediaries, provide Keywords: intermediaries, disintermediation, new opportunities for the existing e-commerce, reintermediation, channel Authorsintermediaries or attract new forms structure of intermediaries. The existing lit- Ravi Sen erature provides support for each is a fourth year PhD student in of these outcomes. However, it is Information Systems at the Department of Business Administration, University difficult to reconcile the debate of Illinois at Urbana-Champaign. His from these existing works because research interests include economics of they use different definition of information and effects of e-commerce intermediaries to argue their point on industries and organizations. of view. In this paper we have used Ruth C. King the definition adopted by supporters 2003 Electronic Markets is an Assistant Professor in Information of disintermediation and used a ᮊ Systems at the Department of Business game theoretic approach to study Administration, University of Illinois at the impact of web-based e-commerce Urbana-Champaign. Her research on traditional intermediated-offline Copyright Volume 13 (2): 153–162. www.electronicmarkets.org Volume interests include IT human resource, channel structures. Specifically, the knowledge management and e-commerce. She has published in paper addresses the following journals such as Information Systems research question – Will the oppor- Research, Journal of Management tunity to trade directly through web- Information Systems and Decision based channels result in (i) demise 153 Sciences. of traditional offline intermediaries, Ravi Sen and Ruth C. King Impact of E-commerce on Channel Structures

(ii) weakening of traditional offline intermediaries, or the electronic markets, (ii) maximum choice at lower (iii) reintermediation by traditional offline intermediaries? price, and (iii) access to a market price without market- The following section reviews the existing literature maker profits attached, if and when interactive agents on the subject. The paper then discusses the need for are feasible. Hoffman et al. (1995) propose that firms another debate on this issue. Finally we define a two- benefit from the use of the Web as a direct distribution stage extensive form game with simultaneous moves in channel. First, the Web potentially offers certain types the first stage that is solved for the sub-game perfect of producer participation in a market in which distribu- equilibrium (SPE). The paper concludes with a discussion tion costs or cost-of-sales shrink to almost zero. This is of the equilibrium outcome and some limitation of this most likely for firms in publishing, information services paper’s analytical approach. or digital product categories. Second, businesses on the Web transfer more of the selling function to the customer, through online ordering and the use of Support for Disintermediation fill-out-forms, thus helping to bring transactions to a conclusion. This permits a third benefit in the form of Academicians and practitioners alike, as far back as capturing customer information. The technology offers 1987, provided arguments in favour of disintermediation the firm the opportunity to gather market intelligence due to e-commerce (Benjamin and Wigand 1995a, b; and monitor consumer choices through customers’ Malone et al. 1987, 1989). Malone et al. (1987, revealed preferences in navigational and purchasing 1989) proposed that once electronic markets emerge, behaviour in the Web. traditional intermediaries might be threatened due to an electronic brokerage effect, also called disintermediation (Chircu and Kauffman 1999). This effect suggests that Support for More Intermediation and Opposition to as search costs facilitated by the information technology Disintermediation fall, the traditional intermediaries who play a role in reducing the search cost for the buyers and the sellers The intuitive appeal of the aforementioned arguments are no longer needed. Therefore, disintermediation in favour of disintermediation is substantial. However, results due to the replacement of traditional middlemen there is a dearth of empirical evidence to support them. (that support the transactions) by new and improved Moreover, disintermediation might not be the only ways for transaction support, which are made possible possible outcome, since new roles for intermediaries, through technological innovations (Evans and Wurster such as aggregation, trust provision, facilitation and 1997), e.g. the Internet. Bakos (1991, 1998) further matching emerge (Bakos 1991, 1998; Sarkar et al. argues that Internet-based electronic marketplaces 1995). This need for matching, and therefore interme- leverage IT to directly match buyers and sellers with diary roles, will be higher in markets with numerous, increased effectiveness and lower transaction costs, infrequently purchased products. In such markets, the leading to more efficient ‘friction-free’ markets, and as electronic communication effect described by Malone

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 a result, the role of the intermediary may be reduced et al. (1987) reduces the cost of IT-supported commu- or even eliminated leading to ‘disintermediation’. Wigand nication, but the same effect also increases the quantity and Benjamin (Benjamin and Wigand 1995a, b) explore of information buyers and sellers must consider in an how purchasing and selling transaction patterns are electronic market. This provides opportunity for another likely to change when appropriate information tech- form of intermediary also known as information brokers. nology (e.g. the Internet) provides manufacturers with In short Internet-based e-commerce may lead to more the opportunity to bypass all intermediaries and reach intermediation. Using economic, social and institu- the consumer directly. Since existing intermediaries may tional logic, Sarkar et al. (1995) also illustrate that the significantly increase the costs of the products, there is outcome of greater rather than less intermediation is a strong incentive for their elimination from the distri- just as plausible as disintermediation. Their analysis bution channel (Benjamin and Wigand 1995a, b). The suggests that any of the following four outcomes are authors also suggest that direct e-commerce between possible – a reinforcement of existing direct producer- producers and their customers could lead to lower to-consumer links, the use of the network by producers coordination costs in the trading structure by reducing to link directly to consumers, a reinforcement of an or eliminating intermediary transactions and the existing intermediary structure, and the emergence of unneeded coordination that goes with intermediation. new network-based intermediaries. They also show Delivery costs will also be minimized because as each how an unbundling of intermediary functions suggests element of the distribution structure is bypassed, a that the role of intermediaries is multifaceted, and physical distribution link and related inventory carrying producers do not easily assume all the functions. They costs will be eliminated. The consumers will also benefit suggest that Internet-based e-commerce enables new from the direct trade opportunities. They will supposedly types of economies of scale, scope and knowledge by have (i) free market access to all sellers participating in intermediaries, leading to the rapid evolution of many 154 Electronic Markets Vol. 13 No 2

new forms of cybermediaries (i.e. Internet-based inter- believe their framework is explanatory of many of the mediaries) who are interposing themselves between developments that they have observed among start-up producers and consumers. Bakos (1998) also argues e-commerce firms and other more traditional firms along similar lines. Like other markets, electronic mar- that have decided to shift strategy and remake them- kets also require price setting, transaction processing selves into ‘e-business’ providers. We have used the and coordination, inventory management, immediacy, term intermediary perspective to describe the logic quality guarantees and monitoring. Therefore, while used by the proponents of reintermediation since they the growth of Internet marketplaces might drive certain incorporate the reaction of existing intermediaries to types of intermediaries to extinction, the electronic the threat from e-commerce. marketplaces will more than compensate for this by promoting the growth of new types of electronic intermediaries. Bakos (1991) hypothesizes that large-scale, NEED FOR ANOTHER DEBATE globally distributed intermediaries, formed by industry participants in collaboration with IT companies, will Literature supporting disintermediation seems to define emerge in the marketplace. Either by capturing domi- an intermediary, from the transactions cost perspective, nant market share in a single industry or by becoming as an economic player who buys from a seller (e.g. electronic market makers across a number of indus- manufacturer) and then sells to a buyer (e.g. end con- tries, such intermediaries will be capable of sustaining a sumer). The role performed by this intermediary is to competitive advantage by securing economies of scale reduce the transaction costs associated with the trade. and scope. The emergence of third-party intermediaries With the advanced functions provided by information in electronic markets will also be enabled by buyers’ technology, the role of economic player is diminishing. willingness to access newly available price comparison On the other hand literature opposing disintermediation information, which might otherwise not be available takes a pragmatic perspective and uses a more realistic in the presence of seller-controlled systems (Bakos definition of intermediary functions by broadening the 1997). intermediary role to include trust provision, facilitation and matching, information brokering (Bakos 1991, 1998; Sarkar et al. 1995). However, if we take this Support for Reintermediation broad definition to examine the economic activities, intermediation is always going to exist (e.g. even in Another possible and equally reasonable outcome is case of consumer-to-consumer online trade information reintermediation (Negroponte 1997). Although they brokers and trust providing functions are required). have not specifically used the same term, a number Therefore, the outcome is inconsequential (i.e. inter- of researchers have described a similar process, where mediaries are going to exist in one form or another), traditional industry players have incentives to develop and the whole debate on disintermediation becomes e-commerce capabilities and start competing in elec- irrelevant. The debate however, becomes interesting if

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 tronic markets as well. Chircu and Kauffman (1999) we argue the issue using a common perspective. We explain reintermediation in terms of characteristics have used the transaction cost perspective in this paper of technological innovation, and characteristics of and adopt the definition of intermediaries as economic the intermediary itself. Most importantly though, are players who reduce the transaction costs for buyer and the types of assets that the intermediary already has sellers – this definition is generally used in industrial in a traditional market, and its ability to reconfigure organization literature (e.g. Fingleton 1997a, b; Gehrig them in the e-commerce-enabled marketplace. These, 1993; Rubinstein and Wolinsky 1987) to argue against they believe, are the core determinants for how well disintermediation. re-intermediation will succeed (Chircu et al. 1999). Besides the difference in the definition of intermediary Unlike most analysts, Chircu and Kauffman (1999) roles, the different perspectives also fail to include all argue that traditional non-technological middlemen the participants in the trade, in their analysis of the issue. have a better opportunity to reintermediate in the long Supporters of disintermediation have analysed the issue run, and even strengthen their position in the market mainly from the sellers’ point of view, predominantly as e-commerce-able intermediaries, mainly because of concentrating on minimizing transaction costs. The their need to reconfigure their existing assets to suit profits for a seller are given by the equation: the electronic marketplace, and thereby improve the returns on the investment they have made in these Profits = Revenues from end-customers − Transaction assets. Although they cautioned that this may not Costs occur in every industry setting – whether it is due to the failed actions of a single competitor, or it is more a Literature supporting disintermediation has assumed function of the broader competitive marketplace in that the Revenues from end-customers remains more or less 155 which technological innovations occur – they nevertheless constant and therefore, sellers can increase their profits Ravi Sen and Ruth C. King Impact of E-commerce on Channel Structures

by minimizing the Transaction Costs. One way to minimize the transaction costs is to replace the intermediary in channel structure by a less costly direct channel enabled by emerging open network technologies (e.g. Internet). This line of thinking implicitly assumes

that a channel structure does not have any major impact Reaction of buyers Not considered Not considered Not considered on buyers’ purchase behaviour, and therefore, on the revenues from these end-consumers. This assumption may be justified for frequently bought commodity products. For example, most buyers may not concern too much if they buy their loaf of bread from a bakery (i.e., direct seller) or the local supermarket (i.e., an intermediary). However, if the product under consideration is a high valued product such as a home entertainment system, most buyers would care about the channel structure they buy from. Therefore, the assumption in many exiting studies (supporting disintermediation), that the consumers have a zero Reaction of existing intermediaries Not considered Considered to some extent, more emphasis on new forms of intermediation Basis of reintermediation argument discomfort cost attached to switching from their familiar channel structure (e.g. intermediated-offline) to a new one (e.g., direct-online-channel) is not a

realistic assumption. suggest

Another major limitation of the existing literature in understanding the conditions for intermediation and disintermediation is that most of these analyses do not incorporate the reaction of offline intermediaries with the exception of Chircu and Kkauffman (1999), if a manufacturer decides to switch to a web-based direct channel. Table 1 summarizes the basic arguments used by the proponents of disintermediation, more intermediation and reintermediation and limitations of their Theory/perspective Transaction cost theory No explicit theory; Sarkar et al. approach. that transaction cost might increase in e-commerce do not give any specific example of the same. No explicit theory; maximizing the utilization of existing channel-specific assets- tangible (e.g. logistics infrastructure)and intangible (e.g. goodwill) To address the aforementioned limitations this paper uses a game theoretic approach to analyse the effect of web-based e-commerce on traditional intermediary Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 channel structures. Game Theory is the study of interactive decision making. In the issue under study, we are interested in situations in which a decision maker’s (e.g. producer’s) behaviour affects not only its own gains and losses, but also those of other decision makers (e.g. traditional intermediaries). Although the mathematical model that represents real-life situations is highly simplified, it is this simplicity that makes it relatively easy to analyze. The next section defines a two-stage extensive for game (with simultaneous Definition of intermediary Buy from producers and sell to buyers Buy from producers and sell to buyers; provide all transaction support to facilitate trade; Provide services (e.g. information brokerage) that helps buyers and sellers to transact Buy from producers and sell to buyers; provide all transaction support to facilitate trade moves in first stage) between a manufacturer, a traditionally offline intermediary, and the consumers. The game is then analysed to identify the equilibrium chan- 1995) nel structure (e.g., disintermediation or stronger inter- .

mediation or re-intermediation etc.) resulting from the (e.g. Bakos Transaction (e.g. Malone strategic choices made by players involved. (intermediary

THE MODEL 1987, 1989; Benjamin and .

Pragmatic Perspective) Reintermediation (e.g. Negroponte 1997; Chircu Kauffman 1999) Wigand 1995a, b) ( Impact of e-commerce- et al 1991, 1998, Sarkar et al ( Various elements of the model are explained below. Table 1. Summary of the existing debate on impact EC channel structure Disintermediation cost Perspective) More intermediation perspective) 156 Electronic Markets Vol. 13 No 2

Buyers example, effectively providing services like customized advice (e.g. Amazon’s recommendations), advanced All the potential buyers have the same intrinsic valuation, encryption (e.g. 128 bit data encryption for credit card V, for the product. The model assumes that there is no information), user-friendly website navigation tools discomfort associated with an offline-intermediated etc. would reduce a buyer’s discomfort factors. The channel since the consumers had historically been trading model assumes that the discomfort cost is a percentage through this channel. They have been doing so because of the buyers’ product valuation and computed by they perceive value addition when buying product multiplying the discomfort factor, δ, by a buyer’s through this familiar channel structure. The consumers, product valuation, V. The decision to relate the dis- however, pay a discomfort cost (proportional to their comfort cost to the product valuation is justified by valuation of the product) when they buy from a com- the assumption that the buyers may feel comparatively paratively new and unfamiliar online channel. This dis- more discomfort, when they buy an expensive product comfort cost is manifested, for example, in the lack of from new online channel structures. The model further immediate gratification, the absence of opportunity to assumes that each consumer will purchase either one experience the product, and difficulties with returns or zero units of the product during the period under and exchanges etc. The discomfort cost could also be study. Without any loss of generality, the total number thought of as loss of any unique value brought by of buyers will be assumed to be n. If pA and pB denote the traditional offline intermediaries that has yet to be the unit offline and online prices respectively that replicated by technology in the online environment (see the buyers are willing to pay, then their utility is as Table 2) with complete success (e.g. risk sharing, trust, follows: personal service). δ VP(1−−δ ) ...... buy −online The discomfort factor, denoted by , is directly  B = − − proportional to the mismatch between the services U VpA ...... buy offline (1)  a seller needs to provide and the effectiveness with 0 ...... not− buy which the online sellers can provide those services. The higher the capability of the manufacturer and the The model also assumes that δ is distributed randomly intermediary to install sophisticated and effective across the population of buyers, letting F(δ) and f(δ) Internet applications to serve online customers, the be the corresponding cumulative and density function, lower will be the discomfort factor and vice versa. For i.e.,

Table 2. Technology-related reasons for some of the discomfort costs associated with online channels

Functions/services Traditional intermediaries Web-based direct trade*

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 (e.g. retailers) (e.g. e-storefronts)

Need assessment Assess customer requirements Manual Software application Product configuration Available Available Product customization Limited; depends on the Limited; depends on the product product Research and Product information dissemination Brochures, booklets, verbal, e-catalogues, websites, multimedia Evaluation Price transparency multimedia Very transparent Purchase influence Not high Website, brand, perception of By Sales Personnel, brand, quality, value, risk etc. perception of quality, value, etc. Consumer Risk Trying to get a feel of the product Available Available for digital products, Management unavailable for others Advise, i.e. product, warranty, By Sales Personnel Information on website finance etc. After Sales Service Servicing/repair Easier to provide from existing Needs alliance with service Follow-ups and customer feedback facilities providers, or in-house service Manual, periodic centres Automated, in real time

Note:* Technology could be a poor substitute for some of the services (e.g. those in italics) that a seller needs to provide to the buyers. 157 This could be another reason for the discomfort cost associated with online channels. Ravi Sen and Ruth C. King Impact of E-commerce on Channel Structures

S Intermediary ∫ fdtFS()δ= () (2) 0 In the model the intermediary is defined as a profit Finally, all buyers are assumed to be risk-averse and maximizing entity that buys the product from the they prefer the familiar offline channel over the new manufacturer and sells it to the end customers at a web-based channel when both channels offer equal marked up price. The intermediary has traditionally utilities. been selling through offline brick-and-mortar stores.

Manufacturer Timing of Decisions

This is a profit-maximizing firm, selling a product This section defines a two-stage game in which, the which is suitable for both the online and offline chan- manufacturer and the intermediary move simultane- nels. Without loss of the generality, the production ously in the first stage (see Table 4) and the buyers costs are assumed to be zero. The assumption means move second in the stage. that in the following analysis all prices have to be inter- preted as a deviation from 0, instead of some other Stage 1. At this stage the actions taken by the manufac- positive number (i.e. the production cost). This helps turer and the existing offline intermediary will deter- us to focus on factors other than the production costs mine the channel structure. These players will also (e.g. demand in the two channels and the mark-up of the decide their profit maximizing prices for the various sellers in our model) when analyzing the equilibrium channel structures at this stage. Both the manufacturer outcomes. The model assumes that both the manufac- and the intermediary are aware of the buyer’s product turer and the intermediary are equally knowledgeable valuation and the distribution of their discomfort cost. about the technology required to start an online It should be noted that given the nature of the game, storefront and capable of deploying this technology. that even if the intermediary and the manufacturer Therefore, both will incur the same cost when starting move in a sequence, the solution would still remain the an online storefront. This cost is also included in the zero same. production cost. The assumption is necessary to sepa- rate the affect of different demands in the channels and Stage 2. Each consumer decides whether to purchase their impact on the channel strategy of the manufacturer one unit of the product. In making this decision, each and the intermediary. consumer treats the channel structure and the end The model also assumes that the manufacturer is price of the product as given. After consumers’ purchase already selling through offline intermediaries. The decisions are made, the manufacturer and the interme- manufacturer charges its intermediaries a price Pr. This diary (if present) collect their revenues from consumers price is related to the price charged by the intermediary and profits are realized. from end customer by the intermediary, as Pr = Pi − m, Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 where i = A, B for offline and online prices, so as to maximize the profits for the intermediary and the SOLUTION

manufacturer. In the initial state of the game, Pi is known to the intermediary and the manufacturer and The game is solved backwards, i.e. first Stage II is

Pr has been negotiated in the contract for the period solved to get the total online and offline demand, and under study. The various parameters, we have already then Stage I is solved to identify the optimal channel defined for the model, are summarized in Table 3. structure.

Table 3. Summary of parameters used in the model

Parameter Possible values Description

1 V Positive Buyer’s valuation of the product 2 δ 0–1 Discomfort cost experienced by the buyers when they make their purchase from online channel. It is percentage of the valuation V of the product purchased.

3 PA Positive End price of the product in offline channel

4 PB Positive End price of the product in online channel

5 Pr Positive Price at which the manufacturer sells to the intermediary 6 m 0 ≤ m < V Mark-up of the intermediary in online or offline market 158 Electronic Markets Vol. 13 No 2

Table 4. Action profiles of the manufacturer and the traditional offline intermediary

Manufacturer’s action

Intermediary’s action Sell to intermediary Also sell online direct

Remain offline Traditional Intermediated Channel Structure Product sold through direct online and intermediated (Initial state) offline channel structure Switch to online Intermediated online channel structure Product sold through direct online and intermediated online channel structure Sell both online and Product sold through intermediated online Product sold through direct online and intermediated offline and offline channel structure online and offline channel structure

Note: We will include pure disintermediation (i.e. Manufacturer sells only through direct-online-channel structure) in the later stage of our analysis. At this stage we will assume that it is too expensive for the manufacturer to abandon its existing intermediaries, a condition too true for most intermediated channel structures present today.

Stage II – Estimation of Demand the manufacturer is better off by adding a direct M M online-channel to its channel structure (i.e. π12 >π11), In the absence of any offline channel, the total online provided that m ≥ δV. When the manufacturer adds a web-based direct channel to its existing offline Vp− B 1 demand will be nF (), provided that pB ≤ V(1 − δ). intermediated-channel structure, the intermediary is V better off by adding an online channel to its already M In the presence of an offline channel, the total online existing offline channel (because π32 is always greater − M M ppAB than both π and π ). When the intermediary starts demand will be nF(), provided p ≤ V(1 − δ)., 12 32 V B selling through both online and offline channel, the pp− manufacturer would continue selling directly through while the total offline demand will benF[(1− AB )], V online channel (in addition to selling through the M M intermediary) because π32 >π31, when m ≥ δV. This provided that pA ≤ V. The total offline demand, in absence analysis leads to the first proposition: of any online option, will be n if pA ≤ V and zero otherwise. All the demand faced by the intermediary ≥ δ is passed on to the manufacturer. In the case of com- Proposition 1: When m V (i.e., the mark-up of the intermediary is more than the reduction in online prices due to the dis-

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 petition between manufacturer’s direct-online-channel comfort cost of buying online), the optimal channel structure structure and intermediated-online-channel structure, for both the manufacturer and the existing intermediary the total online demand is equally shared among involves direct online and intermediated online/offline selling 2 them. by the manufacturer.

This would imply that intermediation would become Stage 1: Choice of Channel Structure stronger due to the emergence of direct selling from the manufacturer. Also, reintermediation will take place The payoffs for the manufacturer and the existing since the offline intermediary would venture into online intermediary for various channel structures are summarized market to compete with the manufacturer’s direct in Table 5. channel structure. However, if m ≥ δV, the manufacturer has no incentive to start direct selling through a web-based channel, Solving for Subgame Perfect Equilibrium (SPE) and it continues selling through the intermediated offline-channel structure. In this case the intermediary It has already been assumed that in the initial state the also has no incentive to switch to an online channel manufacturer is selling through an offline intermediary. strategy or include an online channel in its overall The best option for the intermediary is to remain channel strategy. This leads to the second proposition: offline (with a payoff of nm), since its payoff is reduced πI >πI if it switches to online channel ( 11 21) or sells Proposition 2: When m ≥ δV, the equilibrium outcome will be πI >πI through both online and offline channel ( 11 31). that the product is sold through an intermediated offline channel 159 However, if the intermediary decides to remain offline, structure, i.e. the status quo will be maintained. Ravi Sen and Ruth C. King Impact of E-commerce on Channel Structures

Table 5. Payoff matrix for the manufacturer and the traditional offline intermediary

Manufacturer’s action

Intermediary action Sell to intermediary Also sell online direct

p*r = V − m p*B = V (1 − δ)

= πM = − πI = πδδδπδMI=− −− =− Remain offline p*A V 11 n(V m), 11 mn (initial state) 12nV[ (1 F ( )) m (1 F ( ))], 11 nm [1 F ( )] = − δ πδδπδδMI=−−=−1 1 Switch to online p*B V (1 ) πδπδδMI=− = − 22nV[(2 ) mF ](), 22 nm()() V F 21()(),(VmnF 21 nmVF )() 2 2 δδ δ M I M F() F() Sell both online and offline π31 = n(V − m), π31 = n[m − δVF (δ)] π =−nV[(1 )(1 −m − )], 32 2 2 p*A = V, p*B = V (1 − δ) 1 πδδI =−nm[( VF ) ( )+− 2m(1 F (δ )] 32 2

M I Notes: 1. In each of the cells the first payoff is for the manufacturer and the second one is for the intermediary, i.e. (πy , πy).

2. pA*=> Profit maximizing offline price charged from the end customer.

3. p*B => Profit maximizing online price charged from the end customer.

4. p*r => Profit maximizing price charged from the intermediary.

What About Pure Disintermediation? Proposition 4: The equilibrium – that the manufacturer sells through direct online channel and through intermediated online Let us consider the case where the manufacturer can and offline channel – will hold and pure disintermediation easily abandon its offline intermediary and at a very lit- would not take place as long as the mark-up of offline retailers tle expense. If the manufacturer decides to sell through satisfies the condition: m > V[1 -(1 - d)F(d)] > dV. direct-online-channel structure, it will attract a demand M of nF(δ), and make a profit of: πD = nV(1 − δ)F(δ) by * DISCUSSION AND CONCLUSION selling at pD = V(1 − δ). This profit is less than the profit, when the manufacturer sells through an In conclusion, opportunity provided by web-based intermediated-offline-channel structure i.e.: e-commerce will never result in pure disintermediation. Propositions 1 and 2 could be used to predict the pM < pM when mV<−−[(11δδ )()] F (3) D 11 post-Internet equilibrium channel structure, for any product category, by estimating the parameters m (i.e. It can be shown by simple algebra that: δ

Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 mark-up in that industry), distribution of and the product valuation V. One should be careful not to δδδVV<−−[(11 )()] F (4) is always true. interpret the equilibria as deterministic outcomes since m ≥ δ they depend on the relationship, m ≥ δV or < δ. This implies that when m V (condition in which the V intermediated-offline-channel structure is the equilibrium), m m < V[1 − (1 − δ)F(δ)] (condition given by equation 3) Since δ is a distribution, the probability that δ > or V also holds true. This leads to the third proposition: m 1 − F( ) will determine if the channel structure will Proposition 3: The equilibrium – that the manufacturer and the V intermediary continue selling through an intermediated offline- change. Thus the probability that equilibrium described channel structure – will hold and pure disintermediation would by Proposition 2 will exist is high for products for which not take place as long as the mark-up of offline retailers satisfies the distribution of discomfort cost of buyers is skewed the condition m ≥ δV. towards higher values of d (e.g. jewellery, second hand cars), and low for products for which the distribution of If, however, m ≥ V[1 − (1 − δ)F(δ)] the manufacturer has discomfort cost of buyers is skewed towards low values of an incentive to start selling through a direct-online-channel δ (e.g. books, DVDs). In the latter case, the equilibrium structure (i.e. pure disintermediation). But m ≥ V[1 − described by Proposition 2 is more likely to exist. (1 − δ)F(δ)] implies that m ≥ δV (see equation 4). Un- The equilibrium described in Proposition 1 is already der this condition, as already shown, the equilibrium visible in the PC industry, where manufacturers (e.g. defined in Proposition 2 is also a possibility. This equi- IBM) are selling through direct online channels, and M M librium will be threatened only if πD > π32, which is intermediated online and offline channels (e.g. through never true.3 This leads to the fourth proposition: Best Buy). The buyers are comfortable buying PCs 160 Electronic Markets Vol. 13 No 2

online, as is evident from the large number of these limitations, the analysis does provide us with machines sold online, so the term δV is reduced. As a important insights in understanding the effect of open result even low mark-ups in the industry should satisfy public networks on the channel structures. the condition m ≥ δV for this industry. This equilibrium is also visible in the travel industry where airlines are selling directly through their websites, and also Notes through offline and online travel agents. In this case also the discomfort cost of consumers is low for online 1. Only those consumers with discomfort cost channels and therefore traditional intermediaries can Vp− δ ≤ B will buy online, and the proportion of exist even with low mark-ups. V The equilibrium described by Proposition 2 would Vp− Vp− be visible in industries characterized by products with buyers with δ ≤ B is nF ()B . high product valuation and therefore high discomfort V V cost of buying online and comparatively low mark-ups 2. Undifferentiated product. δ (i.e. m ≤ δV). In these industries the manufacturers would 3. If is assumed to come from one of the widely in all likelihood continue to sell through intermediated assume distribution, e.g. Uniform, Normal, it could πM > πM offline channels (e.g. automobiles). Existing intermediaries, be algebraically verified that D 32 hold for all δ in intermediated markets, can safeguard their position possible values of from these distributions. in the offline-channel structure by keeping their mark-up price in control, because if it increases above the thresh- old value (i.e., δV), they will have to face competition References from the direct online channel and will have to invest in Bakos, J. Y. (1991) ‘A Strategic Analysis of Electronic developing online channels of distribution in order to Market Places’, MIS Quarterly, (September), 295–310. compete successfully. Also, different values of δ for Bakos, J. Y. (1997) ‘Reducing Buyer Search Costs: different products implies that the manufactures and Implications for Electronic Marketplaces’, Management the intermediary will have to offer different online prices Science 43(12), December, 1676–92. to different buyers – a pricing strategy too complex to Bakos, J. Y. (1998) ‘The Emerging Role of Electronic implement. One way around this is to use the expected Marketplaces on the Internet’, Communications of the value of this discomfort cost to arrive at mark-up value ACM 41(8), August, 35–42. and online price. To do this, however, the seller needs Benjamin, R. and Wigand, R. (1995a) ‘Electronic Commerce: to be aware of the distribution of δ – information that Effects on Electronic Markets’, Journal of Computer- can be obtained by conducting consumer surveys. Mediated Communication 1(3), December, online at: The analysis has its limitations. The assumptions http://jcmc.huji.ac.il/vol1/issue3/wigand.html. about the consumer choice between the online and Benjamin, R. and Wigand, R. (1995b) ‘Electronic Markets and offline channels are straightforward. It is important to Virtual Value Chains on the Information Superhighway’, Sloan Management Review 36(2), Winter, 62–72. Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010 acknowledge, however, that consumer choice is guided by more complex heuristics that need to be studied Chircu, A. M. and Kauffman, R. J. (1999) ‘Analysing independently. Another limitation of the game, as Firm-Level Strategy For Internet-Focused described in the paper, is that it does not take into Reintermediation’, International Journal of Electronic account the channel strategies of other intermediaries Commerce 4(4), Summer 2000, 7–42. and producers selling competing products. In many Evans, P. B. and Wurster, T. S. (1997) ‘Strategy and the industries, characterized by intense competition, inter- New Economics of Information’, Harvard Business mediaries are very likely to take into account the chan- Review 75(5), September-October, 70–82. nel strategies of the competing intermediaries, as well Fingleton, J. (1997a) ‘Competition Among Middlemen When as those of the producers of the products they sell, Buyers and Sellers Can Trade Directly’, The Journal of before formulating their own channel strategy. Also, Industrial Economics XLV(4), December, 405–27. the model assumes that the transaction cost of selling Fingleton, J. (1997b) ‘Competition Between Intermediated and the market size are the main criterion for deciding and Direct Trade and the Timing of Disintermediation’, the optimal channel structure. Firms, however, use Oxford Economic Papers 49, 543–56. many other factors like product attributes, control and Gehrig, T. (1993) ‘Intermediation in Search Markets’, flexibility offered by the channel, and distribution Journal of Economics and Management Strategy 2(1), density provided by the various channel options. Spring, 97–120. Finally, the role of information technology in influenc- Hoffman, D. L., Novak, T. P., and Chatterjee, P. (1995) ing the decision of the buyers and sellers has been not ‘Scenarios for the Web: Opportunities and Challenges’, explored in more detail, an issue particularly important Journal of Computer-Mediated Communication 1(3), to the IS discipline. The simplistic game, however, is (December), online at: http://www.ascusc.org/jcmc/ 161 important for a flexible but sturdy model and despite vol1/issue3/hoffman.html Ravi Sen and Ruth C. King Impact of E-commerce on Channel Structures

Malone, T. W., Yates, J. and Benjamin, R. I. (1987) Rubinstein, A. and Wolinksky, A. (1987) ‘Middlemen’, ‘Electronic Markets and Electronic Hierarchies’, Quarterly Journal of Economics, 581–93. Communications of the ACM 30(6), June, 484–97. Sarkar, M. B., Butler, B. and Steinfield, C. (1995) ‘Inter- Malone, T. W., Yates, J. and Benjamin, R. I. (1989) ‘The mediaries and Cybermediaries: A Continuing Role for Logic of Electronic Markets’, Harvard Business Review, Mediating Players in the Electronic Marketplace’, May-June, 166–72. Journal of Computer-Mediated Communication 1(3), Negroponte, N. (1997) ‘Reintermediated’, Wired 5(9), December, online at: http://jcmc.huji.ac.il/vol1/ September 5, 208. issue3/sarkar.html. Downloaded By: [Schmelich, Volker] At: 14:53 16 March 2010

162