Functions of a Market Markets (electronic or otherwise) have three main functions, summarized in Table 1: matching buyers and sellers; facilitating the exchange of information, goods, services and payments associated with market transactions; and providing an institutional infrastructure, such as a legal and regulatory framework, that enables the efficient functioning of the market. In a modern economy, the first two functions are provided by intermediaries, while the institutional infrastructure is typically the province of governments. Internet-based electronic marketplaces leverage information technology to perform these functions with increased effectiveness and reduced transaction costs, resulting in more efficient, “friction-free” markets. Matching Buyers and Sellers. Markets “clear” by matching demand and supply. This process of matching buyers’ demand with sellers’ product offerings has three main components: determining COMMUNICATIONS OF THE ACM August 1998/Vol. 41, No. 8 35 The Emerging Role of Electronic Marketplaces on the Internet Markets play a central role in the economy, facilitating the exchange of information, goods, services, and payments. In the process, they create economic value for buyers, sellers, market intermediaries, and for society at large. Recent years have seen a dramatic increase in the role of information technology in markets, both in traditional markets, and in the emergence of electronic marketplaces, such as the multitude of Internet-based online auctions. Yannis Bakos Internet-based electronic marketplaces leverage information technology to match buyers and sellers with increased effectiveness and lower transaction costs, leading to more efficient, “friction-free” markets. Table 1. Functions of a market Internet Economics Matching buyers and sellers • Determination of product offerings - Product features offered by sellers - Aggregation of different products • Search (of buyers for sellers and of sellers for buyers) - Price and product information - Matching seller offerings with buyer preferences • Price discovery - Process and outcome in determination of prices Facilitation of transactions • Logistics - Delivery of information, good, or service to buyer • Settlement - Transfer of payment to seller • Trust - Credit system, reputations, rating agencies like Consumer Reports and Better Business Bureaus Institutional infrastructure • Legal - Commercial code, contract law, dispute resolution, intellectual property protection • Regulatory - Rules and regulations, monitoring, enforcement product offerings, search, and price discovery. The behavior of buyers, sellers, and intermediaries is motivated by their desire to maximize their private utility. When markets function well, this also leads to an efficient allocation of productive resources. Viewed this way, markets are the engine and steering system of our economy. Markets provide sellers with information about demand that allows them to employ economic inputs such as capital, technology and labor, and develop products with characteristics that match the needs of buyers. Sellers determine a schedule of product offerings that they expect will maximize their profits based on: • information about buyer demand; • the cost of inputs; • the available technology for production and distribution of the information, goods and services purchased by the buyers; and, • the transaction costs of administering production, distribution, and payment. Buyers select their purchases from the available product offerings after considering factors such as price and product characteristics. In obtaining and processing this information, buyers face search costs. These costs include the opportunity cost of time spent searching, as well as associated expenditures such as driving, telephone calls, computer fees, magazine subscriptions, etc. Typically, sellers exploit these search costs by raising their prices, and thus enjoy higher profits. Similarly sellers may face search costs in locating qualified buyers for their products, such as market research, advertising and sales calls. A key function of markets in our economic system is price discovery, which is the process of determining the prices at which demand and supply “clear” and trade occurs. For certain markets, such as financial markets, this is their primary function. Markets can employ a number of mechanisms for price discovery. For instance, some financial markets use one or more of the several types of auctions to determine prices, such as the “call market” auction at the opening of a trading day at the New York Stock Exchange, when bids are accepted up to a certain time and exchange occurs when the market opens. This is the first price that is communicated via the stock market ticker to the market at large, kicking off a day of “continuous market” trading. Other markets, such as the traditional automobile dealership, employ negotiation between buyers and sellers until a price is reached. In still other markets, such as the typical department store, merchants make firm offers that customers can either take or leave. Facilitation of Transactions. The matching function of a market establishes a bilateral relationship between a buyer and a seller. After a transaction is agreed upon, the product sold must be transported to the buyer (logistics), and payment must be transferred to the seller (settlement). Markets typically incorporate mechanisms for logistics and settlement: when a travel agent uses an airline reservations system to book a flight, the system will generate the itinerary and the ticket, and will process a credit card payment. Furthermore, market transactions require the establishment of a certain level of trust, which protects buyers, sellers and intermediaries from the opportunistic behavior of other market participants. For instance, this trust role may include banks issuing letters of credit, credit reporting bureaus, or rating agencies such as Consumer Reports and Better Business Bureaus, which keep track of product information and seller reputations, and thus discourage opportunistic behavior. Finally, markets provide the physical infrastructure that allows transactions between the buyers and the sellers to take place. This includes real assets such as physical structures and trading floors, computers and communication networks, and transportation systems.

1) What are the three functions of any market and what is the potential impact of the Internet on each of these functions?

2) Briefly discuss what the author means by an intermediary. Which two of the three functions are intermediaries involved with?

3) List three ways in which Internet technology has created new possibilities for intermediaries. Give examples of particular actual intermediaries that exemplify each item on your list.

4) Take a look at the list of items under purchasing a new home in Table 2. Then take a look at Zillow.com and explain what advantages Zillow provides for buyers and sellers in the real estate market.