transaction costs in the information age: the impact of information and communcation technology on...
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T R A N S A C T I O N C O S T S I N T H E
I N F O R M A T I O N A G E
THE IMPACT OF INFORMATION AND COMMUNCATION
TECHNOLOGY ON MARKETS, HIERARCHIES,
AND INTERMEDIARIES
E.METSELAAR
9222758
Supervision: Drs. C. Metselaar
University of Amsterdam
Social Science Informatics
Thesis, August 1998
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TABLE OF CONTENTS
1 INTRODUCTION ................................................................................................ 1
2 TRANSACTION COST THEORY ........................................................................... 3
2.1 CLASSIC TRANSACTION COSTS .............................................................. 32.2 INTERMEDIARIES AND TRANSACTION COSTS ............................................ 42.3 NETWORK ORGANISATIONS: MARKETS OR HIERARCHIES?......................... 6
3 TRANSACTION COSTS IN THE INFORMATION SOCIETY........................................... 9
4 THE OPTIMAL NUMBER OF SUPPLIERS.............................................................. 11
5 THE ROLE OF THE INTERMEDIARY.................................................................... 14
5.1 ELECTRONIC MARKETS THROUGH INTERMEDIARIES ............................... 165.2 PREDICTIONS FOR ELECTRONIC MARKETS ............................................. 17
6 THE ROLE OF NON-SPECIFIC ASSETS ............................................................... 19
7 DISCUSSION ................................................................................................. 20
6 REFERENCES................................................................................................ 22
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1 INTRODUCTION
Anyone who wants to form a business to deliver information will have the means of reaching customers. And anyperson who wants information will be able to choose among competing information providers, at reasonable pric-
es. Thats what the future will look like say, in ten to fifteen years.
Al Gore, Vice president of the United States (in Wigand & Benjamin, 1993)
Considerable changes are taking place in the eco-
nomics of marketing channels, patterns of physical
distribution, and the way economic activity is organ-
ised. These changes are in large part caused by the
emergence of information and communication tech-
nology (ICT) and the growing importance of the In-
ternet. However, the exact relationship between ICT
and economic organisation is still subject to a lot of
research and speculation. The theory of transaction
cost economics provides a foundation for empirical
research and theory building in this area.
The predictions made by Malone, Yates, and Ben-
jamin (1983) have led to a lot of reactions from
scholars in this field. In their article Malone et al.
predict ICT will decrease transaction costs, and this
will lead to increasing reliance on co-ordinating eco-
nomic activity through market mechanisms in stead
of hierarchical relationships. In this thesis these pre-
dictions are further investigated. The question that is
going to be answered is: How does ICT influence
the co-ordination mechanisms in the economy?
Transaction cost theory and the predictions that are
derived from this theory by Malone et al. (1987) form
the main theoretical foundation that is used in find-
ing an answer to this question. The influence of ICT
on the forming of markets and hierarchies is investi-
gated and the role of the intermediary in the elec-
tronic world will be examined.
The first chapter of this thesis explains some of the
underlying ideas that have led to predictions about
the changes that ICT will bring. Firstly classical
transaction costs are explained, the dichotomy be-
tween markets and hierarchies is introduced, and
some definitional problems concerning transaction
costs are explored.
Chapter two starts with predictions that are made
about the effect of ICT on markets and hierarchies.
These are derived from applying transaction cost
theory to the electronic world. It is assumed that
transaction costs will be very low in the future, due
to ICT.
The predictions that are made are then further in-
vestigated in the following chapters. Firstly the elec-
tronic market versus electronic hierarchy debate will
be considered, with ideas about the optimal number
of suppliers and about virtual organisations. We
show that there are not only economic arguments
that determine the amount of suppliers considered
by a company, but also there are other factors that
play a very important role.
Secondly the role of intermediaries in the electronic
age is investigated. We argue against the idea that
there are only two options: classic intermediaries will
disappear or they will grow in number. In stead four
possible scenarios for the future of intermediaries
are suggested. Moreover, by pointing out the added
value intermediaries might have in a transaction, we
will show that the role of the intermediary is just as
important, and maybe more so, in the electronic
world.
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Thirdly, we will concentrate on a point of critique on
the transaction cost theory. The critique is aimed at
the role of asset specificity in transaction cost theo-
ry. This critique also has big implications for the
predictions that were done by Malone et al. (1987).
In the final chapter, the arguments that were not in
correspondence with earlier predictions are summa-
rised. The implications are outlined, and sugges-
tions are made for future research.
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2 T RANSACTION COST THEORY
Networks are the fundamental stuff of which new organisations are and will be made.
Manuel Castells in The rise of the network society (1997, p. 168)
2.1 CLASSIC TRANSACTION COSTS
As early as in 1937 Coase pointed out that there are
two distinct ways in which economic activity can be
organised. On the one hand there is the market, in
which resource allocation is taking place through
changes in relative prices. On the other hand there
is the firm. Here, resource allocation is guided by
entrepreneurial decisions. Normally, these decisions
take the form of command, directions or, more gen-
erally, authority. This authority is what the firm (or
hierarchy) distinguishes from the market. The ex-
planation given by Coase for the fact that firms exist
lies in the fact that market transactions have a cer-
tain cost aspect, which might be reduced in a firm
(Pitelis, 1993).
Williamson (1975) extended Coases original ideas,
by developing a more precise framework in which
the term market costs was eventually replaced by
transaction costs. Transaction costs are all the costs
that are made for the delivery of some good or ser-
vice, except the actual production costs. This means
that all costs for finding the right supplier, negotiat-
ing about prices, creating contracts, and controllingthe execution of the contracts belong to transaction
costs. Some authors refer to co-ordination costs in
stead of transaction costs (Bakos & Brynjolfsson,
1993; Kay, 1993). According to Bakos and
Brynjolfsson: ...the cost of setting up a relationship,
search costs, and transaction costs, ... can be col-
lectively labelled: co-ordination costs (1998, p. 3).
It is however remarkable that they do not give a
clear description of what transaction costs actually
are. Apparently they are part of co-ordination costs,
because if search costs and the cost of setting up a
relationship are added to transaction costs, the en-
compassing term co-ordination costs is introduced.
Some scholars are clearer on this point. Kay (1993)
points out that the term transaction is rather ambig-
uous in Williamsons theory. He proposes to use
both the term co-ordination and transaction. He re-
lies heavily on the original ideas of Coase, citing:
within the firm ... in place of the complicated market
structure with exchange transactions is substituted
the entrepreneur - co-ordinator, who directs produc-
tion. It is clear that these are alternative methods of
co-ordinating production. (Coase, 1937, in Kay,
1993, p. 257). Kay further proposes to use the term
transaction costs for exchange relationships, and
co-ordination costs in other cases. It would then be
possible to study co-ordination cost economics, en-
compassing costs of organisation as well as ex-
change costs.
This critique is mainly aimed at the fact that William-
son sometimes uses transaction costs in the sense
of exchange costs in market and hierarchy situa-
tions. This means that Williamson sees transactionscost economics as a study of internal markets ver-
sus external markets, whether capital markets, la-
bour markets or intermediate product markets. Ac-
cording to Kay this is a distorted representation of
hierarchy (1993, p. 256). If Kay refers to the original
definitions that were given about hierarchies, where-
in authority plays an important role, he is right. If
authority is first given as the factor that distinguishes
markets from hierarchies, it is rather strange to sug-
gest that internal versus external markets form the
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difference. However, it seems like Kay means
something else by the distorted representation. In
his opinion, it is simply almost never the case that
internal markets exist. For now, we leave this dis-
cussion for what it is, and go on trying to explain
transaction cost theory. We will use the term trans-
action costs and co-ordination costs interchangea-
bly, focussing on the factors that are the cause of
transaction costs.
Transaction costs arise as the result of three human
and environmental factors (Williamson, 1975):
1. Bounded rationality: This means it is impossi-
ble to be sure that all information about a cer-
tain market is available. When one has to
choose for a certain supplier in a market, there
is always the chance that a better supplier ex-
ists, but was not found. Another situation could
be that it is sometimes impossible to decide
whether for example service, quality of goods,
or delivery speed is actually going to be satis-
fied by the supplier. This becomes even a big-
ger problem when the product information is
rather complex (Malone et al., 1987).
2. Opportunism: Suppliers will bargain for higher
prices than absolutely necessary, because
(they claim) they are the only one who can de-
liver the requested goods or services.
3. Asset specificity: Some goods are so depend-
ent on space and time that they will become
more expensive then expected. Agents will in-
vest in specific assets, which they tend to lock
into transactions by generating sunk costs and
thus high costs of exit. They will use this posi-
tion for bargaining. An example of asset speci-
ficity is site specificity. If a natural resource is
available at just one location and is only mov-
able at great cost, this natural resource can be
called site specific.
All these factors might lead to high transaction costs
in markets. In hierarchies however, these three fac-
tors play a less important role because a reduction
in the number of exchanges and the ability to use
authority to end prolonged disputes in a certain ex-
change. This does not mean that there are no
transaction costs at all in hierarchies, they are just
lower. However, if it the transaction costs in markets
become lower than in hierarchies, no more internali-
sation will occur (Williamson, 1975). One could for
example imagine a marketing department in search
of new customers that will become too expensive
compared to marketing agencies in the market.
Ciborra (1993) explains the existence of these two
organisational forms by making a distinction be-
tween goal congruence and product/service uncer-tainty. If both are low, markets appear, if both be-
come higher, markets will shift towards hierarchies.
Ciborra adds clans to the classical dichotomy as
the organisational form that appears when both fac-
tors become extremely high. Companies with clans
as the predominant form of organisation rely heavily
on agreements made between members of teams.
This means that they surpass the authoritative or-
ganisation principle that forms the basis of hierar-
chies. Clans will not be considered in this thesis.
Despite the vast amount of critique the transaction
cost approach has evoked, the theory has been
(and still is) often used for theorising as well as em-
pirical research in the field of organisational theory
and economics (Pitelis, 1993). This has not only
been concentrated on the market-hierarchy dichot-
omy, but also on the role of the state, the rationale
of international firms, the role of intermediaries in
the market, and the effects on organisations in the
information society (Malone, 1987; Pitelis, 1993).
2.2 INTERMEDIARIES AND TRANSACTION
COSTS
In some situations, markets are co-ordinated by so-
called market makers or intermediaries. These in-
termediaries are the main co-ordinators of the mar-
ket. They bring together sellers and buyers, serving
as sales channels or distribution channels.
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Transaction cost theory is often used in the explana-
tion of the role of intermediaries. Companies have to
choose whether to make or buy a certain channel
activity. In other words, they have to decide between
internalising channel activities within the organisa-
tional boundary or rely on the market (Sarkar, But-
ler, & Steinfield, 1993).
The, rather abstract, description of intermediaries
above is however not complete. They do not just co-
ordinate the market, by bringing demand and supply
together, they also create added value for different
parties in the process, by bearing some parts of the
transaction costs. Cutting these costs up in different
parts shows this.
Intermediary functions that benefit consumers in-
clude assistance in search and evaluation, needs
assessment and product matching, risk reduction,
and product distribution/delivery. Intermediary func-
tions that benefit the producers include creating and
disseminating product information, reducing expo-
sure to risk, and reducing costs of distribution
through transaction scale economies. Finally, pro-
ducer and consumer interests are often in conflict,
and intermediaries might balance and integrate the-
se interests (Sarkar et al., 1993).
We will now give a more detailed description of the-
se functions (after Sarkar et al., 1993).
Benefits for consumers:
Search and evaluation: A consumer choosing
between different sorts of intermediaries, actu-ally chooses between alternative search and
quality criteria. For example, choosing a de-
partment store over a speciality store repre-
sents a choice between two different quality
and search standards. The department store
has more variation, but overall less quality,
while the speciality store has less variation, but
(presumably) more quality.
Needs assessment and product matching: Cus-
tomers often do not know exactly what their
needs are. An intermediary might be helpful in
determining these needs. Examples are hard-
ware stores, who make it their task of providing
information about the products, but also about
the usefulness of the product for the customer.
Customer risk management: By providing con-
sumers with the option to return faulty products
or providing additional warranties, intermediar-
ies reduce the customers exposure to the risks
associated with producer error. Additionally, the
intermediary may further reduce the risk by
providing the option to return a product for anyreason at all. The intermediary thereby reduces
the risk of failure to identify needs accurately or
failure to match them with the characteristics of
different products.
Product distribution: Distribution is critical in
determining the value of consumer goods. It is
evident that certain products only have value if
they are close enough in the vicinity of the pur-
chaser.
Benefits for producers:
Product information dissemination: Intermediar-
ies inform consumers about existing products
and the appearance of new products. Produc-
ers rely on several intermediaries, like tradition-
al retail stores, catalogue and mail order hous-
es, advertising agencies, and media outlet to in-
form consumers. Sometimes the role as distrib-
utor and information provider are tightly linked,
as in traditional retail.
Purchase influence: Intermediaries have sever-
al means to influence consumers purchasing
behaviour. Some of these are: product place-
ment, biased advice, commission compensation
schemes, shelf space payments, and special
discounts.
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Provision of customer information: Intermediar-
ies are able to provide detailed information
about customers. There are even intermediar-
ies that have specialised themselves in collect-
ing and analysing customer information, like
market research firms. If producers can not get
any specific information about customers, the
aggregated sales numbers from the intermedi-
aries still is valuable information.
Producer risk management: The risk of con-
sumer fraud and theft can be lessened by the
use of intermediaries. Normally the intermediary
is exposed to the direct risks of fraud and theft.
Economies of scale: Finally intermediaries give
easy possibilities for economies of scale. Pro-
ducers in search of buyers for their products are
best off by turning to an intermediary that pro-
vides a big potential client base.
Integration of needs
Intermediaries deal with the problems that arise
when consumer interests conflict with those ofproducers. These tensions are very likely to
arise in almost all market situations. For exam-
ple, consumers are best off with complete, ob-
jective information about the products. Produc-
ers however, would prefer to influence the con-
sumers purchase decision, by working in a bi-
ased market. Intermediaries often determine
the balance between the consumers need for
information and the producers need for influ-
ence.
It should be noted that producers do not perform all
the functions that are beneficial for the consumer.
Being aware of this, lots of producers will use inter-
mediaries, not just for their own sake, but also for
the customer.
It is clear that significant (transaction) costs are as-
sociated with the functions described above. This
means that some of the transaction costs that exist
in a direct producerconsumer relationship are
transferred to the intermediary. The intermediary will
however make money from the margins he charges
to the consumers. Also, many intermediaries are in
the position to charge a fee to producers for their
services.
2.3 NETWORK ORGANISATIONS: MARKETS OR
HIERARCHIES?
It seems like the notion of virtual organisations has
been around for quite a while. Toffler (1980) already
struggled with the terminology that had to be applied
to this new organisational form. We do not yet have
a vocabulary for describing these organisations of
the future (p. 264), so he claims. Nowadays there
seems to be a number of interrelated terms for the-
se organisations: virtual organisation, network-
based forms of organisation or simply network-
organisation. These terms will be used interchange-
ably throughout this thesis.
Virtual organisations provide businesses with oppor-
tunities to enter new markets, gain strategic ad-
vantage and reduce transaction costs (OTA, 1994).
Additionally these organisations can benefit from
greater flexibility and responsiveness, stronger
managerial control, and reduced production costs
(Mowshowitz, 1997). What do these organisations
look like and how do they fall into the dichotomy of
markets and hierarchies, if at all?
Definitions of a virtual organisation include a basic
set of ideas: outsourced non-core competencies; a
focus on core strength/business; little or no physicalpresence or traditional infrastructure; a network of
business alliances; optimal use of human capital;
and a heavy reliance on ICT. Virtual organisations
have outsourced the physical and administrative
attributes of traditional business, and expanded and
combined intellectual activities such as problem
solving (Asteroff, 1998). Figure 1 shows how a vir-
tual organisation can be distinguished from a fully
integrated firm.
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It should be noted that companies that only do busi-
ness through the Internet, without having retail out-
lets, are not necessarily virtual organisations (like
Amazon or CDNow). These companies can have a
strong infrastructure, in-house Web hosting, invento-
ry stockpiles and a lack of an outsourcing strategy. It
is more appropriate to label these organisations as
internet-centric, because the Internet is their only
sales channel (Asteroff, 1998). To be able to trans-
fer old-fashioned transactions to the Internet, it is
necessary to capture the rules that the business
processes are build on. Only recently this trend has
gained attention and this will probably be one of the
main issues for future corporations who want to start
using the Internet for their transactions (Hurwitz
Group, 1997; Wentholt, 1998).
In Mowshowitz opinion, virtual organisations are
able to explore and track the abstract requirements
needed to realise some objective while simultane-
ously, but independently, investigating and specify-
ing the concrete means for satisfying the abstract
requirements (Mowshowitz, 1997, p. 33). He labels
the dynamic technique for accomplishing all this
switching. Switching is only possible when the core
firm has a pool of suppliers, designers, etc. to
choose from.
Castells (1997, p. 191) identifies five kinds of net-
works or virtual organisations:
Supplier networks: these include subcontract-
ing arrangements between a client (the focal
company) and its suppliers of intermediate
production inputs.
Producer networks: all co-operation arrange-
ments that enable competing producers to pool
their production capacities, financial and hu-
man resources in order to broaden their prod-
uct portfolios and geographic coverage.
Customer networks: forward linkages of manu-
facturing companies with distributors, market-
ing channels, value added resellers and end
users, either in major export markets or in do-
mestic markets.
Standard coalitions: are initiatives by potential
global standard setters with the explicit pur-
pose of locking-in as many firms as possible
into their propriety product or interface stand-
ards.
Technology co-operation networks: facilitate
the acquisition of product design and produc-
tion technology, enable joint production and
Management
Design
Marketing /Sales
Production
Supplies /Inventory
Firm
Management
Producers, Inc
Designers, Inc
Suppliers, Inc
Marketers/Distributor, Inc
Core Firm
Fully integrated firm Virtual organisation
Figure 1: Fully-integrated firm and virtual organisation (from OTA, 1994)
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process development, and permit generic sci-
entific knowledge and R&D to be shared.
Williamson does not describe network-based organ-
isations like listed above in his theory. Neither does
he provide a clear answer to the question whether
virtual organisations belong to markets or hierar-
chies. Some elaboration on his theory however,
gives us a clue where such organisations would fit
in. Transaction costs can be classified in those that
support co-ordination between buyers and sellers
(markets) and those supporting co-ordination within
the firm, or the industry value chain (hierarchies).
Looking at the different forms of networks above,
some of these networks look like markets, whileothers look more like hierarchies. The supplier and
the producer networks are more like markets, the
customer, and technology co-operation networks,
and the standard coalitions are more like hierar-
chies. Terms that could be used in this context to
identify these different forms of networks are: dy-
namic virtual organisations and static virtual organi-
sations. Naturally, the static organisation is more
like a hierarchy and the dynamic resembles a mar-
ket.
Because the authoritative component of hierarchies
is often absent in these networks, it is necessary to
see them as a special form of a hierarchy. But, fol-
lowing the logic of Ciborra (1993), there is high goal
congruence and the product/service is rather specif-
ic. All members in the network know, presumably,
what they are going to do together.
The supplier and producer networks tend to have a
somewhat large pool of potential partners. It is
therefore legitimate to place these organisations
more on the market side of the spectrum. It should
be noted, however, that at the moment that the large
pool exists, there is only the core firm. It is only
after the teaming up of different parties that the or-
ganisation starts behaving like one, for the outside
world. Trying to realise some objective during the
period of existence (Mowshowitz, 1997).
Network based forms of organisation depend heavi-
ly on modern ICT (OTA, 1994). In the next chapter
we will investigate some of the predictions made
about the role ICT plays in shaping economic reality.
This will be done by applying transaction cost theory
in the world of electronic interaction between pro-
ducers, consumers and intermediaries.
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3 T RANSACTION COSTS IN THE INFORMATION SOCIETY
Certainly all the things were seeing today electronic commerce, networked organisations, outsourcing moreand more things that arent your core competency all of this ... can perhaps be explained by the fact that infor-
mation technology is reducing the cost of co-ordination.
From an interview with Tom Malone (in IEEE Internet Computing, 1997, p. 12)
In an influential paper called: Electronic markets
and electronic hierarchies, the impact of information
and communication technology (ICT) on the devel-
opment of hierarchies and markets is discussed
(Malone et al., 1987). It is argued that transaction
costs will change, indeed become lower, in the in-
formation society. The reason for this is that all fac-
tors that form the core of the transaction cost theory
are altered by the use of ICT.
1. Bounded rationality will play a less important
role, because it becomes easier to gather and
analyse vast amounts of information. Due to
ICT the complexity of product descriptions can
be much higher. Before ICT, complex product
descriptions were partly the cause of bounded
rationality. In other words, what was complex
before is simple now (Malone et al., 1987).
2. Asset specificity will diminish, because flexible
manufacturing systems allow rapid changeover
of production lines from one product to anoth-
er. The locking in of assets in the transactionwill play a less important role (Malone et al.,
1987). An addition to this could be that infor-
mation will become a more important asset
and because of its relative independence of
time and space its asset specificity is lower
then traditional products and services.
Malone et al. do not state anything about opportun-
ism, but following their line of reasoning the effect of
ICT on opportunistic behaviour might be stated as
follows:
3. Opportunism will be difficult to maintain as ICT
makes it possible to search for more suppliers
and it will be easier to compare different sup-
pliers and their terms. Bargaining power of dif-
ferent parties will be undermined and knowing
this their opportunism can not be as big as it
was before the occurrence of ICT.
If these predictions are true, it can be concluded that
in the future, markets will have an advantage in the
electronic world above hierarchies. Malone and col-
leagues state: the overall effect of this technology
will be to increase the proportion of economic activi-
ty co-ordinated by markets (Malone et al., 1987, p.
489).
This effect is further strengthened by two other de-
velopments: the electronic brokerage effect and the
electronic integration effect (Malone et al., 1987).
Electronic integration happens when different par-
ties integrate their databases with product infor-
mation, price, lead times etc. This will make tighter
coupling of these parties possible with fewer errors
in production and more flexible ways of production.
This electronic integration effect will occur more
often in hierarchies than in markets.
The other effect, electronic brokerage, will occur
solely in markets. Here the electronic market in itself
will provide the functions that a broker in a normal
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market does. Through the electronic market it will be
possible to contact many potential buyers and sup-
pliers. The system that is used for this will also help
in matching the different parties with each other. In
short it will:
1. increase the number of alternatives that can be
considered,
2. increase the quality of the alternative eventual-
ly selected, and
3. decrease the cost of the entire product selec-
tion process.
There are two predictions that follow from these
three arguments that will be further explored. The
first prediction is that in the electronic market, there
is no place for intermediaries. The second predic-
tion is that the relative amount of hierarchies will
decrease in favour of markets. We will start with
investigating the second assumption. After that the
role of intermediaries in the electronic world will be
further analysed.
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4 T HE OPTIMAL NUMBER OF SUPPLIERS
... most existing businesses must walk a fine line on the Net. They risk upsetting partnerships with distributorsand retailers. Conflict with an existing sales channel was the biggest impediment to selling online cited by re-
spondents to a recent ... poll.
Business Week, 11-06-1998
Theories about the optimal number of suppliers de-
liver an argument in favour of the opinion that ICT
will not automatically lead to more market like situa-
tions, as predicted by Malone et al. (1987). Bakos
and Brynjolfsson (1993) most extensively describe
this idea. The following line of thought is mostly
based on their observations. As stated before,
Malone et al. (1987) believe that the impact of IT in
business will be a reduction of co-ordination costs,
with more market like arrangements as a conse-
quence. There is however a limit to the number of
different suppliers a buyer firm might consider.
The optimal number of suppliers is determined by
trading off the cost of further searches against the
expected benefit from identifying a better supplier.
Better in this sense means that the supplier has a
competitive price, offers a better product, or more
generally has a better fit. When there are only a
few suppliers, the co-ordination costs are quite low,
but the costs of a bad fit are extremely high. The
more companies that are added to the number of
potential suppliers, the higher the co-ordination
costs become but the lower the costs of a bad fit.
This latter effect is explained by the fact in the large
pool of suppliers there is much more chance that a
good fit will exist. The sum of the co-ordination
costs and the cost of bad fit will determine the op-
timal number of suppliers. When co-ordination costsbecome lower, the optimal number of suppliers will
increase (see Figure 2).
0
2
4
6
8
10
12
14
1 2 3 4 5 6 7 8 9 10 11 12 13
number of suppliers
costfo
rthefirm
costs of bad fit, t(x)
total costs, t(0)
co-ord costs, t(0)
co-ord costs, t(1)
t(0) : before ICT
t(1) : after ICT
total costs, t(1)
Figure 2: The optimal number of suppliers when co-ordination costs become lower
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CONTRACTIBLE NON-CONTRACTIBLE
SPECIFIC Many Few
NON-SPECIFIC Many Many
Table 1: Investment characteristics and number
of suppliers
Despite this compelling economic argumentation
which leads to the conclusion that reducing co-
ordination costs through ICT leads to more suppli-
ers, or market like situations, there are some argu-
ments which might lead to a contradictory conclu-
sion. To explain this we must concentrate on other
factors beside the co-ordination costs. It seems that
the use of ICT also has impact on the bargaining
power of potential suppliers. As ICT makes it easier
to integrate the processes of suppliers with buyers,
the relationships that are formed between the differ-
ent parties can be stronger then they were in the
past. Suppliers will have to invest in these relation-
ships by making specific non-contractible invest-
ments. Specific in the sense that these investments
can only be used in the relationship with this particu-
lar buyer and non-contractible in the sense that a
third party (like a court) will not be able to judge
whether the investments that were done are suffi-
cient. Buyers are forced to provide their suppliers
with incentives to make these kinds of investments.
If a buyer decides that it will use the maximum num-
ber of suppliers for its needs, it is clear that, from the
suppliers point of view, it has no use to put effort in
the relationship-specific non-contractible invest-
ments.
It is easily understood that when the buyer firm de-
creases its pool of suppliers, the remaining suppliers
have more bargaining power then when the number
of suppliers is very large. This bargaining power can
lead to more incentives to make non-contractible
investments. These investments will compensate for
the reduced bargaining power of the buyer firm.
Specific non-contractible investments are often as-
sociated with ICT. An example of this could be a
parts manufacturer for an aeroplane constructor.
The parts manufacturer will not be motivated to in-
vest in ICT to integrate with the constructor if the
constructor has many manufacturers to choose
from. However, if the investments are contractible
this situation will not appear, because every parts
manufacturer that exists can then make the invest-
ments.
Summarising it is clear that buyers require their
suppliers to make investments in their relationships.
If the suppliers can use these investments in a later
stage with other buyers, the investments are non-
specific and if they can be contractually specified,
the buyer can determine the optimal number of sup-
pliers by considerations like economies of scale. If
ICT decreases the co-ordination costs, a potentially
large number of suppliers can be used. If, however
the investments made by the supplier have to be
specific and are non-contractible, it makes more
sense to use a small number of suppliers, otherwise
none of them will be motivated to make the invest-
ments. These arguments are summarised Table 1
and provide a clear argumentation why ICT will not
just increase the number of suppliers (a market situ-
ation) but will also decrease their number in certain
situations (a hierarchy situation).
Bakos and Brynjolfsson (1993) have clearly shown
that the current developments in ICT might some-
times lead to more market like situations and some-
times to more hierarchy like situations in the elec-
tronic marketplace. The assumption has been that
co-ordination costs will decrease. If this assumption
is left for a moment, another scheme unfolds. If the
transaction cost increase in the electronic market-
place, for example due to globalisation, the trend
towards fewer suppliers can also be expected. This
is however not very likely so we will leave that situa-
tion out of our considerations here.
Other arguments against the idea that firms will use
an unlimited supply of companies in their relation-
ships can be deduced from theories about virtual
organisations. Mowshowitz (1997) notes that too
much switching can lead to excessive costs. Fur-
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thermore, extensive use of switching may create an
image problem for virtual organisations. Companies
also risk upsetting partnerships with distributors and
retailers (Business Week, 11-06-1998). To maintain
the appearance of consistency and reliability for
their partners, virtual organisations must create the
illusion of permanence. Stiles (1997) also warns for
the different relationship that will develop between
producers and customers. The informational ad-
vantage that manufacturers and vendors had over
customers is diminished. Customers will become
well informed, also about other players in the mar-
ket. Therefore the selling company should heavily
invest in client-binding and image creation.
Summarising, there are three main reasons why
firms limit the pools of suppliers, clients, etc. they
choose from:
1. It is not beneficial for relationships with part-
ners to undermine their bargaining power.
2. Excessive switching will cost too many re-
sources.
3. Excessive switching can create a negative im-
age for the outside world.
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5 T HE ROLE OF THE INTERMEDIARY
The Net is starting a slow sweep of change through the workplace, rebuilding the order of things, creating wholenew middlemen, forcing changes on others, and leaving some behind. At the end of the day, you end up with
more intermediaries, not fewer.
Paul Saffo, director of the Menlo Park Institute for the Future (Business Week, 1998)
Both the electronic brokerage and the electronic
integration effect leave little place in economic
reality for intermediaries. Until now not much
attention has been paid by the different authors
to intermediaries. They do however form a large
proportion of economic life. There are essential-
ly two opposing views about intermediaries in
the electronic future. In the first view it is argued
that the electronic brokerage effect will cause
many producers to outsource functions they do not
wish to execute themselves. In this case, the num-
ber of intermediaries is likely to increase. If however,
ICT will be used to link directly to customers, therole of the intermediary seems redundant and they
will disappear from economic life (Stiles, 1997;
Sarkar, Butler, & Steinfield, 1993).
To solve this paradox it might be necessary to look
more closely at the possible scenarios. Table 2
summarises four possibilities, instead of the two
predicted above. These scenarios start with two
assumptions, one in which the use of intermediaries
without ICT is cheaper than direct producer-
consumer links. In the other situation direct links
with consumers are more profitable than the use of
intermediaries. After the emergence of networks and
ICT, two things can happen. Direct links may be-
come cheaper or the use of intermediaries may be-
come cheaper. Quadrant 1 and 4 are stay the
same scenarios in which the existing organisation
of the market is strengthened by ICT. Quadrant 2
and 3 are more interesting, the former showing how
intermediaries might disappear and the latter show-
ing how a new brand of intermediaries might ap-
pear, so-called cybermediaries (Sarkar et al., 1993).
This reasoning is purely based on cost aspects of
certain relationships. However, we have seen that
the added value of the intermediary is very big. It
was noted that producers have good reasons to use
intermediaries, most importantly the mediating role
they play between consumers interest in objective
information and the producers interest in manipula-
tion. It could even be argued that some of the roles
that are performed by the intermediaries are exactly
the specific non-contractible investments that were
identified in the discussion about the optimal num-
ber of suppliers.
Due to ICT some producers might easily perform
some of the intermediary functions themselves.
However, it is more likely they will use ICT to differ-
entiate their products, reach new customers, offer
new services, and improve relationships with their
customers. The truth will probably be that producing
firms will use ICT to use more outsourcing and sim-
T1T2+T3
T1T2+T3:(ICT) 3. Cybermediarieswill appear
4. Intermediariesstay with ICTusage
Table 2: Transaction costs between producers and con-
sumers (T1); producers and intermediaries (T2); interme-
diaries and consumers (T3), with and without ICT
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ultaneously establishing electronic presence to the
end consumer. The innovative intermediary will use
this development to couple the different electronical-
ly present producers in one package for the end
consumer.
A good example of such a new intermediary is Car-
Point (www.carpoint.com). The site offers an attrac-
tive interface with options for learning about new
and used cars from different manufacturers. It lists
cars for sale and there are possibilities for soliciting
a bid electronically from a car dealer. CarPoint
makes money by charging dealers about $1600
(monthly) to get their inventories listed. The site
offers possibilities for comparisons between differentcars from different manufacturers. This is really
added value, because you could never get a Mer-
cedes dealer to explain (objectively) the different
characteristics of a Mercedes with a BMW, or any
other brand (Fortune, 1998).
Next to the added value the intermediaries deliver,
there is yet another argument in favour of keeping
the intermediary. The power of intermediaries, often
stemming form their current direct relationship to
end consumers, may force producers to abandon
efforts to fully bypass intermediaries for fear of retal-
iation (Sarkar et al., 1993). This problem might be a
transition problem, because at the moment only a
small number of customers use ICT to buy goods
and services. If an bypassed intermediary retaliates,
it will no longer deliver the goods to the rest of the
consumers, but rather switch to an alternative pro-
ducer.
An example of what can happen if the intermediary
is cut out of the sales process is Apple Computers.
After the enormous success of direct sales through
the Internet by Dell, Apple decided to also start sell-
ing their products through this medium. In the be-
ginning there were big successes, the company
claimed. There is however a drawback. The, limited
amount, of resellers that still sold Apple computers
next to PCs became even smaller than it was. This
might turn out very badly for Apple. The few sup-
porters left of their system will now also decide to
stop selling these machines, because the customer
can do business with Apple directly. This will lead to
the situation wherein new computer buyers come to
the stores to get informed about computers, but will
never see an Apple computer. In this scenario, the
only users that will be left is the old customer base
on which Apple has to depend for the coming years.
It is clear that when no new customers enter the
Apple community, this community is going to shrink,
maybe until there is nothing left.
A final example that explains the important role of
the intermediary is provided in a personal interviewwith the one of the owners of a Dutch travel organi-
sation called Ocean Wide. This organisation organ-
ises trips on boats in the arctic regions. One of the
founders of the organisation is now trying to figure
out whether it would be more profitable to start with
direct sales to customers. Doing this, the 18%
commission travel agencies get from Ocean Wide
can be saved. However, the travel agencies job is
not just selling the trips. They also arrange the ac-
commodation of the passengers and the flights to
the nearest harbour. All these things will have to be
arranged by the people from Ocean Wide them-
selves if they start relying on direct sales. According
to the founder that is not very practical because
'...we dont know anything about flights or hotels.
And whats more, the travel agencies get enormous
discounts, because they generate a lot of flights.
They can probably offer a whole package, including
the trip, transportation and accommodation, cheaper
than we ever could. Letting the customers arrange
their own transportation and accommodation is also
not an option. If you go on a trip in the arctic re-
gions, you want everything arranged for you. This is
true, even when customers can get easy access to
all this kind of information, through ICT, they proba-
bly still want a full package. If Ocean Wide itself
gathered all the information about flights and hotels
through ICT, they still would not have the intermedi-
aries benefit of discounts on flights.
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I once measured the amount of time I spent on di-
rect sales, which we do sometimes in the Nether-
lands, and the sales arranged through agencies. It
proved that 30% of the trips that were booked in the
Netherlands consumed as much as 70% of my time.
The other 70% of the trips were booked through
intermediaries and that only consumed 30% of my
time. I imagine what would have happened if I could
have used the 70% time spent with direct sales on
finding new intermediaries. This man also explained
that the intermediaries very often provided infor-
mation about trends and wishes of customers. If
they say there are about 20 potential clients who
want to visit the south of Greenland, we change our
schedules to get those 20 people on our ship.
So it can be concluded that, even when intermediar-
ies charge a commission, their added value is often
so big that it would be unwise to bypass them. Even
when ICT makes it possible to set up a cheap direct
sales system, a lot of the intermediaries advantages
disappear.
5.1 ELECTRONIC MARKETS THROUGH
INTERMEDIARIES
Whether or not companies will start using intermedi-
aries, or will cut them out of their processes is prob-
ably dependent on a few factors. As we have seen
in the previous paragraphs, disintermediation can
have adverse effects, for example if the previously
used intermediaries were very committed to the
product. Car dealers did not use intermediaries be-
fore, but now that Carpoint and other likewise sites
have been created, they can do nothing but start
using these intermediaries. The examples have
shown that there are not only economic reasons
behind decisions about intermediaries, but also
things like loyalty and providing information play an
important role.
In our opinion the conditions that lead to different
outcomes: yes or no intermediaries and yes or no
electronic markets, depend in some part on the dis-
tinction between business-to-business relationships
and business-to-consumer relationships.
The number of business-to-business relationships
proved to be limited by several reasons: switching
may become too expensive, create a negative im-
age and undermine bargaining power. This is not
changing due to ICT, so the prediction by Malone et
al. that more and more market like relationships will
evolve is quite dubious. So in the business-to-
business case it is logical that businesses will stick
to a limited number of suppliers to fulfil their needs.
This will especially be true if there are specific and
non-contractible arrangements involved. One could
for instance imagine a group of companies workingtogether for several generations. The loyalty in-
volved will create an atmosphere wherein it will be-
come almost impossible to switch to a (electronic)
market situation. These kinds of issues are typically
non-contractible. However, if this is not the case, the
number of suppliers will only be limited to the costs
of switching, and the appearance for the outside
world. Again this does not necessarily leave us with
an increasing proportion of markets. This is howev-
er, where the intermediary might step in. If compa-
nies do want to use a very large pool of potential
partners, switching costs and outside appearance
will become important issues. It might then become
necessary to outsource the switching to specialised
intermediaries who know the market. Because the
intermediary can deliver these kinds of services to
several companies in search for the same products
or services, they can lower the costs needed for
searching, contracting, and switching considerably.
The intermediary can serve as the communication
portal, and thus a consistent picture is held up for
the outside world.
For business-to-consumer relationships, other as-
pects play a role. In the world before ICT, customers
are very much used to the role of intermediaries.
This will make it easy for electronic intermediaries to
create a market. On the other hand, companies, like
Apple, are aware of the possibilities that ICT has for
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dealing directly with end-consumers. This will some-
times make sense, usually in areas where there are
not many competitors. If there is an enormous
amount of companies trying to sell the same kind of
products through direct channels with the consum-
ers, it is clear they can not get a big part of the mar-
ket if they do not make use of channels that know
the customer (intermediaries again). It will be easier
for these intermediaries to attract a considerable
proportion of the market. The selling companies will
have to compete with prices and quality to get a
positive ranking from the market maker. Another
option, but for the customer not positive, is that the
intermediaries become biased, by bribing or other
means. They will then promote a certain member of
their pool more than others. If this happens very
frequently, the state may intervene, or alternative
unbiased channels will appear.
These considerations lead to the conclusion that if
there are markets to appear they will usually be
created by market makers or intermediaries. It is
simply too much trouble to search globally for inter-
esting partners. This is true for the business-to-
business situation and for the business-to-consumer
situation. A consumer would not take the trouble,
when buying a new PC, to start comparing different
kinds of hard disk vendors, chip vendors, video card
vendors, etc. It is more likely he/she will go to one
point where all this information is gathered. The
same reasoning applies the other way around. A
hard disk vendor will not try to create a considerable
market through its own direct sales channel, but will
depend on others to do this for him/her.
5.2 PREDICTIONS FOR ELECTRONIC MARKETS
The distinction between business-to-business rela-
tions and business-to-customers relations is also
recognised by Forrester research. They claim that:
... businesses are ahead of consumers in embrac-
ing the Internet. Even the slow-growing business
markets are bigger than fast-growing consumer sec-
tors. (Business Week, 11-06-1998).
For business purchases through the Internet, they
predict that early adopters will probably spent
around $200 billion in the year 2001. Early adopters
are found in the area of durable goods, like high-
tech hardware and computers, and in the area of
wholesaling office supplies, electronic goods, and
scientific equipment.
Later adopters might be the service industry and
transportation. Services like doctors, lawyers, and
accountants will slowly adopt e-commerce, because
they generally provide their services in person. It is
predicted that the sales by 2001 will be around $19
billion. The transportation sector is often already
committed to EDI, so Internet sales might only be$300 million.
Consumer purchases are maybe quite a bit lower.
Early adopters like travel, computer hard- and soft-
ware and books, music, and entertainment might
only be worth $16 billion. Half of this for travel, and
the other half equally divided by the other industries.
It is expected that flyers will increasingly browse the
Internet for bargain sales. The computer hard- and
software is an ideal sector for e-commerce. Buyers
know how to use the Internet, and there is no need
to sniff, squeeze, or try on merchandise. Online
sales of books, music, and entertainment may raise
total spending in stead of decreasing sales from
brick-and-mortar merchants.
Later adoption is expected for housing, food, and
services for consumers. The Internet is a great
place to browse for houses, apartments, and mort-
gage loans, but transactions are still being done the
old-fashioned way. Predictions for food and bever-
age sales through electronic channels in 2001 are
low ($460 million). Supermarkets do not have to fear
for their business. Health care is still a face-to-face
business. The same is true for most other services,
except computer fixes and updates, which are an
online natural (Business Week, 11-06-1998).
These numbers do not give an indication about the
relative proportion of markets and hierarchies, nor
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do they make a case for the intermediary. What they
do indicate is some developments that were ex-
pected, namely a lot of business going on through
electronic channels, are indeed happening. It also
gives an indication about the relative proportion of
business-to-business and business-to-consumer
sales that are expected. Intermediaries can use
predictions like these to search for a market they
think will be interesting for them.
Remarkably, the predictions for business-to-
consumer sales are very low. This might be caused
by several factors. One of the main reasons could
be that the number of end consumers on the Inter-
net is not as high as the number of businesses. An-other explanation could be that the consumers that
are on-line are still so used to the traditional chan-
nels that they do not change easily. It might also be
that the electronic channels that are available are
still too fragmented. In that case, it can be expected
that electronic intermediaries, who bring some of
these channels together, might generate much more
sales then is predicted now.
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6 T HE ROLE OF NON - SPECIF IC ASSETS
While higher levels of knowledge may normally result in higher levels of output per unit of input, it is the pursuit ofknowledge and information that characterises the technological production function under informationalism.
Manuel Castells in The rise of the network society (1997, p. 17)
In the previous two chapters the concepts bounded
rationality and opportunism were used to give an
account of how developments in ICT do not neces-
sarily lead to more market like situations, as predict-
ed by Malone et al. (1987). There is however one
factor of their argumentation that has been left out of
the discussion, namely asset specificity. It was ex-
plained that asset specificity is an important factor
that could drive transaction costs up. However, this
basic assumption of transaction cost theory has met
considerable critique.
Shortly, this critique states that assets that are non-
specific are much more difficult to protect in terms of
patents and property rights (Kay, 1993). This strug-
gle for protection of the non-specific asset will drive
the transaction costs up. It is therefor logical to cre-
ate hierarchies in cases where assets are highly
non-specific. This in contradiction to the argument
by Williamson that asset specificity (with bounded
rationality and opportunism) will lead to changes
from a market situation to a hierarchy. He claims
that if asset specificity is absent in contractual situa-
tions, then discrete market contracting is unprob-
lematic, thus non-specific assets are more likely in
markets.
An example (after Kay, 1993, p. 249): If knowledge
leaks from firm A to firm B, and firm B uses this
knowledge to improve its competitive position, firm A
is clearly put at a disadvantage. These problems for
firm A are a consequence of the fact that this asset
is, and can not be specialised by use or user. Pa-
tenting may be ineffective in protecting the intellec-
tual property rights of an innovation. Firm A might try
to license the knowledge, but the licensing contract
may incur significant transaction costs for the licen-
sor (firm A), due to the absence of asset specificity.
Another, obvious, solution for firm A could be the
internalisation of the transaction. In other words,
creating a hierarchy like relationship, one way or the
other, with firm B. This relationship could for exam-
ple take the form of a technology co-operation net-
work, as described by Castells (1997).
This critique on Williamson is interesting, because
the arguments made by Malone et al. also depend
partly on the role of asset specificity. If in some cas-
es asset unspecificity leads to forming of hierar-
chies, the argumentation used by Malone et al. that
ICT decreases asset specificity might lead to a
complete other conclusion. The role of decreasing
asset specificity is not used for forming markets, but
for forming hierarchies.
The question remains whether asset specificity will
indeed decrease due to the use of and the devel-
opments in ICT. In our opinion this is indeed thecase. Examples like the one given in this chapter
may be easy to find. The importance of knowledge
and information as an economic commodity in-
creases as many scholars have shown (Toffler,
1980; Castells, 1997). The appearance of words like
knowledge worker, knowledge management, infor-
mation brokers, and knowledge assets are also
quite indicative.
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7 D ISCUSSION
Experts see a big role for sites that bring together buyers and sellers and provide value by offering trusted ad-vice, personal service, or other benefits. This ... is the start of the third wave of Internet commerce: not just saving
money, not just selling existing products online, but generating new wealth.
Business Week, June 11, 1998
The predictions made by Malone et al. were purely
based on economical reasons. However, it appears
that purely economical reasoning can lead to con-
clusions that can be totally contradicted when other
than economical aspects are also taken into ac-
count. This was seen in two situations. The first sit-
uation was the conclusion that could be drawn from
decreasing co-ordination costs. This would automat-
ically lead to possibilities for more suppliers. If how-
ever the bargaining power of these suppliers was
also taken into account, it became clear that too
many suppliers is not an option. Another argument
in this context had to do with the reliability of a firmfor the outside world. This reliability can be nega-
tively influenced when firms decide to switch often
and rapidly between suppliers and client groups. A
final economical argument was that excessive
switching between different suppliers could lead to a
big increase in costs.
Another interesting fact was that decreasing costs of
communication could explain the disappearance of
intermediaries in the electronic market place. If
however other than purely economic roles of inter-
mediaries were added in the argumentation, it
proved that there certainly are aspects of intermedi-
aries that make them essential. The intermediary
delivers services to the consumer and the producer
and might balance the conflicting interest these two
parties often have. The success of electronic inter-
mediaries is proven on the Internet. They range
from portals to the web (Yahoo, a search engine) to
creators of new niche markets (FastParts, couples
parties in search of mechanical parts). Some try to
work like consumer magnets, drawing buyers with
useful info or services and steering them to manu-
facturers and service providers, in return for a fee,
or a cut of the transaction (Business Week, 11-06-
1998).
Looking back at the predictions made by Malone et
al. in 1987, it looks like these predictions were not
correct. The markets situations they envisioned did
sometimes develop due to ICT, but this happens
most of the time through intermediaries. However,
there was no place for these intermediaries in their
argumentation, they assumed direct contact be-
tween producers and consumers through shared
database systems. Nonetheless, their argumenta-
tion provided a good framework for investigating the
role of ICT on (electronic) markets, hierarchies and
intermediaries. And, whats more, the world of elec-
tronic businesses is still developing. More and more
people are getting access to the Internet and com-
panies that previously were afraid that the electronic
market was too small, may very well change their
opinion in the near future.
Unfortunately, no predictions were made about the
number of markets and hierarchies, or even the
exact amount of the relative proportion. Future re-
search in this area should try to concentrate on ex-
act numbers and bring some quantitative data in the
dispute. Limited to the world of ICT, it would be in-
forming to see how many organisations use inter-
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mediaries for their sales process, how many suppli-
ers are chosen, how many companies are normally
served by an intermediary, and of course how many
intermediaries there are. This will undoubtedly raise
questions about exact definitions about what an
intermediary is exactly, as well as the other terms
that are used in the dispute. For example, one of the
issues could be whether or not the telecommunica-
tion provider can be seen as an intermediary.
The question that was posed in the beginning of this
thesis was: How does ICT influence the co-
ordination mechanisms in the economy? Of course
there is not one answer to a general question like
this. However, it proved possible to investigate thematter in some detail. Hopefully this kind of research
will be continued in the future, preferably with some
quantitative data.
A final suggestion for further research has to do with
the different roles of intermediaries. There were
several benefits for the consumer as well as the
producer when they used an intermediary. It would
be interesting to investigate how the different func-
tions of intermediaries are separately influenced. It
could very well be that some of the functions will be
more influenced by ICT than others.
Concluding the idea that there is no place for inter-
mediaries in the electronic world is strongly contra-
dicted by the arguments delivered in this thesis.
Purely economic reasons were not enough to ex-
plain the effects that ICT might have on the number
of intermediaries. The same was true for the devel-
opment of electronic markets at the expense of hi-
erarchies. There are very good reasons for compa-
nies to limit the number of suppliers and thus the
prediction that all will be markets in the future
proved false.
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