Organizational Restructuring - Information and Disintermediation

With information being instantly, constantly and ubiquitously available, buyers and sellers no longer need the intermediary to perform vital functions characterizing successful markets: matching and secure contract enforcement.

Prior to the Internet age, the central feature of markets were intermediaries who had links with buyers and sellers. When trades are conducted through these intermediaries, not only are direct links important, but also the pattern of links. These patterns determine who trades with whom and at what price. A trader cannot conduct business with an unconnected buyer, who may nevertheless link with sellers, but through other traders. For example, in Fig. 1.1(g), Trader G is connected to only a single buyer, C, but three sellers, and therefore can only trade with buyers B and D via trader A. The reverse also holds: if traders are connected with a single seller and multiple buyers, they can sell only what is purchased from this single seller. The local coffee shop can only sell Starbucks’ branded coffee, if it is associated with the chain.

In order to make a profit, a trader must be critical to the trading path. Therefore, if any trader has a critical link to a buyer or seller, such that dissolving this link would eliminate the trade entirely, then that trader would earn positive profits. In Fig. 1.1(g), buyer B can only buy via trader A and seller J can only sell via trader G, allowing both A and G to earn monopoly profits. However, if a seller or buyer is linked to multiple traders, the seller or buyer, respectively, will retain most of the surplus since they can bargain for the best price. This is the case with buyer C who can negotiate a better price due to links with both traders A and G.4 Disintermediation occurs when a link develops directly between buyer C and seller K, thereby eliminating the trader.

Ordinarily, common interests, common friends and common institutions foster connections between individuals. In the network economy, ease of connectivity itself enables information exchange through these links. For example, a single comment on Yelp could generate a connection between a reviewer of a restaurant and a recent diner, who may disagree with the review and connect directly with the reviewer. This reviewer may be the owner of another restaurant, so this interaction is the key that unlocks connections between these two individuals, who may exist in different parts of the network. The restaurant owner (seller) and diner (buyer) are now linked, with the possibility of trade opening up. This seller may present a product to this buyer who had no previous demand for the good - the new link creates awareness of the possibilities of new consumption or dining experiences and a transaction may be consummated. Buyer and seller are directly connected without an intermediary or restaurant critic.

What is the mechanism at work in this example? It is one that has been in existence since ancient times - word of mouth (WOM). This was an operative feature of most markets until the number of buyers and sellers became uncountable and no common ground existed across all market participants. The intermediary-trader was created to fill just such a structural hole or gulf between individuals wishing to trade.

Virtual WOM has been revived in the network economy through the mechanism of reviews, ratings, user feedback and social media, which provides relevant product and market information, as well as powerful contract enforcement.5 Information passing along the links of the network economy has not only eliminated intermediaries but also opened up the possibility of new connections, as we saw in the restaurant example above. Recall that we described informative prices as being the defining feature of a competitive economy. Now, the Internet economy, where information is delivered via virtual WOM, is a competitive economy. The information contained in prices is public information, but now, so is private information, which is delivered voluntarily. Voluntary sharing of information via WOM widens the reach of private information.

Differences in preferences, endowments and private information motivate exchange and buyers and sellers need to have trust in their counterparty that contractual commitments will be fulfilled. Reputation, based on crowd-sourced reviews and ratings, is the single most robust approach to creating this trust. In the virtual world, reviews and ratings become powerful WOM enforcement devices due to their ability to become instantly and ubiquitously available. Their effectiveness is due to the fact that with repeat interactions in virtual space, the most egregious punishment is that of ostracism. Avinash Dixit explains:

Private governance by social groups or industry associations can have advantages of information and expertise, and can use them for arbitration of disputes that the state’s courts would find too complex to interpret and adjudicate. These private forums of governance also have at their disposal quite dire punishments for members who violate the norm or code of conduct; they can ostracize the person, or drive him out of business. [33]

And Douglass North traces the origins of self-enforcement to the system of feudalism in the Middle Ages:

[While] a variety of courts handled commercial disputes, it is the development of enforcement mechanisms by merchants themselves that is significant. Enforceability appears to have had its beginnings in the development of internal codes of conduct in fraternal orders of guild merchants; those who did not live up to them were threatened with ostracism. [34]

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