Pricing and other business strategies for e-Procurement platforms Preliminary

This chapter discusses pricing and other types of business practices by e-Procurement platforms such as offering free services, or bundling, from the perspective of the new economic literature on two-sided markets. This literature focuses on situations where a platform offer services involving externalities between two (or more) sides of the markets, which can be at the participation level or the usage level. Platforms need to attract both sides and to coordinate their behavior. In this context, competitive prices depart from costs, and involve cross-subsidies. This chapter presents insight derived from the literature on the pattern of this departure from “marginal cost pricing”, both in terms of tariffs charged to each sides, and in terms of the balance between subscription fees and transaction fees. It then discusses non-price instruments and incentive issues in the context of platforms. Introduction The pace of innovation in information and communication technologies over the last decades had a dramatic impact for the organization of industries. Traditional vertical relationships are now challenged by new forms of electronic intermediation proposed by emarketplaces, exploiting the possibilities offered by Internet. Foreseen improvements in reliability, security and process innovation open the prospect for a complete reshaping of supply chain management via e-commerce. According to the European e-Business Report (eBusiness W@tch), in 2004 and based on the 5 largest EU countries, 23% of firms were buying more than 5% of their supply on-line. 11 % of the firms where using some e-marketplace for procurement with leading figures for ICT, transport equipment, chemicals or electronics. Beyond these figures lies a huge diversity of situations with services ranging from simple search and matching services to fully integrated supply chain management. For instance eMarket Services (www.emarketservices.com) describes an e-marketplaces as "an aggregation of information portals, trading exchanges and collaboration tools". This diversity comes along with an equally large attrition rates, highlighting the "winners-take-it-all" nature of the electronic intermediation activities. While there is a high rate of entry, few remains after some years, and the collapse of the Internet bubble reminds to all that profitability may not be at the initially expected level. To some extent these changes can be tracked back to a drastic change in the cost structure of intermediation, with a huge reduction in the variables costs of information processing. The reduction in costs comes along with a reduction in prices and an increase in the relative importance of scale economies as a driving force for market evolution. This evolution of cost cannot explain alone however the key features of the markets for electronic intermediation. A second consequence of the reduction in information processing costs and of the increase in the ability to manage complex systems is that it has created new scopes for interaction. In particular e-procurement allows to eliminate some bilateral relationships between buyers and the intermediary, or suppliers and the intermediary, and to replace them by electronically assisted direct negotiations between buyers and suppliers, in a new mix exploiting the best of intermediation and of direct vertical relationships. This highlights the role of the service as a communication platform as opposed to buy and resale services. Indeed most platforms attempt to shape the design of the service to improve the quality of interactions between participants. Increased interactions between buyers and suppliers on e-marketplaces raise the importance of externalities between users of the service to such a level that it becomes crucial for success to understand their role. Indeed the value of communication being the joint outcome of the parties involved, each participant will care about the behaviour of the other potential participants. While this remark is trivial for system designers, it is also of great relevance for economic dimensions such as pricing. The reason is that, as prices affect the behaviour of economic agents, there is a potential for using them to induce efficient usage of the service. New marketplaces then design complex pricing schemes with different prices targeted to different activities (membership fees, transaction fees, options.) or different actors (buyers, suppliers, advertisers, privileged buyer,.). Moreover they also rely on non-price instruments such as free services, gifts. Two-sided markets and e-Procurement These market developments has bring to the forefront of research in economics the analysis of intermediation services such as e-procurement, auction houses, matching services. These services are part of a broader range of activities that economists include in the concept of two-sided platforms. To build on a definition that I used in another paper, the concept refers to "situations where one or several competing platforms provide services that are used by two types of partners to interact and operate an exchange". This includes eprocurement platforms, but also activities as diverse as exchanges, credit cards, shopping malls, dating agencies or operating systems. They all have in common that one can identify two sides of the markets, that the value creation requires the two sides and that each side can receive a specific treatment. This new perception of the nature of the business is clear from the following statement by Jeff Bezos (CEO, Amazon.com): 3 "Ultimately we're an information broker. On the left side we have lots of products; on the right side we have lots of customers. We're in the middle making the connections. The consequence is that we have two sets of customers: consumers looking for books and publishers looking for consumers. Readers find books or books find readers. " While there remains much to understand about these markets, which all have their specificity, some recent progress has been made by economists in their understanding of their two-sided nature, in particular concerning pricing strategies and efficiency, as well as some other aspects such as bundling, vertical integration and anti-trust issues. The object of this chapter is to present some of these results and their implications. Launching a successful e-procurement service requires to solve the classical chicken and egg problem. A downstream firm will be willing to rely on the service for its supplies only if it is confident that it will find an adequate offer. On the other hand securing the offer requires convincing suppliers that their investment in the relationship with the platform will meet adequate demand for their products. The key difficulty is then to start the process, to get one side "on board". This calls for specific pricing strategies that differ from strategies followed in more conventional businesses. Before turning to that, it is worth discussing the underlying logic. The dual nature of the customers of a platform As any other business, platforms sell a service to customers who pay in order to access the platform. However the nature of the economic transaction involved is slightly different 1 General presentations are provided by Rochet, J.C. and J. Tirole (2004a), “Two-Sided Market: an Overview”, IDEI Working Paper, or Jullien B. (2005), "Two-Sided Markets and Electronic Intermediaries", CESifo Economic Studies, 51, 2-3, 235–262. For a friendly introduction to two-sided markets, see Evans D. and R. Schmalensee, "The Industrial Organization of Markets with Two-Sided Platforms", forthcoming in Issues in Competition Law and Policy, W. D. Collins ed., American Bar Association. 2 Clearly, they can be more than two sides involved. Focusing on two sides simplifies the reasoning but the principles apply to multi-sided markets. 3 Quoted in Leadership Online: Barnes & Noble vs. Amazon.com", Harvard Business School (1998), page 11. than in more conventional lines of business. In a typical exchange, the consumer is not involved in the production process that is carried on by the firm. The payment then remunerates the firm who buys inputs on other markets. In the case of a platform, the product is the outcome of the interaction between the customers of the platform. The traditional distinction between the input of the production process and the output becomes to some extent irrelevant. When two economic agents A and B use a platform to conduct a transaction, a key service that the platform offers to agent A is the access to agent B, and vice versa. The agent A is thus a customer willing to pay to access to B through the platform, but at the same time, the operator of the platform should be aware that the willingness to pay of agent B is determined by the participation of agent A to the process. Following this logic, a customer of a platform is both a client buying a service and an input for the service offered to other clients. This dual nature of the customer is key to understand the specificities of the pricing strategies followed by platform, as well as other business practices such a bundling of services, exclusivity rules, free services . For instance, while traditional monopoly pricing results from a trade-off between increasing the margin and reducing the volume of sales, this is not the case for platforms as we shall develop below. This leads to a different approach to the relationship between the firm and its clients. Instead of just asking "what can I bring to the client that has some value to him? ", the firm should also enquire "what value can the client bring to other clients? ". For instance, one consequence of this greater interest for coordination with clients is that one should expect more vertical integration for platforms which is indeed the case: there are numerous cases of platforms owned by their customers or by not-for-profit association setup by users. For instance VISA is not-for-profit a