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September 11, 2000

NSF funds economist's study of electronic markets

By Jennifer McNulty

If electronic commerce hasn't changed the way you do business yet, it's probably just a matter of time. You may still buy your groceries at the local market and prefer to browse the aisles of your favorite bookstore, but whether it's car shopping, day trading, or job hunting, the range of products and services available over the World Wide Web is growing so quickly that you're likely to soon join the ranks of cyberspace consumers.

photo of economist Dan Friedman
Dan Friedman
Photo: Jennifer McNulty
The explosion of economic activity on the Internet hasn't gone unnoticed by academics, among them UCSC economics professor Dan Friedman, who has launched a $450,000 three-year project funded by the National Science Foundation to help identify what works--and what doesn't work--in the world of cyberspace markets.

Despite headline-grabbing stories of boom-and-bust cycles in the world of Internet commerce, the trend is clear: In the next ten to 20 years, a large fraction of all transactions will take place electronically. This dramatic change has given Friedman and his colleagues an opportunity to study market dynamics in cyberspace to see how economic theories apply in this new environment and to develop applicable theories more fully. By assessing the effectiveness of different cyberspace markets, economists will be prepared to use their knowledge to help shape the design of future markets.

"The changes we're seeing in electronic commerce today are comparable to the changes that took place before World War I when the first wave of globalization took place," said Friedman. "With the widespread introduction of telephones and electrical power, and then cars and airplanes, the world changed dramatically. That's happening again today with these new markets, but this time academics have a larger role to play in shaping the changes."

Successful Internet markets that provide familiar consumer services include Amazon.com and eBay, but the larger part of electronic commerce will involve "business-to-business" transactions. And as cyberspace markets take hold, the way goods and services are created will change, said Friedman.

Whether business is conducted electronically or traditionally, the "fundamental problem of commerce remains, which is how to bring together buyers and sellers at mutually beneficial prices," said Friedman. In some areas, like car buying, Internet commerce has revolutionized pricing strategies, streamlined the transaction process, and empowered consumers, said Friedman.

Traditionally, car buyers had to deal with a salesperson, whose job it was to extract the best price from the buyer. Negotiations took place between an amateur buyer and a professional seller. Now that's all changed, said Friedman.

"Now, buyers go to the web, get the dealer invoice, go into their local dealership and offer to pay a bit over invoice," he said. "The new markets are changing the way business is done. Potentially, both buyer and seller will gain."

The web holds similar potential to transform labor-market dynamics, with sites like Monster.com offering a range of career services that help job seekers and prospective employers find each other.

Such dramatic changes were difficult to imagine 20 years ago, said Friedman, who will explore cyberspace markets with Bernardo Huberman, a research scientist who runs the computational dynamics group at the Xerox Palo Alto Research Center.

Different market formats have evolved to match buyers and sellers, ranging from random search and haggling to posted price and auctions, said Friedman. The efficiency of different market formats depends on the nature of the goods or services being exchanged and the conditions of the environment. "New electronic technologies change the environment and create openings for new and more efficient market formats," he said.

In his research, Friedman will integrate four different approaches: laboratory experiments, field data, computer simulations, and theoretical models. "We believe this integrated series of theoretical and empirical studies will generate the fundamental knowledge that will be invaluable to anyone constructing and maintaining cyberspace markets in the future," he said.

Electronic markets can also create new problems. Although day trading has "democratized" stock market investing by allowing individuals to easily play the market, the results so far have not always furthered the real purpose of financial markets, which is to allocate investment in companies based on the value of their activities, said Friedman.

"Your average day trader doesn't know anything about the companies he trades," said Friedman. "Random trades in an effort to show a quick profit are wasteful to society. In the long run, it is not much more profitable to the trader than Las Vegas, so maybe the problem will take care of itself."

The most dramatic example of a negative impact of electronic trading goes back to the October 1987 stock market panic, which was triggered by the widespread use of an automated electronic trading strategy called "portfolio insurance" that was designed to protect stock market investors from significant losses. Individually, such a tool posed little threat, but its widespread use caused the most serious stock market crisis since 1929, said Friedman.

Ultimately, Friedman would like the results of this research to be made accessible not only to other academics and the people designing new markets but also to the policymakers who will be shaping regulations regarding electronic commerce.


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