Electronic Markets, Search Costs, and Firm Boundaries

We study how electronic markets that facilitate broader inter-firm transactions affect the vertical scope of emerging IT-enabled extended enterprises. We do so by modeling firms in a three-tier value chain who are each connected to a common electronic market that facilitates direct business transactions across tiers, and that lowers the search costs associated with finding an appropriate trading partner for each of them. The extent to which search costs are reduced depends on the complexity of B2B search, and the nature of the supporting technologies that the electronic market facilitates. Variation in search costs affect firms across the value chain in three key ways: by a change in the transaction costs of interaction between firms; by a change in the contracting costs associated with outsourcing owing to changes in the costs of moral hazard for delegated search, and by a change in the price dispersion of upstream input commodities. We capture each of these effects in a new model that integrates search theory into the principal-agent framework, and establish that the optimal outsourcing contract has a simple "all or nothing" performance-based structure under fairly general assumptions. We then apply this model to contrast the effect that different information technologies have on the relative B2B search costs of different firms in the value chain, contrasting the predicted changes of proportionate, constant and convergent changes in search costs. When integrated with a detailed analysis of the nature of B2B search, these results predicts that when B2B search is information-intensive, electronic markets will facilitate an increase in outsourcing, market-based transactions and a reduction in the vertical scope of extended enterprises. In contrast, when B2B search is primarily communication-intensive, electronic markets will lead to tighter integration and an increase in the vertical scope of the extended enterprise. Our research suggest that the nature of the information technologies and of the business activities supported by an electronic market are crucial determinants of the organizational and industry changes they induce, and our results have important implications for a variety of industries in which both technological and agency issues will influence the eventual success of global IT-facilitated extended enterprise initiatives. We thank Mariagiovanna Baccara, Yannis Bakos, Ramayya Krishnan, Tridas Mukhopadhyay, Roy Radner, Jennifer Reinganum, and seminar participants at Carnegie-Mellon University, National University of Singapore, New York University, Tulane University, the University of Connecticut, and the 2004 North American Summer Meeting of the Econometric Society for their suggestions and feedback on earlier drafts. We are responsible for any remaining errors. School of Business, University of Connecticut, OPIM Dept., 2100 Hillside Road, Unit 1041, Storrs, CT 06269. [email protected] Leonard N. Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012. [email protected]