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The Impact of Internet-BasedCommunication Systems on Supply Chain

Management:An Application of Transaction Cost Analysis

Sung-Yeon ParkGi Woong Yun

Bowling Green State University

Abstract

Introduction Existing Views on the Impact of Internet-Based Communication Systems on

Supply Chain Managemento TheMove-to-the-Market hypothesiso TheMove-to-the-Middle hypothesis

The Internet-Based Supply Chain Management and Governance Mechanismo Fundamental governance problems addressed in transaction cost analysiso The impact of Internet-based communication systems on transaction costs

The Internet-based Communication Systems and Governance MechanismChoice

Williamson on Technological Determinism

Footnotes References About the Authors

Abstract

New communication technology1brought high expectations and a great deal offrustration into the business world. Business managers were thrilled by promises of

efficiency, effectiveness and innovation that would overcome barriers in time andgeography. At the same time, however, many early adopters of electronic marketsystems experienced bitter failures. By using transaction cost analysis, this paperclosely examines the effect of new communication technology on supply chainmanagement. In particular, it looks at three major sources of transaction costs:transaction asset specificity, behavioral uncertainty and environmental uncertainty.Consequently, we propose that transaction asset specificity is the major factor to be
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considered in the adoption of new communication technology to supply chainmanagement.

Introduction

Like many changes experienced in other areas of business, the introduction ofcomputer technology brought unprecedented changes in the way organizations managetheir communication processes. From their use in product development to surveys ofafter-sales customer satisfaction, computers have been playing pivotal roles in the flowof information, not only within individual organizations but also between organizations.

Business-to-business (B-to-B) exchanges have been significantly affected by thetransformation in communication processes. Starting with the automated order entry

system in the mid 1970s, computer technology has facilitated communication betweenorganizations involved in inter-organizational transactions. One of the most recentapplications of computer technology involves the Internet in the area of supply chainmanagement.

B-to-B exchanges using Internet-based communication systems have attracted specialattention because of their market growth potential and impact on business structuresthroughout the world. Even after the demise of the dot.com boom at the turn of thecentury, this particular sector has experienced a steady growth. The revenue fromInternet-based B-to-B exchange was $43 billion in 1998 (E-procurement, November 20,2000). In the year 2002, the market size grew to $870 billion. After another four years,

the number is expected to reach $5.8 trillion (Hamm, 2002). Adoption of Internet-basedcommunication systems in industrial purchasing is not limited to particular industry typesor certain firm sizes. It is happening in the high-tech, aerospace industry as well as inagricultural and dairy industries. Also, companies of various sizes, from industrial giantssuch as GE to small start-ups, are conducting Internet-based B-to-B exchanges.

Even before the Internet became available for commerce, business managers werethrilled by the prospect of its efficiency, effectiveness and innovation, which theybelieved would overcome barriers in time and geography and improve inter-organizational relationship (Hammer & Mangurian, 1987). The core of its benefits is costreduction, which results from timely and speedy transactions, inventory reduction, easy

access to new markets and suppliers, and efficient management of the whole supplychain process, to name a few. In the 1980s and early 1990s, many Americancompanies introduced interorganization networks in their supply chain managementwhich enabled themjust-in-time procurement.

The immediate connection between a buyer and a supplier increases cooperation andefficiency between firms. The success of worldwide retail chain Wal-Mart frequently hasbeen attributed to the electronic data interchange (EDI) system installed among its pool


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of suppliers. Also, the ubiquity of the Internet allows more companies to operate on acommon platform without heavy investment in closed information networks such as EDI.And the more those companies conduct trades online, the more profitable Internet-based supply chain management will become.

In retrospect, it was this nave optimism about B-to-B e-commerce that fundednumerous venture capital initiatives and speeded up rampant investment in hardwareand software in many industries. Although there was a fair amount of skepticism basedon both reasonable caution and fear of the unknown (Berman, July 17, 2000), the riskinvolved in the adoption of Internet-based supply chain management was not fullyunderstood by managers until they witnessed several major shakeouts in recent years(Swisher, Dec 18, 2000). Furthermore, this skepticism was addressed by strategicanalysis that could help managers to deal with this new technological environment.

McFarlan (1984) emphasized that executives should understand if communicationtechnology can be the core of their competitive strength or if it will simply play a

supporting role. Wigand (1997) also emphasized the importance of optimalorganizational fit and alignment in the deployment of information technology. He made itclear that what brings added value to a firm is not information technology itself, but well-tuned coordination between business strategies and technology. A recent issue ofthe McKinsey Quarterlyreported that some companies that made heavy investments insupply chain management information systems performed worse than companies thatdid not, although technological investment in supply chain management increased theefficiency of firms on average (Kanakamedala, Ramsdell, & Srivatsan, 2003). Thesefindings clearly demonstrate what managers have been told repeatedly. To adopt thisnew communication technology successfully, firms must have a working supply chainand know how the technology can improve their existing supply chain.

While these lessons are invaluable to managers, there has been little researchon howto integrate Internet-based communication systems in order to conductsuccessful supply chain management. Although intensive research has improved ourunderstanding of the new communication technology as a tool of supply chainmanagement, the efforts seem to be lacking two attributes that can be crucial formarketing research as a discipline striving to solve managerial problems and as aresearch tradition based on cumulative knowledge.

First of all, many of previous studies focused on either the overall picture of Internet-based B-to-B e-commerce or technical details of how the transactions will be executed.Whereas such information is essential for understanding the status of B-to-B e-commerce, its applicability to individual firms supply chain management decisions isoften too remote. In addition, overwhelming interest in market transformation hasaccompanied relative ignorance of hierarchical governance mechanisms. In previousstudies on B-to-B e-commerce, the market system is offered as a governancemechanism of supply chain management. However, the market is only one of the twoclassical forms of governance mechanisms. The other governance mechanism,hierarchy, deserves equal attention in the context of B-to-B e-commerce. Additionally,


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there exist many variations of the market depending on the relationship betweentransacting partners. Scrutiny of the overall geography of supply chain management,which includes the markets and hierarchy and various hybrids in-between, may broadenour perspective on the role of new communication technology.

Second, few previous studies consider Internet-based communication systems on acontinuum of supply chain management problems that have existed long before theInternet. Although the use of the Internet is new, the problems accompanied by its useare not. In discussions about B-to-B e-commerce, Internet-enabled markets are oftendescribed as entirely novel phenomena. But, in reality, except for some purely onlinemarket makers that account for only a fraction of B-to-B e-commerce, it is extremelydifficult to separate traditional markets from Internet-based markets. By failing torecognize the evolutionary rather than revolutionary nature of markettransformation, some of the research adds confusion to the understanding of the currentmarketplace.

We address these two issues neglected in previous literature by employing transactioncost analysis (TCA). Since Coase wrote The nature of the firm in 1937, TCA hasserved as a robust theoretical framework that analyzes complicated businessphenomena and diagnoses appropriate strategies in supply chain management. Thebasic theorem of TCA is that markets are more efficient than hierarchies whentransaction asset specificity, environmental uncertainty, and behavioral uncertainty arelow. Unfortunately, it appears that the first part of this statement has been widelyembraced by industry analysts and academic researchers while the necessaryconditions often were overlooked as the focus of attention.

We intend to provide a balanced view of the matter by paying close attention to the

impact of the Internet on transaction costs that are heavily affected by transaction assetspecificity, environmental uncertainty, and behavioral uncertainty. By examining theeffects of Internet use on fundamental governance problems that persist in inter-firmrelationships both online and offline, we want to demonstrate that the level of assetspecificity, not the adoption of the Internet, is a major force determining the governancemechanism in a B-to-B exchange. We also want to emphasize that there is an inherentlimitation in the potential of the Internet in reducing the asset specificity. To achieve thisgoal, we will first survey existing literature examining the impact of new communicationtechnology on supply chain management. Then, we will discuss the fundamentalgovernance problems identified by TCA. Subsequently, scrutiny of the impact ofInternet-based communication systems on each component of the transaction cost will

lead to a prediction of governance mechanisms in the new communication environment.


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Existing Views on the Impact of Internet-BasedCommunication Systems on Supply Chain

Management

Move-to-the-Market Hypothesis

The basic argument of the move-to-the-market hypothesis stated that reduction intransaction costs enabled by new communication technology would shift overallgovernance mechanisms from either cooperative or hierarchical relationships to adecentralized market system. Research by Malone, Yates, and Benjamin (1987) is oftenregarded as the cornerstone of the debate on communication technology andgovernance mechanisms under the paradigm of TCA. Because the move-to-the-market claim itself seems so self-evident, there has not been any noticeableexplication of it. From technological and policy perspectives, Wigand and Benjamin

(1995) outlined several prerequisites for the electronic market, such as high rate ofconnection, high bandwidth of the connection, cheap and high-speed computercapability, and no market access favoritism. Similarly, Picot, Bortenlaenger, and Roehrl(1997) added that full-fledged electronic market transactions require changes in marketorganizers, such as transparency institutions, access institutions, price discoveryinstitutions, and settlement institutions.

The most salient weakness of the move-to-the-market hypothesis lies in theassumption that a sweeping reduction of transaction costs would follow the introductionof the Internet. Malone and his colleagues (1987) identified major sources of transactioncosts to be coordination costs, asset specificity, and complexity of product description.

They predicted that the new communication technology would reduce them all. Theirposition on this issue was reaffirmed later (Malone, Yates, & Benjamin, 1989). Thesame problem is observable in an argument made by Picot et al. (1997). Picot and hiscolleagues believed that reduction in asset specificity was one of the fundamentalchanges leading toward the market. Their argument was that the adoption of theInternet tends to speed up knowledge diffusion, and, thus, reduce the specificity ofgoods, which favors the market as a coordination mechanism. In both cases, theseresearchers could have received more credit for their arguments if they had looked intoasset specificity more closely.

Transaction specific assets refer to assets that cannot be redeployed to alternative

uses without substantial sacrifice of productive value (Williamson, 1991). And, as theadvocates of move-to-the-market hypothesis asserted, some of them are expectedto lose their transaction specificity to a substantial degree with a wide adoption of theInternet in supply chain management. One type of such transaction-specific asset iscommunication technology itself. Before the introduction of the Internet,interorganizational communication networks were considered transaction-specificassets. Although there will be some delays, however, the Internet is highly likely tomake other closed communication networks obsolete eventually. Another category


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includes products and services for which the production depends heavily on specializedknowledge and skills. These assets will lose their transaction specificity because ofdrastically increased information duplicability and transferability. Temporal specificity, atype of site specificity in which timely responsiveness by on-site human assets is vital(Williamson, 1991), will also be greatly reduced by speedy and precise information

exchange. Since all these assets are common in their heavy dependence oninformation, we may call them information-based specific assets collectively.

Other than these, however, most transaction-specific assets are grounded on morephysical capitals. Out of six transaction-specific assets identified by Williamson (1991),five of them are considered not to be information-based specific assets. Site specificityrefers to a condition in which successive stations are located in close proximity to eachother to economize on inventory and transportation expenses. An example of physicalasset specificity is specialized dies to produce a component for a particular buyer.Human asset specificity involves both skilled labor and experienced sales staffs in aparticular product or service area with established personal connections. Dedicated

assets are discrete investments made for a particular customer in general purposeplants and brand name capital refers to investments exclusively made to brand productsor services together with a transaction partner. By their nature, these types of assets,while accounting for the majority of transaction-specific assets in the current U.S.economy, are not likely to be affected by the Internet in any significant way.

In summary, themove-to-the-market hypothesis was only partially acceptable.Indeed, the researchers seemed to have been aware of the problems in theirarguments. Somewhat paradoxical to their main theses, Malone et al. (1987) left roomfor electronic hierarchies and tightly coordinated interorganizational relationships.Wigand and Benjamin (1995) also briefly mentioned that low asset specificity and ease

of description are required for a product to be tradable in electronic markets.

TheMove-to-the-Middle Hypothesis

The central theme of the move-to-the-middle hypothesis was that newcommunication technology would call firms into a middle ground from either end(hierarchy or decentralized market). According to this line of thought, closelycoordinated interdependent firms would be a dominating governance mechanism insupply chain management. Unlike the move-to-the-market hypothesis, however,there were several different reasons for supporting the same diagnosis. In some cases,different economic and organizational theories were employed.

One of the branches of the move-to-the-middle hypothesis was based onBusiness Networks. Although each sub-unit of a business network is a highlyintegrated dyadic relationship, a network could be distinguished from a dyadicrelationship as sets of connected relationships going beyond the dyad (Anderson,Hkansson, & Johanson, 1994). Johnston and Lawrence (1988) argued that value-adding partnershipsgroups of small companies sharing information freelywereemerging rapidly and, consequently, would become a more prevalent form of


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organizational coordination.

A few years later, the network idea was developed further by several other researchers.Based on an observation of large U.S. manufacturers and the Teletelnetwork system inFrance, Steinfield and his colleagues (1995) predicted that firms would be more likely to

use interorganizational networks to build tight relationships with their trading partnersthan to use spot markets. Nouwens and Bouwman (1995) also argued that the newcommunication technology would abolish the traditional dichotomy between market andhierarchy and, eventually, lead to the development of the network-organization, aset of independent organizations that cooperate to manage the flow of products andservices in the value chain.

Another line of thought has evolved from an observation that, with the wide adoption ofnew communication technology, the supplier basis for the firms in many industriesdecreased rather increased, contrary to what had been predicted by Malone et al.(1987). Intrigued by this phenomenon, Bakos and Brynjolfsson considered several

alternative explanations and, finally, formulated a conclusion based on the incompletecontract theory" (Bakos, 1991a, 1991b; Bakos & Brynjolfsson, 1993a, 1993b).According to their reasoning, new information technology gave more significance tononcontractible investments by suppliers, such as quality, responsiveness, andinnovation. In turn, when such investments were especially required, firms wouldemploy fewer suppliers. Based on a continuum of the incomplete contract theoryexplanation, Brynjolfsson (1994) created a model describing the influence of newcommunication technology on organizational structure. According to the model, newcommunication technology would result in less integration and smaller firms by reducingasset specificity.

Unlike other advocates of the move-to-the-middle hypothesis, Clemons, togetherwith his colleagues, closely examined every component of transaction costs one by one(Clemons, Reddi, & Row, 1993 Clemons & Row, 1992). According to their analyses,choice of governance mechanism was dependent on the costs of coordination and thetransaction risk associated with the coordination. Normally, decreases in coordinationcosts would cause increases in transaction risk. However, in their view, newcommunication technology would create a unique environment where both coordinationcosts and related transaction risk could be reduced simultaneously and therefore twohighly coordinated, interdependent firms would be a dominating governance mechanismin supply chain management.

Since themove-to-the-middle hypothesis originated from several differentperspectives, each line of thought had distinct problems in its argument. Supporters ofelectronicbusiness networks had a similar dilemma with the supporters of themove-to-the-hierarchy hypothesis. Although they strongly argued that network-organizations would be the future of organizational governance choice, they were awareof the possibility that technological innovation might make room for a decentralized puremarket (Nouwens & Bouwman, 1995; Steinfield et al., 1995). Also, they left the dooropen for hierarchy by briefly mentioning product attributes. However, their consideration


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of product attributes was not fully integrated in their argument.

Although Bakos and Brynjolfsson (1993a, 1993b) captured parts of the reality, and theirreasoning appeared seamless, they did not explain why they thought that newcommunication technology would increase the significance of noncontractible

investments. Contrary to their assumption, in reality, many kinds of noncontractibleinvestments became more obtainable with new communication technology. Also,Brynjolfsson (1994)s modeling was particularly concerned with information assets, asopposed to other kinds of specific assets such as site-specific assets and physically-specific assets. Therefore, application of his model should be limited to situations whereonly information-based specific assets are involved.

Two studies by Clemons and colleagues were based on a notion that the impact of newcommunication technology on organizational coordination should be predicted bydecomposing transaction costs. Since this position is shared by our analyticalframework, these studies were subjected to a more thorough examination (Clemons et

al., 1993; Clemons & Row, 1992). Clemons and Row (1992) broke down transactioncosts as follows:

Transaction costs = Costs of coordination + Costs of transaction risk

Transaction risk = Transaction-specific capital + Information asymmetries + Loss ofresource control

Primarily, Clemons and Row (1992) argued that new communication technology wouldreduce coordination costs. They also stated that coordination costs are largelyindependent of whether an interaction occurs within a single firm or across firm

boundaries. For the part of transaction risks, they reasoned, new communicationtechnology would reduce transaction risk by reducing the level of transaction-specificcapital and by reducing the cost of monitoring and control among separate firms.

Later, Clemons, Reddi and Row (1993) made some changes in their previous argumentand analyzed transaction costs as follows:

Transactions cost = Coordination cost + Operations risk + Opportunism risk

They defined coordination cost as the cost of exchanging information and incorporatingthe information into decision processes in a broad sense. Operations risk was definedas the risk that the other parties in the transaction willfully misrepresent themselves orwithhold information, or underperform their agreed-upon responsibilities. They addedthat the operations risk stems from differences in objectives among transacting partiesand is supported by information asymmetries between the parties or by difficulties inenforcing agreements. The last component of transaction costs, opportunism risk, wasreferred to as the risk associated with a lack of bargaining power or a loss of bargainingpower directly resulting from the execution of a relationship. They broke down theopportunism risk into three parts, relationship-specific investments, small-numbers


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bargaining, and loss of resource control.

The themes lying beneath these analyses of transaction costs were the same: Newcommunication technology would lead to more tightly coupled interfirm relationshipsacross various industries by reducing coordination costs while not increasing

transaction risks previously incurred by high coordination. Indeed, this notion contains agreat deal of truth. At the same time, however, we cannot help disagreeing on fourcrucial points. First, we assert that coordination costs are not independent of whetherthe interaction occurs within a single firm or across firm boundaries. On the contrary,coordination costs are heavily affected by whether a firm buys in-house or buys in amarket. If coordination costs were not appreciably different in the two cases,outsourcing would be more desirable for any firm as long as its transactions withsuppliers do not involve a substantial amount of transaction-specific assets. Second,opportunism is not limited to a small portion of transaction costs. Rather, opportunism isone of the two basic behavioral assumptions of TCA and widespread across the wholeprocess of transaction activities (Williamson, 1985). Third, they did not show how new

communication technology could lower asset specificity other than information-basedasset specificity. Therefore, their prediction could be true only within a limited range.Finally, it seemed that they were violating a basic assumption of TCA. According to theirreasoning, the most desirable governance mechanism was a middle ground betweenmarket and hierarchy, a so-called cooperative relationship, which was unobtainable onlybecause of high coordination costs and transaction risks. In this scenario, the biggestcontribution of new communication technology would be reduction in coordination costsand transaction costs, which enables cooperative relationships between suppliers andbuyers. Quite differently, TCA regards a market as the ideal governance choice. Onlywhen procurement through market mechanisms become too expensive because of highuncertainties and asset specificity will the firm search for better alternatives such as aclosely coordinated cooperative relationship or hierarchy.

While most of the arguments supporting the move-to-the-middle hypothesis werebased on theoretical speculation or conceptual modeling, Stump and Sriram (1997)actually tested the move-to-the-middle hypothesis with empirical data. Notsurprisingly, they failed to establish a direct relationship between a buyers investmentin new communication technology and the overall closeness of the buyer-supplierrelationship. The two variables were only indirectly associated by a mediating variable,the percentage of purchasing transactions using new communication technology. Thesefindings illuminate the possibility that organizations use new communication technologyin diverse ways for their unique needs, not just for transactions with other firms.

The problems in the move-to-the-market and move-to-the-middle hypothesesmight be attributable in part to the various directions that communication technologydevelopments have taken since the formation of the hypotheses. It must have been adifficult job to predict exactly how information technology would unfold within five to tenyears for the researchers in the 1990s, let alone for those writing in the 1980s. Althoughthere was a general consensus on the future direction of technological development,they were still living in the age of Electronic Data Exchange (EDI), a 20-year-old


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technology. Albeit it was the harbinger of electronic commerce, expensive installationand implementation costs have kept more than 99% of U.S. businesses from using it(Wilde, 1997). Consequently, there were not enough suppliers and buyers to form anelectronic spot market. Also, once having adopted EDI, the companies would ratherclosely coordinate with their suppliers and buyers to recover the sunk cost. Still, there

are a lot of companies in the field running on EDI. Some of them may want to stay withthe old technology while some may be trying to integrate new and more standardizedtechnology into their existing system. Even if companies want to adopt the newtechnology, there are many financial, technological, regulatory, and other environmentalobstacles. From observation of the capital market automation process, Picot (1995)named this phenomenon vision-reality discrepancy. Unlike the prediction ofunanimous transformation to one or the other, capital market automation resulted in aheterogeneous spectrum of electronic trading systems. The main cause of thephenomenon was a substantial amount of variation in the completeness of informationobtainable through electronic systems. However, this chronological disadvantagecannot excuse the hypotheses from their technology-deterministic perspective. The

principal drawback of the hypotheses was not their shortsightedness about the directionof technological progress, but their misunderstanding of the fundamental governanceproblems addressed in TCA and their consequent prescription of global remedies fororganizations with different governance problems.

The Internet-Based Supply Chain Managementand Governance Mechanism

The fact that new communication technology cannot favor one governance mechanismover others does not suggest that it has no influence on supply chain management.Quite contrarily, the technology is expected to bring tremendous changes in the wayfirms interact with each other. The technology itself cannot be a direct cause ofgovernance choice, but the way the technology is used by organizations will lead toeither an earthshaking transformation or the status quo. Therefore, understandingfundamental governance-related problems and the effects of new communicationtechnology on these problems is essential for sound decision making.

Fundamental governance problems addressed in transaction cost analysis

Transaction costs analysis (TCA) is a theory about the governance mechanism ofeconomic organizations. According to this theory, the tradeoff between production costsand transaction costs of a firm indicates the most appropriate governance mechanismfor the firm among three broadly generalized types of interorganizational coordination:market, hierarchy, and hybrid. The major advantage of market over hierarchy stemsfrom production costs because of the economy of scale and scope. On the other hand,hierarchy mostly benefits from transaction costs because of high adaptability and tight


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control. Between the two, TCA maintains market as a default mechanism in moderncapitalist economies.

TCA maintains that there are three dimensions in which one transaction is different fromanother: transaction asset specificity, environmental uncertainty, and behavioral

uncertainty. TCA assumes that the most basic unit of the economic agent, the human, isintentionally rational, but only to a certain extent (Simon, 1961). Also, TCA assumes thateconomic man seeks self-interest with guile (Williamson, 1985). Under theseassumptions of bounded rationality and opportunism, the presence of transaction-specific assets gives rise to various governance-related problems.

Since transaction-specific assets cannot be salvaged without a substantial loss in theirvalues, transactions that require a significant investment in transaction-specific assetscreates lock-in situations. Lock-in situations carry the risk of holdup problems toprocurers. On the other hand, it can also damage providers by forcing an unbearableamount of discount upon them. To avoid these lock-in problems, transaction parties

often spend extra money as a part of transaction costs to safeguard their assets invarious ways including crafting lengthy contracts and broadening supply bases.

Environmental uncertainty can be interpreted as unanticipated changes incircumstances surrounding an exchange (Noordewier, John & Nevin, 1990). Hence,adaptability to the unanticipated changes is crucial. Adaptation is not only requiredwithin organizations, but also between organizations. However, it is not always easy toinduce cooperation from transaction partners in market governance. To adapt tochanging environments in a timely and efficient manner, therefore, firms have to expendheavily on communication, negotiation, and coordination costs.

Behavioral uncertainty is often understood as the degree of difficulty associated withassessing the performance of transaction partners (Rindfleisch & Heide, 1997). Inevaluating the performance of transacting partners, information asymmetry is the coreproblem. Some information asymmetry can be of a non-strategic kind, caused by asimple lack of communication. However, some information asymmetry can be createdstrategically to take an unfair advantage of transaction partners. Firms may not releaseinformation important to transaction partners intentionally. Furthermore, they mayprovide their partners with false information. To prevent these problems, firms have tofind appropriate partners and constantly monitor their performances. And theseactivities incur prior screening and selection costs and subsequent measurement costs.

The impact of Internet-based communication systems on transaction costs

Although environmental uncertainty has been conceptualized in many different ways,unpredictability seems to be its most common aspect. Instability in existing markets canmake it difficult to predict sales volume. Constant advances in production technologyare another contributing factor. Predicting new products or new markets almost alwaysbears some degree of uncertainty. In addition, unpredictability may stem fromunfamiliarity with the business environment such as policy and culture in foreign


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markets. Facing these uncertainty issues, participants of a supply chain maysignificantly benefit from the seamless communication made possible by the adoption ofnew communication technology. Increased bandwidth and decreased response time ininformation exchange, among many benefits, are expected to eliminate various sourcesof uncertainty and subsequently reduce adaptation costs.

Volume instability in extant markets is the most common problem of environmentaluncertainty that economic organizations face on a daily basis (Rindfleisch & Heide,1997). Even within this narrowed area of environmental uncertainty, there are manyways that new communication technology can reduce the problem. In the first place,rich information can be exchanged between transacting partners with a greater speedand efficiency at less expense. In procurement, time and resources needed for thesearch for suppliers can be drastically reduced. Firms can improve their prospects ofacquiring a sufficient quantity of goods or services in case of demand surge. In thesales of products and services, firms can at all times have one extra outlet with a hugenumber of potential buyers. Faster and accurate communication within a supply chain

has positive effects on inventory management as well. Although just-in-timeprocurement has already been in place with the introduction of EDI, expansion of thenetwork without significant further investment enables firms to cut every corner ofinventory handling costs. The rapid flow of information without interruption enables firmsto renegotiate terms or adjust to design changes before incurring irrecoverable costs fortransacting partners. Therefore, the damage caused by failure to adapt to environmentalchanges can be ameliorated in a relatively expedient manner.

The notion that Internet-based communication systems reduce coordination costs haslargely been supported by researchers. Earlier, Bakos (1991b) simulated the reductionin stockout costs with the deployment of new information technology. Gebauer and

Segev (2001) also indicated drastic reduction in coordination costs as an underlyingmechanism of integrated procurement functions led by the Internet. Case analyses of aused car market and a nutraceutical industry revealed reduction in coordination coststhrough processing improvements, marketplace benefits, and indirect improvements(Garicano & Kaplan, 2000).

The impact of new communication technology on behavioral uncertainty can be morecomplicated because of the partially strategic nature of behavioral uncertainty. Theproblems of behavioral uncertainty originate from information asymmetry of bothstrategic and non-strategic kinds. On the positive side, new communication technologycan extend choices for firms to pick their transaction partners ex ante. It can beespecially useful for firms that had been experiencing difficulties in finding suppliers orbuyers within their geographic boundaries. Without the technology, identifying potentialtransaction partners and then selecting one of them based on the information obtainedfrom various sources can be a drain on both time and resources. Internet-basedcommunication systems enable firms to receive bids from both regional and nationalorganizations. By comparing bids from many candidates, firms can understand themarket situation more fully and thus increase their ability to select the best fit for theirdemands. Also, managers can utilize electronic information sources and communication


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tools to check the backgrounds of potential transaction partners. In addition, acompanys Website can provide prospective bidders with detailed information aboutthe company. Subsequently, the information on the Website may help the biddersself-selection. During and after transactions, Internet-based communication systemscan make sales records more transparent. For less standardized performances,

increased capacity of the network may allow more frequent samplings of thedownstream processes and result in decreased monitoring costs (Bakos, 1991b).Furthermore, new communication technology may make access to customers easier.With the increased accessibility to customers, managers can gain insights aboutagents hard-to-measure performances.

Still, a substantial amount of information asymmetry may remain, especially if theasymmetry were intentionally created by transacting partners. Even worse, too muchdependence on new communication technology for performance evaluation can causeanother set of problems. The emergence of spot markets supported by the Internet callsfor an authentication process. Although some market makers have set up

prequalification systems, there are still a lot of holes to be filled (Kambil, 1997; Kambil,Nunes, & Wilson, 1999). Besides, information about a transacting partner other thanprice and product specification is hard to convey via the Internet. Cultural incompatibilitybetween two trading firms, undetected at the moment of contract, can interrupt the flowof information and products later. Also, socialization, one of the most effective ways ofreducing monitoring costs, may become inapplicable. Socialization occurring betweentransacting partners over the course of the business process often takes care of a greatmany monitoring problems. However, automation of transaction processes deprivestransaction partners of socialization opportunities. As a result, the relationship maybecome more vulnerable to opportunism and, consequently, incur more monitoringexpenses.

The risks associated with the heavy dependence on Internet-based communicationtechnology are also present after a transaction is completed. Traditionally, mosttransactions have been executed within certain industrial and geographical boundaries.Therefore, local reputation kept opportunistic behaviors in check. It was also relativelyeasier to recover from the damages done by an adverse selection. If firms choose theirtransaction partners outside of conventional industrial and geographical boundaries,purely based on the information provided on the Internet, the social embeddedness ofeconomic behaviors has no power to either reduce the amount of damage beforehandor enforce compensation for the damage afterwards. Although any social relationshipbetween transaction parties had been regarded as a threat to efficiency by some

economists, the notion that concrete personal relations and networks of such relationsgenerate trust and discourage malfeasance has gained popularity during the past twodecades (Granovetter, 1985).

There are even more variables to consider regarding the effects of Internet-basedcommunication systems on asset specificity and the subsequent costs required tosafeguard transaction specific assets. More than anything else, the Internet can reducetransaction asset specificity by simply broadening the choice for procurers. The


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broadened choice overcoming geographical boundaries reduces a firms reliance onits existing partner and opens up the whole world of potential suppliers with thecapability and willingness to engage in a transaction. Scholars also added that theInternet will reduce asset specificity by facilitating techniques like flexible manufacturing(Brynjolfsson, Malone, Gurbaxani, & Kambil, 1994), making more specific information

contractible (Brynjolfsson, 1994), removing barriers between different communicationsystems (Clemons et al., 1993), and speeding up knowledge diffusion (Picot et al.,1997).

Although these changes are important enough to be noticed, however, the Internetsability to reduce asset specificity appears to be somewhat overstated. Production ofnon-information goods still requires certain material equipment, skilled labor, physicalspace, and a certain amount of specialized capital. Also, the produced goods orservices should be handled by sufficiently knowledgeable sales agents who alsomaintain a strong bond with their customers. Even if Internet-based communicationsystems can help managers to draft, negotiate, enforce, and resolve contract terms to

safeguard specific assets, it may take some time before managers are willing to performsuch crucial activities online. Steinfield, Chan, and Kraut (2000) found no evidence thatthe use of the Internet reduces transaction specificity of assets in four differentindustries. They also revealed a tendency for only the firms with previous electronictransaction experience to use the Internet more to procure major supplies.

For the national or global economy as a whole, opportunity costs of asset specificitymay increase with wide adoption of Internet-based communication systems. Theprospect of investing in production facilities to produce transaction specific assetsseems to be significantly diminished. So far, too much emphasis has been placed onthe mere execution of electronic transactions, while strategies for electronic transactions

have been virtually ignored. Firms have been busy with conducting businesses onlinewithout a vision of what their competitive edge would be in Internet-assisted markets.Similarly, start-up market makers hurriedly opened their businesses without a long-termplan of how to differentiate themselves from others. As a result, firms in electronicmarkets cannot exchange credible commitments with their transaction partners. Indeed,most transactions currently occurring through the Internet are solely based on pricecompetition (Bakos, 1991a, 1997; Kambil, 1997; Porter, 2001). An empirical study(Kraut, Steinfield, Chan, Butler, & Hoag, 1998) provides direct support for thisperspective. In an examination of the relationships between the use of electronicnetworks, asset specificity, and the degree of outsourcing, outsourcing of transactionspecific assets decreased with an increase in the use of electronic networks.

Gebauer and Zagler (2000) speculated on the notion that the nature of the transactiondetermines the governance mechanism. They stated that products low in value and highin process cost should be obtained by short-term oriented buying processes, whereasproducts characterized by high complexity, innovation and strategic relevance should beprocured by long-term oriented sourcing processes. When the focus of the transactionis the cost of products, according to Gebauer and Zagler, the transaction occurs midwaybetween sourcing and buying. For each of the three product types, the role of Internet-


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based communication systems was different. When sourcing, information technologywas expected to provide context information, decision support, and/or collaboration.When buying, information technology was expected to serve as traditional EDI and/ordesktop purchasing in horizontal exchanges. When the focus was on product cost, theypredicted that information technology would create bidding systems, supplier

directories, and/or industry exchanges.

The Internet-based Communication Systemsand Governance Mechanism Choice

Making a decision between hierarchy and market is a two-step process. First, amanager of a firm should figure out how much cost reduction will be gained under ahierarchy system and a market system respectively. Second, the amount of cost savingin procuring the same product/service using market versus hierarchy systems should be

compared. This comparison process is crucial, but often neglected because researcherstend to assume that Internet-based communication systems reduce procurement costsbetween firms more than they do within a firm. The whole discussion of the move-to-the-market hypothesis was built on this unproven assumption. Earlier, Kraut and hiscolleagues (1998) raised a question concerning its validity. They insisted that thedominant view of the effects of electronic networks underestimated benefits to firmsadopting the technology for internal uses and proved their point by demonstrating apositive effect of electronic network use on the level of in-house production.

Market systems will mostly benefit from the reduction in transaction costs, whereashierarchy systems will benefit from the reduction in production costs. A firm might have

been taking hierarchical governance mechanisms because of high asset specificity,high environmental uncertainty, high behavioral uncertainty, or any combination of thethree. If a firm adopted hierarchical governance mechanisms mainly because of assetspecificity of a non-information kind, then cost reduction resulting from the adoption ofthe Internet-based procurement system would be minimal. Conversely, if either non-strategic behavioral uncertainty or environmental uncertainty were the primary reasonfor deploying hierarchical governance mechanisms, a firm would be able to reducetransaction costs significantly. In such a case, switching to a market system would be astrategically sound choice. Of course, the reduction in transaction costs under themarket system should be bigger than the reduction in production costs under thehierarchy system (Figure 1). This thesis can be summarized into a set of normative

statements as follows:

Principle 1. To assess the impact of the Internet on governance mechanism choicebetween market and hierarchy, transaction cost reduction in market and production costreduction in hierarchy should be compared.

Hypothesis 1-1. With high asset specificity, use of the Internet in supply chainmanagement is less likely to affect the choice of market or hierarchy as the governance


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mechanism.

Hypothesis 1-2. With low asset specificity, use of the Internet in supply chainmanagement is more likely to favor market over hierarchy as the governancemechanism.

Figure 1. Internet-based supply chain management and market or hierarchy

Just as asset specificity can be the main reason for firms to stay with the hierarchysystem, asset specificity can make firms choose more closely coordinated inter-firmrelationships among various hybrid forms of market-oriented governance mechanisms.Both arms-length relationships and more closely coordinated markets would benefitfrom the reduction in transaction costs. Assuming that the cost reductions in bothmarket systems cancel each other out, it would be asset specificity that decides thechoice between these two governance mechanisms (Figure 2). Firms with high assetspecificity will prefer closely coordinated market governance mechanisms over arms-length relationships. This thesis can be summarized as follows:

Principle 2. To assess the impact of the Internet on governance mechanism choice

between arms-length relationship and close coordination, transaction cost reductionbetween the two should be compared.

Hypothesis 2-1. With high asset specificity, use of the Internet in supply chainmanagement is less likely to affect the choice of arms-length relationship or closecoordination as the governance mechanism.

Hypothesis 2-2. With low asset specificity, use of the Internet in supply chain


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management is more likely to favor arms-length relationship over closely coordinatedmarkets as the governance mechanism.

Figure 2. Internet-Based Supply Chain Management and Hybrid Markets

At the same time, there are several factors that can delay the application of this trade-off model in governance choice. Traditional arms-length relationships were perceivedto be relatively safe from opportunism because they had been established for the spottransaction of non-specific assets, under low environmental and behavioral uncertainty.Aside from the real level of risk, however, electronic transactions seem to haveincreased the perceived vulnerability to opportunism. Consequently, arms-lengthrelationships will become more vulnerable to the reputation effect, which used to besalient mainly in hybrid contracting (Williamson, 1991). Although systematic research onthis matter is virtually non-existent, anecdotal evidence is not hard to find. Proliferationof hybrid online/offline business compared to pure online players is one piece ofevidence (Useem, October 30, 2000). A survey by Visa U.S.A. showed that 45% of

purchase managers were not engaging in electronic procurement because of a lack ofsenior management support (E-procurement, November 20, 2000). And the untrustingvoice of the senior management can be heard from many places (Bennett, October 23,2000).

Business managers increased risk perception of electronic transactions is expected toresult in strengthened relationships with their previous offline transaction partners. Manymanufacturers are not going to dump their previous suppliers for the sake of cheaper


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bidders online. Business media report on many companies maintaining their existingrelationships with offline partners although they have a capability to find substitutesonline (Bennett, October 23, 2000; Bulkeley, July 17, 2000; McGinnis, October 30,2000). A case study examining 18 firms employing the online-offline hybrid approachdrew a similar picture. Although the hybrid channel system presented such advantages

as cost savings, improved differentiation, and enhanced trust, it promoted marketextension mostly in the context of B-to-C retailing, not in B-to-B procurement (Steinfield,Bouwman, & Adelaar, 2002).

Williamson on Technological Determinism

It was widely believed during the continuous technological innovations of 70s and 80sthat complex organizations achievable from comprehensive integration were the right

means by which complex products and services should be created and delivered tocustomers. Consequently, large, hierarchically integrated firms were supposed to be therule of governance systems.

Opposing this technological determinism, Williamson insisted on adhering to the TCAframework. According to Williamson, goods or services can be supplied by either of twoalternative technologies: general-purpose technology and specific-purpose technology.Special-purpose technology, in contrast to general-purpose technology, was defined astechnology that required a greater investment in transaction-specific durable assets.And it was the significance of specific-purpose technology involved in the productionand transaction processes that determined governance mechanism choice. His position

is well expressed in this paragraph:technology is fully determinative of economic organization only if (1) there is a single technology that isdecisively superior to all others and (2) that technology implies a unique organization form. Rarely, Isubmit, is there only a single feasible technology, and even more rarely is the choice among alternative

organization forms determined by technology(Williamson, 1985, p.87).Approximately two decades later, we find ourselves in a situation where the abovestatement is very applicable. Ironically, this time, the warning should be issued to acouple of perspectives that regard markets, not hierarchies, as ideal governancemechanism for economic organizations.

In terms of Williamsons (1985) criteria for organizational form determining technology,the Internet is a single technology that is decisively superior to all others. At the sametime, it is at best a production-assistant technology, rather than a production technology.Therefore, it is very unlikely that one particular governance mechanism isrecommended to every firm because of the Internet.

Still, the theses presented here need empirical support. It may come from various formssuch as case or survey studies. And once this simplified frame is verified, moreresearch has to be conducted with specific dimensions of asset specificity,environmental uncertainty, and behavioral uncertainty. With an improved understanding


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of what the Internet can and cannot do, managers will be able to maximize benefitsoffered by the advancing technology.

Footnotes

1. Throughout this manuscript, the termsnew communication technology andInternet-based communication systems are used interchangeably. Since there arenumerous kinds of e-commerce systems, the two terms refer to a wide range ofInternet-based procurement systems that include both net marketplaces andprivate industrial networks identified by Laudon and Traver (2002).

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About the Authors

Sung-Yeon Park(Ph.D., University of Wisconsin-Madison) is a lecturer at theDepartment of Telecommunications, Bowling Green State University. She studies newcommunication technology and gender issues.

Address: 302 West Hall, Bowling Green, Ohio 43403. Tel: (419) 372-3403 ,fax: (419) 372-9449. Tel: (419) 372-9516 , Fax: (419) 372-0202.

Gi Woong Yun(Ph.D., University of Wisconsin-Madison) is an assistant professor at theDepartment of Telecommunications, Bowling Green State University. His research areais new communication technology and Internet research methodology.Address: 302 West Hall, Bowling Green, Ohio 43403. Tel: (419) 372-8638 ,Fax: (419) 372-0202.

Copyright 2004 Journal of Computer-Mediated Communication
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