Delivering Liquidity: An Analysis of the Impact of Dealers in Electronic Markets Wenjing Duan, † Bin Gu, ‡ Andrew B. Whinston ‡ 1 Extended Abstract for Consideration in WISE 2006 1. INTRODUCTION The past decade has witnessed an explosive growth of electronic marketplaces supported by the new Internet-based technologies (Brynjolfsson and Smith 2000; Smith and Brynjolfsson 2001; Weber 2006). Electronic marketplaces are consumer-to-consumer (C2C) communities through which multiple buyers and sellers exchange information about products and prices, identify and select trading partners, and transact using the Internet technologies (Bakos 1998). Prominent examples of such markets include eBay, Yahoo!, and Amazon’s online auctions. It was widely believed that the availability of real-time market information, reduced search cost, and instant electronic transaction would allow buyers and sellers to bypass traditional intermediaries in the market (Bakos 1991; Bakos 1997). Experience over the past years has shown little evidence to support such a belief (Choudhury et al. 1998). Just as asserted by Russell Braziel (2001): “Intermediaries are not inefficiencies to be wrung out of spot markets by e-commerce. Instead, they are key to the development of efficient, electronic transaction processes.” The web behemoth eBay is by far the most popular and successful C2C electronic market, with more than 100 million users and $40 billion gross in 2005. While eBay does provide a marketplace to millions of users to sell off their unwanted stuff, currently most of the trading volume on the site is conducted by actual businesses. 2 For instance, the top 5% of eBay’s music sellers are mostly professional dealers or retailers, who generate over 50% of the sites’ business. 3 Since the addition of the “Buy it Now” feature which allows the seller to sell at a fixed price, it has attracted a growing volume of transactions from dealers and retailers. The growth of eBay shows that, intermediaries (e.g. dealers and retailers) not only still exist, but also seem to play an important role in electronic markets. In this paper we aim to take the initial step to examine the role of intermediaries (dealers in our context) in C2C electronic markets. The key function for intermediaries to exist in the first place is to make transactions happen, i.e. to provide liquidity in the market (Cosimano 1996). Extant economics and finance literature suggests that intermediaries can make markets more liquid by increasing the probability of successful trade and stabilizing market price (Cosimano 1996; Barclay and Henershott 2006; Grossman 1992). Such a function is still indispensable in electronic marketplaces. For an electronic market, liquidity is about a critical mass of transactions that draws buyers and sellers to the market. For the buyers and sellers, liquidity can be defined as the capability to get transactions done quickly at a fair price. Dealers’ knowledge of products and the market enables them to be more informed of the intrinsic value of items in the marketplace and to match unsynchronized supply and demand over time. Accordingly, the presence of dealers increases the probability of trade. In addition, dealers also can be more resilient to changes in transaction volume in the market given their large inventory. They can choose to strategically enter or exit the market as opposed to occasional buyers and sellers, thus providing liquidity to the market. Furthermore, existence of dealers also provides product quality and price references for other buyers and sellers, which facilitate price discovery in the marketplace, resulting in higher market prices. Electronic marketplaces are also susceptible to information asymmetry between buyers and sellers (Dewan and Hsu 2004). First, buyers face higher uncertainty of product quality in online markets without direct observations than in conventional brick and mortar stores. Second, participants in electronic markets are often remote buyers and sellers who have little or no prior interactions. Third, electronic transactions expose participants to an even greater risk with the lack of enforceable regulatory policies. Building trust has therefore become a crucial factor in influencing trading in electronic marketplaces (Ba and Pavlou 2002). Existing literature has addressed the roles of third parties, institutions, and feedback and reputation systems in evaluating sellers’ credentials and improving trust building (Pavlou and Gefen 2004). Consequently, new entrants would face the barrier of establishing reputation in the market before they can be fully recognized. The presence of dealers can reduce such reputation penalty in dealing with less established buyers and sellers. Dealers often have established reputation and can bear more risks in buying and selling. As a result, they can 1 † School of Business, the George Washington University; ‡ McCombs School of Business, the University of Texas at Austin 2 Forrester research report 2005 3 Music Trades, August, 2004 1