The Impact of Internet-Based Communication Systems on Supply Chain Management: An Application of Transaction Cost Analysis

Sung-Yeon Park Gi Woong Yun Bowling Green State University

Abstract Introduction Existing Views on the Impact of Internet-Based Communication Systems on Supply Chain Management o The Move-to-the-Market hypothesis o The Move-to-the-Middle hypothesis The Internet-Based Supply Chain Management and Governance Mechanism o Fundamental governance problems addressed in transaction cost analysis o The impact of Internet-based communication systems on transaction costs The Internet-based Communication Systems and Governance Mechanism Choice Williamson on Technological Determinism Footnotes References About the Authors

Abstract
New communication technology1 brought high expectations and a great deal of frustration into the business world. Business managers were thrilled by promises of efficiency, effectiveness and innovation that would overcome barriers in time and geography. At the same time, however, many early adopters of electronic market systems experienced bitter failures. By using transaction cost analysis, this paper closely examines the effect of new communication technology on supply chain management. 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

considered in the adoption of new communication technology to supply chain management.

Introduction
Like many changes experienced in other areas of business, the introduction of computer technology brought unprecedented changes in the way organizations manage their communication processes. From their use in product development to surveys of after-sales customer satisfaction, computers have been playing pivotal roles in the flow of information, not only within individual organizations but also between organizations. Business-to-business (B-to-B) exchanges have been significantly affected by the transformation in communication processes. Starting with the automated order entry system in the mid 1970s, computer technology has facilitated communication between organizations involved in inter-organizational transactions. One of the most recent applications of computer technology involves the Internet in the area of supply chain management. B-to-B exchanges using Internet-based communication systems have attracted special attention because of their market growth potential and impact on business structures throughout the world. Even after the demise of the dot.com boom at the turn of the century, this particular sector has experienced a steady growth. The revenue from Internet-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-based communication systems in industrial purchasing is not limited to particular industry types or certain firm sizes. It is happening in the high-tech, aerospace industry as well as in agricultural and dairy industries. Also, companies of various sizes, from industrial giants such as GE to small start-ups, are conducting Internet-based B-to-B exchanges. Even before the Internet became available for commerce, business managers were thrilled by the prospect of its efficiency, effectiveness and innovation, which they believed would overcome barriers in time and geography and improve interorganizational relationship (Hammer & Mangurian, 1987). The core of its benefits is cost reduction, which results from timely and speedy transactions, inventory reduction, easy access to new markets and suppliers, and efficient management of the whole supply chain process, to name a few. In the 1980s and early 1990s, many American companies introduced interorganization networks in their supply chain management which enabled them just-in-time procurement. The immediate connection between a buyer and a supplier increases cooperation and efficiency between firms. The success of worldwide retail chain Wal-Mart frequently has been attributed to the electronic data interchange (EDI) system installed among its pool

of suppliers. Also, the ubiquity of the Internet allows more companies to operate on a common platform without heavy investment in closed information networks such as EDI. And the more those companies conduct trades online, the more profitable Internetbased supply chain management will become. In retrospect, it was this nave optimism about B-to-B e-commerce that funded numerous venture capital initiatives and speeded up rampant investment in hardware and software in many industries. Although there was a fair amount of skepticism based on both reasonable caution and fear of the unknown (Berman, July 17, 2000), the risk involved in the adoption of Internet-based supply chain management was not fully understood by managers until they witnessed several major shakeouts in recent years (Swisher, Dec 18, 2000). Furthermore, this skepticism was addressed by strategic analysis that could help managers to deal with this new technological environment. McFarlan (1984) emphasized that executives should understand if communication technology can be the core of their competitive strength or if it will simply play a supporting role. Wigand (1997) also emphasized the importance of optimal organizational fit and alignment in the deployment of information technology. He made it clear that what brings added value to a firm is not information technology itself, but welltuned coordination between business strategies and technology. A recent issue of the McKinsey Quarterly reported that some companies that made heavy investments in supply chain management information systems performed worse than companies that did not, although technological investment in supply chain management increased the efficiency of firms on average (Kanakamedala, Ramsdell, & Srivatsan, 2003). These findings clearly demonstrate what managers have been told repeatedly. To adopt this new communication technology successfully, firms must have a working supply chain and know how the technology can improve their existing supply chain. While these lessons are invaluable to managers, there has been little research on how to integrate Internet-based communication systems in order to conduct successful supply chain management. Although intensive research has improved our understanding of the new communication technology as a tool of supply chain management, the efforts seem to be lacking two attributes that can be crucial for marketing research as a discipline striving to solve managerial problems and as a research tradition based on cumulative knowledge. First of all, many of previous studies focused on either the overall picture of Internetbased 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 ecommerce, its applicability to individual firms supply chain management decisions is often too remote. In addition, overwhelming interest in market transformation has accompanied relative ignorance of hierarchical governance mechanisms. In previous studies on B-to-B e-commerce, the market system is offered as a governance mechanism of supply chain management. However, the market is only one of the two classical forms of governance mechanisms. The other governance mechanism, hierarchy, deserves equal attention in the context of B-to-B e-commerce. Additionally,

there exist many variations of the market depending on the relationship between transacting partners. Scrutiny of the overall geography of supply chain management, which includes the markets and hierarchy and various hybrids in-between, may broaden our perspective on the role of new communication technology. Second, few previous studies consider Internet-based communication systems on a continuum of supply chain management problems that have existed long before the Internet. Although the use of the Internet is new, the problems accompanied by its use are not. In discussions about B-to-B e-commerce, Internet-enabled markets are often described as entirely novel phenomena. But, in reality, except for some purely online market makers that account for only a fraction of B-to-B e-commerce, it is extremely difficult to separate traditional markets from Internet-based markets. By failing to recognize the evolutionary rather than revolutionary nature of market transformation, some of the research adds confusion to the understanding of the current marketplace. We address these two issues neglected in previous literature by employing transaction cost analysis (TCA). Since Coase wrote The nature of the firm in 1937, TCA has served as a robust theoretical framework that analyzes complicated business phenomena and diagnoses appropriate strategies in supply chain management. The basic theorem of TCA is that markets are more efficient than hierarchies when transaction asset specificity, environmental uncertainty, and behavioral uncertainty are low. Unfortunately, it appears that the first part of this statement has been widely embraced by industry analysts and academic researchers while the necessary conditions 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 asset specificity, environmental uncertainty, and behavioral uncertainty. By examining the effects of Internet use on fundamental governance problems that persist in inter-firm relationships both online and offline, we want to demonstrate that the level of asset specificity, not the adoption of the Internet, is a major force determining the governance mechanism in a B-to-B exchange. We also want to emphasize that there is an inherent limitation in the potential of the Internet in reducing the asset specificity. To achieve this goal, we will first survey existing literature examining the impact of new communication technology on supply chain management. Then, we will discuss the fundamental governance problems identified by TCA. Subsequently, scrutiny of the impact of Internet-based communication systems on each component of the transaction cost will lead to a prediction of governance mechanisms in the new communication environment.

Existing Views on the Impact of Internet-Based Communication Systems on Supply Chain Management
Move-to-the-Market Hypothesis The basic argument of the move-to-the-market hypothesis stated that reduction in transaction costs enabled by new communication technology would shift overall governance mechanisms from either cooperative or hierarchical relationships to a decentralized market system. Research by Malone, Yates, and Benjamin (1987) is often regarded as the cornerstone of the debate on communication technology and governance mechanisms under the paradigm of TCA. Because the move-to-themarket claim itself seems so self-evident, there has not been any noticeable explication of it. From technological and policy perspectives, Wigand and Benjamin (1995) outlined several prerequisites for the electronic market, such as high rate of connection, high bandwidth of the connection, cheap and high-speed computer capability, and no market access favoritism. Similarly, Picot, Bortenlaenger, and Roehrl (1997) added that full-fledged electronic market transactions require changes in market organizers, such as transparency institutions, access institutions, price discovery institutions, and settlement institutions. The most salient weakness of the move-to-the-market hypothesis lies in the assumption that a sweeping reduction of transaction costs would follow the introduction of the Internet. Malone and his colleagues (1987) identified major sources of transaction costs to be coordination costs, asset specificity, and complexity of product description. They predicted that the new communication technology would reduce them all. Their position on this issue was reaffirmed later (Malone, Yates, & Benjamin, 1989). The same problem is observable in an argument made by Picot et al. (1997). Picot and his colleagues believed that reduction in asset specificity was one of the fundamental changes leading toward the market. Their argument was that the adoption of the Internet tends to speed up knowledge diffusion, and, thus, reduce the specificity of goods, which favors the market as a coordination mechanism. In both cases, these researchers could have received more credit for their arguments if they had looked into asset 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 the advocates of move-to-the-market hypothesis asserted, some of them are expected to lose their transaction specificity to a substantial degree with a wide adoption of the Internet in supply chain management. One type of such transaction-specific asset is communication technology itself. Before the introduction of the Internet, interorganizational communication networks were considered transaction-specific assets. Although there will be some delays, however, the Internet is highly likely to make other closed communication networks obsolete eventually. Another category

includes products and services for which the production depends heavily on specialized knowledge and skills. These assets will lose their transaction specificity because of drastically increased information duplicability and transferability. Temporal specificity, a type 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 on information, we may call them information-based specific assets collectively. Other than these, however, most transaction-specific assets are grounded on more physical capitals. Out of six transaction-specific assets identified by Williamson (1991), five of them are considered not to be information-based specific assets. Site specificity refers to a condition in which successive stations are located in close proximity to each other to economize on inventory and transportation expenses. An example of physical asset specificity is specialized dies to produce a component for a particular buyer. Human asset specificity involves both skilled labor and experienced sales staffs in a particular product or service area with established personal connections. Dedicated assets are discrete investments made for a particular customer in general purpose plants and brand name capital refers to investments exclusively made to brand products or 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, the move-to-the-market hypothesis was only partially acceptable. Indeed, the researchers seemed to have been aware of the problems in their arguments. Somewhat paradoxical to their main theses, Malone et al. (1987) left room for 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. The Move-to-the-Middle Hypothesis The central theme of the move-to-the-middle hypothesis was that new communication technology would call firms into a middle ground from either end (hierarchy or decentralized market). According to this line of thought, closely coordinated interdependent firms would be a dominating governance mechanism in supply 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 on Business Networks. Although each sub-unit of a business network is a highly integrated dyadic relationship, a network could be distinguished from a dyadic relationship as sets of connected relationships going beyond the dyad (Anderson, Hkansson, & Johanson, 1994). Johnston and Lawrence (1988) argued that valueadding partnershipsgroups of small companies sharing information freelywere emerging rapidly and, consequently, would become a more prevalent form of

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 Teletel network system in France, Steinfield and his colleagues (1995) predicted that firms would be more likely to use interorganizational networks to build tight relationships with their trading partners than to use spot markets. Nouwens and Bouwman (1995) also argued that the new communication technology would abolish the traditional dichotomy between market and hierarchy and, eventually, lead to the development of the network-organization, a set of independent organizations that cooperate to manage the flow of products and services in the value chain. Another line of thought has evolved from an observation that, with the wide adoption of new communication technology, the supplier basis for the firms in many industries decreased 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 incomplete contract theory" (Bakos, 1991a, 1991b; Bakos & Brynjolfsson, 1993a, 1993b). According to their reasoning, new information technology gave more significance to noncontractible investments by suppliers, such as quality, responsiveness, and innovation. In turn, when such investments were especially required, firms would employ fewer suppliers. Based on a continuum of the incomplete contract theory explanation, Brynjolfsson (1994) created a model describing the influence of new communication technology on organizational structure. According to the model, new communication technology would result in less integration and smaller firms by reducing asset specificity. Unlike other advocates of the move-to-the-middle hypothesis, Clemons, together with 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 the transaction risk associated with the coordination. Normally, decreases in coordination costs would cause increases in transaction risk. However, in their view, new communication technology would create a unique environment where both coordination costs and related transaction risk could be reduced simultaneously and therefore two highly coordinated, interdependent firms would be a dominating governance mechanism in supply chain management. Since the move-to-the-middle hypothesis originated from several different perspectives, each line of thought had distinct problems in its argument. Supporters of electronic business networks had a similar dilemma with the supporters of the move-to-the-hierarchy hypothesis. Although they strongly argued that networkorganizations would be the future of organizational governance choice, they were aware of the possibility that technological innovation might make room for a decentralized pure market (Nouwens & Bouwman, 1995; Steinfield et al., 1995). Also, they left the door open for hierarchy by briefly mentioning product attributes. However, their consideration

of product attributes was not fully integrated in their argument. Although Bakos and Brynjolfsson (1993a, 1993b) captured parts of the reality, and their reasoning appeared seamless, they did not explain why they thought that new communication technology would increase the significance of noncontractible investments. Contrary to their assumption, in reality, many kinds of noncontractible investments became more obtainable with new communication technology. Also, Brynjolfsson (1994)s modeling was particularly concerned with information assets, as opposed to other kinds of specific assets such as site-specific assets and physicallyspecific assets. Therefore, application of his model should be limited to situations where only information-based specific assets are involved. Two studies by Clemons and colleagues were based on a notion that the impact of new communication technology on organizational coordination should be predicted by decomposing transaction costs. Since this position is shared by our analytical framework, these studies were subjected to a more thorough examination (Clemons et al., 1993; Clemons & Row, 1992). Clemons and Row (1992) broke down transaction costs as follows: Transaction costs = Costs of coordination + Costs of transaction risk Transaction risk = Transaction-specific capital + Information asymmetries + Loss of resource control Primarily, Clemons and Row (1992) argued that new communication technology would reduce coordination costs. They also stated that coordination costs are largely independent of whether an interaction occurs within a single firm or across firm boundaries. For the part of transaction risks, they reasoned, new communication technology would reduce transaction risk by reducing the level of transaction-specific capital and by reducing the cost of monitoring and control among separate firms. Later, Clemons, Reddi and Row (1993) made some changes in their previous argument and analyzed transaction costs as follows: Transactions cost = Coordination cost + Operations risk + Opportunism risk They defined coordination cost as the cost of exchanging information and incorporating the information into decision processes in a broad sense. Operations risk was defined as the risk that the other parties in the transaction willfully misrepresent themselves or withhold information, or underperform their agreed-upon responsibilities. They added that the operations risk stems from differences in objectives among transacting parties and is supported by information asymmetries between the parties or by difficulties in enforcing agreements. The last component of transaction costs, opportunism risk, was referred to as the risk associated with a lack of bargaining power or a loss of bargaining power directly resulting from the execution of a relationship. They broke down the opportunism risk into three parts, relationship-specific investments, small-numbers

bargaining, and loss of resource control. The themes lying beneath these analyses of transaction costs were the same: New communication technology would lead to more tightly coupled interfirm relationships across various industries by reducing coordination costs while not increasing transaction risks previously incurred by high coordination. Indeed, this notion contains a great deal of truth. At the same time, however, we cannot help disagreeing on four crucial points. First, we assert that coordination costs are not independent of whether the 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 a market. If coordination costs were not appreciably different in the two cases, outsourcing would be more desirable for any firm as long as its transactions with suppliers do not involve a substantial amount of transaction-specific assets. Second, opportunism is not limited to a small portion of transaction costs. Rather, opportunism is one of the two basic behavioral assumptions of TCA and widespread across the whole process of transaction activities (Williamson, 1985). Third, they did not show how new communication technology could lower asset specificity other than information-based asset 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 their reasoning, the most desirable governance mechanism was a middle ground between market and hierarchy, a so-called cooperative relationship, which was unobtainable only because of high coordination costs and transaction risks. In this scenario, the biggest contribution of new communication technology would be reduction in coordination costs and transaction costs, which enables cooperative relationships between suppliers and buyers. Quite differently, TCA regards a market as the ideal governance choice. Only when procurement through market mechanisms become too expensive because of high uncertainties and asset specificity will the firm search for better alternatives such as a closely coordinated cooperative relationship or hierarchy. While most of the arguments supporting the move-to-the-middle hypothesis were based on theoretical speculation or conceptual modeling, Stump and Sriram (1997) actually tested the move-to-the-middle hypothesis with empirical data. Not surprisingly, they failed to establish a direct relationship between a buyers investment in new communication technology and the overall closeness of the buyer-supplier relationship. The two variables were only indirectly associated by a mediating variable, the percentage of purchasing transactions using new communication technology. These findings illuminate the possibility that organizations use new communication technology in 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 hypotheses might be attributable in part to the various directions that communication technology developments have taken since the formation of the hypotheses. It must have been a difficult job to predict exactly how information technology would unfold within five to ten years for the researchers in the 1990s, let alone for those writing in the 1980s. Although there 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

technology. Albeit it was the harbinger of electronic commerce, expensive installation and 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 an electronic spot market. Also, once having adopted EDI, the companies would rather closely 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 with the old technology while some may be trying to integrate new and more standardized technology into their existing system. Even if companies want to adopt the new technology, there are many financial, technological, regulatory, and other environmental obstacles. From observation of the capital market automation process, Picot (1995) named this phenomenon vision-reality discrepancy. Unlike the prediction of unanimous transformation to one or the other, capital market automation resulted in a heterogeneous spectrum of electronic trading systems. The main cause of the phenomenon was a substantial amount of variation in the completeness of information obtainable through electronic systems. However, this chronological disadvantage cannot excuse the hypotheses from their technology-deterministic perspective. The principal drawback of the hypotheses was not their shortsightedness about the direction of technological progress, but their misunderstanding of the fundamental governance problems addressed in TCA and their consequent prescription of global remedies for organizations with different governance problems.

The Internet-Based Supply Chain Management and Governance Mechanism

The fact that new communication technology cannot favor one governance mechanism over 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 way firms interact with each other. The technology itself cannot be a direct cause of governance choice, but the way the technology is used by organizations will lead to either an earthshaking transformation or the status quo. Therefore, understanding fundamental governance-related problems and the effects of new communication technology 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 of economic organizations. According to this theory, the tradeoff between production costs and transaction costs of a firm indicates the most appropriate governance mechanism for the firm among three broadly generalized types of interorganizational coordination: market, hierarchy, and hybrid. The major advantage of market over hierarchy stems from 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

control. Between the two, TCA maintains market as a default mechanism in modern capitalist economies. TCA maintains that there are three dimensions in which one transaction is different from another: transaction asset specificity, environmental uncertainty, and behavioral uncertainty. TCA assumes that the most basic unit of the economic agent, the human, is intentionally rational, but only to a certain extent (Simon, 1961). Also, TCA assumes that economic man seeks self-interest with guile (Williamson, 1985). Under these assumptions of bounded rationality and opportunism, the presence of transactionspecific assets gives rise to various governance-related problems. Since transaction-specific assets cannot be salvaged without a substantial loss in their values, transactions that require a significant investment in transaction-specific assets creates lock-in situations. Lock-in situations carry the risk of holdup problems to procurers. On the other hand, it can also damage providers by forcing an unbearable amount 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 in various ways including crafting lengthy contracts and broadening supply bases. Environmental uncertainty can be interpreted as unanticipated changes in circumstances surrounding an exchange (Noordewier, John & Nevin, 1990). Hence, adaptability to the unanticipated changes is crucial. Adaptation is not only required within organizations, but also between organizations. However, it is not always easy to induce cooperation from transaction partners in market governance. To adapt to changing environments in a timely and efficient manner, therefore, firms have to expend heavily on communication, negotiation, and coordination costs. Behavioral uncertainty is often understood as the degree of difficulty associated with assessing the performance of transaction partners (Rindfleisch & Heide, 1997). In evaluating the performance of transacting partners, information asymmetry is the core problem. Some information asymmetry can be of a non-strategic kind, caused by a simple lack of communication. However, some information asymmetry can be created strategically to take an unfair advantage of transaction partners. Firms may not release information important to transaction partners intentionally. Furthermore, they may provide their partners with false information. To prevent these problems, firms have to find appropriate partners and constantly monitor their performances. And these activities 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 can make it difficult to predict sales volume. Constant advances in production technology are another contributing factor. Predicting new products or new markets almost always bears some degree of uncertainty. In addition, unpredictability may stem from unfamiliarity with the business environment such as policy and culture in foreign

markets. Facing these uncertainty issues, participants of a supply chain may significantly benefit from the seamless communication made possible by the adoption of new communication technology. Increased bandwidth and decreased response time in information exchange, among many benefits, are expected to eliminate various sources of uncertainty and subsequently reduce adaptation costs. Volume instability in extant markets is the most common problem of environmental uncertainty that economic organizations face on a daily basis (Rindfleisch & Heide, 1997). Even within this narrowed area of environmental uncertainty, there are many ways that new communication technology can reduce the problem. In the first place, rich information can be exchanged between transacting partners with a greater speed and efficiency at less expense. In procurement, time and resources needed for the search for suppliers can be drastically reduced. Firms can improve their prospects of acquiring a sufficient quantity of goods or services in case of demand surge. In the sales of products and services, firms can at all times have one extra outlet with a huge number of potential buyers. Faster and accurate communication within a supply chain has positive effects on inventory management as well. Although just-in-time procurement has already been in place with the introduction of EDI, expansion of the network without significant further investment enables firms to cut every corner of inventory handling costs. The rapid flow of information without interruption enables firms to renegotiate terms or adjust to design changes before incurring irrecoverable costs for transacting partners. Therefore, the damage caused by failure to adapt to environmental changes can be ameliorated in a relatively expedient manner. The notion that Internet-based communication systems reduce coordination costs has largely been supported by researchers. Earlier, Bakos (1991b) simulated the reduction in stockout costs with the deployment of new information technology. Gebauer and Segev (2001) also indicated drastic reduction in coordination costs as an underlying mechanism of integrated procurement functions led by the Internet. Case analyses of a used car market and a nutraceutical industry revealed reduction in coordination costs through processing improvements, marketplace benefits, and indirect improvements (Garicano & Kaplan, 2000). The impact of new communication technology on behavioral uncertainty can be more complicated because of the partially strategic nature of behavioral uncertainty. The problems of behavioral uncertainty originate from information asymmetry of both strategic and non-strategic kinds. On the positive side, new communication technology can extend choices for firms to pick their transaction partners ex ante. It can be especially useful for firms that had been experiencing difficulties in finding suppliers or buyers within their geographic boundaries. Without the technology, identifying potential transaction partners and then selecting one of them based on the information obtained from various sources can be a drain on both time and resources. Internet-based communication systems enable firms to receive bids from both regional and national organizations. By comparing bids from many candidates, firms can understand the market situation more fully and thus increase their ability to select the best fit for their demands. Also, managers can utilize electronic information sources and communication

tools to check the backgrounds of potential transaction partners. In addition, a companys Website can provide prospective bidders with detailed information about the company. Subsequently, the information on the Website may help the bidders self-selection. During and after transactions, Internet-based communication systems can make sales records more transparent. For less standardized performances, increased capacity of the network may allow more frequent samplings of the downstream 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 about agents hard-to-measure performances. Still, a substantial amount of information asymmetry may remain, especially if the asymmetry were intentionally created by transacting partners. Even worse, too much dependence on new communication technology for performance evaluation can cause another set of problems. The emergence of spot markets supported by the Internet calls for 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 than price and product specification is hard to convey via the Internet. Cultural incompatibility between two trading firms, undetected at the moment of contract, can interrupt the flow of information and products later. Also, socialization, one of the most effective ways of reducing monitoring costs, may become inapplicable. Socialization occurring between transacting partners over the course of the business process often takes care of a great many monitoring problems. However, automation of transaction processes deprives transaction partners of socialization opportunities. As a result, the relationship may become more vulnerable to opportunism and, consequently, incur more monitoring expenses. The risks associated with the heavy dependence on Internet-based communication technology are also present after a transaction is completed. Traditionally, most transactions have been executed within certain industrial and geographical boundaries. Therefore, local reputation kept opportunistic behaviors in check. It was also relatively easier to recover from the damages done by an adverse selection. If firms choose their transaction partners outside of conventional industrial and geographical boundaries, purely based on the information provided on the Internet, the social embeddedness of economic behaviors has no power to either reduce the amount of damage beforehand or enforce compensation for the damage afterwards. Although any social relationship between transaction parties had been regarded as a threat to efficiency by some economists, the notion that concrete personal relations and networks of such relations generate trust and discourage malfeasance has gained popularity during the past two decades (Granovetter, 1985). There are even more variables to consider regarding the effects of Internet-based communication systems on asset specificity and the subsequent costs required to safeguard transaction specific assets. More than anything else, the Internet can reduce transaction asset specificity by simply broadening the choice for procurers. The

broadened choice overcoming geographical boundaries reduces a firms reliance on its existing partner and opens up the whole world of potential suppliers with the capability and willingness to engage in a transaction. Scholars also added that the Internet 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 communication systems (Clemons et al., 1993), and speeding up knowledge diffusion (Picot et al., 1997). Although these changes are important enough to be noticed, however, the Internets ability to reduce asset specificity appears to be somewhat overstated. Production of non-information goods still requires certain material equipment, skilled labor, physical space, and a certain amount of specialized capital. Also, the produced goods or services should be handled by sufficiently knowledgeable sales agents who also maintain a strong bond with their customers. Even if Internet-based communication systems 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 perform such crucial activities online. Steinfield, Chan, and Kraut (2000) found no evidence that the use of the Internet reduces transaction specificity of assets in four different industries. They also revealed a tendency for only the firms with previous electronic transaction experience to use the Internet more to procure major supplies. For the national or global economy as a whole, opportunity costs of asset specificity may increase with wide adoption of Internet-based communication systems. The prospect of investing in production facilities to produce transaction specific assets seems to be significantly diminished. So far, too much emphasis has been placed on the mere execution of electronic transactions, while strategies for electronic transactions have been virtually ignored. Firms have been busy with conducting businesses online without 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-term plan of how to differentiate themselves from others. As a result, firms in electronic markets cannot exchange credible commitments with their transaction partners. Indeed, most transactions currently occurring through the Internet are solely based on price competition (Bakos, 1991a, 1997; Kambil, 1997; Porter, 2001). An empirical study (Kraut, Steinfield, Chan, Butler, & Hoag, 1998) provides direct support for this perspective. In an examination of the relationships between the use of electronic networks, asset specificity, and the degree of outsourcing, outsourcing of transaction specific assets decreased with an increase in the use of electronic networks. Gebauer and Zagler (2000) speculated on the notion that the nature of the transaction determines the governance mechanism. They stated that products low in value and high in process cost should be obtained by short-term oriented buying processes, whereas products characterized by high complexity, innovation and strategic relevance should be procured by long-term oriented sourcing processes. When the focus of the transaction is the cost of products, according to Gebauer and Zagler, the transaction occurs midway between sourcing and buying. For each of the three product types, the role of Internet-

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

The Internet-based Communication Systems and Governance Mechanism Choice

Making a decision between hierarchy and market is a two-step process. First, a manager of a firm should figure out how much cost reduction will be gained under a hierarchy system and a market system respectively. Second, the amount of cost saving in procuring the same product/service using market versus hierarchy systems should be compared. This comparison process is crucial, but often neglected because researchers tend to assume that Internet-based communication systems reduce procurement costs between firms more than they do within a firm. The whole discussion of the move-tothe-market hypothesis was built on this unproven assumption. Earlier, Kraut and his colleagues (1998) raised a question concerning its validity. They insisted that the dominant view of the effects of electronic networks underestimated benefits to firms adopting the technology for internal uses and proved their point by demonstrating a positive effect of electronic network use on the level of in-house production. Market systems will mostly benefit from the reduction in transaction costs, whereas hierarchy 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 the three. If a firm adopted hierarchical governance mechanisms mainly because of asset specificity of a non-information kind, then cost reduction resulting from the adoption of the Internet-based procurement system would be minimal. Conversely, if either nonstrategic behavioral uncertainty or environmental uncertainty were the primary reason for deploying hierarchical governance mechanisms, a firm would be able to reduce transaction costs significantly. In such a case, switching to a market system would be a strategically sound choice. Of course, the reduction in transaction costs under the market system should be bigger than the reduction in production costs under the hierarchy 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 choice between market and hierarchy, transaction cost reduction in market and production cost reduction in hierarchy should be compared. Hypothesis 1-1. With high asset specificity, use of the Internet in supply chain management is less likely to affect the choice of market or hierarchy as the governance

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

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 hierarchy system, asset specificity can make firms choose more closely coordinated inter-firm relationships among various hybrid forms of market-oriented governance mechanisms. Both arms-length relationships and more closely coordinated markets would benefit from the reduction in transaction costs. Assuming that the cost reductions in both market systems cancel each other out, it would be asset specificity that decides the choice between these two governance mechanisms (Figure 2). Firms with high asset specificity will prefer closely coordinated market governance mechanisms over armslength 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 reduction between the two should be compared. Hypothesis 2-1. With high asset specificity, use of the Internet in supply chain management is less likely to affect the choice of arms-length relationship or close coordination as the governance mechanism. Hypothesis 2-2. With low asset specificity, use of the Internet in supply chain

management is more likely to favor arms-length relationship over closely coordinated markets 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 tradeoff model in governance choice. Traditional arms-length relationships were perceived to be relatively safe from opportunism because they had been established for the spot transaction of non-specific assets, under low environmental and behavioral uncertainty. Aside from the real level of risk, however, electronic transactions seem to have increased the perceived vulnerability to opportunism. Consequently, arms-length relationships will become more vulnerable to the reputation effect, which used to be salient mainly in hybrid contracting (Williamson, 1991). Although systematic research on this matter is virtually non-existent, anecdotal evidence is not hard to find. Proliferation of hybrid online/offline business compared to pure online players is one piece of evidence (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 of senior management support (E-procurement, November 20, 2000). And the untrusting voice of the senior management can be heard from many places (Bennett, October 23, 2000). Business managers increased risk perception of electronic transactions is expected to result in strengthened relationships with their previous offline transaction partners. Many manufacturers are not going to dump their previous suppliers for the sake of cheaper

bidders online. Business media report on many companies maintaining their existing relationships with offline partners although they have a capability to find substitutes online (Bennett, October 23, 2000; Bulkeley, July 17, 2000; McGinnis, October 30, 2000). A case study examining 18 firms employing the online-offline hybrid approach drew a similar picture. Although the hybrid channel system presented such advantages as cost savings, improved differentiation, and enhanced trust, it promoted market extension 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 80s that complex organizations achievable from comprehensive integration were the right means by which complex products and services should be created and delivered to customers. Consequently, large, hierarchically integrated firms were supposed to be the rule of governance systems. Opposing this technological determinism, Williamson insisted on adhering to the TCA framework. According to Williamson, goods or services can be supplied by either of two alternative technologies: general-purpose technology and specific-purpose technology. Special-purpose technology, in contrast to general-purpose technology, was defined as technology that required a greater investment in transaction-specific durable assets. And it was the significance of specific-purpose technology involved in the production and transaction processes that determined governance mechanism choice. His position is well expressed in this paragraph:
decisively superior to all others and (2) that technology implies a unique organization form. Rarely, I submit, 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).

technology is fully determinative of economic organization only if (1) there is a single technology that is

Approximately two decades later, we find ourselves in a situation where the above statement is very applicable. Ironically, this time, the warning should be issued to a couple of perspectives that regard markets, not hierarchies, as ideal governance mechanism 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 same time, it is at best a production-assistant technology, rather than a production technology. Therefore, it is very unlikely that one particular governance mechanism is recommended to every firm because of the Internet. Still, the theses presented here need empirical support. It may come from various forms such as case or survey studies. And once this simplified frame is verified, more research has to be conducted with specific dimensions of asset specificity, environmental uncertainty, and behavioral uncertainty. With an improved understanding

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

Footnotes
1. Throughout this manuscript, the terms new communication technology and Internet-based communication systems are used interchangeably. Since there are numerous kinds of e-commerce systems, the two terms refer to a wide range of Internet-based procurement systems that include both net marketplaces and private 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 the Department of Telecommunications, Bowling Green State University. She studies new communication 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 the Department of Telecommunications, Bowling Green State University. His research area is 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