Marketplaces Part I - What is a Marketplace Business

While on a diplomatic visit to the United States in the Fall of 1989, future Russian president Boris Yeltsin visited Randall’s, a local supermarket in Houston. At Randall’s, Yeltsin was floored not only by the selection of groceries available to the common American, but also by how little skill or training it took to become the store manager who provided it. This experience, contrasted against the long lines and limited selection of Soviet markets, shook Yeltsin’s belief system to its core:

“When I saw those shelves crammed with hundreds, thousands of cans, cartons and goods of every possible sort, I felt quite frankly sick with despair for the Soviet people” [link]

An aide who accompanied Yeltsin on his visit later remarked that through this experience, “the last vestige of Bolshevism collapsed” inside [Yeltsin].” [link]

Randall’s supermarket wasn’t merely better than the average markets of Soviet Russia, it was orders of magnitude better than even what was available to Russia’s most powerful citizens like Yeltsin.

How could one system of organization, despite possessing similar enough resources and ambitions, produce something so remarkably different?


What is a Marketplace Business

For as long as there has been civilization, there has been trade. While trade undoubtedly existed with nomadic tribes, pre-antiquity societies offer the first evidence of buyers and sellers congregating to exchange goods. Physical congregation allowed buyers and sellers to more easily find each other, while the added number of participants created competition and greater certainty in fair transactions. Overtime, cities formalized these spaces with designated districts, purpose built structures, and new laws, all of which enabled greater levels of trade. [link]

As life’s necessities increasingly became obtainable via trade, quality of life improved. Where once survival monopolized an individual’s time, through trade, they could specialize in a valued craft and exchange surplus production for necessities. Trade is a major reason why making something as seemingly simple as a sandwich “from scratch” (read: on your own) requires $1,500 and 6 months of time.

Today, “Marketplace Businesses” like eBay, AirBnB, and Amazon extend trade even further by congregating buyers and sellers in what are now digital spaces. Just like the physical marketplaces of history, digital marketplaces create significant value for the economy and society. To understand what marketplaces are and how they creates value, requires an exploration of exchange, price, and firms.

Exchange

In The Wealth of Nations, Adam Smith observes that exchange creates value:

“Give me that which I want, and you shall have this which you want, is the meaning of every [exchange]; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of”

Given agency and proper information, individuals will only engage in exchange (or any activity) if it benefits them individually. For an exchange to occur under this assumption, both the buyer and the seller must be made better off. Mutual exchange, therefore, creates economic value where it did not exist before, and because of this, its participants can acquire more “good offices” (i.e. utility) than they could have produced on their own. According to Smith, exchange creates this value by enabling specialization, which itself leads to greater output, efficiency, and innovation:

“the certainty of being able to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men's labour as he may have occasion for, encourages every man to apply himself to a particular occupation, and to cultivate and bring to perfection whatever talent or genius he may possess for that particular species of business...”

When individuals are confident that the goods and services they need are obtainable through exchange, they are more likely to specialize and trade. When individuals specialize, they become more efficient and knowledgeable, seek innovations specific to their craft, and realize economies of scale. These factors create real value, which Smith observed in the elevated output of specialized pin makers.

In addition to creating value through specialization, exchange also creates prices. Exchanging a quart of milk for a carton of eggs, for instance, establishes an egg-denominated price for milk. When prices are denominated in a common currency (i.e. money), the value of all goods and services become directly comparable. Buying milk with money, removes the need to fully understand the value of eggs. Prices represents information, which money then desomanates.

Price

In his 1945 essay The Use of Knowledge in Society, Friedrich Hayek describes how this transitive property of price enables markets to efficiently communicate information and reach organizational solutions that only an omniscient “single mind” could have on its own:

“The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.”

Through exchange and price, a buyer of milk places a valuation on pasture lands, cattle feed, labor, bottling, and transportation without knowing anything about the production of milk itself. When many commonly denominated transactions coalesce into a single complex system, we call it a market. As Hayek observed, price driven markets exhibit emergent behavior that organize resources in ways resembling pareto efficiency.

Randall’s supermarket floored Yeltsin by leveraging this sort of hive mind. Unlike a Soviet grocery store, Randall’s didn’t rely on a far off authority to guide the stocking of its shelves. Instead, Randall’s served as a local node within a larger organizational system, allowing the stocking of its shelves to be dictated by supply and demand (i.e. exchange and prices). If Randall’s customers consistently under-purchased a particular item, Randall’s managers may demand fewer units or a lower price from their suppliers. Suppliers who could not remain profitable at the lower prices would seek alternative uses for their labor, land, and equipement, while suppliers most suited to produce the item at a low cost would stay in business.

This market process, repeated across many products and overlapping businesses, rearranges and optimizes the entire economy’s resources, allowing the demands of society to be met a the lowest possible cost. For Yeltsin’s Russia to achieve parity at the grocery store, it would need to efficiently collect all relevant economic information and conduct an incomprehensibly complex set of optimizations to direct the economy’s production. Exchange creates value both in the act itself and in the resource optimization that follows.

However, this begs the question. If prices and open market exchange are so superior for allocating resources, why is Randall’s or any other business required at all? What separates the managers at Randall’s from the bureaucrats in Moscow? Why can’t buyers and sellers in an economy transact directly?

Firms

In The Nature of Firms, Ronald Coase observes that leveraging the “price mechanism” of a market’s exchange has a cost of its own, and when the cost of exchange exceeds the allocative benefits of exchange, firms emerge to dictate resource allocation centrally:

But in view of the fact that it is usually argued that co‐ordination will be done by the price mechanism, why is such organisation [by firms] necessary?...

It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism...The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism...

A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.

Randall’s, as an entity, existed to foot the transaction costs that made it too expensive for buyers and sellers to reach mutually beneficial exchange on their own. To transact directly with buyers of finished milk, a dairy farmer would need to identify where these buyers lived, secure refrigerated storage near those buyers, and convince those buyers that the milk was safe to drink. Instead, Randall’s secured all of those capabilities and, in return, made a profit.

When costs are high, businesses (read: firms) emerge to internalize functions that are too expensive to acquire via exchange. Though they may not directly face the end consumer, all firms reside within a value chain that transforms raw materials into finished goods and services through a series of internal (firm) and external (market) exchanges:

value_chain_coase_hayek_firm_market.png


The more activities can be completed via exchange, the more efficient the system will be at allocating resources.

Like firms, individuals internalize transactions when the cost of market exchange exceeds the benefit. For instance, to ensure reliable access to food, individuals learn a skill (cooking), expend time finding ingredients (grocery shopping), and purpose a portion of their homes for food preparation (the kitchen). Because the transaction costs associated with finding a reputable cook who can deliver finished meals at a knowable price are comparably high, individuals are better off preparing meals on their own, even if it requires them to “waste” time, money, and space on the process.

The firm, whether a business or an individual, represents both inefficiency and necessity. The firm lacks the market’s “hive mind” for resource allocation, but can allocate resources endogenously through “internal exchange.” While internal exchange is a less efficient allocator, it enables transactions and economic activity that would otherwise not exist.

Enter, Marketplace Businesses

While the standard firm develops capabilities around internalizing transaction costs, marketplaces implement systems that reduce them--this is the defining function of a Marketplace Business.

Hotels, for example, package well located real-estate, excess room capacity, on-premise services, and branding into a lodging product that end customers can buy. Hotels develop these capabilities, at considerable cost, because arranging quality lodging through exchange is too costly for the end consumer. Hotels internalize the costs of discovery, reputation, and reliability.

AirBnB on the other hand reduces these transaction costs through listings, reputation, and payment systems. By reducing transaction costs, AirBnB enables lodging to be acquired through exchange between a buyer and seller. More importantly, AirBnB accomplishes this through scalable systems rather than less scalable, internal capabilities like the development of physical property.

Allocating resources via exchange rather than through a firm dramatically improves the end product. Even if a single Hotel firm monopolized an entire market, it could never individually posses 1) the information necessary to accurately predict future demand and 2) the flexibility to adjust its supply fluidly. Conversely, a market built on exchange places a valuation on lodging--and its inputs--in real time, allowing individual agents to meet demand dynamically using price as a coordinating signal. An analysis of any marketplace will reveal a wider selection of products, offered more reliably, and at comparably lower prices.

This principle also impacts the demand side. When products are available through exchange, buyers can eliminate the firming behavior they previously exhibited to enable consumption. For instance, if reliable personal transport can be acquired via exchange, individuals no longer need to own cars for on demand transportation. Marketplaces release the money stored in owned assets. Because the marketplace product is always cheaper, this means higher consumption, surplus funds, or both.

How Marketplaces Create Value

Marketplaces reduce transaction costs with technology, enabling acquisition via exchange where previously firms were required to deliver the end product. By enabling exchange, marketplaces drive greater specialization and unlock resource allocation via price. As observed by both Smith and Hayek, these mechanisms are the foundation on which our modern prosperity is based.

Though marketplaces represent a transition from centralized to decentralized decision making, marketplace businesses are neither self-forming nor devoid of central management. Marketplaces must be built and some functions must managed like a firm…


Part II of this series will explore the role management plays in marketplaces