The economic model

Friday, April 16, 2014

Buying and selling on the web now touches almost everyone on the planet. With small business becoming increasingly globalised, a professor at Yale University is suggesting that web-based commerce has just seen a radical transformation. We asked economist Ian Alexseev to explain the background to the evolution in online trading he describes in his new book The multi-factor auction. E-commerce comes of age.

You can now buy anything over the internet. Even online business-to-business trading in services has gone viral. Can you explain why this sort of e-commerce just keeps growing and growing?

Alexseev: There has been a fundamental shift in how we do business online. In the late 90’s web businesses mushroomed because the possibility of reaching millions of customers became a practical reality. The “dot-com” business model relied on harnessing network effects to quickly build market share. But the underlying economic model of online business was weak, and the dotcom bubble quickly burst.

What was wrong with the model?

Alexseev: Successful economic activity requires the enthusiastic participation of both buyers and suppliers. Early e-commerce models tended to favour one group or the other. Auction-style marketplaces were a classic example. B2B buyers needed little prompting to jump into an auction where the price was likely to tumble rapidly to rock bottom. But suppliers were less enthusiastic. Intolerable pressure on price meant that suppliers were forced into unsustainable business relationships, and they often ended up going broke.

So what changed?

Alexseev: The realisation that customers don’t buy on price alone. We don’t buy on price alone in the real world, and the other factors which influence our purchasing decisions become even more important in the more restricted online environment. Customers want to weigh up the pros and cons of different offerings, and assess the risks and the benefits of one choice over another. Suppliers want to be able to win business on the basis of their own particular competitive advantages – not just price. Early web auctions didn’t allow for this sort of flexibility and so they were never really very satisfactory and many failed.

The multi-factor auctions that we see today took the world by storm because taking part suddenly became economically viable for all parties – everyone got a benefit. Buyers are looking for advantages across a range of factors and suppliers can play to their competitive strengths. In the old reverse auction models, the supplier was always in a weak position – the new models have seen a fundamental shift in the power relationship between buyers and suppliers.

So these new auction models created a more level playing field for buyers and suppliers. How did that happen?

Alexseev: The introduction of non-price factors that could be auctioned made the fundamental difference. Suppliers could now bid on delivery times, or different levels of customer service as well as price. This gave suppliers more than one lever to pull in an online auction. Rather than just drop his price, a supplier could now ramp up the customer benefits he offered to improve his competitive position. Buyers responded enthusiastically because they now had the suppliers vying for their custom on a whole range of factors that were important to them.

The factors up for auction are the buyer’s “hot buttons”. Suppliers compete to press as many of the buyer’s hot buttons as they can. Buyers choose the supplier who can provide the best possible combination. Price is a hot button – but it’s not the only one.

I did a Google search on multi-factor auctions a few years ago. It only gave me 4 or 5 hits. Now it’s everywhere! So where did the idea come from?

Alexseev: In the early 2000’s the idea was virtually unknown. It was kicked around by a few academics and discussed informally at the odd international e-commerce conference. Hardly anyone understood the model. It comes from work done by John Nash at Princeton in the 1950’s. In 1994, he won the Nobel prize for economics for his radical ideas. In popular culture Nash is known as the father of the “win-win” theory from his portrayal in the 2001 movie A Beautiful Mind. He provided a mathematical solution to the problem of how deals can be negotiated where both parties get a beneficial outcome.

So how does that work in practice?

Alexseev: For both parties to get an economic advantage from a deal, each party has to know what the other has to trade in exchange for the advantages it wants. This is the theory that launched OpenBorder. They were the first to implement the model in a practical way that triggered massive buy-in from small business around the globe – both buyers and suppliers.

So what did OpenBorder do with Nash’s theories to cause such explosive growth in their business?

Alexseev: OpenBorder managed to tap into buyers’ and seller’s most fundamental motivation for being in business – to make a profit and negotiate a successful deal on every transaction. The theory requires some “give and take” between the traders. An advantage to one party is counter-balanced with an equivalent advantage to the other party. Disadvantages are traded too – accepting a disadvantage can be traded to gain a bigger advantage. So the system implies a delicate balance of trade-offs until the negotiating parties have both got the most favourable outcome possible under the particular circumstances. Just like in Nash’s mathematical model – both parties get to win from the transaction.

When you can make everyone really happy with the outcome of a business deal, you’ve got the formula for a huge and profitable business. This is just what OpenBorder did.

So how did OpenBorder incorporate these types of win-win trade-offs into its cross-border business model?

Alexseev: The buyer gets to put the supplier under pressure, on price, quality, delivery time etc through the auction system – but this advantage is counterbalanced by the buyer carrying the risk of a forex exposure should the deal go sour.

The supplier, on the other hand, accepts the disadvantage of being put under pressure to perform on price, delivery and other factors, but this is counterbalanced by the certainty of being paid their exact bid price in the currency of their choice. It is this sort of fair balance of risk and rewards which ensures that both parties get good outcomes from the deal. The buyer wouldn’t be interested unless the system maximizes the benefits he can extract from suppliers. And small business suppliers would never risk entering a cross-border auction if the price he had negotiated was subject to change from currency fluctuations after the deal was struck.

OpenBorder was the first to solve the currency problem for countless small businesses around the globe and made it possible for them to get involved in international trading. Once this barrier was removed, it was just as easy to do business in Bulgaria or Ecuador as it was to do a deal with someone across town.

It was OpenBorder’s entry into the market around 2012 that saw the real beginning of the globalisation of small business. It triggered a huge explosion of economic activity between hundreds of thousands of small businesses scattered around the globe.

So was it just OpenBorder’s application of Nash’s economic theories to the currency problem that made the company grow so huge?

Alexseev: No. OpenBorder incorporated these simple ideas into the very fabric of its business, right down to the very design of its websites. The whole business runs on a system of trading advantages between the players during the course of an auction to ensure that there is always a good outcome for both parties.

There’s a dynamic relationship between all the factors in the auction. If suppliers can see that a buyer is in a hurry to receive his work, then the focus of competitive bidding might centre on who can deliver earlier. A supplier who promises to deliver earlier than his competitors must balance the risk of failing to deliver (and not getting paid) by asking a higher price. The buyer however might be willing to trade the advantage of earlier delivery against a higher price. This is the counterbalance. If the supplier can deliver earlier then he might well win the auction at a higher price than his competitors were asking. This is just the online equivalent of market forces in the real world.

The auction process is transparent to all the players. Bidders can see what other competitors are offering and can figure out if they have any competitive advantage. There’s a built-in counterbalancing advantage to this – bidders don’t waste their time entering auctions they have no chance of winning, and rather look elsewhere for opportunities.

Balance and counterbalance are the mechanisms that bidders use to compete. If someone drops his price, then another might counter in response by shortening his delivery time.

If a supplier has a low order book, then he can afford to drop his price as part of his strategy. In times when he has plenty of work, he can afford to raise his price. If he has other competitive advantages, he’s in a position to win more work at higher margins.

It can get more complex. A buyer might be looking for higher quality but is relaxed about delivery timeframes. Higher quality will reduce the number of bidders who can supply and will push the price up, but the lack of urgency will favour a lower price. OpenBorder offers six factors in its auctions – so the number of possible combinations of different factors is huge – and this complexity offers immense opportunities for competitive bidding.

So the buyer and the supplier can both make these sorts of trade-offs in the course of an auction?

Yes. During a multi-factor auction bidders jockey for position by offering combinations of factors that they think might meet the buyer’s needs. OpenBorder’s auctions are open to all-comers on a global scale, so buyers get to choose from the best possible combinations of competitive advantages available at that time on the planet.

But in any auction, only one bidder can win. This doesn’t really seem like a win-win situation does it?

Alexseev: There is a powerful win-win counterbalance here too. OpenBorder’s system offers service providers hundreds of opportunities to compete, but the ultimate pay-off is not just the chance to win a one-off contract. Successful suppliers get the chance to develop long-term commercial relationships with buyers. So the effort put into competitive bidding can represent an important long-term economic benefit.

As I show in my book, these new business models, with their more complex multi-factor auctions, are the online equivalent of what happens in the real world – but ramped up to a global scale across scores of countries. With small business now becoming increasingly globalised, e-commerce has now really come of age.

8 Responses to The economic model

  1. Pingback: Real-time, cross-border trading for the language services industry | The translation business

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  4. Pingback: Special invitation | OpenBorder blog

  5. Pingback: “Trade Me” exec joins ambitious language services internet start-up | The translation business

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  8. Armands says:

    Is this a bluff?
    Or OpenBorder was just a project in theory, not working in real life?

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