Markets, as mechanisms for scarce-resources allocation under competing demands, have evolved and adapted to changing circumstances, such as climate change, epidemics, famine and human nature, periodically creating imbalances in the economic system. Currently, we are in the throes of another shock to the system, a technological shock in the form of digital connectivity, creating a network of economic agents, a network economy. What does this perturbation mean for resources and trade? Are there new scarcities? Is the exchange of goods and services governed by new rules? How can we characterize the network economy? (I use the acronym internet to refer to the architecture of mobile, digital communication technology as well as the entire cyberspace of connectivity. In 1995, Tim Berners-Lee called this the World Wide Web, WWW, or a multi-purpose network of packet switched data.)
If the rules of the trading game have changed, is there more cooperation or more competition?
My answer, in brief, is that we are witnessing the simultaneous existence of granular, peer-to-peer digital transactions and organizational behemoths, as well as new scarcities and new mechanisms for resource allocation, as digital communication technology (DCT) shifts boundaries between economic agents. The scope of trade has been redefined by four trends.
The first is the trend towards organizational restructuring (OR) due to disintermediation on an economy-wide scale. The second trend is a recalibration of competition. The third trend is the development of organizational behemoths (OB). And the fourth trend is commoditization of time. While the outcome is cooperation resulting from massive sharing of personal information on social media, in some situations, the likely outcome can become adversarial.
In the restructuring trend (OR), products are becoming more granular and intermediaries are less dominant in the economic landscape. (By granular, I mean “small”, comparable to grains of sand. In other words, no economic participant is distinguishable in size from another. However, the character of each grain will differ.) Granularity of products arises from an unbundling of lumpy purchases, such as ridesharing replacing vehicle ownership. Organizational granularity empowers smaller trading units, which retain control with a concomitant reduction in size, where size is measured by the number of employees. Connectivity allows information transfer, which enables restructuring the organization of trading units into smaller entities. Connectivity has the potential to generate heterogeneity of ideas and cultural diversity, thereby providing fertile ground for startups and entrepreneurial activity. Connectivity becomes more potent in its impact because of the mobile dimension—the anytime and anywhere idea. According to a recent Pew Research Center survey, nearly two-thirds (64 percent) of American households own a smartphone and 7 percent of American households do not have any internet connectivity at home or elsewhere, other than via their smartphones.
The data shows that the number of small firms in the United States has been increasing year-over-year since 2005, with small being defined as firms that have between 3 and 250 employees. But while the number of small firms is increasing, the number of employees at these firms is decreasing. Entities such as Elance-oDesk (founded in 2003 but rebranded as Upwork in 2015), Grubhub (2004), Airbnb (2007), TaskRabbit (2008), Uber (2009), Blue Apron (2012), Instacart (2012) and Shyp (2014) were all founded as small firms. While firm age and size are likely to be correlated at inception, the notion of startup is best captured by firm age and not firm size.
The data on entrepreneurial activity suggests a resurgence of entrepreneurship: The Kauffman Index of Startup Activity, a composite of entrepreneurial activity in the US, increased in 2015, reversing a five-year downward trend that began in 2010. Particularly noteworthy is that this index defines startups as firms younger than one year, with at least one employee other than the owner.
Disintermediation in financial markets is evidenced by innovations such as the digital wallet (Apple Pay, Google Pay, Venmo and Square), shortening the financial supply chain by unbundling the intermediation function of bank deposits and providing a payment mechanism but not a store of value. Most new payments technologies ultimately link back to bank deposits; but by making processing easier, these new payments services are eliminating banks from the lucrative part of the payment supply chain—connection with customers. What may be eliminated is cash as a form of payment. Boundaries between products and between industries have become blurred, giving rise to a fluid economy in which definitions of markets and transactions are ambiguous. For example, the distinction between financial intermediaries and payments services, such as Venmo, has widened.
In order to build the connection between technology and disintermediation, we have to start with the most elementary feature of economies—markets.
In ancient Greece, bazaars were physical congregations of buyers and sellers, the product quality was uncertain, and the exchange rate, or “equivalence” in Aristotle’s terminology, was ambiguous. What was the precise composition of tin and copper in the bronze weapon that was for sale? How were you to believe the seller? Did this depress the exchange rate between weapons and horses, for example? Did different sellers have different sized inventories, and if so were buyers aware that some sellers might be willing to bargain for lower values? Did buyers have to search the entire bazaar for these “lower-value” sellers, and if so were these search costs manageable?
As John McMillan writes, “Two kinds of market frictions arise from the uneven supply of information. There are search costs: the time, effort and money spent learning what is available, where and for how much. And there are evaluation costs, arising from the difficulties buyers have in assessing quality. A successful market has mechanisms that hold down the costs of transacting that come from the dispersion of information”.
In the days of Aristotle, these informational requirements were addressed by the intervention of friendly and neutral traders, who became the intermediary between the seller and buyer of goods and also the monopoly holder of valuable information. These traders could be the horse-dealers who traded horses for gold and steel weapons. Using reputation as collateral, these traders would assure both parties of the veracity of their proposed contract, thus ensuring the trade. Thus was born what became known as an intermediary-trader who created and monitored the trading links in bazaars, managing trading orders and reducing search costs, thereby ensuring the successful matching of buyers and sellers.
Moving from the ancient bazaar to the internet bazaar, the release of the iPhone in January 2007 marked the introduction of a technology that has connected or linked markets, so that information is instantly, continuously and ubiquitously available to all participants. The intermediary-trader was eliminated. The phone was no longer merely a communication device but a computer and a camera, linking the actual world to the virtual world. The smartphone changed the way people connected to each other and the world.
This technology provided a necessary condition, price transparency, for markets to function efficiently. Information was now made available about (i) what is available, (ii) where it is available and (iii) at what exchange rate it is available, thus fulfilling the matching and price discovery functions of markets.
In the traditional neoclassical economic world, competition, defined as an environment with multiple traders or intermediaries, results in informative prices. Interaction between traders agglomerates disparate bits of relevant information, making prices accurate representations of the underlying technology and tastes.
The second trend is a pragmatic definition of competition. What aspect of competition is truly meaningful in a network economy? An environment of multiple traders, or an outcome of informative prices? The first aspect of the definition had more support in the pre-internet days when the only way to have informative prices was the agglomeration of information from multiple traders, in a static model. Today, connectivity increases the likelihood of informative prices. So, in a network economy, a meaningful definition of competition is informative prices, not necessarily the presence of multiple intermediaries. Are the prices charged by the behemoth retailer Amazon competitive? Yes, if these prices are a true signal of underlying scarcities and the logic of multi-product production. But no, if these prices result from the proprietary ownership of a scarce input, such as data.
The third trend, development of organizational behemoths (OB), arises as connections explode across the global network of individuals, and network size effects dominate. The digital economy is a network economy much like the aspen root system. For every aspen grove you see above ground, there is a vast system of underground roots connecting multiple groves. The roots can get entangled, and the aspen trees can get denser within a single grove. Similarly, as connections multiply, powerful network effects, information cascades and data-driven algorithms lead to the concentration of economic power in organizational behemoths. We are familiar with Amazon dominating in the retail arena, Facebook in the social dimension, Google in the search area and Netflix in entertainment. If we add Microsoft, eBay, Priceline, Salesforce and Starbucks, we have a network economy that could be described as culturally homogenous and short of business dynamism. The risk of starting new ventures increases in this hyper-connected network. Startups are acquired by the behemoths and then torn apart, absorbing only those pieces that add synergy to the acquiring firm.
Price transparency and free information are at the heart of current policy debates over privacy and data sharing, which addresses the fourth trend. In the network economy, where information is the key commodity, the notion of property rights over information becomes awkward to define. “Security of property and of contract”, writes Avinash Dixit, are two basic prerequisites of markets, such that there is confidence in ownership rights over the property or good to be bought or sold, and in the successful implementation of the property contract. How can you restrict the flow of information when it is cheap or costs nothing to share this information between multiple economic units? Information as a product is non-excludable like oxygen in the atmosphere—once it is out there, you cannot exclude people from consuming it. It is also non-rival, like viewing a sunset, since my consumption of information doesn’t preclude anyone else from consuming this same information. Note that we have two separate notions of privacy. One is ownership rights over personal data. The other is ownership rights over attention, so individuals have a right to not be addressed or to be left alone.
The multiple demands of this fourth trend of free information have struck against the hard resource constraint of attention, creating a new scarcity in cognitive bandwidth, or more simply attention. Attention is a scarce resource and, therefore, a tradeable commodity. Individuals provide personal information, at no cost, in exchange for free content. This information is sold to marketing firms who create precisely tuned messages and purchase advertising space to acquire consumer attention or eyeballs. Individuals buy free content by directing attention to this content and pay using personal data. Paradoxically, free content, the good purchased with personal information, is not only vast but also uncensored and un-curated, compromising attention.
Most measures of digitization of the economy focus on the implementation of digital technology: investment in digital assets, access to broadband and mobile devices, and the incorporation of this technology into the production process. More difficult to measure is the set of economic possibilities—in terms of new products, new markets and new ways of doing business and consuming—arising from this technology. Connectivity has proposed a form of market design based on cooperation among trading units. Cooperation and coordination are inherent to market economies, in which all entities play by the same rules and prices serve as the hand of coordination, matching demand with supply. But cooperation in the context discussed here is beyond observing the rules of the game—it rests on the sharing of information. Proprietary data on consumer behavior is the source of monopoly power for the OB, but the world of ideas has never been more open.
Human interaction and engagement generate an intricate web of connections. These connections form coherent patterns that determine how information is transmitted through the network of relationships. Simultaneously, the very exchange of ideas across the network—the transmission of information—influences human behavior and network formation. For example, strong social ties may mobilize individuals to act, whereas economic incentives, which focus on the rational individual, may fail to generate action. Social connections provide value to individuals, and these connections can be used to apply pressure for change.
References: Smith, Aaron, “U.S. Smartphone Use in 2015”, Pew Research Center, accessed April 1, 2015  Kauffman Index of Startup Activity. Accessed July 3, 2016  McMillan, John, Reinventing the Bazaar: A Natural History of Markets, W.W. Norton, 2002  Dixit, Avinash, Microeconomics: A Very Short Introduction, Oxford University Press, 2014