TO BE OR NOT TO B2B? AN EVALUATIVE MODEL FOR E-PROCUREMENT CHANNEL ADOPTION. Qizhi Dai Doctoral Program in Information and Decision Sciences

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1 TO BE OR NOT TO B2B? AN EVALUATIVE MODEL FOR E-PROCUREMENT CHANNEL ADOPTION Qizhi Dai Doctoral Program in Information and Decision Sciences Robert J. Kauffman Associate Professor of Information and Decision Sciences Carlson School of Management University of Minnesota, Minneapolis, MN qdai; ABSTRACT With the popularity of commercial use of the Internet and WWW, business-to-business (B2B) e- commerce and e-procurement are moving corporate purchasing to the Web. Basically, there are two types of B2B e-commerce business models. Extranets connect the buyer and its suppliers with a closed network. In contrast, electronic markets create open networks for buyer and supplier interactions. Extensive IS and economic research has studied the benefits and costs of interorganizational information systems (IOS), and has examined the changes in buyer-supplier relationships caused by implementation of IOS. For example, Bakos and Brynjolfsson (1993) have argued that IT will turn buyer-supplier relationships into partnerships. Yet recently, we have observed a new trend towards the use of electronic markets as an alternative channel for buyers to search for and exchange supplies with a large supplier base. What are the motivations for buyers to move from extranets to electronic markets? Why is this value-maximizing for the firms? This paper models this choice and indicates that the buyer s decision about an e- procurement approach depends on: (1) desired gains from lower search costs and operation costs enabled by an electronic market; (2) the importance of information sharing between its suppliers; (3) the competition present in the supplier market; and (4) the desired levels of supplier relationship-specific investments. KEYWORDS: Business-to-business e-commerce, buyer-supplier relationships, e-business, electronic markets, e-procurement, interorganizational information systems ACKNOWLEDGEMENTS The authors would like to acknowledge the useful input of Alina Chircu, Baba Prasad and the participants of the "Information Systems, Electronic Commerce and Economics" doctoral seminar during Spring 2000 at the Carlson School of Management at the University of Minnesota. 1

2 INTRODUCTION Broadly speaking, business-to-business (B2B) e-commerce involves conducting business with suppliers, customers and other companies through computer and telecommunication technologies. The Internet provides new opportunities for developing electronic links among businesses. Since it is a public network infrastructure, the costs of conducting e-business on the Internet are greatly reduced. Connecting business partners via the Internet for information and data exchange is growing rapidly. By 2004, B2B e-commerce is predicted to grow to more than $7 trillion in the United States (Sapp, 2000). Supporting this prediction is another recent trend: companies increasingly also are moving to purchase and procure supplies on the Internet (Ovans, 2000; Sawhney and Kaplan, 1999). As a result, new business models in supply chain management are emerging that are based on the Internet and the World Wide Web, and that aim to create new value within traditional supply chains. The changes in the way that firms purchase goods and services occur across three purchasing stages: information search, negotiation and settlement (Gebauer and Segev, 1998). E-catalogs, for example, allow buyers to browse and search online, online auctions and bidding support real-time negotiation, and electronic bill payment provides new mechanisms for financial settlement. As a whole, these new electronic markets of the World Wide Web facilitate the basic functions that markets are supposed to deliver: matching and aggregation. To aid managerial decision makers in understanding how to decide between alternatives for e-procurement, in this article we will derive a choice model that employs theories from information systems and economics research, and that emphasizes the contrasting aspects of different e-procurement approaches. Extranets and Electronic Markets 2

3 B2B e-commerce is built upon interorganizational information systems (IOS) or extranets, and electronic markets. IOS and Extranets. Interorganziational systems (IOS) are automated information systems that create, store and exchange information between business partners (Cash and Konsynski, 1985). During the 1980s, organizations began to deploy information systems to support information sharing and communications with suppliers, distribution channels and customers. These IOS started the practice of B2B e-commerce and electronic procurement. The functions of IOS range from simple order entry and invoicing, to product promotion, to document and data sharing, to joint product development and knowledge transfer (Johnston and Vitale, 1988; Riggins and Rhee, 1999; Chatfield and Yetton, 2000). One important type of IOS is electronic data interchange (EDI), the business-to-business exchange of electronic documents in a standard machine-processable format. Using EDI, business partners are able to electronically exchange structured documents, such as purchase orders and invoices, with little or no human intervention. Companies typically use EDI solutions to achieve more efficient data and information management; they reduce processing time and eliminate redundant data entry. The potential benefits of EDI are attractive, but the costs of implementing and running such systems solutions are relatively high. A typical first-time implementation of EDI for a small firm, including hardware, software, implementation and training, is estimated to cost around $50,000 (Waltner, 1997). Besides the initial investment, companies using EDI have to pay in excess of $100,000 per year in value-added-network (VAN) charges. These large expenditures create barriers for small and medium-sized companies that want to adopt EDI. This reduces the net benefits that such extranets can provide to the companies. 3

4 The commercialization of the Internet has brought about Internet-based EDI or Web EDI, by which firms transmit data via public network infrastructure instead of proprietary value-added networks or VANs (Riggins and Mukhopadhyay, 1999). By Web EDI, small businesses are able to send ordering or invoicing data using web browsers to business partners, especially their large EDI-enabled customers. Although Web EDI systems aim to support whole business processes involving manufacturing, billing, shipping, accounting and so on, these capabilities are not fully implemented. Most current Web EDI solutions function as message translators between EDI messages and data collected from Web forms in order to bridge the gap between small businesses and their EDI-enabled big customers or suppliers. For example, 3Com built a Web EDI system for its customers to enter orders using web forms which will be sent directly into 3Com s database. Another form of Internet-based B2B e-commerce is the extranet which is a secure, private, Web-based network, providing suppliers, customers and other business partners the access to the initiator s corporate databases, or facilitating collaborative tasks among a group of organizations (Riggins and Rhee, 1998). Via extranets, firms not only can order and purchase from suppliers, but they also can share product and sales information with each other. Although IOS like EDI and extranets utilize different technologies, they share some important features with respect of business models. First of all, companies conduct transactions electronically on these networks. More importantly, information sharing is common between the initiator and its business partners via electronic document exchange and controlled data retrieval. Another key feature is that they are proprietary closed networks in the sense that these networks only open to pre-selected business partners. Considering these characteristics, we think of these 4

5 networks as one type of e-procurement channel, and use extranets or IOS interchangably to refer to such IT-based procurement channels in the following discussion. Electronic Markets for E-Procurement. According to Kaplan and Sawhney (2000), there are four types of business models for electronic marketplaces, classified by the type of product and the characteristics of transactions they support: MRO hubs (maintenance, repair, and operation) enable systematic purchasing for operating supplies and they are horizontal markets. Yield managers are horizontal markets supporting spot purchasing for operating supplies. Electronic catalog hubs provide integrated product information in vertical markets and are used for systematic purchasing for manufacturing inputs. Exchange hubs are vertical markets for spot purchasing of manufacturing inputs. To participate in these markets, firms first must register on the markets as members. Then they must be verified by the market makers. With a verified membership, participating firms then can post product catalogs and requests for proposals, and participate in auctions. Some B2B e-markets even provide the capability of streamlining procurement processes via software systems that integrate with corporate enterprise systems and organizational intranets. In order to transact on these online markets, firms either pay license fees, or transaction-based fees, or monthly fees, or combinations of quote fees and transaction fees. For example, ChemConnect.com ( for each transaction, charges the buyer and the seller either 0.1% of the transaction sales value or $250, whichever is higher. Compared with the costs of setting up and maintaining EDI systems, e-markets are more cost-efficient. Along with electronic catalogs, electronic auctions and other capabilities, electronic markets aggregate product and price information, match supply and demand, and facilitate 5

6 transactions. Through these online markets, buyers can do one-stop, comparison shopping for thousands of suppliers and select the best source in real time. They also can negotiate with suppliers, place orders, make payments and receive invoices. Fundamental features of these procurement mechanisms distinguish them from extranets are. They are open networks with potentially larger pools of business partners for their member firms. And they give firms more flexibility and opportunities of searching for and selecting suppliers or customers. On the other hand, these networks are inferior to extranets in supporting information sharing and collaboration between suppliers and buyers. Theorizing About Channel Adoption. Buying firms are faced with choosing between two adoption alternatives: extranets and the new electronic procurement markets of the Internet. Theories about electronic markets argue that information technologies (ITs) facilitate the market functions of matching and aggregating by reducing search costs and coordination costs (Malone, Yates and Benjamin, 1987). Lower search costs, in turn, enable buyers to search more and thus obtain better offers (Bakos, 1991). Electronic markets also bring a larger potential supplier (customer) base to buyers (suppliers) due to their abilities to bridge both spatial and temporal distances. And, as a larger business network attracts adopting firms (Kauffman, McAndrews and Wang, 2000), electronic markets become an even more advantageous procurement channel for buyers. Contrary to the positive network externalities exhibited in electronic markets, negative network effects are found in suppliers adoption of IOS (Riggins, Kriebel and Mukhopadhyay, 1994), and as a result, buyers usually induce suppliers to join the EDI systems by subsidy or punishment (Barua and Lee, 1997). A commonly observed result of adopting IOS is a reduced number of suppliers transacting with a particular buyer. This is because the buyer wants to give 6

7 its suppliers incentives to make non-contractible relationship-specific investments (Bakos and Brynjolfsson, 1993). Another reason is that an IOS links the buyer and its suppliers more closely through electronically sharing data and information. This reduces the buyer s bargaining power and then encourages the buyer to develop closer ties with a small number of suppliers (Clemons, Row and Reddi, 1994). But, empirical research has found that firms can obtain more business value by exchanging strategic data and information with business partners via IOS (Chatfield and Yetton, 2000). The interorganizational coupling enabled by the IOS actually improves the firm performance based on enhanced interdependence and coordination between buyers and suppliers (Clark and Lee, 2000). Starting from these theories and prior research, we will answer the basic (Shakespearian) question posed in the title of this paper: To be or not to B2B? What e-procurement channel should be selected, depending on the competitive conditions, firm characteristics, and the various important qualities of the systems solutions? An extranet? Or an electronic market? And how important are network externalities? To answer, we will develop and analyze a formal model of buyers choices in adopting the extranet and electronic market e-procurement channels. BENEFITS AND COSTS OF E-PROCUREMENT EXTRANETS AND E-MARKETS We next consider the benefits and costs of two potential e-procurement channel choices: extranets and electronic markets. Our assessment provides the basis for formal modeling of the benefits and costs, in a manner that reflects what we know about the referent literature and current industry practice. Extranet Benefits and Costs Research on IOS, including traditional EDI systems, provides useful insights for examining the benefits and costs of adopting extranets for e-procurement. Traditional IOS 7

8 require a lot of expenses for setting up the systems. These costs include expenses for computer systems, system supporting personnel and training. Both buyers who initiate these systems and the suppliers who participate in the systems have to bear such costs. For a large volume buyer, these costs may be compensated by benefits. But for a small supplier, these costs may prohibit adoption. When it comes to the benefits of IOS, Mukhopadhyay, Kekre and Kalathur (1995), and Riggins and Mukhopadhyay (1994) found that the implementation of an IOS improved the operational efficiency of the buyers who initiated the systems. Using electronic means for purchasing, buying companies can reduce order entry costs and inventory management costs, and at the same time get quicker responses from their suppliers. For suppliers participating in the systems, timely information about customer demand may help them to forecast demand and schedule their production more efficiently. Suppliers can also save expenses on order entry and at the same time improve customer services. Such benefits deliver strategic value to the suppliers, which cannot be obtained without joining the systems. Moreover, the participating suppliers obtain a competitive advantage relative to their rivals who do not participate: First, the participating supplier will be able to increase its sales because the buyer may reduce its orders to those suppliers who do not participate and increase orders to those who participate (Barua and Lee, 1997). Second, with access to the buyer s inventory, sales and product information, the participating supplier will be able to accumulate expertise about market demand and 8

9 product features, which usually will lead to product innovation and market expansion (Subramani, 1999; Riggins and Rhee, 1999). Another important benefit of extranets is that they give the suppliers access to the buyers business information, including inventory management data, and product design and sales data. Once suppliers have such information, buyers will find it difficult to control the use of these resources and inevitably become more vulnerable to supplier opportunism (Clemons, Reddi and Row, 1993). As a result, suppliers will gain bargaining advantage relative to their buyers for pricing and more beneficial contract terms. From the viewpoint of buyers, this is a cost due to sharing business information with the suppliers. In other research on buyer-supplier relationships, Bakos and Brynjolfsson (1993) found that there are non-contractible investments from the side of the suppliers that benefit the buyer in terms of responsiveness, higher quality, innovation and technology adoption. To protect suppliers incentives to make these non-contractible and relationship-specific investments, the buyer typically will keep its supplier network small. Electronic Markets Benefits and Costs Similar to extranets and EDI systems, e-procurement via electronic markets also improves purchasing efficiency for buying companies. At the same time, e-procurement applications can cost as much as other enterprise information systems. For example, the licensing fees for these systems are reported to range from $1,000 to $4 million (Waltner, 1999). Thus, the system setup costs are comparable for adopting either extranets or electronic markets. However, the operational costs associated with the adoption of an electronic market approach are lower than with an extranet approach. The reason is that the buyer needs only one link via an 9

10 electronic market -- instead of several links with an extranet mechanism -- to be electronically connected with its suppliers. In contrast to closed extranets, electronic markets are open networks where buyers have access to more product and price information. In recent studies of automatic teller machine (ATMs) adoption in consumer banking, Kauffman and Wang (1999), Kauffman, McAndrews and Wang (2000) argued that banks that expect to obtain a larger customer base will adopt ATM networks earlier and will achieve higher profits. By the same token, we argue that the potential access to a larger supplier base will attract buyers to join electronic markets, by virtue of the positive network externalities that are created on the buyers side. At the same time, search costs and coordination costs are reduced in electronic markets (Bakos, 1991), and buyers are more likely to receive better offers than they can get with extranets. With extranets, buyers have long-term contracts with suppliers, and prices are preset even when market prices change. In electronic markets, however, the buyer will do more searches, or participate in more auctions to hunt for information and get better offers (Barua, Ravindran and Whinston, 1997). In addition, the level of information sharing between buyers and suppliers will be lower than in extranets. Suppliers may obtain ordering information but not inventory information. As a result, the suppliers bargaining advantage relative to the buyer and competitive advantage relative to its rivals will be less compared to what can be achieved with extranets. Since the supplier knows that there is a large number of potential suppliers in the marketplaces whose product and price information is available at the mouse click of the buyer, the supplier will feel the threat that the buyer may switch to its rivals easily. Using Shapley value analysis from game theory, Raupp and Schober (2000) argued that when the number of 10

11 suppliers increases, the value that one supplier can obtain from the buyer-supplier relationship decreases. This lower ex post gain will reduce the supplier incentive to make non-contractible investments. Therefore, in electronic markets, suppliers will make fewer such investments than in extranets. MODEL AND ANALYSIS Seidmann and Sundararajan (1997) proposed a general framework for describing the contract games that occur between one buyer and two suppliers in choosing levels of information sharing in supply chain management. In this paper, we extend their model to understand decision making regarding the adoption of extranets versus electronic markets for e-procurement. (We will refer to the choice of an extranet as E, and the choice of an electronic market as M in the remainder of the paper.) Modeling Preliminaries Let us assume that there is one big buyer and two suppliers. The buyer is going to make a choice between an extranet and an e-market mechanism for procurement, and the suppliers will decide whether to join the buyer network. This is a simplification of the real world cases where big buyers initiate electronic procurement channels and request suppliers to participate. For example, Chrysler launched its EDI program in 1984 and almost all its suppliers adopted this network by 1990 (Mukhopadhyay, kekre and Kalathur, 1995). More recently, when big buyers start to move to online markets, they also request suppliers to join the e-markets, just like Schlumberger, which asked its suppliers to participate in CommerceOne s MarketSite when it chose MarketSite for purchasing office supplies (Ovens, 2000). We also assume that the two suppliers are symmetric: that is, the benefits and costs are the same for the suppliers. As we discussed in previous sections, the buyer will obtain savings i from reduced inventory and 11

12 ordering costs. (See Table 1 for an overview of all the variables that we will use in our model.) No matter what type of information systems are in use, either an extranet, E, or an electronic market, M, mechanism, the buyer is able to obtain the same cost reductions that derive from improved internal efficiencies. Considering the fact that the system deployment costs incurred by the buyer firms are comparable for adopting either extranets or electronic markets, we do not include these setup costs in our model. In adopting the extranet approach, the supplier who is participating in the system will have access to the buyer s inventory information and will know how its product is sold, and thus the information asymmetry will be reduced (Seidmann and Sundararajan, 1997). Benefiting from this, the supplier will obtain the benefits from greater relative bargaining power, b, compared to the buyer. The buyer will think of this as receiving a payment for achieving efficiency. However, when the buyer-supplier relationship occurs in an electronic market, this value will be discounted by d, with 0 < d < 1. This discount is due to the fact that in the market the supplier will have only limited information about how the buyer is consuming its products. The information available to the supplier is provided by the buyer, and it may be incomplete or may not be what the supplier desires. 12

13 Table 1. Definitions of Variables Variable Name B C D I K N Q S Definition Supplier benefits from bargaining power over the buyer Supplier competitive advantage (disadvantage) when only one supplier is doing business electronically with the buyer Discount rate, 0 < d < 1, on competitive advantage (disadvantage) from information sharing in electronic markets relative to the extranet channel Buyer benefits from improved efficiency Supplier s system setup costs in adopting an extranet approach Buyer s benefits from adopting an electronic market approach Competitiveness in supplier market, with 0 < q <1 Supplier s benefits from strategic value S j Supplier j, where j {1, 2} v E, v M w E, w M Supplier relationship-specific investment value with an extranet approach, E, or an electronic markets approach, M Buyer s net welfare or benefits with an extranet (electronic market) approach Comments Suggested by Clemons, Reddi and Row (1993) Derived from Seidmann and Sundararajan (1997), Riggins and Rhee (1999), and Subramani (1999) Suggested by Mukhopadhyay, Kekre, and Kalathur (1995) Based on Bakos (1991). Also motivated by Seidmann and Sundararajan (1997) For analytical tractability, we limit our analysis to just two supplier firms, as did Seidmann and Sundararajan (1997) v E1 and v E2 ( v M1 and v M2 ) represent how much the buyer requests of a supplier for relationship-specific investment in its strategy to induce one supplier (either 1 or 2) to join its extranet (electronic market). w E1 (w M1 ) is the buyer s net benefits when only one supplier is joining the extranet, and w E2 (w M2 ) is the benefit when both suppliers are using extranets. Being electronically connected with the buyer increases the supplier s capability to better forecast product demand and to schedule its production more efficiently. These strategic benefits for the supplier, s, occur when only one supplier is electronically connected with the buyer. When both suppliers do business electronically with the buyer, this advantage is reduced by a 13

14 factor of q, with 0 < q < 1 representing the competitiveness among suppliers. When q 1, the competition is very low; in contrast, as q 0, competitive pressures become very high. If only one supplier, S 1, is using an extranet, then the supplier S 2, who is not participating, will suffer a loss in competitive position because S 1 will accumulate the knowledge and expertise for product innovation and market expansion based on its exclusive access to the buyer s proprietary information. We express the amount of this loss as c for S 2. At the same time, S 1 will obtain a benefit c. Similarly, in electronic markets, S 2 may also incur some loss because it does not have the knowledge about the buyer s demand that S 1 has. However, the amount of this loss is reduced in proportion to the degree of reduced information sharing between the buyer and S 1, i.e., S 2 will lose dc and S 1 will gain dc. In addition, in electronic markets the buyer will enjoy low search costs and an expanded supplier base. Moreover, the buyer will incur lower operating costs with an electronic market solution than with an extranet. We consider this as another of the benefits that is derived from adopting an electronic market mechanism. In our model, such benefits are expressed as n, which are generated only in electronic markets. In buyer-supplier relationships, the non-contractible value from the suppliers relationship-specific investments is represented as v E for extranets and v M for electronic markets. We assume that v E and v M are paid by the supplier to the buyer. When they become negative, a subsidy is required and the buyer has to pay for the supplier to participate in the systems. When extranets are adopted, the suppliers have to incur setup costs k, including the expenses for computer systems to communicate directly with the buyer. Finally, our model enforces the logical constraint that the buyer will adopt either an extranet or an electronic market approach, but cannot adopt both at the same time. As a result, 14

15 there will be no case where one supplier is using an extranet while the other supplier is using an electronic market. Therefore, there are five possible situations requiring further analysis. (See Table 2.) Table 2. Non-Electronic and Electronic Procurement Cases Case Name Description 1 Non-Electronic No electronic approach is adopted. 2 Focal Extranet The buyer implements an extranet involving just one supplier S 1 3 Spanning Extranet The buyer uses an extranet to connect to both suppliers, S 1 and S 2. 4 Focal Market The buyer purchases from one supplier S 1 using an electronic market mechanism. 5 Spanning Market The buyer purchases from both suppliers S 1 and S 2 using an electronic market mechanism. The benefits and costs that materialize for each party in each situation are summarized in Table 3. The sums of the net benefits of the buyer and the two suppliers are displayed as Total in Table 3 to show the social welfare in the above five cases. Table 3. Net Benefits of the Buyer and Suppliers Case Name Buyer Supplier 1 Supplier 2 Total 1 Non- Electronic Focal Extranet i -b+ v E b + s + c - v E - k -c i + s k 3 Spanning Extranet 2i 2b + 2v E b + qs v E k b + qs v E - k 2i + 2qs - 2k 4 Focal Market i db + v M + n db + s + dc - v M - dc i + s + n 5 Spanning Market 2I 2db + 2v M + n db + q s v M db +qs v M 2i + 2qs + n Adopting an Extranet (E) Approach Let us examine Cases 2 and 3 where the buyer intends to use an extranet approach. Since the buyer has two suppliers and there is a loss of competitive advantage for a supplier who does 15

16 not join the extranet if the other supplier does, the buyer can design a strategy to induce suppliers to participate. Proposition 1 The Supplier-Specific Extranet Investment Proposition: The supplier relationship-specific investment will be less than the sum of the gain from bargaining power, the gain from strategic value, and twice the gain from competitive value, less the implementation costs. This is given by v E < b + s + 2c k. Proof. The highest possible gain for a supplier to agree to do business with the buyer via an extranet is b + s + c v E k. The lowest possible gain is c, when one supplier does not do business this way and the other supplier does. Suppliers are rational, however, and will select an extranet when they will be better off by so doing. That is, b + s + c v E k > - c. Thus, we get v E < b + s + 2c k. ' From the Supplier-Specific Extranet Investment Proposition, we see that the possible relationship-specific investment the buyer can obtain from one supplier is capped at b + s + 2c k. Thus, a supplier will not be willing to make effort or investment costing more than this amount that will be specific to the buyer. Under what circumstances will both suppliers adopt an extranet approach? Our next proposition analyzes this question in terms of the extent of the relationship-specific investments that these firms must make: Proposition 2 The Supplier Extranet Adoption Proposition: If the relationshipspecific investment v E satisfies v E < b + qs + c k, then both suppliers will adopt an extranet with the buyer. Proof. Assume that supplier S 1 first joins the extranet. In this case, if supplier S 2 also decides to join the extranet, it will get b + qs v E - k > c. The latter value is what supplier S 2 will get if it does not join under the condition of v E < b + qs + c k. Therefore, S 2 will join the extranet. If S 1 does not join, however, then the net benefit S 2 will obtain from joining the extranet will be b + s + c v E k, which is greater than zero with v E < b + qs + c k. As a result, S 2 will accept, 16

17 and thus S 1 will end up with c. But, with v E < b + qs + c k, S 1 will prefer to join the extranet to get net benefit b + qs v E k, which is greater than c. So, both suppliers will join the buyer s extranet. ' The Supplier Extranet Adoption Proposition indicates that if the buyer wants two suppliers to both join the extranet, it will not get a relationship-specific investment from each supplier that exceeds the sum of each supplier s gain in bargaining power, the reduced gain from strategic value and the gain from competitive value, less the implementation costs. If the buyer wants more relationship-specific investment, it has to use other strategies to obtain the funding. Now to obtain at least one supplier to participate in the extranet, the buyer may first try to set up a connection with one supplier, say S 1 (since the suppliers are symmetric, this arrangement will not lose generality) requiring relationship-specific investment v E1. If S 1 accepts, then the buyer may stop. If S 1 rejects, then the buyer may invite S 2 to join with a relationship-specific investment of v E2. The result is as follows: Proposition 3 The Focal Extranet Proposition: If v E1 < b + s +2c k and b + qs + c k < v E2 < b + s + c k, then there will be two equivalent outcomes: (3A). The buyer invites S 1 to join the extranet with v E1 and S 1 accepts. (3B). The buyer invites S 2 to join the extranet with v E1 and S 2 accepts. Proof. If S 1 rejects when the buyer first invites it to join, then the buyer will invite S 2 with investment v E2 < b + s + c k. In this case the net benefit S 2 will obtain is b + s + c k - v E2 > 0, and thus S 2 will agree to join the buyer extranet. As a result, S 1 will lose c. Using backward induction, it can be shown that S 1 will accept when the buyer initially invites it with v E1. Since v E2 > b + qs + c k, S 2 will not join after S 1 has already joined. S 1 and S 2 will not join together. Therefore, the outcome will be that the buyer will work with either S 1 or S 2, and obtain supplier relationship-specific investment v E1 < b + s +2c k. ' 17

18 The buyer s net benefit will be different in Cases 2 and 3. Our examination of the conditions that will occur when the buyer makes a choice yields the following result: Proposition 4 The Buyer s Supplier-to-Extranet Connection Preference Proposition: The buyer will select the appropriate supplier-to-extranet connections based on the following preference conditions in terms of q, a measure of the firm s competitiveness: (4A). When q < (k + s - i)/2s, the buyer will prefer an extranet with one supplier, and its net benefit will not exceed i + s +2c k. (4B). When q > (k + s i)/2s, the buyer will prefer an extranet with both suppliers, and its net benefit will not exceed 2i + 2qs +2c 2k. (4C). When q = (k + s i)/2s, the buyer will be indifferent about the number of supplier-to-extranet connections, and its net benefit will not exceed i + s +2c k. Proof. The Supplier Extranet Adoption Proposition shows that the highest possible relationshipspecific investment the buyer can obtain is b + qs + c k. In this case, the buyer s maximum net benefit or welfare for an extranet will be: w E2 = 2i 2b + 2(b + qs + c - k) = 2i + 2qs + 2c 2k The Focal Extranet Proposition indicates that the buyer will get relationship specific investment no more than b + s + 2c k. This will give the buyer maximal net benefit: w E1 = i b + (b + s + 2c - k) = i + s + 2c k If q < (k + s i) /2s, then w E2 = 2i + 2qs + 2c 2k < 2i + 2s*(k + s i) /2s + 2c 2k = i + s + 2c k = w E1 As a value-maximizing firm, the buyer will choose suppliers based Max (w E2, w E1 ). In this case, the buyer firm will invite only one supplier to join the extranet. Similarly, if q > (k + s i) /2s, then w E2 > w E1, and as a result, the buyer will prefer two suppliers joining the extranet. If q = (k + s i) /2s, then w E1 = w E2, and the buyer will be indifferent. ' 18

19 The Buyer s Supplier-to-Extranet Connection Preference Proposition implies that when the level of competition in the supplier market is high, the buyer will prefer to invite one supplier to join its extranet. And when the competition is reduced to lower levels, the buyer will ask both suppliers to join the extranet. Also note that when the buyer efficiency benefits i and supplier strategic benefits s increase, it is more likely that both suppliers will participate in the extranet. But when the supplier implementation costs k are high, this will increase the likelihood that only one supplier will want to join the network. The buyer s preference is illustrated in Figure 1. (See Figure 1.) Figure 1. The Buyer s Supplier-to-Extranet Connection Preference w E q < (k+s-i)/2s w E2 q > (k+s-i)/2s A C w E1 2i - 2b i - b B b - i qs + b + c - k s + b + 2c - k ve Figure 1 depicts the buyer s welfare (w E ) as a function of the supplier s relationshipspecific investment (v E ) with an extranet approach. Line w E1 represents the possible buyer welfare when one supplier joins the extranet, and point A (Va, Wa) shows the buyer s maximum possible welfare in this case. If both suppliers join the extranet, the buyer s welfare will fall on line w E2 and the maximum value is at point C (Vc, Wc). We are going to show how the change in q changes the maximum possible benefits the buyer can obtain with such a mechanism, with all 19

20 other things being equal. This means that point C is fixed, while point A will move as q changes. When q = (k + s i)/2s, A and C have the same value along the y-axis which represents the buyer s welfare, i.e., Wa = Wc, indicating that the buyer is indifferent about the number of connections with the suppliers. When q increases, line AB moves to the right. That is, the buyer s welfare with two suppliers joining its extranet increases to surpass the buyer welfare when only one supplier joins, and thus A moves above C, resulting in Wa > Wc. This is the case when q > (k + s i)/2s, which is represented as the area on the right of line AB in Figure 1. In this case, the buyer will prefer a spanning extranet strategy. On the other hand, when q < (k + s i)/2s, line AB moves to the left, causing A to be lower than C, or Wa < Wc. That is, the buyer s maximum possible welfare is less when both suppliers join in the extranet than if only one supplier joins the extranet. This is shown by the area on the left of line AB. In this case, the buyer will prefer the focal extranet strategy. Figure 1 also shows that when the supplier relationship-specific investment that the buyer can obtain is less than b i, the buyer s welfare will become negative, and thus it will not initiate the extranet. At the other end, the maximum supplier relationship-specific investment is s + b +2c k, beyond which neither supplier will agree to join the buyer extranet. Adopting an Electronic Market (M) Approach Now, let us examine Cases 4 and 5 where the buyer decides to use an electronic market. Proposition 5 -- Supplier-Specific Electronic Market Investment Proposition: The supplier relationship-specific investment will be less than the sum of the gain from reduced bargaining power, gain from strategic value and twice the gain from discounted competitive value. That is, v M < db + s + 2dc. (Our proof follows the same logic as that for the Supplier-Specific Extranet Investment Proposition. See the Appendix.) 20

21 The Supplier-Specific Electronic Market Investment Proposition implies that, in using an electronic market, the buyer can expect the possible relationship-specific investment from one supplier to be no more than db + s + 2dc. This is due to the fact that the supplier will not obtain positive net benefits if it has to make an investment exceeding this amount. Next, let us examine the case where both suppliers are invited to participate in an electronic market. Proposition 6 -- Supplier Electronic Market Adoption Proposition: If both suppliers participate in the electronic market, the supplier s relationship-specific investment will be less than the sum of its gain from its discounted bargaining power, its gain from strategic value under competition and its gain from discounted competitive value. That is, v M < db + qs + dc. (Our proof is similar to that for the Supplier Extranet Adoption Proposition and also is given in the Appendix.) Suppose the buyer is satisfied with the case where only one supplier participates in the electronic market. It may follow a strategy that is similar to the one it used to induce one supplier to join the extranet. That is, the buyer may first try to set up a connection with one supplier, say S 1. Since the suppliers are symmetric, this arrangement will not lose generality. This will require supplier relationship-specific investment v M1. If S 1 accepts, then the buyer may stop. If S 1 rejects, then as before, the buyer may invite S 2 to join with v M2 relationship-specific investment. The result is as follows: Proposition 7 -- The Focal Electronic Market Proposition: If v M1 < db + s + 2dc and db + qs + dc < v M2 < db + s + dc, then there will be two equivalent outcomes: (7A). The buyer invites S 1 to join the electronic market with v M1 and S 1 accepts. (7B). The buyer invites S 2 to join the electronic market with v M1 and S 2 accepts. (The proof is similar to that for the Focal Extranet Proposition and also is given in the Appendix.) 21

22 The buyer will compare the maximum possible net benefits it can obtain in the two electronic market cases, and make a choice as suggested by the following proposition. Proposition 8 -- Buyer s Supplier-to-Market Connection Preference Proposition: The buyer selected the appropriate supplier-to-market connections based on the following preference conditions: (8A). When q < ( s i)/ 2s, the buyer prefers to transact with one supplier in the electronic market, and its net benefit will not exceed i + s + 2dc+ n. (8B). When q > ( s i)/ 2s, the buyer prefers to have both suppliers in the electronic market, and its net benefit will not exceed 2i + 2qs +2dc+ n. (8C). When q = ( s i)/ 2s, the buyer is indifferent about the number of supplier-tomarket connections, and its net benefit will not exceed i + s +2dc + n. (The proof for this proposition is similar to that for the Buyer s Supplier-to-Extranet Connection Preference Proposition and is included in the Appendix.) Based on our analysis of Cases 4 and 5, we display the buyer firm s preferences in Figure 2. (See Figure 2.) Figure 2. The Buyer s Supplier-to-Market Connection Preference w M q < (s-i)/2s w M2 A q > (s-i)/2s C w M1 2i - 2db + n i - db + n B -n - (i - db) qs + db + dc s + db + 2dc vm Figure 2 depicts how the buyer s welfare changes with supplier relationship-specific investment in an electronic market. As in Figure 1, the buyer s possible welfare, when both 22

23 suppliers are in the electronic market, is described by line w M2, and the maximum value is indicated by point A (Va, Wa). When only one supplier is in the electronic market, the buyer s possible welfare is represented by line w M1, and point C (Vc, Wc) captures the buyer s maximum welfare. Supposing that only q changes, we view point C as fixed and point A as changing. When q = (s i)/2s, Wa = Wc, which means that the buyer will obtain the same maximal welfare no matter how many suppliers join the network. In this case, the buyer is indifferent about the number of connections with the suppliers via an electronic market mechanism. When q > (s i)/2s, w M2 increases and leads A to be higher than C, i.e., Wa > Wc. In this case, the buyer will prefer a spanning electronic market with more than one supplier participant. On the other hand, when q < (s i)/2s, w M2 decreases and thus A moves below C, i.e. Wa < Wc. In this case, the buyer will prefer a focal electronic market strategy. Figure 2 also shows that when the supplier relationship-specific investment that the buyer can obtain becomes less than n (i db), the buyer s welfare will become negative, and thus it will not initiate the electronic market. At the other end of this value spectrum, the maximum supplier relationship-specific investment is s + db +2dc, beyond which neither supplier will agree to join the buyer electronic market. Choosing Between an Extranet and an Electronic Market Facing the two alternatives, the buyer will compare the maximum possible net benefits it can obtain in the two arrangements and make a choice. The results are shown in the following proposition. Proposition 9 -- The Buyer s Choice Proposition: If n > (2 2d)c k, then the buyer will choose the electronic market approach. Proof. Since k > 0, the following inequality is true: (k + s i)/2s > (s i)/2s. Now, let us examine the following three situations that describe the extent of the suppliers competitiveness q, via constraints on its values: 23

24 1. q (k + s i)/2s. In this case, q also satisfies q > (s i)/2s. Under this condition, the maximum net benefits the buyer can obtain from adopting the extranet and the electronic market approach are w E2 and w M2, respectively. Since n > (2 2d)c k, we have: w M2 = 2i + 2qs + 2dc + n > 2i+ 2qs + 2dc + (2 2d)c k = 2i+ 2qs + 2c k > 2i + 2qs + 2c 2k = w E2 Therefore, the buyer will choose an electronic market. 2. q (s i)/2s. This case also implies that q < (k + s i)/2s. Under such condition, the maximum net benefits the buyer can obtain from adopting the extranet and the electronic market approach are w E1 and w M1 respectively. Since n > (2 2d)c k, we get w M1 = i + s + 2dc+ n > i+ s + 2dc + (2 2d)c k = i+ s + 2c k = w E1 Therefore, the buyer will choose electronic market. 3. (s i)/2s < q < (k + s i)/2s. In this case, the maximum net benefits the buyer can obtain from adopting the extranet and the electronic market approach are w E1 and w M2 respectively. The difference between these two possible values is given by: = w M2 w E1 = 2i + 2qs + 2dc + n (i + s + 2d k) = i + (2q 1)s + n (2 2d)c + k Plugging (s i)/2s < q < (k + s i)/2s, we get n (2 2dc) + k < < n (2 2dc) + 2k. Thus, given that n > (2 2d)c k, > 0, then w M2 > w E1. Therefore, the buyer will choose an electronic market. ' So we see that the Buyer s Choice Proposition suggests that no matter how competitive the supplier market is, the buyer still will prefer an electronic market. This is predicated upon whether the buyer s electronic market gains from lower search costs, the expanded potential 24

25 supplier base and lower operation costs are greater than the suppliers loss in competitive value less the suppliers savings on system implementation. Figure 3 depicts the buyer s choice. (See Figure 3.) Figure 3. Buyer s Choice Between the Extranet and the Electronic Market Approach 3(a). q > (k + s - i)/2s 3(b). q < (s - i)/2s 3(c). (s - i)/2s< q < (k+s-i)/2s w wm2 w wm1 w wm2 2i + 2qs + 2c - 2k we2 i + s + 2c - k we1 i + s + 2c - k we1 2i + 2qs + 2dc (2-2d)c - k n i + s + 2dc (2-2d)c - k n 2i + 2qs + 2dc (2-2d)c - k n Figure 3 shows the buyer s welfare w as a function of its gains derived from adopting an electronic market approach in the three different supplier market competition situations 3(a), 3(b) and 3(c). When its gains from the market exceed the adoption threshold, (2 2d)c k, the buyer will obtain higher net benefits by adopting an electronic market mechanism. Figure 3 also shows that when d decreases, the adoption threshold moves to the right. This implies that the buyer needs higher gains from adopting the electronic market mechanism when the reduction in information sharing has a larger impact. DISCUSSION Prior research in IS and economics has studied the effects of ITs on buyer-supplier relationships. This article applies these theories to examine the impact of emerging e- procurement electronic markets and finds some interesting results. Our work also offers a number of practical implications for buyers and suppliers who wish to make choices between adopting extranets and electronic markets for their purchasing activities. 25

26 Interpreting E-Procurement Channel Adoption Decision Making Buyer Decision Making. What do we learn about the buyer s decision making process? From the buyer s point of view, the decision will involve two levels. At the first level, the buyer makes a choice between an extranet and an electronic market approach. Our results indicate that when the buyer moves from an extranet to an electronic market, it gains the value conferred by lower search costs and lower operation costs. Such benefits vary across products and transaction types, however. Specialized products and spot purchasing will benefit more from lower search costs, while systematic purchasing benefits from lower operation costs. Therefore, if a procurement system is mainly used for systematic purchasing, then the buyer will examine the reduction in operation costs by adopting an electronic market. If a buyer expects to purchase specialized products in small quantities, it will check the various search mechanisms supported by an electronic market and the number of suppliers participating in the electronic market. Information Sharing Effects. What are the impacts of reduced information sharing? Besides the possible gains from adopting an electronic market, the effects of reduced information sharing will also influence the buyer s preference. When the information sharing discount rate d decreases, more information sharing is lost by moving from extranets to electronic markets. This means that the supplier will lose bargaining power relative to the buyer and thus will make fewer non-contractible investments. Therefore, the buyer will desire a higher return n from using an electronic market to offset benefits lost due to the reduced non-contractible gain. Why Product Characteristics Matter. And are there implications that can be drawn from the kinds of products that are exchanged? We believe that the characteristics of the product purchased will affect d. If the product is of low strategic value to the buyer, then the access to the information will not increase the supplier s bargaining power in an extranet channel. And so, 26

27 when the supplier moves to an electronic market, reduced access to buyer information does not reduce its benefits (in other words, d will be large). As a result, the supplier will not significantly reduce its investments that complement those of the buyer. Therefore, the buyer does not need a large gain from adopting an electronic market to compensate for its loss from supplier investments. This helps explain the large amount of online purchasing for office and operation supplies. These products are of low strategic significance to the buyer, and will cause little impact on reduced information sharing between the buyer and its suppliers. Implementation-Related Cost Savings. How do the supplier s cost savings affect the adoption decision? Our results suggest that the higher the supplier s cost savings due to a shift from an extranet to an electronic market, the more likely the electronic market will be adopted. The increase in the implementation costs will lead the supplier to make fewer relationshipspecific investments for the buyer in order to obtain positive net benefits. As a result, the buyer s welfare will be reduced. Therefore, the buyer will be more likely to use an electronic market when the suppliers cost savings are higher. This is particularly true for small suppliers. The implementation cost savings for small suppliers will greatly affect their decisions about participating in an electronic channel with the buyer. Number of Suppliers. After deciding whether to adopt an electronic market or an extranet approach, how will the buyer decide upon the desired number of suppliers? Our model shows that, with either an extranet or an electronic market, individual supplier s relationshipspecific investment for the buyer is higher when only one supplier joins in the electronic connection. Therefore, a buyer who wants more non-contractible investments from a particular supplier will choose to have a dedicated link with that supplier. However, the buyer s net benefits depend on the competitiveness of the supplier market. When the competition is intense 27