Why Online Marketplaces are Important
Updated: June 2013

Capitalism is based on mutually beneficial trade. In the idealized version of the free market, goods and services are allocated in an efficient manner. However, in the real world, existing opportunities for mutually beneficial trade are often not realized. For example, potentially productive workers across the world waste time working on low productivity projects because of their country of birth. Houses, machines and cars sit idle while their owners are doing something else. Used goods remain in garages because owners don’t want to expend the effort to try to sell them. Valuable goods and services aren’t provided because there is no good way to sell them.

The reason for the above inefficiencies is the presence of transaction costs (costs that are auxiliary to the actual amount of money exchanged in the transaction). Search, screening and negotiation are time consuming tasks but are necessary for exchange. Large transaction costs make some markets highly inefficient, if not altogether nonexistent. Online marketplaces have the ability to drastically reduce transaction costs through iterative optimization. The reduction in transaction costs due to online marketplaces will create enormous value for the world.

One role of early marketplaces was bringing together a mass of people in a predefined area at a predefined time. By coordinating buyers and sellers, marketplaces reduced the costs of search. Marketplaces also had another important role. They created rules for the interaction between buyers and sellers. Rules determined where in the market merchants were located, which merchants were allowed to participate and how to create institutions to conducive trade. Further, marketplaces often set and enforced standard contracts for particular types of trades. However, the power of old marketplaces was limited due to their limited ability to monitor exchange.

Online marketplaces have a key advantage over old marketplaces in that they can see the non-monetary costs of a transaction. Previously, it was almost impossible to record how long a person searches, which actors behave badly and how long it takes to agree upon a contract. Now, marketplaces like Ebay, Etsy, Uber, Airbnb, Odesk, Taskrabbit and others can measure user activity precisely using click data, messaging activity and reviews. Using their data, the above platforms can enact and enforce better policies.

Uber is a great example of what transaction cost data allow a marketplace to do. It uses sophisticated models to dispatch drivers and set prices efficiently. According to its blog, the probability of getting an Uber cab in less than 15 minutes is 95%, while the probability of getting a regular cab in the same time is just 27%. Further, the probability of getting an Uber cab quickly has been increasing over time. Because of Uber, people are wasting less time waiting for cabs.

Other online marketplaces have the potential to enable similar efficiency improvements. In aggregate, online marketplaces will allow space, machines, cars, and labor to be used in a way that maximizes value. Most importantly, they will create more opportunities for people to make a living and to enjoy life.