An economic model of optimal fraud control and the aftermarket for security services in online marketplaces

Abstract

The anonymity of online markets allows traders to easily behave opportunistically. Online marketplaces can lower the uncertainty of participants’ identities by adopting preventative controls such as privacy disclosure rules. However, the use of severe privacy controls to engender risk-free environments might sacrifice not only the size of transactions in the marketplace but also the demand for optional security services like escrow services, which constitute a very sizable revenue source for the marketplace services provider. In this vein, we investigate the probability that an integrated online marketplace (IOM) with security services strategically adjusts privacy controls to incentivize traders to self-select both basic transactions and optional security services. Our results show that an integrated marketplace increases the probability of allowing more fraud than is socially optimal by lowering privacy controls. Market risk can be viewed as an asset for an integrated marketplace rather than a liability that inflicts transaction costs on worried traders. Our study argues that marketplaces may differ in terms of their fraud control from what is socially optimal, according to their revenue structures so that the control of online fraud needs to be regulated from the social perspective. However, under certain conditions, integration of this aftermarket will not harm traders or the social welfare.

Introduction

Creating markets is a mainstay of dotcom business models (Kambil and Heck 2002). While the extensive listings of tradable goods and powerful search technologies make online markets liquid,¹ the electronic media connecting trading participants and sharing quality information remains lean. With direct trades between unknown customers over great distances, online transactions are vulnerable to many types of fraudulent conduct.² The main reason that the online marketplace easily attracts fraud originates from a unique characteristic of Internet transactions. Under considerable information asymmetry – the uncertainty of trader identity and the uncertainty of merchandise quality – online trade allows sellers or buers to easily engage in opportunistic behavior (Klein and Leffler 1981).

One way to directly resolve fraudulent actions in anonymous markets is lowering the uncertainty of identity through disclosure of private information, which makes individuals identifiable (Culnan and Armstrong 1999). The anonymity of the Internet is a double-edged sword, however. Honest traders may prefer this characteristic for the protection of their privacy, while opportunistic people take advantage of it to commit fraud. If the practices of an online business raise privacy concerns resulting in a perception that customers must reveal too much personal information or that the information may be used unfairly, customers unwilling to disclose additional personal information may spread bad word-of-mouth (Culnan and Armstrong 1999). The result may be that businesses will have difficulty attracting new customers, which can negatively impact the bottom line.

Online marketplaces need to do a very tricky balancing act, mitigating the opportunity costs of electronic transactions that result from anonymity while protecting the privacy of the majority of their customers. This issue presents possible conflict between strict security control and infringement of consumer privacy, as discussed by prior studies (Culnan and Armstrong 1999, Rowland 2000). However, we go further by identifying the business value of security services (e.g., escrow services) for online marketplaces and explore the possibility that market risk is intentionally under-controlled and strategically utilized according to the revenue structure.

We pay attention to the fact that security services that insure traders against transaction risk may not only be good ex post measures against the risk of online fraud but also a very sizable revenue source for online marketplaces. For example, eBay integrated both trading and escrow services when it took over PayPal in July 2002 and eBay’s recent good business performance is largely attributed to PayPal (Cullen 2007).³ Note that imposition of excessively austere privacy controls not only incites online users’ privacy concerns but also gives them less incentive to adopt security services due to reduced market risk (Antony et al. 2006, Zhang et al. 2007). However, loosely controlled market risk brings about more opportunity for online fraud. Therefore, when an online marketplace provides in-house security services along with basic transaction services, its decision on the preventative privacy controls is complicated by the issues of privacy concern and the promotion of security services.

We are primarily concerned with how the integration of transaction and security services distorts online market decisions on privacy controls from social optimality. In other words, this study examines the conditions under which the provision of security services should be integrated with an online marketplace or independently managed by third parties. Given that online commerce is claiming a rapidly growing share of worldwide business, and customers have concerns about security and privacy, we believe that this is a very pressing research question.