Abstract The recent explosion of attempts to form B2B exchanges and the large failure rate of these attempts raise questions about when and why B2B exchange formation succeeds. Our model provides a theory of B2B exchange formation by investigating conditions under which B2B exchanges attract enough buyers and suppliers to form. Our most important result is that, when the number of potential suppliers is large enough, successful formation of a B2B exchange hinges on its ability to subsidize suppliers selectively. Since there are externalities among participation decisions, charging the marginal cost of connection does not lead to the e¢cient outcome. O¤ering a subsidy to a selective group of suppliers is to "divide and conquer" them to induce full participation. Selective subsidy is also necessary to insure that the optimal number of suppliers join the exchange. When such subsidy is feasible, the full participation equilibrium becomes the unique subgame-perfect Nash equilibrium. The theory also yields implications for the ownership structure needed to support B2B exchange formation ¤ John M. Olin School of Business, Washington University in St. Louis. We wish to thank the Boeing Center on Technology, Information, and Manufacturing for providing funding to support this research and Wes Frick of the Boeing company for sharing with us his knowledge of B2B exchanges and of Boeing's e¤orts in this regard. We also thank Yuriy Fedyk for his reliable research assistance
