How does eBay actually work?

If you've been involved with the Internet for any length of time, I think it's inevitable that you've bumped into either eBay (Nasdaq:EBAY) or one of its huge subsidiaries, Paypal or Skype. I know I use all three of these with alarming regularity!

In terms of how eBay actually works, though, that's an interesting question, because in many ways, eBay represents a perfect implementation of what we could call Economy 2.0: it's a business that makes money by being an intermediary. They have no warehouses, no stock, no shipping department, no salespeople and no retail storefronts. Yet for all that, they make billions of dollars in profit. With competitors like that, why bother with retail, temporary staff, the hassles of shipping and all the rest of the burden of a traditional business?

Apocryphally, when Pierre Omidyar founded eBay (originally called AuctionWeb), he created it to allow his girlfriend to buy and sell Pez dispensers with other collectors. In fact, the first thing sold on eBay was Pierre's broken laser pointer, which -- amazingly -- someone bought for $14! I won't belabor the company history as there are many excellent sources for that, including an authoritative Wikipedia entry and literally hundreds of books.

In many ways, eBay offered up a completely frictionless marketplace where sellers gained the benefit of far greater visibility for their goods than they could obtain through other outlets (e.g., flea markets, garage sales) and buyers gained access to a far wider range of goods than possible in a physical setting. If each party had to pay a small transaction fee on a consummated transaction, the price was easily absorbed when compared with the benefits. What I believe really made eBay a harbinger of things to come in the online commerce world (remember, eBay was started up in 1995) was the rating system, which allowed the community to police itself, promote and recognize great buyers and sellers, and grow without being trapped in the vacuum of anonymity that's one of the banes of the Internet.

However, as with all things, scammers have figured out how to game eBay and while the percentage of transactions that are fraudulent are surprisingly low, it's not hard to find someone who has been ripped off, almost always from a fraudulent seller. How can this be, in a world of ratings and user feedback? It's not hard, especially if you create a shilling circle or other group of people who collectively intend to scam others.

It can work like this: five of my best pals and I all create eBay accounts and then auction off ridiculously cheap items like pencils or gum wrappers. Each transaction costs perhaps $0.25 in fees and if we're all bidding on each other's auctions, each complete the transaction, and each give the other positive feedback as a buyer/seller, it won't take long to establish a good community rating and seem legit. 20-30 low-cost items, less than $1/transaction in fees, and now you can move into selling $2500 plasma TVs or high-end laptops without appearing like someone who just started on eBay. Meanwhile, though, your intent is to take the payment but not ship the goods. If you run a half-dozen auctions simultaneously, you could pocket a quick $10,000 or more through this strategy, even though it's clearly illegal.

The best way I have found to avoid scams is to #1 not buy from anyone with less than a few hundred feedback votes, at least 95% positive (things happen, I don't expect 100% clean feedback), and to avoid anything with a strange payment scheme. Wiring a money order, sending a check to a Post Office Box, or similar are all warning signs. Instead, use an escrow service and if you use Paypal, opt for the insurance they offer.

Hopefully that answers your question and offers some basic tips on how to avoid being ripped off. Good luck to you, and perhaps other eBay enthusiasts will add their own best practices in terms of avoiding being ripped off, which none of us want.