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TECH TALK: Two-Sided Markets: Overview

November 7th, 2006 · No Comments

Wikipedia provides this definition:

Two-sided markets, also called two-sided networks, are economic networks having two distinct user groups that provide each other with network benefits. Example markets include credit cards, comprised of cardholders and merchants; HMOs (patients and doctors); operating systems (end-users and developers), travel reservation services (travelers and airlines); and video games (gamers and game developers). Benefits to each group exhibit demand economies of scale. Consumers, for example, prefer credit cards honored by more merchants, while merchants prefer cards carried by more consumers.

In some networks, users are homogenous, that is, they all perform similar functions. For example, although participants in a telephone network originate and receive calls, these roles are transient. Almost all phone users play both roles at different times. Likewise, almost all instant messaging, FAX, and email users both. Networks with homogenous users are called one-sided to distinguish them from two-sided networks, which have two distinct user groups whose respective members consistently play the same role in transactions.

In a two-sided network, members of each group exhibit a preference regarding the number of users in the other group; these are called cross-side network effects. Each groups members may also have preferences regarding the number of users in their own group; these are called same-side network effects. Cross-side network effects are usually positive, but can be negative (as with consumer reactions to advertising). Same-side network effects may be either positive (e.g., the benefit from swapping video games with more peers) or negative (e.g., the desire to exclude direct rivals from an online business-to-business marketplace).

A paper by Jean-Charles Rochet and Jean Tirole (Two-Sided Markets: A Progress Report, November 2005) elaborates:

Two-sided (or more generally multi-sided) markets are roughly defined as markets in which one or several platforms enable interactions between end-users, and try to get the two (or multiple) sides on board by appropriately charging each side. That is, platforms court each side while attempting to make, or at least not lose, money overall.

Examples of two-sided markets readily come to mind. Videogame platforms, such as Atari, Nintendo, Sega, Sony Play Station, and Microsoft X-Box, need to attract gamers in order to convince game developers to design or port games to their platform, and need games in order to induce gamers to buy and use their videogame console. Software producers court both users and application developers, client and server sides, or readers and writers. Portals, TV networks and newspapers compete for advertisers as well as eyeballs. And payment card systems need to attract both merchants and cardholders.

But what is a two-sided market and why does two-sidedness matter? On the former question, the recent literature has been mostly industry specific and has had much of a You know a two-sided market when you see it flavor. Getting the two sides on board is a useful characterization, but it is not restrictive enough. Indeed, if the analysis just stopped there, pretty much any market would be two-sided, since buyers and sellers need to be brought together for markets to exist and gains from trade to be realized. We define a two-sided market as one in which the volume of transactions between end-users depends on the structure and not only on the overall level of the fees charged by the platform. A platforms usage or variable charges impact the two sides willingness to trade once on the platform, and thereby their net surpluses from potential interactions; the platforms membership or fixed charges in turn condition the end-users presence on the platform. The platforms fine design of the structure of variable and fixed charges is relevant only if the two sides do not negotiate away the corresponding usage and membership externalities.

Tomorrow: Pricing

TECH TALK Two-Sided Markets+T

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