6 Two-Sided Markets - White Paper

Two-sided markets:

Models and business cases

White Paper

Carlo Alberto Carnevale Maffè – Giulia Ruffoni

Bocconi University

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Abstract

After a brief introduction on the topic of two-sided markets, we are going to

define them formally and present some real-world examples. We will then

investigated why they arise and presented some aspects that set two-sided

markets apart from traditional ones. Taking on a more managerial approach, we

are going to lay out the main research findings on how to succeed in two-sided

markets. Specifically, we are going to present the factors to consider when

pricing the platform, investigate winner-take-all dynamics, explain the threat of

envelopment and finally introduce a model for assessing the lifetime value of a

free customer. Lastly, we are going to conclude with the payment card industry

as an example of two-sided markets: we will describe its working, explain some

interchange fee dynamics and explore strategies for overcoming the chicken-

and-egg problem.

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Table of contents

1. Introduction

2. What are two-sided markets?

3. Real world examples of two-sided markets

a. Portals and media

b. Text processing

c. Video games

d. PC operating systems

4. Why do two-sided markets arise?

a. Transaction costs

b. Volume-insensitive costs

c. Platform-determined constraints

5. How are two-sided markets different?

a. Endogenous competitive bottlenecks

b. Customer loyalty

c. Price structure

6. How to succeed in two-sided markets?

a. Pricing the platform

b. Winner-take-all dynamics

c. The threat of envelopment

d. The lifetime value of a free customer

7. An example of two-sided markets: Payment cards

a. Payment cards network

b. Interchange fee

c. The “chicken-and-egg” problem

8. Conclusions

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1. Introduction

According to Eisenmann, Parker and Van Alstyne (2006), many, if not most,

of the products and services that have redefined the global business landscape

in recent times tie together two distinct groups of users in a network: in other

words, they serve what economists call two-sided markets or two-sided

networks. Products and services that bring together groups of users in two-

sided networks are platforms: they provide infrastructure and rules that facilitate

the two groups’ transactions and can rely on physical products or be places

providing services.

In the traditional value chain, value moves from left to right: to the left of the

company is cost, to the right is revenue. In two-sided networks, cost and

revenue are both to the left and to the right, because the platform has a distinct

group of users on each side; it incurs costs in serving both groups and can

collect revenues from each, although one side is often subsidized. According to

Eisenmann (2007) estimates, this business model accounts for a majority of the

revenues of 60 of the world’s 100 largest companies. Such a system is possible

because the two groups are attracted to each other, a phenomenon that

economists call cross-side network effect.

In traditional businesses, growth beyond some point usually leads to

diminishing returns. Because of (cross-side and same-side) network effects,

however, successful platforms in two-sided markets might enjoy increasing

returns to scale, leading to fierce competition.

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2. What are two-sided markets?

Two-sided markets are thus roughly defined as markets in which one or

several platforms enable interactions between end-users and try to get the two

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. “Getting

the two sides on board” is a useful characterization, but, if the analysis just

stopped there, pretty much any market would be two-sided, since buyers and

sellers always need to be brought together for markets to exist and gains from

trade to be realized.

Rochet and Tirole (2006) 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 platform’s 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.

An alternative and common definition refers to the existence of cross-group

externalities: the net utility on one side increases with the number of members

on the other side. While this alternative definition has much intuitive appeal, we

will stick to the former, being it more precise and accurate: two-sided markets

are ones in which the price structure affects the economic outcome.

Conceptually, the theory of two-sided markets is related to the theories of

network externalities (where there are non-internalized externalities among end-

users) and of multi-product pricing (which focuses on price structures,

considered less likely to be distorted by market power than price levels).

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3. Real world examples of two-sided markets

Following are some real world examples of two-sided markets drawn from

Eisenmann, Parker and Van Alstyne (2006), Rochet and Tirole (2003), and

Parker and Van Alstyne (2005).

Two-sided market Subsidy side Profit side Examples

PC operating systems

Application developers

PC users Microsoft Windows, Apple

Macintosh

Online recruitment Job seekers Employers Monster, Career Builder

Yellow Pages Consumers Advertisers

Web search Searchers Advertisers Google, Yahoo

Video games Players Game

developers Sony PlayStation, Microsoft Xbox,

Nintendo Wii

Shopping malls Shoppers Retailers

Streaming media Consumers Servers Real Player, Windows Media

Player

Web browsers Users Web servers Microsoft Internet Explorer, Mozilla

Firefox

Portals, newspapers and

TV networks

Visitors, readers and viewers

Advertisers

Text processing Readers Writers Adobe Acrobat, Microsoft Word

Credit and differed debit cards

Cardholders Merchants Visa, MasterCard, American

Express

Real estate Home buyers Home sellers

Auctions Buyers Sellers E-bay, Sotheby’s

Reservation systems

Travelers Hotels, airlines,

rental cars Expedia, eDreams

Ladies’ nights at bars and clubs

Women’s admission and drinks

Men’s admission and

drinks

Stock exchanges Equity purchasers Listed

companies NYSE, NASDAQ

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a. Portals and media

The business model of (non pay) TV, and to a large extent,

newspapers has been to treat viewers and readers as a loss leader

and use them to attract advertisers. This business model has also

been adopted by Internet portals, which have supplied cheap or free

Internet access as well as free content (share quotes, news, e-mail,

etc.) to consumers. The profit center has been advertising revenue,

including both fixed charges for banner placement and proportional

referral fees.

b. Text processing

A key issue confronting purchasers of text processing software is

whether they will be able to “communicate” with people who don’t

make the same choice. Commercial software vendors have in this

respect converged on the following business model: they offer a

downgraded version of the paying software as “freeware”, which

allows nonusers to open, view, and print, but not edit documents

prepared with the paying software, and copy information from those

documents to other applications. Examples of such free viewers are

Word Viewer, PDF Viewer, and Scientific Viewer.

c. Video games

The video game market is a typical two-sided one: a platform

cannot sell the console without games to play on and cannot attract

game developers without the prospect of an installed base of

consumers. History has repeatedly shown that technically impressive

platforms (e.g., Mattel in 1981, Panasonic in 1993, and Sega in 1985

and after 1995) fail when few quality games are written for them. The

business model that has emerged uses consoles as the loss leader

and draws platform profit from applications developers who are

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charged both a fixed fee and a per-unit royalty on the games they

produce, ensuring that only high-quality games make it to the market.

d. PC operating systems

PC and video game networks look similar, with end users on one

side wishing to link to software or games on the other side who buy a

platform consisting of an operating system (OS) bundled with

hardware – a PC or a game console. Also, the two businesses exhibit

similarly positive cross-side network effects: end users favor

platforms that offer a wide variety of complements and developers

favor platforms with more end users because this improves the odds

that they will recover the fixed, upfront costs of creating complements.

However, while in video games end users are subsidized and game

developers are on the network’s money side, in the PC industry end

users are the money side, paying well above cost for the platform’s

essential element, its OS, and application developers are the subsidy

side, as they pay no royalties and receive free software development

kits from the OS vendors.

This difference is due to the fact that video game consoles users,

typically teenagers, are both far more price sensitive and quality

conscious than typical PC users. PCs are often purchased for work

and are otherwise more likely viewed as household necessities than

game consoles are, so price sensitivity is lower. Gamers’ need for

quality seems to be stronger, as does game developers’ need for

large numbers of consumers. PCs, on the contrary, accumulate lots

of applications, with a huge range of price and quality levels.

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4. Why do two-sided markets arise?

A network effect, or network externality, is the effect that one user of a good

or service has on the value of that product to other people. It can be positive, if

any additional user increases the value of the product for other users (e.g.

telephone) or negative, if it decreases such value.

According to Rochet and Tirole (2003), most markets with network

externalities are two- (or multiple-) sided markets. A market with network

externalities is a two-sided market if platforms can effectively cross-subsidize

between different categories of end users that are parties to a transaction, that

is, the volume of transactions on and the profit of a platform depend not only on

the total price charged to the parties to the transaction, but also on its

decomposition.

Platforms may be unable to perform such cross-subsidization if both sides of

the market coordinate their purchases (the platform is in fact dealing with a

single party) or if pass-through and neutrality are possible. We have neutrality if,

even when end users on the two sides of the market act independently,

monetary transfers between them undo the redistributive impact and prevent

any cross-subsidization (e.g. value-added tax). If such neutrality holds, markets

with network externalities are one-sided, that is, only the total per transaction

price charged by the platform matters and not its decomposition between end

users.

In practice, however, neutrality does not hold because of three main

reasons:

1. Transaction costs refer to a broad range of frictions that make it

costly for one side of the market to pass through a redistribution of

charges to the other side. They can be associated with small

stakes for individual transactions (which can become substantial

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when applied to a large number of transactions), be related to the

absence of a low cost billing system or arise from the impossibility

of monitoring and recording the actual transaction or interaction.

2. Volume-insensitive costs exist when at least one side of the

market incurs costs that are influenced by the platform and are not

proportional to the number of transactions on the platform.

3. Platform-determined constraints on pass-through may also take

place.

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5. How are two-sided markets different?

The concept of two-sided markets is relatively new and, as such, it has not

yet been completely understood and explained. Recent research, however, has

helped to shed some light on this interesting topic; this paper now presents

some of the main findings that set two-sided markets apart from traditional

ones.

a. Endogenous competitive bottlenecks

Noticing that, in many two-sided market, agents on one or both

sides multihome and that platforms often charge little or nothing to

one side of the market, Armstrong and Wright (2007) investigate two-

sided markets in the case when one side views the platforms as

homogeneous, while the other views the platforms as heterogeneous.

They make the realistic assumption that sellers view the competing

platforms as more or less homogenous (controlling for the size of the

network benefits), while buyers have preferences for using one

particular platform over the other, and they allow agents to join a

single platform, to “singlehome”, or both, to “multihome”. Finally, they

consider the use of exclusive contracts that prevent agents from

multihoming.

Where there is strong product differentiation on each side of the

market, the model predicts all agents singlehome. If attracting one

group of agents (say, buyers) makes the platform particularly

attractive to the other group (sellers), then buyers will be “subsidized”.

In the case where product differentiation arises only on one side of

the market (say, buyers), an equilibrium exists where agents on the

other side (sellers) will multihome. This case represents a “

competitive bottleneck”: platforms compete aggressively to sign up

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buyers, charging them less than cost (perhaps nothing), and make

their profits from sellers who want to reach these buyers and don’t

have a choice of which platform to join in order to reach them. In

equilibrium, sellers are left with zero surplus. A similar outcome can

also arise when there is no product differentiation on either side.

Finally, they show that competitive bottleneck equilibria can be

undermined when platforms can offer exclusive contracts to the seller

side, which work by making it easier for a platform to persuade

multihoming sellers to abandon the rival platform. A platform can set

arbitrarily high non-exclusive prices (so that sellers never choose to

multihome regardless of the rival platform’s offer) and then offer a

slight price cut relative to the rival platform to attract all sellers

exclusively. Even if the platforms are otherwise symmetric, this allows

a platform to attract all sellers, and therefore be able to charge a

premium to buyers. When network effects are strong, this can lead to

an equilibrium where all agents sign up exclusively to a single

platform even though it sets high prices to both sides. Competition in

such exclusive contracts can result in buyers having all their surplus

extracted.

b. Customer loyalty

Competing firms in any industry are likely to be asymmetric in their

customer loyalty as a result of differences in product positioning,

marketing effectiveness, and order-of-entry of the firms. Also, an

incumbent in an industry is more likely to enjoy higher customer

loyalty than a potential entrant: examining the impact of asymmetric

loyalty is thus also important in understanding firms’ entry strategies.

Firms in two-sided markets face competition in multiple

interdependent markets so that the installed user base and customer

loyalty in one market affect competition not only in that market but in

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other markets as well. Moreover, loyalty build-up is especially

important among industries characterized by the cross-market

network effect because consumer commitments and switching costs

play very significant roles in competition. Finally, understanding the

competitive implications of asymmetric loyalty is practically relevant

for industries in two-sided markets as they are witnessing the entry of

new players.

Previous literature has suggested a positive effect of customer

loyalty on a firm’s competitive advantage. In order to test this

relationship in the contest of two-sided market, Chen and Xie (2007)

have developed a model composed of two competing firms, each

selling two products (a primary and a secondary product) in two

markets with a cross-market network effect, i.e., the value of the

secondary product depends on the demand for the primary product.

The firms differ in customer loyalty in the market of the primary

product.

They show that a mid-range loyalty advantage in the market of the

primary product may lead to a lower total profit for the firm compared

with its competitor. This is possible because a firm with a mid-range

loyalty advantage has an incentive to set a high price to target its

loyal segment, because its loyalty advantage is quite significant and

the existence of a price lower bound limits its ability to obtain non-

loyal customers by further undercutting the competitor in price. As a

result, this can lead to a disadvantage in market share in the primary

product market if the firm’s customer loyalty advantage is not high

enough to outnumber the non-loyal customers attracted by its

competitor. Consequently, its profit from the secondary product can

be lower than that of its competitor, and its total profit from both

markets can also be lower than that of its competitor.

Their main findings are the following:

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• Differently from traditional markets, where an advantage

in customer loyalty leads to an advantage in profit, in two-

sided markets a firm with an advantage in customer

loyalty can be leapfrogged by its rival in both profit and

market share if its advantage in loyalty is neither

sufficiently small nor sufficiently large.

• A cross-market network effect generates strategic

dependence between the two markets such that the more

competitive the secondary product market the more likely

it will be for the firms to adopt differentiated pricing

strategy in the primary product market, and the more

likely that the firm with a loyalty disadvantage will be the

market share leader in the primary product market.

• If the fixed cost of entry is low and the incumbent can only

build a mid-sized loyalty segment, a second mover

advantage may endogenously occur because the entry

cannot be deterred and the entrant may leapfrog the

incumbent in profit.

c. Price structure

Rochet and Tirole (2003) focus on the fact that, under

multisidedness, platforms must choose a price structure and not only

a price level for their service. Their work studies how the price

allocation between the two sides of the market is affected by: platform

governance (for-profit vs. not-for-profit), end users’ cost of

multihoming, platform differentiation, platforms’ ability to use volume-

based pricing, the presence of same-side externalities and platform

compatibility.

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They find that monopoly and competitive platforms design their

price structure so as to get both sides on board. Specifically,

• An increase in multihoming on the buyer side facilitates

steering on the seller side and results in a price structure

more favorable to sellers

• The presence of marquee buyers (buyers generating a

high surplus on the seller side) raises the seller price and

(in the absence of price discrimination on the buyer side)

lowers the buyer price

• Captive buyers tilt the price structure to the benefit of

sellers

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6. How to succeed in two-sided markets?

Platforms serving two-sided networks are not a new phenomenon, but,

thanks largely to technology, they have become more prevalent in recent years:

new platforms have been created and traditional businesses have been

reconceived as platforms. Yet, for all the potential they’ve spotted, platform

providers have struggled to establish and sustain their two-sided networks

mainly because, in creating strategies, managers have typically relied on

assumptions and paradigms that apply to products without network effects. This

paper is now going to present three unique challenges facing executives that

operate in two-sided networks as discussed in Eisenmann, Parker and Van

Alstyne (2006) and a model for assessing the lifetime value of a free customer

as presented by Gupta and Mela (2008).

a. Pricing the platform

Transactions in two-sided networks always entail a triangular set

of relationships. Two user groups – the network’s “sides”– interact

with each other through one or more intermediaries called platform

providers. Platforms exhibit two types of network effects, which may

be either positive or negative: a same-side effect, in which increasing

the number of users on one side of the network makes it either more

or less valuable to users on the same side; and a cross-side effect,

in which increasing the number of users on one side of the network

makes it either more or less valuable to the users on the other side.

For two-sided networks, pricing is a complicated affair. Platform

providers have to choose a price for each side, factoring in the

impact on the other side’s growth and willingness to pay. Typically,

two-sided networks have a “subsidy side,” that is, a group of users

who, when attracted in volume, are highly valued by the “money

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side,” the other user group. Because the number of subsidy side

users is crucial to developing strong network effects, the platform

provider sets prices for that side below the level it would charge if it

viewed the subsidy side as an independent market. Conversely, the

money side pays more.

If the platform provider can attract enough subsidy side users,

money-side users will pay handsomely to reach them. Also, the

presence of money-side users makes the platform more attractive to

subsidy-side users, so they will sign up in greater numbers. Finally,

pricing is further complicated by “same-side” network effects.

The challenge for the platform provider with pricing power on both

sides is to determine the degree to which one group should be

encouraged to swell through subsidization and how much of a

premium the other side will pay for the privilege of gaining access to

it. When making pricing decisions, the provider should consider the

following factors:

• Ability to capture cross-side network effects: your

giveaway will be wasted if your network’s subsidy side

can transact with a rival platform provider’s money side.

• User sensitivity to price: it makes sense to subsidize the

network’s more price-sensitive side and to charge the

side that increases its demand more strongly in response

to the other side’s growth.

• User sensitivity to quality: rather than charge the side that

strongly demands quality, you charge the side that must

supply quality.

• Output costs. Pricing decisions are more straightforward

when each new subsidy-side user costs the platform

provider essentially nothing, like when the giveaway takes

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the form of a digital good. However, when a giveaway

product has appreciable unit costs, as with tangible

goods, platform providers must be more careful: If a

strong willingness to pay does not materialize on the

money side, a giveaway strategy with high variable costs

can quickly rack up large losses.

• Same-side network effects. Platform providers normally

welcome growth in the user base on either side, because

it encourages growth on the other side. However, in the

face of strongly negative same-side network effects,

platform providers should consider granting exclusive

rights to a single user in each transaction category and

extracting high rent for this concession (they must,

however, make sure that sellers do not abuse their

monopoly positions).

• Users’ brand value. The participation of “marquee users”,

which may be exceptionally big buyers or high profile

suppliers, can be especially important for attracting

participants to the other side of the network. A platform

provider can accelerate its growth if it can secure the

exclusive participation of marquee users in the form of a

commitment from them not to join rival platforms.

However, it can be expensive, especially for small

platforms, to convince marquee users to forfeit

opportunities in other networks. Also, when the

participation of a few large users is crucial for mobilizing a

network, conflict over the division of value between

platform providers and large users is common.

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b. Winner-take-all dynamics

The prospect of increasing returns to scale in network industries

can lead to winner-take-all battles, so an aspiring platform provider

must consider whether to share its platform with rivals or fight to the

death. First, executives must determine whether their networked

market is destined to be served by a single platform. When this is the

case, the second step, that is, deciding whether to fight or share the

platform, is a bet-the company decision.

A networked market is likely to be served by a single platform

when:

• Multi-homing costs are high for at least one user side.

“Homing” costs comprise all the expenses network users

incur, including adoption, operation, and the opportunity

cost of time, in order to establish and maintain platform

affiliation. When users make a “home” on multiple

platforms, they increase their outlays accordingly; if multi-

homing costs are high, users need a good reason to

affiliate with multiple platforms.

• Network effects are positive and strong, at least for the

users on the side of the network with high multi-homing

costs. When cross-side network effects are positive and

strong, those network users will tend to converge on one

platform. The odds of a single platform prevailing also

increase when same-side network effects are positive.

• Neither side’s users have a strong preference for special

features. If certain users have unique needs, then

smaller, differentiated platforms can focus on those needs

and carve out niches in a larger rival’s shadow. In cases

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where special features are not important, however, users

will tend to converge on a single platform.

Even though proprietary control promises monopoly profits once

rivals are vanquished, there may be reasons to decide to share a

platform, like if senior managers believe that their company’s platform

is not likely to prevail. However, even those firms that have a fighting

chance of gaining proprietary control stand to realize benefits from

sharing: the total market size will be greater with a shared platform

(during a battle for dominance in a two-sided network, some users will

delay adoption, fearing that they will be stranded with obsolete

investments if they back the loser) and rivalry tends to be less intense

with a shared platform, reducing marketing outlays (since the stakes

are so high in battles for network dominance, firms spend enormous

amounts on upfront marketing).

• Winning the battle. To fight successfully, you will need, at

a minimum, cost or differentiation advantages. Three

other assets are important in establishing proprietary

control: platform providers gain an edge when they have

pre-existing relationships with prospective users, often in

related businesses; high expectations generate

momentum in platform wars, so a reputation for past

prowess helps a great deal; and in a war of attrition, deep

pockets matter. Moreover, first-mover advantages can

also be significant in platform battles, but they are not

always decisive: when the market evolves slowly, late

mover advantages may be more salient. Late movers

may, for example, avoid the pioneer’s positioning errors,

be better placed to incorporate the latest technology into

product designs, or be able to reverse engineer pioneers’

products and beat them on cost. Finally, in a battle for

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platform control, first and late movers alike will feel strong

pressure to amass users as quickly as possible; in most

cases, this urgency is appropriate and positive word-of-

mouth favors the early mover. But racing to acquire users

can be a mistake under two circumstances. First,

executives must ask whether their business is readily

scalable. Second, due to their explosive growth potential,

platform-mediated networks are prone to boom or bust

valuation cycles: when they launch cash-draining “get big

fast” strategies, therefore, top managers need to be sure

that funding will be forthcoming should capital-market

sentiment turn negative.

c. The threat of envelopment

Your platform may be “enveloped” by an adjacent platform

provider that enters your market. Platforms frequently have

overlapping user bases: leveraging these shared relationships can

make it easy and attractive for one platform provider to swallow the

network of another. The real damage comes when your new rival

offers your platform’s functionality as part of a multi-platform bundle.

Such bundling hurts the stand-alone platform provider when its

money side perceives that a rival’s bundle delivers more functionality

at a lower total price: the stand-alone platform provider cannot

respond to this value proposition because it cannot afford to cut the

price on its money side and it cannot assemble a comparable bundle.

Networked markets, especially those in which technology is

evolving rapidly, are rich with envelopment opportunities that can blur

market boundaries; this blurring is called “convergence.” In many

cases, a stand-alone business facing envelopment has little choice

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but to sell out to the attacker or exit the field; some, however, manage

to survive.

Here is what a focused firm can do to survive envelopment:

• Change business model. It might be possible to switch

the money side leveraging existing relationships. Also, a

specialist can reinvigorate its business model by offering

services as a systems integrator, helping enterprises knit

together diverse systems and technologies. Facilitating

transactions across a two-sided network requires platform

providers to coordinate users’ activities; hence, managing

a platform builds system integration skills that can be

exploited.

• Find a “bigger brother”. When bullied on the playground, a

little guy needs a big friend: find allies through

partnerships.

• Sue. Firms facing envelopment are wise to consider legal

remedies, because antitrust law for two-sided networks is

still in dispute. Dominant platform providers that offer

bundles or pursue penetration pricing run the risk of being

charged with illegal tying or predation.

The threat of envelopment means that vigilance is crucial for a

focused platform provider: when market boundaries blur,

envelopment attacks can come from any direction. However, focused

firms are not without advantages when competing with large,

diversified companies. Big firms can be slow to recognize

envelopment opportunities and even slower to mobilize resources to

exploit them. Also, envelopment requires cross-business-unit

cooperation, a significant barrier in many diversified companies.

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d. The lifetime value of a free customer

Customers who pay little or nothing and are subsidized by another

set of customers are essential to a vast array of businesses. The

rationale for this approach is that by charging one set of customers

little or nothing, the business will attract the critical mass of them

required to draw in large numbers of another set of customers, and

the income generated by the latter will handsomely exceed the cost of

acquiring and serving the former. Executives, however, tend to

underestimate the significance of free customers both because

managers naturally focus more on customers who generate the bulk

of revenues and because traditional customer-valuation models focus

exclusively on paying customers (estimating the net present value of

their purchases minus the cost of marketing to them).

This model considers the precise role that each customer segment

plays in growing the business and creating value: it takes into account

how the number of free customers influences the number of paying

customers and vice versa, and how both are affected by the firm’s

marketing efforts. The lifetime value of a free customer is thus defined

as his or her incremental effect on the net present value of cash flows

from the population of fee customers. It depends on the degree to

which a free customer attracts other fee and free customers and the

ripple effects those customers have on still other customers.

Direct network effects (how a buyer attracts more buyers or a

seller more sellers) can be positive or negative. When direct network

effects are strong and negative, a firm faces the challenge of building

a critical mass of players on the side in question. Indirect network

effects, between buyers and sellers, can be positive or negative as

well. When indirect network effects are strong and positive, the firm

benefits tremendously from the snowball effect and may eventually

become the sole industry standard. In such situations, free customers

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in the early stages of the business are crucial, and the firm should be

willing to invest a lot of resources to get them on board.

Knowing the lifetime value of free customers is crucial to

determining:

• the optimal way to grow: how much a company should

spend at various points in time to acquire and retain free

or heavily subsidized customers.

• the real value of the enterprise: how much investors or

acquirers should pay for all or part of a business with

such customers.

• the best organizational design: how the business and its

incentive systems should be structured to encourage the

units responsible for the free and the paying customers to

work together.

Companies employ a variety of crude approaches to place a value

on free or heavily subsidized customers but, because these

techniques do not rigorously quantify the impact of network effects,

their valuations are wild guesses. One simple approach apportions

the prior period’s profits equally among free and paying customers; it

ignores the relative size of the two groups as well as the degree of

influence each has on the other.

Another approach assigns profits according to the proportion of

buyers to sellers; it can grossly miscalculate the value of buyers and

sellers because it ignores network effects and the changing value of

buyers and sellers over time.

The best of the common approaches is one employed by

publications whose subsidized customers (subscribers) pay

something: in valuing a subscriber, they typically take into account

both subscription fees and advertising revenues per reader. While

25

this is a reasonable approach, it, too, ignores the rippling impact that

readers’ referrals can have on circulation and ad revenues.

In analyzing a major international online auction house, Gupta and

Mela (2008) collected historical data on the number of sellers and

buyers, their growth rates, the prices charged (to sellers) and the

marketing expenses incurred. They then examined how the growth in

the number of both sellers and buyers was affected by the firm’s

marketing strategies, by direct network effects and by indirect network

effects and devised two related equations which were used to

determine the magnitude of the network and marketing effects.

Their model showed the growth patterns of buyers and sellers,

how the value of a newly acquired buyer changed over time and the

effect of pricing strategies on profits. This analysis also helped the

firm to strengthen its marketing operations, to cater more to buyers

and to make its case to investors.

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7. An example of two-sided markets: Payment cards

The payment card industry is a typical two-sided market where two different

groups of agents, the merchants and the cardholders, interact with each other

via a common network platform, the payment card network, and the value of

participating in a particular card network for agents in one group (say, the

merchants) depends on the number of participants from the other group (the

cardholders, correspondingly). For example, if more consumers carry a VISA

card, merchants accepting VISA cards will be able to capture higher sales

volume from these cardholders; on the other hand, if more merchants accept

VISA cards, it will be more convenient for VISA cardholders to pay for their

purchases.

We will now describe the payment cards network more in detail and then

present some research findings from Rochet and Tirole (2002) and Sun and

Tse (2007).

a. Payment cards network

In a two-sided market, the two sides interact with each other

through a common network platform; in the payment card network,

the electronic payment systems and equipment (e.g. point-of-sale

POS terminals) are the platforms via which consumers interact with

merchants. Besides the two sides, there is a third party who creates

and services the network: the network platform owner or sponsor:

VISA, MasterCard, American Express, and Discover are platform

owners of the U.S. payment card network.

Each merchant installs a POS terminal in his store, which is linked

to the electronic payment system owned by network platform owners

(e.g. VISA, MasterCard); consumers can then purchase goods or

services from any merchant in the network. The platform owners

operate the payment system and provide services to network

27

participants (e.g. clearing & settlements, fund transferring, fraud

protection).

In many two-sided markets, there is also a fourth type of agents:

the distributors of a network. They are the agents who produce and

sell network-specific products to participants on either or both sides of

the market; in the payment card network, banks such as Bank of

America, Wells Fargo, Chase, etc. issue VISA or MasterCard cards to

consumers and sign up merchants. They are neither the network

platform owner nor any side of the market: instead, they are the

distributors of the corresponding network (i.e. VISA or MasterCard).

Although inessential to a two-sided network, network distributors may

affect the diffusion speed of a network: their collective efforts in

signing up network participants and in improving the quality and

features of the network could have a critical impact on the growth and

even survival of a network.

The fee structure is also worth noticing. Since the network

platform provides added-value to both sides of the market, the

platform owner can charge both sides for its service, either on lump-

sum basis or on per-transaction basis. Payment card network owners

(e.g. VISA) charge merchants on per-transaction basis which is

usually 2-3% of the transaction value. They could also charge

cardholders a lump-sum membership fees, although most choose not

to do so or only charge cardholders of certain risk profiles (e.g. those

with low credit scores).

The defining characteristics of two-sided markets are the cross-

group network externalities: a consumer’s decision to use VISA card

imposes positive externalities to merchants, while a merchant’s

decision to accept VISA card imposes positive externalities to

consumers. There could also be within-group externalities, either

positive or negative, within either side of the market. In the payment

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card network, negative externalities exist among merchants: given the

number of cardholders, more merchants in a particular card network

will lead to less incremental sales from accepting the card for an

individual merchant. This is because merchants are competing

against each other for businesses from the same cardholders. Such

negative within-group externality is called the congestion effect.

b. Interchange fee

Rochet and Tirole (2002) explore the workings of the payment

card industry from an economic perspective. They underline that, in a

payment card transaction, the consumer's bank, called the issuer,

and the merchant's bank, the acquirer, must cooperate to enable the

transaction. Two successful not-for-profit joint ventures, Visa and

MasterCard, have designed a set of rules to govern the

"interconnection" between their members:

• Interchange fee: the acquirer pays a collectively

determined interchange fee (the analog of an access

charge in telecommunications) to the issuer.

• Honor-all-cards rule: affiliated merchants must accept any

card of any issuing member.

• No-surcharge rule: affiliated merchants are not allowed to

impose surcharges on customers who pay with a card.

They base their model on three starting considerations.

First, when (at least some) consumers know which stores take

payment cards before they select which to patronize, or may leave

the store when they discover the card is not accepted, merchants use

card acceptance to attract customers. A merchant's total benefit, and

thus his decision whether to accept a card, then depends not only on

his technological benefit (fraud control, theft protection, speed of

29

transaction, customer information collection, etc.), but also on the

product of the increase in demand due to system membership and its

retail markup. Thus, they conclude that the earlier literature

overstated merchants' resistance to an increase in the merchant

discount and, therefore, to an increase in the interchange fee.

Second, when merchants are allowed to offer cash discounts, a

consumer's decision to use a card depends not only on the

technological benefit (convenience, theft and fraud control, etc.), but

also on the extra charge for using a payment card.

Third, when several payment card systems compete, a merchant's

opportunity cost for accepting a card is endogenous as long as some

customers hold cards on multiple systems. For example, a merchant

who turns down American Express (Amex) may see the customer pay

with Visa or MasterCard rather than with cash or a check. Thus, the

earlier literature understated merchants' resistance under system

competition.

They conclude that, in the absence of unobserved heterogeneity

among merchants, an increase in the interchange fee increases the

usage of payment cards, as long as the interchange fee does not

exceed a threshold level at which merchants no longer accept

payment cards. At this threshold level, the net cost for merchants of

accepting the card is equal to the average cardholder benefit. The

interchange fee selected by the payment card association either is

socially optimal or leads to an overprovision of payment card

services.

c. The “chicken-and-egg” problem

The cross-group network effect is a double-edge sword: it can

either lead to spiral growth of the network or create the “chicken-and-

egg problem”: without sufficient merchants accepting a particular card

30

network, few consumers are willing to apply for the card; without

sufficient cardholders, few merchants are willing to accept the card.

For example, if few consumers carry VISA cards, few merchants will

be willing to accept VISA, which further discourages consumers from

using this type of cards. Unless the network has reached a critical

mass in the number of participants, it cannot take off.

While economists have addressed the issue from a social welfare

perspective, Sun and Tse (2007) focus on business strategy

implications: modeling network externalities in dynamic systems, they

explore strategies for overcoming the chicken-and-egg problem.

The model developed shows that if a network starts with small

numbers of merchants and consumer members, it can never move

across the saddle path and its growth cannot be sustained;

eventually, the network will shrink to zero as the small number of

participants on one side of the market cannot provide large enough

value to attract or keep participants from the other side. However, if a

network can manage to gather enough participants on both sides of

the market at the very beginning, the network will be able to grow to

infinity on its own momentum. It is interesting to see that a network

needs not have large numbers of participants from both sides of the

market: instead, as long as it has sufficient participants from one side

of the market, it will be able to achieve sustainable growth.

Though the model is based on the market structure of the

payment card system, it is also applicable to other two-sided markets

with similar structures such as yellow page directory and PC

operating system. Therefore, although they discuss the findings using

the payment card industry as a background, the business insights in

the following propositions apply to many two-sided markets.

31

• Proposition 1: to overcome the chicken-and-egg problem,

firms entering two-sided markets as network platform

owners should leverage on their existing networks or

customer relationships from other businesses in order to

boost the number of initial participants of the network.

• Proposition 2: platform sponsors of two-sided networks

might overcome the chicken-and-egg problem by lowering

price/fee, increasing the benefit and/or decreasing the

potential risks faced by its participants.

• Proposition 3: platform sponsors of two-sided networks

can dynamically increase fees or lower the benefits they

provide to network participants after the chicken-and-egg

problem has been resolved.

• Proposition 4: two-sided networks with insufficient

participants from either or both sides of the market might

overcome the chicken-and-egg problem through merger

and acquisition, licensing or forming strategic alliances.

• Proposition 5: to overcome the chicken-and-egg problem

and/or increase the growth rate, two-sided networks

should leverage on the new information technology and

internet to reduce participant’s search/transportation cost.

• Proposition 6: to increase the growth rate of the network,

two-sided networks may resort to advertising, marketing

and promotion to mitigate the impact of incomplete

information and inertia to adoption.

• Proposition 7: to increase the rate of network growth, two-

sided network platform sponsors should allow and

encourage third-party distributors to distribute their

network.

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8. Conclusions

We first explained how two-sided markets tie together two distinct groups of

users in a network, how they are characterized by the existence of a cross-

group network effect (the net utility on one side increases with the number of

members on the other side) and how platforms provide infrastructure and rules

that facilitate the two groups’ transactions. We then more formally defined 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. We populated this definition with real world examples;

among the many, we highlighted the cases of portals and media, text

processing software, video games and PC operating systems.

The paper investigated why two-sided markets arise and explained the main

reasons because of which neutrality does not always hold (transaction costs,

volume-insensitive costs and platform-determined constraints). It then

presented some aspects that set two-sided markets apart from traditional ones;

namely, the possibility of competitive bottlenecks to arise endogenously, the

different relationship between customer loyalty and competitive advantage and

some findings on the price structure.

Taking on a more managerial approach, we presented the main research

findings on how to succeed in two-sided markets. Specifically, we presented the

factors to consider when pricing the platform: ability to capture cross-side

network effects, user sensitivity to price, user sensitivity to quality, output costs,

same-side network effects and users’ brand value. Investigating winner-take-all

dynamics, we explained that a networked market is likely to be served by a

single platform when multi-homing costs are high for at least one user side,

when network effects are positive and strong and when neither side’s users

have a strong preference for special features. Moreover, we investigated the

main assets important in establishing proprietary control. The threat of

envelopment, leading to convergence, was then explained and, even though we

33

recognize that a stand-alone business facing envelopment often has little choice

but to sell out to the attacker or exit the field, we underlined how a focused firm

can sometimes survive envelopment by changing business model, finding a

“bigger brother” and suing. Finally, we introduced a model for assessing the

lifetime value of a free customer which is crucial to determining the optimal way

to grow, the real value of an enterprise and the best organizational design.

Finally, we concluded with the case of a typical two-sided market: the

payment card industry. We explained its working, presented its distinguishing

elements (platform, platform owners, distributors, fee structure and network

externalities) and some considerations on the interchange fee from an

economic perspective. Lastly, we described the “chicken-and-egg problem”:

without sufficient merchants accepting a particular card network, few consumers

are willing to apply for the card and without sufficient cardholders, few

merchants are willing to accept the card. The case concludes with seven

propositions that, although developed specifically for the payment card industry,

apply to many other two-sided markets as well.

In conclusion, as new platforms are being created and traditional businesses

are being reconceived as platforms, two-sided markets are taking up an

increasingly important share of today’s economy. While this paper offers an

overall picture of the topic and presents relevant research findings, it appears

evident that much work is still to be done, especially in terms of managerial

implications.

34

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