U. Porto – Doctoral Programme in Economics

The Economics of Two-sided Markets
1. Overview of basic concepts!
Paul Belleflamme, CORE & LSM!
Université catholique de Louvain!

April 10-13, 2012

Economics of 2SM – Basic concepts"

Map of the course 1. Overview of basic concepts (± 2 hours)
o Various groups of participants interact via a platformo Cross-side (or inter-group) effects are present.
o Platforms are often actively managed.
o Few platforms are active in a single market.

 2. Platform competition (± 3 hours)
o Viability of competition in two-sided marketso Effects of competition in two-sided markets
o Competition in two-part tariffs
o Dynamic issues

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Map of the course (2) 3. Application to specific industries (± 3 hours)
o Media markets
o Software platforms
o E-commerce, B2B and matching platforms.
o Mobile telephonyo Payment cards

 4. Competition policy and regulation (± 2 hours)
o Exercise of unilateral market powero Mergerso Coordinated practices
o Regulation

 Assessment: final exam, open book, 2 hours
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Overview of basic concepts

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Learning objectives
 At the end of this lecture, you should be able to…
o Understand what is a two-sided platform.
o Identify the various externalities that are at play on such platforms.
o Understand how prices are set by a monopoly platform.

 Background readings
o Evans, D.S. (2011). Platform Economics: Essays on Multi-Sided Businesses.

Competition Policy International. Chapters 1 to 3.
o Belleflamme, P. and Peitz, M. (2010). Industrial Organization. Markets andStrategies. Cambridge: Cambridge University Press. Chapter 22. Section 3.

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Economics of 2SM – Basic concepts"

Multi-sided platform markets: Definition (Evans, 2011)!
 Multi-sided platforms coordinate the demand of distinctgroups of customers who need each other in some way.!
 There is an opportunity for a platform to increase social
surplus when 3 necessary conditions are true:!
o There are distinct groups of customers.!
o A member of one group benefits from having his demand

coordinated with one or more members of another group.!
 Presence of indirect network effects!
 Cross-side or inter-group externalities !
o An intermediary can facilitate that coordination more efficiently thanbilateral relationships between the members of the group.!
 Transaction costs and free-riding problems make it difficult for membersof distinct customer groups to internalize the externalities on their own.!
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Multi-sided platform markets: Typology (Evans, 2011)!
 Exchanges
o Help ʻbuyersʼ and ʻsellersʼ search for feasible contracts and for thebest prices.!
o Market is two-sided if the Coase theorem does not apply to thetransaction between the two sides.!
o Examples!
 Match-making activities: dating services, employment agencies.!
 Traditional exchanges: stock exchange, auction houses, B2B, B2C andC2C web sites!
 Brokerage services: publishers (readers and authors), literary agents(authors and publishers), travel services (travelers and travel-relatedbusinesses), ticket services (people who go to events, and people whosponsor events). !

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Economics of 2SM – Basic concepts"

Multi-sided platform markets: Typology (2)!
 Advertising-supported media
o Examples!

 Magazines, newspapers, free television, and web portals!
o The platform either creates content (newspapers) or buys content

from others (free television).!
o The content is used to attract viewers. The viewers are then used toattract advertisers.!

 Transaction systems
o Any method for payment works only if buyers and sellers are willingto use it.!
o Examples!
 Government backed systems: coins and notes!
 For-profit transaction systems: debit and credit cards, Paypal, …!
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Economics of 2SM – Basic concepts"

Multi-sided platform markets: Typology (3)!
 Software platforms
o Allow applications developers and users to interact!

 Platform provide services for applications developers (e.g., obtain accessto the hardware for the computing device in question).!
 Users can run these applications only if they have the same software
platform as that relied on by the developers.!
 Developers can sell their applications only to users that have the same
software platform they have relied on in writing their applications.!
o Examples!

 Personal computers!
 Smartphones!
 Video games!
 Digital music devices!

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Identifying externalities"

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Identifying externalities (2)" Some examples!

11A. Game developers	

B. Users	

A to B: +	

B to A: +	

In A: -	In B: +	A. Readers	B. Advertisers	

A to B: +	

B to A: - (+?)	

In A: /	In B: -	A. Women	

B. Men	A to B: +	

B to A: +	

In A: / (-?)	

In B: / (-?)	

A. Merchants	

B. Consumers	

A to B: +	

B to A: +	

In A: -	In B: /	

Economics of 2SM – Basic concepts"

Single- vs. multihoming"
Intuition!
Platforms havea monopoly foraccess tosinglehomers.!
Singlehomers
are courted.!
Multihomers areexploited.!

12Economics of 2SM – Basic concepts"“Getting both sides on board”!
 Platforms face a “chicken-and-egg” problem
o Side A is willing to participate only if side B participates and viceversa (also called “circular conundrum”- Spulber, 2009).

 Ways to solve the problem
o Minimizing transaction costs

 Matchmaking (exchanges)
 Building audiences (advertising-supported media)
 Minimizing duplication costs (software platforms, transaction systems)
 Example doing all 3: MySpaceo Designing correctly the price structure Aim: internalize the various externalities across and within the sides ofthe platform

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Economics of 2SM – Basic concepts"

Pricing" A market is two-sided if the platform can affect the volumeof transactions by charging more to one side of the market
and reducing the price paid by the other side by an equalamount. (Rochet and Tirole, 2006)
o The price structure matters (not just the total price).
o There must be externalities between the two groups that themembers cannot sort out for themselves.
o ↔ “one-sided market”: textbook wheat market → no externalities
connecting buyers and sellers → price structure doesn’t matter(a tax on wheat levied on buyers has the same effect on quantity as
the same tax levied on sellers).

 2 types of “prices”
o Usage feeso Membership fees

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Economics of 2SM – Basic concepts"

Monopoly platform" Example 1o 3 buyers and 3 sellers
o Each buyer buys one unit from each sellero Buyers and sellers derive a positive gross surplus from each buyer-seller transaction

 Buyers: each one derives 2 per transaction
 Sellers: sellers 1, 2 and 3 derive, resp., 1, 2 and 3 per transactiono Intermediary sets usage (transaction) fees: Pb and Ps
o Net surplus if nb buyers and ns sellers are on the platform: Buyers: Ub(ns) = (2-Pb) x ns
 Sellers:- Us(nb) = (1-Ps) x nb for seller 1- Us(nb) = (2-Ps) x nb for seller 2- Us(nb) = (3-Ps) x nb for seller 3
o Intermediary’s profits (Assumption: no cost): Π = (Pb+Ps) x nb x ns15

Economics of 2SM – Basic concepts"

Monopoly platform (2)!
 Example 1 (cont’d)o Profit-maximizing price on the buyer side: Pb = 2

 Buyers are homogeneous → intermediary can extract all surplus frombuyers and still assure participation by all buyers

o Profit-maximizing price on the seller side: Ps = 2

 2 sellers join → 6 buyer-seller transactions Π = 6 x 2 + 6 x 2 = 24

o Profit-maximizing prices overall: Pb = 2 and Ps = 1

 All sellers join → 9 buyer-seller transactions
 Profits on the seller side ↓: 9 x 1 = 9 < 6 x 2 = 12
 But, profits on the buyer side ↑: 9 x 2 = 18 > 6 x 2 = 12
 Net effect is positive : Π = 9 x 2 + 9 x 1 = 27 > 24 → OPTIMUM

Lesson 1. Usage prices tend to be lower on the market side with a higher
price elasticity and which exerts a stronger externality on the other side.

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Monopoly platform (3)" Example 2!
o 6 buyers and 6 sellers!
o Net surplus if nb buyers and ns sellers are on the platform:!

 Buyers: Ub(ns) = (6-Pb) x ns
 Sellers: Us(nb) = (i-3-Ps) x nb for seller i = 1, 2, ..., 6 Note: even at price Ps=0, sellers 1 and 2 prefer not to participate!
o Profit-maximizing price on the buyer side: Pb = 6
o Profit-maximizing price on the seller side (given that all buyers join): Ps = 2

 2 sellers join → 12 buyer-seller transactions!
 Π = 12 x 6 + 12 x 2 = 96!

o But this price does not maximize overall profits!!

 Ps ↓ → ns ↑ → more transactions → more revenues on the buyer side!
 If lowest authorized price is Ps= 0 → 24 transactions and Π = 24 x 6 = 144!
 If subsidies are allowed, then Ps = -1 → 30 transactions and Π = 30 x 6 + 30 x(-1) = 150 → OPTIMUM!
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Monopoly platform (4)" Example 2 (cont’d)o Welfare-maximizing solution?

 W = nb x (6-Pb) x ns + Σi (i-3-Ps) x nb + (Pb+Ps) x nb x ns
 Pb = 6 and Ps = -2 implement full participation, which is the welfaremaximizing solution.
Lesson 2. A profit-maximizing intermediary may subsidize one side of themarket because this generates a higher volume of trade and, thereby,
higher profits on the other side of the market.

Lesson 3. Pricing below cost may be socially desirable, but the subsidy
chosen by a profit-maximizing intermediary may be too low from a social
point of view.

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Economics of 2SM – Basic concepts"

Monopoly platform (5)" Modelo Sellers sell independent products on a single platform.
o All buyers accessing the platform have the same demand at eachseller.
o Each seller has a seller-buyer relationship with each buyer.
o Platform charges a membership fee on each side.

buyers	Mb

Platform	

Access cost	

Derive utility u perseller	

19Ms
Cb , Cssellers	

Derive profit π perbuyer	Economics of 2SM – Basic concepts"

Monopoly platform (6)" Surplus when nb buyers and ns sellers join the platform!

vb = ns u − M b and vs = nbπ − M s Buyers and sellers join if their surplus is larger than their(heterogeneous) opportunity cost
→ number of buyers and sellers on platform given by!

nb = N b (vb ) and ns = N s (vs ) Platform profits!

Π = nb (M b − Cb ) + ns (M s − Cs )20

Economics of 2SM – Basic concepts"

Monopoly platform (7)" Platform profits (contʼd)!
o Use!

M b = N s (vs )u − vb and M s = N b (vb )π − vso To express profits as functions of surpluses:!

Π = N b (vb )(N s (vs )u − vb − Cb ) + N s (vs )(N b (vb )π − vs − Cs )

 FOCs for profit-maximization can be rewritten as!

N b (vb )N s (vs )M b = Cb − π n s +and M s = Cs − unb +N b′ (vb )N s′ (vs )o Monopoly prices = cost of providing access!

 adjusted downward by the external benefit exerted on the other side of
the market, and!
 adjusted upward by a factor related to the sensitivity of participation onthe platform.!

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Economics of 2SM – Basic concepts"

Monopoly platform (8)" For a given number of participants on the other side,demand elasticities for access can be expressed as!
ηb (M b ns ) = M bN b′ (ns u − M b )N ′ (n π − M s )and ηs (M s nb ) = M s s b
N b (ns u − M b )N s (nbπ − M s ) Hence, markups are!
M b − (Cb − nsπ )1
M s − (Cs − nbu)
1
=and=Mbηb (M b ns )Msηs (M s nb )o Markups are set as if there were lower costs (i.e., costs are adjusted

downward by the external benefits that one group exerts on theother).!
o The monopoly intermediary internalizes indirect network
externalities.!

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Economics of 2SM – Basic concepts"

Monopoly platform (9)" The standard formula for profit-maximization (inverseelasticity rule) must be adapted.
 Why?
o There is no way to allocate the increases in revenues from changes

in prices to one side or the other; nor is there any way to allocate
the costs.
o Opportunity cost < marginal cost of serving a buyer (seller), as
attracting an extra buyer (seller) generates revenues on the seller(buyer) side.

 The non adjusted margin is lower on the side where theelasticity is the highest and/or the externality created islarger.

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Economics of 2SM – Basic concepts"

Non-price strategies: Design decisions (Evans, 2011)!
 Design decisions have an impact on…
o the willingness of customers to join a platform;o the way they interact with each other once they have joined.

 Design decisions may have conflicting effects.
o Shopping mall → Shoppers prefer to get to stores quickly, while

merchants like to maximize foot traffic outside their stores.!
o Advertising-supported media → TV watchers might benefit fromhaving ads clustered, but TV providers typically intersperse the ads.!
o Software platforms → Include features that do not benefit mostusers, but developers value knowing that any user will havefeatures allowing them able to run their applications.!
o Payment card systems → Merchants must take a card for payment
regardless of who presents it or which entity issued it. Merchants
may benefit from being selective, but this would reduce theconfidence that cardholders have that their cards will be taken atstores that display the acceptance mark.
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Economics of 2SM – Basic concepts"

Non-price strategies: Rules (Evans, 2011)"
 Clear incentive to devise rules that promote positive
externalities and limit negative externalities amongcustomers.
 Examples
o Exchanges → rules against “front-running”

 Occurs when a broker receives a large purchase order from a customer,
first buys on his own account, and then executes the customer order, which
drives the price up slightly, and then sells on his own account and pockets
the resulting profit.
 Banning this practice directly harms brokers, but it makes buyers andsellers more confident that they are getting the best price possible, andthereby boosts volume on the exchange.
o Cooperative two-sided platforms → further need for rules because

their members’ behavior can affect the platform value as a whole.

 Visa: rules that govern the appearance of cards issued by members(common brand), rules that address disputed transactions (acquirers wouldfavor merchants while issuers would favor cardholders)..
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Economics of 2SM – Basic concepts"

Platform competition"
 Variant 1: Two-sided singlehoming• Price smaller on both sides• Expectations of users play animportant role(potential multiplicity of equilibria)• "Divide and Conquer"

Platform 1	

Platform 2	buyers	

sellers	

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Economics of 2SM – Basic concepts"

Effects of multihoming" Variant 2: Competitive bottlenecks

Platform 1	 lower prices for buyers
 higher prices for sellers
Platform 2	

buyers	(singlehoming)	

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sellers	

(multihoming)	

Economics of 2SM – Basic concepts"

Effects of multihoming (2)!
 Competitive bottlenecks (contʼd)!
o Charge « monopoly prices » in multihoming market!
o High profits on the multihoming side but dissipation of these profits

through the competition on the singlehoming side.!
o Illustration!
 Advertisers multihome, eyeballs don't (and even if they do, repetitioneffect) → Subsidize eyeballs!
o Endogenous multihoming!

 Easy to divide but difficult to conquer!
o Multihoming reduces tipping by facilitating coexistence of platforms.!

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Economics of 2SM – Basic concepts"

Platform competition: summary" Determinants of the number and relative sizeof competing platforms

Forces leading toconcentration

Forces leading tocoexistence of platforms

Indirect network effects
Scale economiesMultihoming
Platform differentiation(horizontal or vertical)
Congestion

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