New two-sided wineskins

For the past few years, I’ve been hearing a lot about “two-sided markets”. There’s been a series of well-cited papers by Jean Tirole, there’s now a book and even some of my friends (like Tom Eisenmann) are getting into the act.

To me, two-sided markets looked like “old wine in new wineskins”: from what I saw, calling it a “two-sided market” doesn’t change the phenomenon or what we know about the role of complements in providing value. We already knew about the hardware-software paradigm, network effects, ecosystem management, and a range of other issues about managing the creation of value for IT systems. Much of this was published by the greek-letter economists (name like Katz, Shapiro, Farrell, Saloner) in the top economics journals (and at least one book).

The two-sided literature emphasizes getting money from one party while encouraging (or even subsidizing) another party. However, cross subsidies are also old hat. For more than two decades platform vendors (like Apple) have been subsidizing their developer relations program from sales of their products, while for nearly that long videoconsole makers have been selling consoles at cost while exacting a tax on videogames.

Sunday night, in a London hotel before a conference, I ran into one of the leading economists studying two-sided markets, Geoffrey Parker. Geoff and I met back in February 2000 when I visited Tulane for a job interview. Among other things, Geoff is a co-author with Eisenmann of several papers on two-sided markets.

So at the Regency Hotel, I cornered Geoff and pointedly asked: “what’s really new about two-sided markets?” Geoff was equally honest, and said there are three main points

1. The two- (or multi-sided) market emphasizes that you can charge for any part of the value created, as long as you charge somehow. If they are “sides” rather than “product” and “complements” you don’t make an a priori assumption about which part is the paid part.
2. As with any good economists’ breakthrough, it provides a mathematical way to find the optimal strategy — in this case, the joint optimization of the returns from both (or all) sides of the market.
3. Antitrust regulators dislike predatory pricing (selling products below cost), but total consumer welfare may actually be better off with cross-subsidies (or at least no worse) if it raises volumes and thus economies of scale.

In other words, to optimize your returns from a two-sided market, you charge more either for the bigger market or where the demand is less elastic.

On these modest claims, I’m now sold. Two-sided markets provide an incremental improvement over prior knowledge, and I will cite it in my own work. Otherwise, it’s just econometricians and game theorists crowing about having greek letters where none went before.