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July 8, 2007
David Warsh, Proprietor

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Everything You Wanted To Know (But Were Afraid To Ask) About Two-Sided Markets

The task facing a certain kind of entrepreneur these days is no more unfamiliar than the engineering of a successful dinner party.  The French ambassador would never so much as respond to an invitation — unless you intimated that Rupert Murdoch, say, would be there, in which case he would accept. Murdoch, if he thought that the Attorney General would attend, would show up, too. And if you led the AG to think his dinner partner would be his favorite movie star, who, you let slip, so badly wanted to meet him (while telling her the same thing) …. Well, pretty soon you’d have a famous dinner party. After three or four such successes, your reputation as a host would make your job much easier, with chefs, provisioners, decorators, and florists anxious to work for you.

Such situations, involving the bringing-together of two or more groups of distinctly different customers who value each other’s participation, are common in the business world. Think of newspapers (wherein publishers bring together advertisers, editorial staffs and readers); or the shopping mall business (developers round up retailers, restaurants, gasoline stations, film exhibitors, architects, highway engineers and customers); or computers (operating systems architects unite hardware manufacturers and applications developers with end-users); or credit card companies (merchants, banks, ATM manufacturers and customers).

But not until very recently has technical economics had much to say about these market systems, except in relatively vague terms:  “network effects” and so on. In the last few years, however, the literature of two-side markets — of many-sided markets — has been exploding, to the point it is almost certainly the most exciting area of microeconomics research today, everything from everyday applications to high econometrics.

The new ideas, for the most part, came tumbling out of the highly-practical economics of antitrust. As big new technological systems began to collide in the 1960s, competitors — and sometimes the government — shouted foul.

The great Justice Department suits of the 1970s — against computer giant IBM Corp. and the regulated telephone monopoly of American Telephone and Telegraph — produced a voluminous literature on “bandwagon effects,” “complementarities” and “network externalities,” loosely summarized in the 1980s as “QWERTY-nomics,” after the typewriter keyboard design that served for a time the standard illustration of an industrial standard.

A quartet of seminal papers in 1985 and 1986, one pair by Michael Katz and Carl Shapiro, another by Joseph Farrell and Garth Saloner, set out the broad outlines of the field, and ushered in a decade of work on pricing strategies and tactics in multi-product markets in which evolving standards were a key.

But it was the bitter antitrust battles of the 1990s that now seem to have broken the case wide open, at least where economics is concerned:  US v. Microsoft, of course, and, especially, the battles among Visa, Mastercard, Discover and their would-be issuers in particular, culminating in the US v/ Visa and MasterCard in 1998.

It was in 1991 that Visa hired Richard Schmallensee and David Evans to help fend off a private antitrust suit by Sears, which wanted to issue Visa cards to its customers.  Schmallensee was professor of economics at the Massachusetts Institute of Technology, trained there in the golden age of the 1960s;  Evans, consultant for National Economics Research Associates with a 1983 PhD from University of Chicago, the very end of its golden age of  “price theory.” Before long, Microsoft signed up the pair as well. A decade of furious briefing followed.

In 1999, Schmallensee and Evans published Paying With Plastic: The Digital Revolution in Buying and Borrowing. The book was framed as a defense of the credit card industry.  It was true, the authors wrote, that credit cards encouraged some people to spend beyond their means and to become mired in debt. But plastic also had allowed millions of people to “enjoy life earlier than their current incomes and savings permit” and created a boom in the process.

The authors had a subsidiary aim as well:  to demonstrate how competition worked in an industry that did not fit the standard models that lawyers brought with them to court.  It began with a series of novel solutions to the “chicken and egg problem” — consumers don’t want cards that merchants won’t accept, and merchants don’t want cards that consumer do not carry.  Most of these solutions involved collaboration, a tactic that had become ubiquitous in the modern age, but one viewed with suspicion at least since Adam Smith wrote that “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

The book was a tour de force of thick description, a narrative history of the development of payment cards, plus an analysis of the unique “interdependent pricing” of the industry. Charge card systems such as American Express had two sources of revenue: merchant fees and cardholder fees. Credit card systems backed by banks enjoyed finance charges paid by cardholders as well.

But the real light bulb went on a year later, when Jean Tirole and Jean-Charles Rochet, a pair of French economists that Schmallensee had hired to study the problem (Tirole being a former student at MIT), came to a startling realization. “They realized that lots of businesses followed the same economic model as the payments business,” says Evans — that is, they relied on platforms to link customers who might not otherwise get together. More often than not these platforms consisted of nothing more substantial than computer code, software that enabled appliances to work smoothly together.  But what were television broadcasts or newspapers, after all, but virtual shopping malls, whose customers were attracted by programs or columns of news (at least as far as the advertisers were concerned)? “It was a magical moment.”

In Two-Sided Markets: A Progress Report, Rochet and Tirole explained the thinking behind the bourgeoning literature as of the end of 2005. “Getting the two sides on board” might be a useful characterization, but it didn’t go nearly far enough.  “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.”

The two sides’ willingness to trade depends on the policies of the platform; its membership (or fixed) fees get them into the tent; its usage (variable) fees condition their enthusiasm once they are there. A favorite example: dating bars, which charge men a stiff fee and let women in for free, making money on the sale of drinks. But in fact the model illuminates matchmaking in everything from portals such as Google and Yahoo, TV networks and newspapers (in which “eyeballs” are the stock-in-trade) to mobile phone networks, personal computers, credit cards and videogames (in which more sophisticated commodities are marketed).

Tirole, the most gifted student of industrial organization of his generation, and Rochet, a mathematical economist, teach at the Institut D’Economie Industrielle in Toulouse, the improbable creation of the late Jean-Jacques Laffont, which, in a relatively short span of time, has become the world’s premier center of microeconomic theory.  There is some justice in this: it was a French engineer, Jules Dupuit, and his colleagues at the Corps des Ingéniuers des Ponts et Chausées, who pioneered much of modern microeconomics in the 1840s and 1850s, only to be completely ignored by a series of English economists who painstakingly re-created it for themselves (a story told at satisfying length in Secret Origins of Microeconomics: Dupuit and the Engineers, by Robert Ekelund Jr. and Robert Hébert).

(Completive with Toulouse is Princeton University, where a stream young PhD students have been enthusiastically engaging the new ideas. Chief among them is Glen Weyl, undergraduate salutorian this year, whose paper on the regulatory aspects of two-sided markets is being widely cited. “Glen is the most impressive undergraduate with whom I have ever worked in 30-plus years,” says his advisor José Scheinkman. Weyl is expected to compete his PhD next year and then enter the job market.)

It will take years for the impact of the new ideas on antitrust economics to become clear. Certainly they offer better ways of understanding the intricacies of entrepreneurial genius in figures like Microsoft’s Bill Gates and Steve Ballmer. No doubt they offer new ways to defend their sometimes indefensible behavior as well.

The immediate gain, however, is in the powerful light they shed on the strategies of new and unfamiliar technologies. Invisible Engines: How Software Platforms Drive Innovation and Transform Industries, by Evans, Andrei Hagiu (once of those Princeton PhDs, now of Harvard Business School) and Schmallensee, was voted best book in the Business, Management & Accounting category in the Professional/Scholarly Publishing Annual Awards last year. And this year’s Catalyst Code: The Strategies Behind the World’s Most Dynamic Companies, by Evans and Schmallensee, describes itself as “the handbook for 21st century business,” offering tips on how to create the often-hidden value associated with getting multiple customer groups together on the same platform.

Time, then, for the authors to smell the roses; let the technical economists carry on. Probably there are still deeper mysteries to fathom here. Schmallensee is stepping down as Dean of MIT”s Sloan School of Management (the search to replace him is thought to be nearly complete).  Evans, a principal now of LECG Corp., a consulting firm, splits his time among Boston, London (where he teaches at University College) and France. There are board memberships instead of lawsuits; strategic consulting instead of expert testimony.  (For a glimpse of a very busy practice, see Evans’ Market Platform Dynamics site.)As Evans says, “Litigation inevitably comes down to throwing sand in the gears.  It is so much more interesting to try to figure out how to ignite a company involved in one of these markets.”

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2 Trackbacks/Pingbacks

  1. […] Tirole has been focused on “platform markets” that bring together two different parties—payment networks that join merchants and […]

  2. […] Tirole has been focused on “platform markets” that bring together two different parties—payment networks that join merchants and […]

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