Two-sided networks

What is a two-sided network?

Wikipedia defines them as:

"economic platforms having two distinct user groups that provide each other with network benefits". 

Two-sided networks can be found in many industries, sharing the space with traditional product and service offerings. They exist in both physical and digital markets. Example from the physical world can include newspapers where subscribers are connected with advertisers. In digital words the obvious example is Google connecting users and advertisers or eBay - connecting buyers and sellers.

Economic platform (as used in the definition above) is a product or service that brings together groups of users in two-sided networks. It provides an infrastructure and rules that facilitate the two groups’ transactions. It also Incur costs in serving both groups and can collect revenue from each.

Two sided network effect

The two groups attract each other and value for a given user depends on the number of users on the other side. Platforms in two-sided networks enjoy increasing returns to scale. Leaders can leverage their higher margins to invest more in R&D or to lower prices to grow further the platform and benefit further from increasing returns to scale. This is driving out weaker rivals and only few biggest players remain in the market.

The platform attract subsidy side users. Once the platform reaches the critical number of users the company starts to monetize the platform - money side users will pay to reach the critical mass of subsidy side users. The bigger the network the more users will pay to access it. Generally, margins improve as the user base grows.

Pricing the platform

One of the biggest challenges in the two-sided networks is how to choose a price for each side of the platform? What will be the impact on the other side’s growth and willingness to pay? In other words,  how much subsidy should one side get – and how much premium should the other side pay?

If the subsidy-side was an independent market it would have to pay more. In this scenario giveaway might be wasted if the network subsidy side can transact with rival platform’s money side.

Pricing is further complicated because of same side network effect. Bigger the network on either side - subsidy or money - attracts more users.

In a nutshell, there are couple factors to be considered:

• ability to capture cross-side network effect,
• user sensitivity to price, e.g. PDF readers are very sensitive about price and publishers will yield more revenue by reaching out to more users than charging less users premium price,
• user sensitivity to quality, e.g. gaming platforms are very sensitive about quality of games delivered by the developers, as one 'low-quality' game may disturb the whole reputation of the platform discouraging other developers and users.

When Apple launched Mac, it charged third party developers $10,000 for the software development kit. In the same time Microsoft gave the Windows kit for free. As a result, Windows had 3 times as many applications.

Winner-takes-all dynamics

A single platform is likely to control the market when:

1. Multi-homing costs are high for at least one user side (the cost of establishing and maintaining platform affiliation)
2. Network effects are positive and strong
3. Neither side’s users have a strong preferences for special features

Sony provides a classic case study example of failure of emerging network with  its Betamax videotape system introduced in 1974. In a nutshell, in mid 70s two platform emerged (1) Betamax, developed by Sony and VHS, developed by Matsushita. Although Sony had better product, in the end VHS was widely adopted mainly because of Matsushita's distribution partnerships that resulted in building the critical mass that enabled cross-side network effect.