Behavior and Choice: EC 102

The services of a platform are demanded by consumers on each side of the market. Let’s use OpenTable as our example. The services of OpenTable are demanded by both diners (the buyers? side of the market) and restaurants (the sellers? side of the market.) Therefore, it is as if OpenTable is demanded by two groups: buyers and sellers.

This may appear to resemble a firm who engages in third-degree price discrimination¹, where the firm sells a good or service to different groups of consumers at different prices. As we will see, however, the platform differs in a key way.

In short, the platform does not sell the same service to each group. Diners do not buy meals from OpenTable, but use the platform to more easily find restaurants from whom to buy. Therefore, what OpenTable sells to diners is both its platform and its slate of restaurants to potential diners! Likewise, it sells its platform and access to its pool of potential consumers to restaurants who sign up². A user on one side of the market ultimately seeks the platform insofar as the platform helps to facilitate that match or connection with a party on the other side of the market. In this way, demands on each side of the market are interconnected.

When buyers and sellers match, a transaction occurs. Not every home buyer is willing to purchase every home on the market, and not every seller is willing to sell to every buyer. The platform then generates revenue off of the transactions which occur³. Unlike a traditional firm, the platform must balance the demand characteristics (preferences, price sensitivity) of multiple contingents to make the platform work. A music streaming service would not survive very long if they only had artists whose music listeners didn’t like!

The interconnectedness of demand forces the platform to rely on positive network externalities. You may know that a positive externality is an additional benefit which is generated from economic activity and which is outside of the initiating user. When you get a flu shot, for example, this generates a positive externality because on top of benefiting you, your protection against the flu will make others around you less likely to get the flu. A positive network externality is a positive externality which is generated due to each users’ contribution to the size of the overall network of users. When you download a social media app, there is an immediate benefit you receive; but this download also generates a positive network externality by expanding the size of the network of users, making the app more desirable for others.

The role of positive network externalities is critical for platforms precisely because of interconnected demand. In order for OpenTable to be successful, restaurants need to sign up. But restaurants value OpenTable only insofar as there are diners who use its service - and diners only value OpenTable provided there is a wide selection of restaurants who participate. Like any firm who produces a network externality good, a platform seeks to reach a critical mass of users and start a positive feedback loop of growth: get enough restaurants so the number of diners grows, which will encourage growth from restaurants. There are many different strategies which can be used to kickstart this growth: be the first platform in the market (this is often referred to as first-mover advantage); focus on major players, such as inviting major recording artists to your streaming service; or create a particularly innovative or user-friendly platform to lower the costs for new users to join.

These network externalities function both across sides of the market (buyers need a selection of sellers and sellers need a large pool of buyers) and within sides of the market. As a potential diner, having more users on OpenTable is generally good, since as the network grows, it becomes more attractive for additional restaurants. However, this can backfire and lead to increased competition for the reservations desired by each individual diner. Think of a seller on Amazon, who may simultaneously welcome additional sellers to the site (which attracts more potential consumers) and express concern that additional sellers will increase competition and diminish profit.

Since they need to take advantage of the network externalities across sides, platforms typically charge one side of the market a very low, zero, or negative price - the subsidy side⁴ of the market. This ensures enough users on this side to attract demand on the other side of the market - the money side⁵ - which is charged a higher price. For example, OpenTable does not collect a fee from diners for signing up, but they do charge restaurants for access to their platform.

The determination of which side is money and which side is subsidy is a key one for the platform. In some models, the sellers’ side is money (OpenTable, Amazon), while in others, the buyers’ side is charged the higher price (streaming music apps charge listeners subscription fees while subsidizing artists.) Generally, though, price elasticity of demand⁶ can help the platform to plan its pricing strategy.

Recall that the price elasticity of demand measures buyers’ sensitivity to changes in price. Relatively elastic demand characterizes consumers who are more sensitive to changes in price, while relatively inelastic demand characterizes consumers who are less sensitive to changes in price. As a general rule, platforms tend to subsidize the side of the market where demand is more elastic, while charging a higher price on the side where demand is more inelastic.

Interconnected demand and positive network externalities tell the story: the platform needs users on both sides of the market to participate in order to create transactions. But how to incentivize diners to use a site with no restaurants on it? Or incentivize restaurants to post openings on a site with no customers? The platform will often use the subsidy side of the market to charge a sufficiently low price to grow and maintain the number of users on that side, making the platform more attractive to users on the money side.

Platforms adhere to a different pricing strategy. The platform will charge a price above its marginal cost to the money side and charge a price below its marginal cost to the subsidy side. This behavior runs counter to other models of firm pricing. If there is a cost to running the platform, how can the platform offer it to users for free? Or even pay users to participate?

Let’s use Spotify to develop the intuition. Listeners are the money side: paid subscribers fork over $10 per month for access to the service; artists are the subsidy: they receive payments from Spotify whenever a track of theirs is listened to. Musical artists demand Spotify, but they are charged a negative price. But Spotify needs those artists in order to attract listeners! So, naturally, Spotify may need to pay artists to participate. It’s the interconnected demand story again: by attracting enough listeners, Spotify can cover their costs - and their payments to artists - through subscription fees.

In the next section, we will use a theoretical model of platform profit maximization to see if our pricing story is supported!

As we have discussed, two-sided platforms connect two groups of users, such as buyers and sellers. But more generally, platforms are described as multisided because they can feasibly connect more than two sides of a given market. It may seem counterintuitive - what would the third side be?

The most common example of the third side of the market is advertising. This is particularly relevant to online content and social media platforms. Consider Facebook. If the sellers (creators of content) and buyers (consumers of content) are both able to access the platform for free, how does Facebook generate revenue? Where is the money side? Advertisers are Facebook’s money side, since they demand the platform for its “eyeballs”: the views from users on either side. If advertisers aim to get their content in front of as many eyeballs as possible, they are willing to pay the platform for access to those eyeballs.

In a way, the buyers’ side is part subsidy and part money. Users whose willingness to pay is lower sign up for the free version, are forced to see ads, and the platform earns revenue from advertisers. Users whose willingness to pay is higher sign up for the premium version, and therefore become an additional money side for the platform. With more than two sides to the platform, there are additional configurations for money sides and subsidy sides, and the platform can in effect price discriminate to extract revenue from an otherwise subsidy side of the market.