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Two-Sided Markets, Pricing, and Network Effects

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Two-Sided Markets, Pricing, and Network Effects Two-sided Markets, Pricing, and Network Effects∗ Bruno Jullien Alessandro Pavan Toulouse School of Economics Northwestern University and CEPR Marc Rysman Boston University July 2021 Abstract The chapter has 9 sections, covering the theory of two-sided markets and related em- pirical work. Section 1 introduces the reader to the literature. Section 2 covers the case of markets dominated by a single monopolistic firm. Section 3 discusses the theoretical literature on competition for the market, focusing on pricing strategies that firms may follow to prevent entry. Section 4 discusses pricing in markets in which multiple plat- forms are active and serve both sides. Section 5 presents alternative models of platform competition. Section 6 discusses richer matching protocols whereby platforms price- discriminate by granting access only to a subset of the participating agents from the other side and discusses the related literature on matching design. Section 7 discusses identification in empirical work. Section 8 discusses estimation in empirical work. Fi- nally, Section 9 concludes. 1 Introduction Consider a consumer that starts the day by searching for news on a tablet computer and then ordering a car ride from a ride-sharing company over a mobile telephone. At each of these points, an intermediary connects the consumer to various providers. The consumer's search terms for news are processed by a web search engine that mediates between content consumers and content providers. Simultaneously with this search, a separate intermediary system connects the consumer (and the consumer's search behavior) to advertisers, leading to advertisements. The ride-sharing service is an intermediary between the consumer and ∗Chapter book to appear in the Handbook of Industrial Organization. For comments and suggestions, we thank the editors, anonymous referees, as well as Mark Armstrong, Jay-Pil Choi, Avi Goldfarb, Hanna Halaburda, Igal Hendel, Chuqing Jin, Marshall Van Alstyne, Shuang Wang, Stefan Weiergraeber, Julian Wright, and Junjie Zhou. Special thanks to Martin Peitz for very detailed comments. Jishan Du, Tyler Haas, and Shuang Wang provided excellent research assistance. Bruno Jullien acknowledges funding from ANR under grant ANR-17-EURE-0010 (Investissements d'Avenir program) and ANITI (ANR grant 3IA), and from the European Research Council (ERC) under the European Union's Horizon 2020 research and innovation programme (grant agreement No 670494). 1 potential ride providers. Payment for the ride-sharing service is processed through a pay- ment network, an intermediary that facilitates payments between buyers and sellers. These interactions are enabled by an internet service provider that is an intermediary between consumers and a complex market of telecommunication systems. In addition, the devices in this story, the tablet and phone, can be regarded as intermediaries themselves, connecting consumers to software applications via the devices' operating systems. And most likely, at least one of them was purchased through an online marketplace that connects consumers to sellers. Economics regards these intermediaries as platforms. Platforms are firms, or services of firms, that connect market participants and allow them to interact or transact. Platforms are prevalent in many markets: health insurance companies, for example, mediate between consumers and care providers, stock exchanges mediate between buyers and sellers (or liquidity providers and liquidity takers) and cable television companies mediate between content providers and viewers. The rise of platforms, especially on the internet, has changed the way vast parts of the economy are organized and has led to intense reexamination of the nature of market power, competition policy, and regulation. Platform economics is central to understanding a wide variety of recent policy debates, such as net neutrality, financial market reforms, antitrust policy, as well as related topics such as privacy, consumer protection, and media diversity. A central aspect of platform economics is the role of network effects, which apply when a product is valued based on the extent to which other market participants adopt or use the same product. Of particular interest are indirect network effects, which emerge when the adoption and use of a product leads to increased provision of complementary products and services, with the value of adopting the original product increasing with the provision of such complementary goods. For instance, as more consumers adopt a video game console such as the Sony Playstation, more game-developers invest in developing games for that platform, raising the value of the console to consumers. In this sense, indirect network effects lead the platform firm to take into account the various interdependencies between the two sides of the market, and the pertinent literature studying such interdependencies is often termed the study of two-sided markets. Naturally, one can also consider multi- sided markets consisting of more than two sides. For instance, in producing the Windows operating system, Microsoft manages a three-sided market between hardware providers, software providers, and consumers. One might even distinguish between different types of hardware (CPUs, printers, screen devices, etc.) and types of software (productivity apps, games, etc.), in which case Windows mediates a large many-sided market. As a product with network effects diffuses into the market, it becomes more valuable and drives further adoption. Indirect network effects thus lead to a feedback loop as more participants on each side of the platform find it more valuable to adopt and use the platform when they expect the other side to attract more users. This phenomenon leads to efficien- cies as more market participants are able to interact with each other but also, in some circumstances, market power, as network effects can protect platform owners from entry. In markets with low marginal costs, as is the case for many digital markets, platforms with strong network effects can grow to be enormous and eventually dominate the market.1. 1See also Goldfarb and Tucker (2019) for an extended analysis of digital markets 2 The most obvious tool that a platform has to manage and expand its use is price. Pricing decisions in the face of indirect network effects are complex because raising the price on one side of the market affects demand not only on that side of the market but also on the other, as each side responds to changes in the participation on the other side. Finding the correct approach to pricing is key to the success of a platform. For policy-makers attempting to evaluate the performance of a market, understanding the complex determinants of prices is also crucial. In this chapter, we provide an overview of the literature on platform economics, focusing on indirect network effects and pricing. We first provide a unified theoretical treatment of a wide variety of approaches to these issues. We derive equilibrium and welfare-maximizing prices and compare the factors that lead to deviations from optimality. Standard intuition about how prices should respond to costs and competition often do not hold, and we lay out the intuition required to understand these markets. We discuss different treatments of how network effects may enter into consumer decision-making. For instance, whether agents have heterogeneous valuations for the number of agents on the platform turns out to have important implications. In addition, the platforms' ability to price-discriminate is critical, leading to the so-called divide-and-conquer strategies. Modeling platform firms may also require new equilibrium concepts as the relevant models are rife with multiple equilibria and one may wish to focus on the most relevant ones. We contrast monopoly platforms with oligopoly platforms. Whether each agent multi- homes across several platforms or single-homes on one platform plays an important role. One may think that if agents are divided into two sides of the market, such as buyers and sellers, and one set of agents multi-homes, then irrespective of whether this set comprises buyers or sellers, all agents can interact with all agents on the other side and this guarantees a level of efficiency. However, a robust result in the literature is that which side multi-homes has important implications for pricing and the efficiency of the ensuing allocation. When only one side multi-homes, platforms compete on the single-homing side but behave like monopolists on the side that multi-homes, selling access to their single-homing agents. Total network benefits increase, but prices on each side may increase or decrease as a result of multi-homing. We also take on some more challenging concepts to model, such as consumer information and beliefs, and dynamics. Furthermore, in many contexts, a platform plays the central role of a matchmaker. Matching markets, and more generally market design, play an important role in platform economics. We provide an overview of the matching-design literature, once again focusing on pricing. Although we show that prices respond to this wide variety of modeling assumptions, we are able to draw out some consistent themes about pricing in these markets. Next, we turn to empirical work in this area. A starting point and a central issue in this literature is estimating the magnitude of network effects. We view network effects as a form of \social spillover" or \neighborhood effect”; the choice of an agent is influenced by the choices of the agent's peers. Identifying network effects is fraught with problems of simultaneity and omitted variables. These problems are similar to those in the literature on peer effects in social economics, such as identifying how the performance of one student affects the performance of classmates, or how out-of-wedlock childbirth and criminal arrest are influenced by the behavior and outcomes of peers. The social economics literature has 3 made great strides in understanding the identification of these peer effects, exemplified by the work of Manski (1993, 1995) on the reflection problem and the literature that followed. We view the relationship between the social economics and network effects literatures as under-explored.
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