TIP: For two-sided markets, always validate the riskiest one first.
ABSTRACT:
If you listed the blockbuster products and services that have redefined the global business landscape, you’d find that many of them tie together two distinct groups of users in a network. Case in point: The most important innovation in financial services since World War II is almost certainly the credit card, which links consumers and merchants. The list would also include newspapers, HMOs, and computer operating systems—all of which serve what economists call two-sided markets or networks. Newspapers, for instance, bring together subscribers and advertisers; HMOs link patients to a web of health care providers and vice versa; operating systems connect computer users and application developers.
Two-sided networks differ from traditional value chains in a fundamental way. In the traditional system, value moves from left to right: To the left of the company is cost; to the right is revenue. In two-sided networks, cost and revenue are both to the left and to the right, because the “platform” has a distinct group of users on each side. The platform product or service incurs costs in serving both groups and can collect revenue from each, although one side is often subsidized.
Because of what economists call “network effects,” these platform products enjoy increasing returns to scale, which explains their extraordinary impact. Yet most firms still struggle to establish and sustain their platforms. Their failures are rooted in a common mistake: In creating strategies for two-sided networks, managers typically rely on assumptions and paradigms that apply to products without network effects. As a result, they make many decisions that are wholly inappropriate for the economics of their industries. In this article, the authors draw on recent theoretical work to guide executives negotiating the challenges of two-sided networks.
If you listed the blockbuster products and services that have redefined the global business landscape, you’d find that many of them tie together two distinct groups of users in a network. Case in point: What has been the most important innovation in financial services since World War II? Answer: almost certainly the credit card, which links consumers and merchants. Newspapers, HMOs, and computer operating systems also serve what economists call two-sided markets or two-sided networks. Newspapers, for instance, join subscribers and advertisers; HMOs link patients to a web of health care providers, and vice versa; operating systems connect computer users and application developers.
Products and services that bring together groups of users in two-sided networks are platforms. They provide infrastructure and rules that facilitate the two groups’ transactions and can take many guises. In some cases, platforms rely on physical products, as with consumers’ credit cards and merchants’ authorization terminals. In other cases, they are places providing services, like shopping malls or Web sites such as Monster and eBay.
Two-sided networks can be found in many industries, sharing the space with traditional product and service offerings. However, two-sided networks differ from other offerings in a fundamental way. In the traditional value chain, value moves from left to right: To the left of the company is cost; to the right is revenue. In two-sided networks, cost and revenue are both to the left and the right, because the platform has a distinct group of users on each side. The platform incurs costs in serving both groups and can collect revenue from each, although one side is often subsidized, as we’ll see.
The two groups are attracted to each other—a phenomenon that economists call the network effect. With two-sided network effects, the platform’s value to any given user largely depends on the number of users on the network’s other side. Value grows as the platform matches demand from both sides. For example, video game developers will create games only for platforms that have a critical mass of players, because developers need a large enough customer base to recover their upfront programming costs. In turn, players favor platforms with a greater variety of games.
Because of network effects, successful platforms enjoy increasing returns to scale. Users will pay more for access to a bigger network, so margins improve as user bases grow. This sets network platforms apart from most traditional manufacturing and service businesses. In traditional businesses, growth beyond some point usually leads to diminishing returns: Acquiring new customers becomes harder as fewer people, not more, find the firm’s value proposition appealing.
Fueled by the promise of increasing returns, competition in two-sided network industries can be fierce. Platform leaders can leverage their higher margins to invest more in R&D or lower their prices, driving out weaker rivals. As a result, mature two-sided network industries are usually dominated by a handful of large platforms, as is the case in the credit card industry. In extreme situations, such as PC operating systems, a single company emerges as the winner, taking almost all of the market.
Platforms serving two-sided networks are not a new phenomenon. Energy companies and automakers, for example, link drivers of gasoline-powered cars and refueling stations in a well-established network. However, thanks largely to technology, platforms have become more prevalent in recent years. New platforms have been created (Google, for example, links advertisers and Web searchers) and traditional businesses have been reconceived as platforms (for instance, retail electricity markets are evolving into platforms that match consumers with specific power producers, allowing them to express their preferences for cheaper coal or more costly renewable power). Yet for all the potential they’ve spotted, platform providers have struggled to establish and sustain their two-sided networks. Their failures are rooted in a common mistake. In creating strategies for two-sided networks, managers have typically relied on assumptions and paradigms that apply to productswithout network effects. As a result, they have made many decisions that are wholly inappropriate for the economics of their industries.
In the following article, we draw on recent theoretical work1 to guide executives in negotiating the challenges of two-sided networks. We begin by looking at the factors that senior managers must consider in designing their platforms’ business models. The key decision here is pricing. As we’ve noted, providers of platforms for two-sided networks are able to draw revenue from both sides. In most cases, though, it makes sense to subsidize certain users. The crucial strategy question is, Which side should you subsidize, and for how long?
Buy PDF from HBR: Strategies for Two-Sided Markets
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