Two-sided Markets and Network Effects

Table of Content

1 Introduction

2 Two-Sided and Multi-Sided Markets
2.1 Differences between Single-Sided vs Multi-Sided Markets
2.2 Focal Aspects
2.2.1 Creating a Healthy Ecosystem and Reducing Frictions
2.2.2 Design and Governance of a Platform
2.2.3 Multi-Homing and Platform Differentiation
2.3 Solving the Major Hurdles
2.4 Investment strategies
2.5 Pricing Strategies
2.5.1 Factors for Pricing Decisions
2.5.2 Money Side vs. Subsidy Side
2.5.3 Access and Usage Fees

3 Network Effects
3.1 Historical Background
3.2 Types of Network Effects and Two-Sided Markets
3.3 Theoretical Approach on Price Setting
3.4 Classification of Network Effects
3.5 Indirect Network Effects: Market Size- and Assorting Externality
3.6 Influencing Factors in Network Markets
3.7 Roadmap for Platform Founders

4 Social Networks as Multi-Sided Platforms
4.1 The Growth of new Technologies and the Internet
4.2 How Social Networks Change the Communication Landscape
4.3 GAFAnomics
4.4 Case Studies of Social Networks
4.4.1 Facebook
4.4.2 Instagram
4.4.3 LinkedIn
4.5 Comparison of Social Networks

5 Social Networks and SMEs
5.1 Classification of SMEs
5.2 Prerequisites
5.3 Challenges for SMEs to join Social Networks
5.4 Improvement Areas for Businesses
5.5 SMEs in Germany
5.6 Stakeholder Groups of Social Networks
5.6.1 Benefits of an Internal Social Network
5.6.2 Advices for External Social Networks
5.6.3 Social Media Readiness Check
5.7 Checklist for Social Network Business Usage
5.8 Other Ways to be successful as an SME

6 Conclusion

List of References

List of Illustrations

Illustration 1: What happens in one Internet Minute?

Illustration 2: Difference between Traditional and Two-Sided Markets

Illustration 3: Multi-homing (Competitive Bottleneck)

Illustration 4: Critical Mass Frontier with Implosion and Growth Zone

Illustration 5: Demand Curve of Rohlfs for Network Markets

Illustration 6: Network Externalities on Two-Sided Markets

Illustration 7: Network Effects between Customer Groups of VHS

Illustration 8: Network Effects between Customer Groups of Facebook

Illustration 9: Technology Adoptions

Illustration 10: Growth of the Worldwide Internet Usage

Illustration 11: Monthly Active Users in Millions (as of January 2017)

Illustration 12: Social Networks by Market Share of Visits 2008 to 2017

Illustration 13: Facebook's four Customer Groups

Illustration 14: Interaction Rates of Social Networks (in Percent)

Illustration 15: Comparison of Social Networks

Illustration 16: Survey about Challenges of Businesses using Social Networks

Illustration 17: Main Benefits for a Business by using Social Networks

Illustration 18: Innovation and Social Engagement

Illustration 19: Stakeholder Groups of Internal and External Networks

Illustration 20: Social Media Usage of Businesses in Germany

List of Tables

Table 1: Exemplars of Two-Sided Markets

Table 2: Checklist for Platform Pioneers

Table 3: Social Network Statistics

Table 4: Overview of quantitative demarcations of SMEs

Table 5: Qualitative characteristics of an SME

Table 6: Checklist for Social Network Business Usage

List of Abbreviations

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1 Introduction

Every minute, 900,000 users log in to Facebook worldwide.¹ One attempt to put it into perspective is imagining that almost the whole population of the state of Saarland would log in to Facebook at the same time, every minute. The magnitudes are virtually not conceivable.

Illustration 1: What happens in one Internet Minute?

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Source: Own representation based on Visual Capitalist (2017), Web.

Online platforms have changed the overall business and communication's landscape - interactions are simpler, global markets are more accessible and innovations are pushed to a greater extent.

What made platforms like Facebook, Google or Uber so successful in such a short period of time? How are they able to generate large-scale revenues without receiving any payment from the end-users? How do they get large numbers of users involved?

The answer to these questions is as follows: The founders understood the principle of two- or multi-sided markets, catalyzed by network effects.

Economists realized the rising importance of this topic only recently. While a traditional business that has physical assets like e.g. machines, a platform's most valuable asset is the user him- or herself. Gustav Söderström, Chief R&D Officer of Spotify, published a model representing the three main resources of a social network, i.e. communication, information and relations.²

This topic is gaining more and more relevance nowadays. Platforms are taking the business world by storm - especially Social Networks like Facebook, LinkedIn or Twitter offer a revolutionary kind of communication for several online customer groups, especially for businesses.

The Internet Growth pushed the globalization to a great extent which leads to markets being more transparent and competitive. The customer behavior has changed to a more active position - they want to be connected to businesses with the effect of reaching a new dimension in Customer Relationship Management.

Large enterprises are doing well in social networking by staying in an ongoing communication with their customers - SMEs still struggle with this approach.

Questions arise if utilization potential of social networks exists for middle-class businesses and how effectiveness and efficiency of SMEs, however, have improvement opportunities through the usage of social media channels.

In terms of structure, this thesis is separated into two parts. Firstly, two-sided markets and networks effects are explained in general by analyzing focal aspects and major hurdles for platform founders. Afterwards, the focus will shift from platform pioneers to platform users regarding social networks where these platforms are analyzed to a great extent in combination with usage terms for SMEs.

2 Two-Sided and Multi-Sided Markets

Two-Sided Markets, also called platforms, have mushroomed enormously in the last decades. They can be found almost everywhere, especially where it is rather not expected. To give a proper definition, Evans and Schmalensee describe platforms as establishments that serve distinct groups of customers who need each other in some way, and the core business of the two-sided platform is to provide a common (real or virtual) meeting place and to facilitate interactions between members of the two distinct customer groups.”³

Platforms seem to be a new trend in businesses today - even the subtitle of the newest book of Evans and Schmalensee is “The New Economics of Multisided Platforms”. However, describing Multisided Platforms as a new phenomenon is rather questionable. Multisided platforms have existed for more than 3000 years. An example would be a marketplace in Athens in 300 BCE. Even such market squares can be seen as platforms which serve the purpose of simplifying matters for the two distinct customer groups - in this case, the buyer and the seller. They find each other for an interaction more easily, i.e. the purchase of goods.⁴ The interaction between the customer groups is easier and comfortable with the help of a platform.

In the table below different industries which use two-sided markets with corresponding examples are illustrated:

Table 1: Exemplars of Two-Sided Markets

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Source: See Evans (2003), p.194 and Lorenz / Yousfi (2015), p.11-12

Combining two-sided markets with the occurrence of the Internet, a more recent example is a social network such as Facebook. It serves as a platform to bring both platform users and advertisers together in a virtual place. Since Facebook is a highly growing business, it has already developed into a multisided platform with four customer groups: friends, businesses, advertisers and game developers. With adjustments like offering gaming activities, they already involved billions of people on their platform.⁵

Platforms arise in various industries and are either of physical or virtual nature. The newest online platforms can be further separated into four types:⁶

1. Transaction platforms act as intermediaries in order to facilitate exchange between user groups, e.g. Uber, Amazon Marketplace and eBay.
2. Innovation platforms function as a groundwork which is used by other firms to foster complementary goods, e.g. Apple App Store.
3. An Integrated platform is a mixture of transaction and innovation platforms where both matching and ecosystem development are supported. A good example is Apple with the App Store together with the development support as an exchanging tool.
4. Investment platforms evaluated a platform portfolio strategy and act as active platform investors or as a holding company to support startups, e.g. Rocket Internet.

Platform Evolution pushed by new Technologies

Nowadays platforms are widely discussed which has been mainly catalyzed by new technologies.⁷ According to an article in the Harvard Business Review, the key drivers pushing the intensification of platforms are the emergence of clouds, social networking, and the mobile broadband.⁸ These Turbocharging Technologies made it convenient to connect globally in almost every part of the world and facilitated creating a new transparent global market.⁹

The emergence of new technologies made it possible to introduce lots of online platforms.¹⁰ Some of the newest ones operate as matchmakers and generate their revenues by offering a service to find a perfect interaction partner in industries like lodging, selling products as a private seller or dating agencies. All of this is possible without having any “tangible assets” like e.g. real estate agencies.¹¹

Thinking about businesses it is difficult to determine if a market is two-sided or traditionally one-sided in some instances. In the next section, the differences between platforms and ordinary markets are clarified.

2.1 Differences between Single-Sided vs Multi-Sided Markets

Sometimes it can be difficult to determine whether a business is single-sided or multi­sided. A platform is basically defined as a market with the main goal of getting two or more sides on board.¹² Nevertheless, with this sloppy definition, almost every business could be defined as two-sided, since it is always necessary to find suitable buyers, suppliers and sellers.

A simple comparison of both is illustrated below.

Illustration 2: Difference between Traditional and Two-Sided Markets

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Source: Haigu (2007), p. 116

As demonstrated on the illustration's right side, the seller and buyer do not interact in an ordinary market. Only the merchant has the opportunity to communicate with both groups.

On a platform, on the other hand, buyer and seller interact actively in the market for the purpose of a sale. The platform owner is not directly involved in this process, but serves as an intermediary instead.

Distinct Characteristics of a Two-Sided Platform

To facilitate the separation, three distinct characteristics for the identification of platforms have been evaluated.

Firstly, a platform directly serves two or more different customer groups in a market, in which the interaction is the major feature. The platform acts as an intermediary in order to facilitate the communication between customer groups.¹³ This is a value creation for both customer groups since mutual interest are brought together on a platform.¹⁴ Comparing those two types of markets, platforms are more interested in their customers than in the actual output. However, a single-sided business purchases products or raw materials from a supplier and sells these profitably to their clients. There is no obvious interaction between the supplier and the consumer, hence the firm solely functions as a junction between both groups.¹⁵

It also has to be distinguished if the two-sided market is a system or a communications market - then again, differences occur in peoples' interactions. This will be further analyzed in chapter 3.2.

The second characteristic of a platform is the pricing method - a single-sided platform would never sell something for less than its costs or give it away something for free.¹⁶ To give a typical pricing strategy for ordinary businesses: They equalize prices to marginal costs under perfects competition in order to maximize their profits.¹⁷

On the contrary, a platform needs a more complex pricing structure in order to satisfy both customer groups. It is crucial to please both groups in order to save the existence of a platform. Usually, one side is more price sensitive than the other. In case the number of participants on one side decreases or its extension is not sufficient, other customer groups lose value for the medium and act in the same manner.

For a better understanding, eBay is a typical two-sided market for which it is important to have both sides on board. Buyers would not visit eBay without the variety of products that are offered by the sellers. Because of this, the buyers are more valuable for the platform than direct payments through users and thus they do not get charged for the usage of the platform. The sellers cover the whole profits of eBay by paying a provision of 10% for private sales.¹⁸ Occasionally, it is difficult to determine which side is more price sensitive and valuable for a platform.

Finding the “price insensitive” side is essential when building a platform and therefore one of the major hurdles.¹⁹

Rochet and Tirole's paper, which was published in 2005, largely focuses on price structures and distribution of the total price between two customer groups.²⁰ An even more detailed approach on pricing structures in combination with network externalities will be given in chapter three.

The third characteristic that identifies whether a market is one- or two-sided are the existing network effects, also called network externalities. A platform experiences direct and indirect network effects, which are either positive or negative. Especially two-sided businesses should highly consider the indirect network effects since these externalities affect the immediate interaction between the different customer sides.²¹ Network effect will be further analyzed in the third chapter.

2.2 Focal Aspects

Running a multi-sided platform involves many important aspects that traditional businesses usually do not have to consider. In the following, some of the most prominent ones will be highlighted.

First, aspects about the significance of establishing a healthy ecosystem in order to reduce frictions are analyzed in great detail. Afterwards, the design and governance of a platform will be a part of the analysis, followed by the understanding of platform differentiation which is vital to identify multi-homing users. In the end, major hurdles with corresponding strategies to overcome problems like the capturing and keeping of participants are illustrated.

2.2.1 Creating a Healthy Ecosystem and Reducing Frictions

According to Evans and Schmalensee (2016), “An ecosystem consists of all the people, businesses, institutions, and other things that, because they interact with each other, affect the value a platform can create.”²²

The very first step has to be the consideration of the market to ascertain if the establishment of a platform is truly needed.²³ If participants experience difficulties concerning interaction with other customer groups, also called transaction costs, the foundation of a platform is worthy of consideration. A businessperson has to understand the acuteness for a platform and what has to be done to eliminate major frictions in this occasion.²⁴

In order to create a healthy ecosystem, knowledge of its business environment is indispensable. The surroundings determine its success, which is the reason why getting along with the ecosystem's partners is crucial. Especially knowing the actions of the competitors that serve potential participants is important and they need to be studied intensively.

Apart from that, one has to decide how many customer sides the platform should cover. Possible strategies are either mixed, single or multi-sided realizations.²⁵ For example, many companies start with just one customer side and execute vertical integration in the introductory phase. Later, they adjust more sides when people's awareness increases and the business succeeds. A suitable example is Amazon -they first sold products stocked by themselves. In the next step, they created “Amazon Marketplace” where it became possible for other resellers to sell their products on the platform as well. Through this step, they created a new customer group.²⁶ Implications about the right design of a platform are illustrated in further detail in chapter 2.2.2.

When “opening” the platform to other customer sides, it is important to find the perfect time for inclusion.²⁷ A platform hands over a part of the platforms control to the side of the customers because their participation estimates the network performance. Therefore, the platform must already be stable and established in the market.²⁸ When handing over some degree of control to participants, it creates value for them to join. In an article, Palmquist (2017) states that “Founders face a trade-off between retaining control and increasing the value of a young firm.”²⁹ Therefore, a platform needs to trust in their customer sides.

To resolve the issue of creating a healthy ecosystem as a platform pioneers, they need a highly-sophisticated business strategy. Usually, the first plan does not last for the whole business life cycle. Especially platform creators adapt or change their decisions because of unforeseen events and environmental developments.

2.2.2 Design and Governance of a Platform

There is still little known about the “perfect” design of a platform, but there are some discrete facts that help finding the individual design that goes in line with an appropriate governance. Both the design and the governance, have to be cultured which makes the platform attractive and stimulating for customer groups.

Harm one Side to further push the other

First, even if the main goal is to satisfy all customer sides in the best way, a platforms design sometimes harms one side in order to give a further advantage to the other one. A shopping mall demonstrates this occurrence perfectly. Analyzing the foot traffic in such a mall, it becomes clear that shoppers prefer to spend the least amount of time running around from one store to another. Merchants on the other side, merchants want to have as much foot traffic as possible to raise interest and attract potential customers. This is the reason why some shopping malls are designed to increase distances customers have to cover by positioning the escalators at the end and anchor stores at the corners of the malls.³⁰

Number of Participants on a Platform

Apart from that, an appropriate number of participants on every side makes a platform very attractive. A defined number of participants does not exist and varies from industry to industry. Therefore, the overall market size also plays a key role in finding the ideal number of participants.³¹

It is suggested to make markets thick, but not overcrowded. Having enough people is crucial for interactions and the platforms attraction. Overcrowding, also called congestion, leads to higher transaction costs and an unappealing environment for customers. Taking the shopping mall example again, an overcrowded mall impedes the customer movement and long waiting lines annoy buyers.³² To prevent congestion, some platforms have introduced numerical limitations for platforms or specialized on exclusive goods and services. Hence, mainly people who are really interested in these products will use the platform, for example a luxury shopping mall.³³ No matter if a pioneer wants to specialize or address a broad audience, the platform should have dense number of participants. This number also depends on the industry in question.

Setting Standards for Platforms

Sometimes people do not know if the platform is beneficial for them or not which might lead to platforms buying marquee players.³⁴ People tend to use the platform more frequently if they know that a celebrity or a blogger suggested visiting it. This decreases the probability of having “wrong” participants and reduces congestion furthermore.

Another aspect that needs to be taken into consideration by platform founders is setting standards for interactions. This reduces transaction costs drastically and makes it very easy and reasonable to join. With standard processes, prices and organizations, a platform can be “shaped” to make it easier to handle for participants.³⁵

Network externalities also play a major role in the design of a platform. Especially when negative indirect network effects occur, standards have to be set and governed. Giving an example, a newspaper publisher should watch out how many advertisements he will be put in his journal since readers get frustrated if their number is too high.³⁶

Platform Governance

Looking at the importance of governance on a platform, issues like having the right participants is fundamental. Wrong participants damage the image of a platform and decrease others attraction. As an example, advertising beauty products in magazines about machinery does not make sense. This is the reason why rules and regulations have to be set.³⁷ In a social network like Facebook, users get removed from the platform in case of disregarding laws and regulations. Offending people as well as publishing discriminating or pestering posts harms the image of Facebook and will be thrown out consequently.³⁸

Ideal and standardized usage guidelines for the design and governance of platforms do not exist - but if the aspects discussed within this paragraph are taken into consideration, a platform pioneer knows which aspects are crucial to consider.

2.2.3 Multi-Homing and Platform Differentiation

Lots of two-sided markets exist with the same or identical kind of product or service on a global scale, which truly intensifies competition. To mitigate this concern, platforms can differentiate from one other by charging different prices or providing exclusive quality.³⁹ However, in fact the resulting horizontal differentiation leads the customer to use several similar platforms at the same time in the case that implementation and learning costs are low. Rochet and Tirole call this phenomenon “multi-homing”.⁴⁰ Contrary to multi-homing, single-homing describes the usage of only one platform.

A typical case of a competitive bottleneck occurs in the media industry, e.g. in the newspaper business. Advertisers usually position their commercials in several newspapers, whereas readers typically only read one.⁴¹

In the illustration below, an abstract illustration of these occurrences is shown, whereas one side does multi-homing and the other single-homing. This is also called “Competitive Bottleneck”.⁴²

Illustration 3: Multi-homing (Competitive Bottleneck)

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Source: Rochet/Tirole (2005), p. 26

In the payment card industry, multi-homing is seen very often. In this case, both sides use the strategy of multi-homing since merchants accept various types of debit and credit cards. In addition to this, the cardholders usually own more than one payment card as well.⁴³ Both sides can decide whether they want to use several platforms or not. In some cases, it would not be advantageous to use more than one medium due to switching costs. Long-lasting contracts, habituation effects or costs of searching and time can be influencing factors that lead to remaining with just one platform. However, when looking at platforms that are free of charge and easy to handle, competition is enormous and multi-homing is seen very often.⁴⁴ To give an example, social network users usually do multi-homing.

For additional forms of platform usage, Armstrong (2006) analyzed different variants, e.g. where both sides do single- or multi-homing.

Talking about all the aspects on how to be successful as a platform founder, the most important success factor is the interaction of people. In order to study this, several aspects need to be taken into consideration which will be done in the following section exclusively.

2.3 Solving the Major Hurdles

Creating a platform involves several risks that cannot be disregarded. A platform gets nourished by people from different customer sides. The initial problem when it comes to the establishment of a platform is that there are no people, so coordination problems arise - nobody will join any side of the platform without knowing that the other group is already established and will eventually join as well.⁴⁵ Many academic papers have already discussed this issue, called the Chicken and Egg Problem: How does a platform get both sides on board? Before switching to a new format, customers want to be sure about the potential benefit of using a platform.⁴⁶ The best initiatives that could be used to get people on board are either investment or pricing strategies, which will be discussed in the next section.

Considering a two-sided business in the introductory phase, David S. Evans mentioned that “getting the formula right for a successful catalyst is harder than for an ordinary business, and most catalysts fail. Setting off and managing a catalytic reaction among economic agents requires ingenuity, stamina, and a sound business strategy executed with steadiness and agility”⁴⁷. This citation highlights that even if running a platform can be very profitable, it is also harder than having a traditional one-sided business. Knowledge, sure instinct and responsiveness are enormously important.

Having these skills as a platform pioneer, another hurdle is to reach the critical mass frontier. Critical mass means a certain number of users in a network from which the user number begins to grow exponentially, mainly pushed by network effects.⁴⁸ When a platform experiences a rising number of customers per side, the network will only stay successful by reaching the critical mass.

In the illustration below an abstract visualization of the critical mass frontier is shown.

On the axes, the number of participants of distinct customer groups are given. Depending on the valuation between the customer groups and different industries, quantities of customer sides differ largely. Because of this the critical mass frontier shape is unsteady.

Illustration 4: Critical Mass Frontier with Implosion and Growth Zone

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Source: Evans / Schmalensee (2016), p. 78

As an example, entering a (heterosexual) nightclub with only a few people inside is not fun for visitors. People tend to leave the club. In this table, this effect is described as the “Implosion Zone”. In a nightclub with a high number of visitors, both male and female, the critical mass frontier is reached more easily and the platform can ignite. Once the growth zone is reached, ignition and momentum start automatically.⁴⁹

Unfortunately, a standard number for the critical mass frontier cannot be predicted. Reaching this border and defining a business as “well-established” highly depends from industry to industry. In the implosion zone, a platform requires strategies in the areas of pricing and investment to overcome this area. These strategies are presented below.

2.4 Investment strategies

There are three main investment strategies on how to start introducing a platform to the community and how to reach the critical mass - i.e. getting both sides' people on board and to overcome the chicken and egg problem to assure sustainable growth.⁵⁰

1. Zigzag Strategy: The Zigzag strategy is a continuous flip-flopping procedure where customer sides get convinced to join incrementally. The network starts with a small number of participants on both sides. Afterwards, it encourages agents on either side to connect. A good example for this is YouTube. The founders first published their own videos via vertical integration in 2005 and tried to attract viewers for their website. When some people started using the platform for viewing videos, YouTube began to focus on users interested in uploading their own videos. Establishing these customer groups by sequentially switching the focus between the sides, it was a very long-lasting approach until YouTube became one of the most successful platforms worldwide. This approach requires a lot of patience on the side of network creators.
2. Two-Step Strategy: Other businesses are obliged to use the two-step strategy, in which one group is persuaded to join the network first. The first group is usually the one that is more valuable for the opposite site and for the platform.⁵¹ Afterwards, the other customer groups get persuaded by arguing that the other group has already joined the network. OpenTable for example first convinced restaurants and then customers using the argument that there are lots of restaurants available on the platform. In the newspapers industry, they first convince readers and later advertisers, because readers are more valuable for advertisers in terms of positive indirect network effects and readers have negative indirect network effects concerning advertisers since they are more interested in the content instead of the commercials.
3. Commitment Strategy: With this approach, one side has to make investments in order to be actually able to use the platform. To encourage this side, financial guarantees and securities are offered. To give an example, operating systems like PlayStation had to persuade game developers into generating video games. Since this is a very difficult strategy, many platform pioneers try to avoid such action by applying vertical integration in the early stages. Several platforms first started as a one-sided business and only developed into a platform after they had enough participants on one side. This shows potential customers that the system is well working and worth to join.⁵² Even if it is a challenging strategy, especially in the operating systems industry, the usage of this strategy is unavoidable for several businesses.

2.5 Pricing Strategies

Setting right prices for a platform, which is crucial for the success, can be difficult in the first set when a comparable precursor has not already set a price which can be adjusted. Even Rochet and Tirole, one of the first publishers concerning two-sided markets also put a high emphasis on prices. For them, prices are the major aspect for two-sided markets since they “affect the volume of transactions by charging more to one side of the market and reducing the price paid by the other side by an equal amount.”⁵³ This has a lot in common with price sensitivity.

It is a “balancing act on a moving train”⁵⁴ to set the right and appropriate prices to avoid losing customers since two or more sides have to be satisfied.⁵⁵ For a one-sided market, it is less difficult for there is only one price they have to take into consideration. In a usual perfect competition environment, the price is set equal to marginal cost such as the Lerner condition implies.⁵⁶ Platform runners have to determine both a price level (i.e. the overall charge) and a price structure (i.e. which side pays which price).⁵⁷ Unfortunately, there is no universal success code for a platform pioneer to use since it is a very complex matter. Of course, prices are also influenced by competition laws, the market size and the type of a market. It also has to be considered if it is a perfectly competitive or an oligopoly market, but this section will only focus on how the prices have to be assigned under perfect competition.⁵⁸ Usually, a skewed price is set in a platform.⁵⁹

2.5.1 Factors for Pricing Decisions

Setting the right prices in two-sided markets, the following four points have to be focused on by a platform owner:⁶⁰

1. Customers' price sensitivity: Price sensitivity depends on different sides because of dissimilar needs and values for the transactions and can thus vary. A distinction between the money side and the subsidy side has to be made. The less price­sensitive should be used as the money side since great value is put on the transactions, which makes this side more willing to pay more than other sides. The side that is more quality- and price sensitive should be subsidized.⁶¹ Subsequently, they do not lose the more valuable customer group and the more price sensitive side is more interested in the participation. Sometimes the subsidized one even gets rewards or gifts when joining a platform.
2. Which side is more contingent on the other, and why? This is also concerning the price sensitivity across the groups. When it is possible to have cross-side network externalities and one side is depended on the other one, the more depended side should be charged more.
3. Does one side initiate the interaction? If this is the case, the whole platform only works when the “controlling side” starts the interactions. Then, a platform owner should subsidize the controlling side to give them a gentle push to start.
4. Are there other external factors that have to be considered? Rochet and Tirole found that multi-sided platforms also have to reflect governance and regulations, costs of multi-homing, the extent of platform differentiation and they need to check the existence of a prestigious brand value. This could change the price determination drastically.⁶² The power of the indirect network externalities should not be ignored either.⁶³

2.5.2 Money Side vs. Subsidy Side

In two-sided markets, the price level and especially the price structure can be helpful to attract people - sometimes the optimal price for one side is even zero or below, although this would be an offer for a negative price. This has something in common with the indirect network effects which will be explained later greater detail. Usually, when a customer side A has a higher value for the opposite customer side B, A will be charged a lower price since they are more valuable for both the platform and the other customer side.⁶⁴ This also means that the more customer sides a platform has, the more complicated it will be to charge the right prices. The side that pays less or nothing is called “Subsidy Side”. The other one that gets skewed towards paying more is called the “Money Side”. A businessperson has to consider the growth and willingness to pay on each side in order to find a direction on how to set the right prices.⁶⁵

For a more practical approach, there are some examples from real life:

In social networks like Facebook with two main customer sides, the users and the advertisers, the advertisers are charged the whole price whereas the users do not have to pay a cent. In 2012, 82% of its revenue arose from advertisements.⁶⁶

In Television Channels like RTL with Viewers and the Advertisers as major customer groups, profit is mostly generated by advertisers (approx. 49%).⁶⁷

Tilted vs. Flat Pricing Structure

Entrepreneurs have the possibility to decide if they want to offer a tilted pricing or a flat pricing structure - i.e. where one side pays more than the other or both sides pay the same price. It is important to set the right relative prices, i.e. how much to capture from the sides in relation, to be successful.⁶⁸

Having a tilted pricing structure usually implies feedback loops that can be either positive or negative.⁶⁹ A two-sided market is assumed with customer sides A and B, applying the tilted price structure. By lowering the price on side A for example, there will be more people on side A that want to join. Since there are indirect network effects on platforms, B will benefit from a larger number of participants on side A and will also grow, further initiating momentum. This is called a positive feedback effect.

The major problematic is finding the side that should pay more. In a paper of Armstrong and Wright (2005) it is said that a platform should subsidize the side where demand elasticities and network externalities are higher compared to the other side.⁷⁰

2.5.3 Access and Usage Fees

There is also another technique for platform owners to further extend pricing methods. By having access and usage charges, also called membership fees, it is possible to separate prices and make customer using the platform paying different charges. They can charge lower prices to the more valuable customers, which makes it easy and cheaper for them to join. The access fee is a charge that has to be paid once or in regular intervals. The usage fee is used for every interaction on the platform and further shows the amount of exchange in a network.⁷¹ To give an example, OpenTable charges restaurants monthly and usage fees. On the one hand, the access fee is about $199 monthly, whereas $1 is paid as a usage fee for every seat reserved with OpenTable.⁷²

In the last preceding sections, the term “network effect” was vitally important to get a basic understanding in the successful establishment of a platform. This is the reason why the next section will mainly focus on the occurrence of network effects and its different variations.

3 Network Effects

A Network effect is a certain type of externality that has an influence on others. It is an important consideration aspect for both traditional and two-sided markets.⁷³ A general definition of a network effect is “(...) a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes.”⁷⁴

Network effects happen as direct or indirect. These have different impacts whether it is a general complementary product, i.e. a system market, or a direct communications platform which is further analyzed in the next sections. Since the thesis will mainly consider social networks as two-sided communication markets, two-sided markets with direct communication ways are analyzed primarily.

Some economists also call direct network effects as same-side and indirect network effects as cross-side externalities. If these terms are truly identical and if it is possible to find a differentiation is presented in this chapter, too.

To answer the question why a customer favors specific communication platforms more than other ones, the direct and indirect network effects play a crucial role besides factors like scaling results, lock-in effects and switching costs that bind the customer to a product and hinder them to use a competitor's product instead.⁷⁵

In the following sections, the occurrence of network effects on two-sided markets will be analyzed in great detail in terms of history, pricing, indirect network effects and market challenges as well as opportunities for two-sided markets.

3.1 Historical Background

First implications of Artle and Averous

Since the 1970s, there are some nameable authors who put their focus on the emergence of economic externalities. Artle and Averous were two of the first authors who analyzed studies of network externalities in the context of telecommunication systems. Having identified that the benefit of a telephone user is highly dependent on the number of other subscribers, they were sure about the fact that this analysis should be seen as a paradigm for lots of more complex communication goods.⁷⁶ They were totally right - the growth of new technologies is comparable with the telephone system - enormously pushed by direct and indirect network externalities.⁷⁷

Rohlfs Model (1974)

In 1974, Jeffrey Rohlfs has further analyzed the interdependencies of different customer groups for a communication product in a system market. Assuming a monopoly market, he identified that “The utility that a subscriber derives from a communications service increases as others joining the system.”⁷⁸ He also realized that a traditional demand curve cannot be adapted to a network market. Therefore, he published the first model that concerns the correlation between the price and the expected number of participants in a network of a complementary good. Rohlfs modeled an inverse demand curve which has both downward and upward sloping segments.

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¹ See Visual Capitalist (2017), Web.

² See Söderström (2009), Web.

³ Evans / Schmalensee (2008), p. 667

⁴ See Evans / Schmalensee (2016), p. 199

⁵ See Pak (2016), p. 3

⁶ See Evans / Gawer (2016), pp. 7 - 9

⁷ See Maffè / Ruffoni (2009), p. 12

⁸ See Bonchek / Choudary (2013), Web.

⁹ See Evans / Schmalensee (2016), pp. 19 - 20

¹⁰ See Evans (2005), p. 5

¹¹ See Evans / Schmalensee (2016), p. 18

¹² See Maffè / Ruffoni (2009), p. 2

¹³ See Lorenz / Yousfi (2015), p. 8

¹⁴ See Evans / Schmalensee (2016), p. 16

¹⁵ See Rochet / Tirole (2005), p. 8

¹⁶ See Evans / Schmalensee (2016), p. 15

¹⁷ See Goodwin et al. (2015), pp. 344 - 346

¹⁸ See eBay (N.Y. given), Web.

¹⁹ See Rochet / Tirole (2005), pp. 3 - 4

²⁰ See Rochet / Tirole (2005), pp. 6 - 8

²¹ See Peitz (2006), p. 1

²² Evans / Schmalensee (2016), p. 103

²³ See Evans (2007), p. 6

²⁴ See Evans / Schmalensee (2016), p. 36

²⁵ See Hagiu (2013), Web.

²⁶ See Rysman (2009), p. 132

²⁷ See Spedaliere (2015), Web.

²⁸ See Evans / Schmalensee (2016), p. 104

²⁹ Palmquist (2017), Web.

³⁰ See Evans / Schmalensee (2005), p. 13

³¹ See Bodoh-Creed / Boehnke / Hickman (2013), p. 1

³² See Evans / Schmalensee (2008), p. 680

³³ See Evans / Schmalensee (2016), pp. 122 - 126

³⁴ See Parker / Alstyne / Choudary (2016), pp. 94 - 95

³⁵ See Hagel / Brown / Davison (2008), p. 7

³⁶ See Van Cayseele / Vanormelingen (2009), pp. 5 - 6

³⁷ See Evans / Schmalensee (2016), pp. 135 - 140

³⁸ See Gillespie (2017), pp. 12 - 15

³⁹ See Evans / Schmalensee (2008), p. 680

⁴⁰ See Rochet / Tirole (2005), pp. 25 - 28

⁴¹ See Peitz (2006), pp. 328 - 329

⁴² See Lorenz / Yousfi (2015), p. 13

⁴³ See Evans (2003), p. 198

⁴⁴ See Dewenter / Rösch (2015), pp. 28 - 30

⁴⁵ See Evans / Schmalensee (2016), p. 71

⁴⁶ See Parker / Alstyne (2002), p. 1

⁴⁷ Evans (2007), p. 5

⁴⁸ Wirtschaftslehre (N.Y. Given a), Web.

⁴⁹ See Maffè / Ruffoni (2009), p. 21

⁵⁰ See Evans (2003), pp. 195-196 and Evans / Schmalensee (2016), pp. 78-82 and Spedaliere (2015), Web.

⁵¹ See Griffin (N.Y. given), Web.

⁵² See Evans (2005), p. 2

⁵³ Rochet / Tirole (2005), p. 665

⁵⁴ Evans / Schmalensee (2016), p. 98

⁵⁵ See Evans / Schmalensee (2016), pp. 83 - 89

⁵⁶ See Elzinga (2011), p. 6

⁵⁷ See Rochet / Tirole (2005), p. 6

⁵⁸ See Katiyar (2011), pp. 162 - 166

⁵⁹ See OECD (2009), p. 12

⁶⁰ See Evans / Schmalensee (2016), p. 96 and Maffè / Ruffoni (2009), p. 11

⁶¹ See Eisenmann / Parker / Van Alstyne (2006), pp. 3 - 4

⁶² See Maffè / Ruffoni (2009), p. 8

⁶³ See Evans / Schmalensee (2005), p. 11

⁶⁴ See Evans (2005), p. 193

⁶⁵ See Maffè / Ruffoni (2009), p. 10

⁶⁶ See Business Management Degree (2012), Web.

⁶⁷ See RTL Group (2016), Web.

⁶⁸ See Evans / Schmalensee (2016), pp. 91 - 92

⁶⁹ See Peitz (2006), p. 326 - 328

⁷⁰ See Armstrong / Wright (2005), p. 7

⁷¹ See Evans / Schmalensee (2008), p. 675

⁷² See Miller (2011), Web.

⁷³ See Lorenz / Yousfi (2015), p. 17

⁷⁴ Liebowitz (N.Y. given), Web.

⁷⁵ See Farrell / Klemperer (2007), p. 1970

⁷⁶ See Knieps (2007), p. 117

⁷⁷ See Artle / Averous (1973), p. 90

⁷⁸ Rohlfs (1974), p. 16