Two-sided markets:

Models and business cases

White Paper

Carlo Alberto Carnevale Maffè – Giulia Ruffoni

Bocconi University
Abstract

After a brief introduction on the topic of two-sided markets, we are going to

define them formally and present some real-world examples. We will then
investigated why they arise and presented some aspects that set two-sided
markets apart from traditional ones. Taking on a more managerial approach, we
are going to lay out the main research findings on how to succeed in two-sided
markets. Specifically, we are going to present the factors to consider when
pricing the platform, investigate winner-take-all dynamics, explain the threat of
envelopment and finally introduce a model for assessing the lifetime value of a
free customer. Lastly, we are going to conclude with the payment card industry
as an example of two-sided markets: we will describe its working, explain some
interchange fee dynamics and explore strategies for overcoming the chicken-
and-egg problem.

2
Table of contents

1. Introduction
2. What are two-sided markets?
3. Real world examples of two-sided markets
a. Portals and media
b. Text processing
c. Video games
d. PC operating systems
4. Why do two-sided markets arise?
a. Transaction costs
b. Volume-insensitive costs
c. Platform-determined constraints
5. How are two-sided markets different?
a. Endogenous competitive bottlenecks
b. Customer loyalty
c. Price structure
6. How to succeed in two-sided markets?
a. Pricing the platform
b. Winner-take-all dynamics
c. The threat of envelopment
d. The lifetime value of a free customer
7. An example of two-sided markets: Payment cards
a. Payment cards network
b. Interchange fee
c. The “chicken-and-egg” problem
8. Conclusions

3
 1. Introduction

According to Eisenmann, Parker and Van Alstyne (2006), many, if not most,
of the products and services that have redefined the global business landscape
in recent times tie together two distinct groups of users in a network: in other
words, they serve what economists call two-sided markets or two-sided
networks. 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 rely on physical products or be places
providing services.
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 to the right, because the platform has a distinct
group of users on each side; it incurs costs in serving both groups and can
collect revenues from each, although one side is often subsidized. According to
Eisenmann (2007) estimates, this business model accounts for a majority of the
revenues of 60 of the world’s 100 largest companies. Such a system is possible
because the two groups are attracted to each other, a phenomenon that
economists call cross-side network effect.
In traditional businesses, growth beyond some point usually leads to
diminishing returns. Because of (cross-side and same-side) network effects,
however, successful platforms in two-sided markets might enjoy increasing
returns to scale, leading to fierce competition.

4
 2. What are two-sided markets?

Two-sided markets are thus roughly defined as markets in which one or

several platforms enable interactions between end-users and try to get the two
sides “on board” by appropriately charging each side. That is, platforms court
each side while attempting to make, or at least not lose, money overall. “Getting
the two sides on board” is a useful characterization, but, if the analysis just
stopped there, pretty much any market would be two-sided, since buyers and
sellers always need to be brought together for markets to exist and gains from
trade to be realized.
Rochet and Tirole (2006) define a two-sided market as one in which the
volume of transactions between end-users depends on the structure and not
only on the overall level of the fees charged by the platform.
A platform’s usage or variable charges impact the two sides’ willingness to
trade once on the platform and, thereby, their net surpluses from potential
interactions; the platforms’ membership or fixed charges in turn condition the
end-users’ presence on the platform. The platforms’ fine design of the structure
of variable and fixed charges is relevant only if the two sides do not negotiate
away the corresponding usage and membership externalities.
An alternative and common definition refers to the existence of cross-group
externalities: the net utility on one side increases with the number of members
on the other side. While this alternative definition has much intuitive appeal, we
will stick to the former, being it more precise and accurate: two-sided markets
are ones in which the price structure affects the economic outcome.
Conceptually, the theory of two-sided markets is related to the theories of
network externalities (where there are non-internalized externalities among end-
users) and of multi-product pricing (which focuses on price structures,
considered less likely to be distorted by market power than price levels).

5
 3. Real world examples of two-sided markets

Following are some real world examples of two-sided markets drawn from
Eisenmann, Parker and Van Alstyne (2006), Rochet and Tirole (2003), and
Parker and Van Alstyne (2005).

Two-sided market Subsidy side Profit side Examples

PC operating Application Microsoft Windows, Apple
PC users
systems developers Macintosh

Online recruitment Job seekers Employers Monster, Career Builder

Yellow Pages Consumers Advertisers

Web search Searchers Advertisers Google, Yahoo

Game Sony PlayStation, Microsoft Xbox,

Video games Players
developers Nintendo Wii

Shopping malls Shoppers Retailers

Real Player, Windows Media

Streaming media Consumers Servers
Player
Microsoft Internet Explorer, Mozilla
Web browsers Users Web servers
Firefox
Portals,
Visitors, readers
newspapers and Advertisers
and viewers
TV networks

Text processing Readers Writers Adobe Acrobat, Microsoft Word

Credit and differed Visa, MasterCard, American

Cardholders Merchants
debit cards Express

Real estate Home buyers Home sellers

Auctions Buyers Sellers E-bay, Sotheby’s

Reservation Hotels, airlines,

Travelers Expedia, eDreams
systems rental cars
Men’s
Ladies’ nights at Women’s admission
admission and
bars and clubs and drinks
drinks
Listed
Stock exchanges Equity purchasers NYSE, NASDAQ
companies

6
a. Portals and media
The business model of (non pay) TV, and to a large extent,
newspapers has been to treat viewers and readers as a loss leader
and use them to attract advertisers. This business model has also
been adopted by Internet portals, which have supplied cheap or free
Internet access as well as free content (share quotes, news, e-mail,
etc.) to consumers. The profit center has been advertising revenue,
including both fixed charges for banner placement and proportional
referral fees.

b. Text processing
A key issue confronting purchasers of text processing software is
whether they will be able to “communicate” with people who don’t
make the same choice. Commercial software vendors have in this
respect converged on the following business model: they offer a
downgraded version of the paying software as “freeware”, which
allows nonusers to open, view, and print, but not edit documents
prepared with the paying software, and copy information from those
documents to other applications. Examples of such free viewers are
Word Viewer, PDF Viewer, and Scientific Viewer.

c. Video games
The video game market is a typical two-sided one: a platform
cannot sell the console without games to play on and cannot attract
game developers without the prospect of an installed base of
consumers. History has repeatedly shown that technically impressive
platforms (e.g., Mattel in 1981, Panasonic in 1993, and Sega in 1985
and after 1995) fail when few quality games are written for them. The
business model that has emerged uses consoles as the loss leader
and draws platform profit from applications developers who are

7
charged both a fixed fee and a per-unit royalty on the games they
produce, ensuring that only high-quality games make it to the market.

d. PC operating systems
PC and video game networks look similar, with end users on one
side wishing to link to software or games on the other side who buy a
platform consisting of an operating system (OS) bundled with
hardware – a PC or a game console. Also, the two businesses exhibit
similarly positive cross-side network effects: end users favor
platforms that offer a wide variety of complements and developers
favor platforms with more end users because this improves the odds
that they will recover the fixed, upfront costs of creating complements.
However, while in video games end users are subsidized and game
developers are on the network’s money side, in the PC industry end
users are the money side, paying well above cost for the platform’s
essential element, its OS, and application developers are the subsidy
side, as they pay no royalties and receive free software development
kits from the OS vendors.
This difference is due to the fact that video game consoles users,
typically teenagers, are both far more price sensitive and quality
conscious than typical PC users. PCs are often purchased for work
and are otherwise more likely viewed as household necessities than
game consoles are, so price sensitivity is lower. Gamers’ need for
quality seems to be stronger, as does game developers’ need for
large numbers of consumers. PCs, on the contrary, accumulate lots
of applications, with a huge range of price and quality levels.

8
 4. Why do two-sided markets arise?

A network effect, or network externality, is the effect that one user of a good
or service has on the value of that product to other people. It can be positive, if
any additional user increases the value of the product for other users (e.g.
telephone) or negative, if it decreases such value.
According to Rochet and Tirole (2003), most markets with network
externalities are two- (or multiple-) sided markets. A market with network
externalities is a two-sided market if platforms can effectively cross-subsidize
between different categories of end users that are parties to a transaction, that
is, the volume of transactions on and the profit of a platform depend not only on
the total price charged to the parties to the transaction, but also on its
decomposition.
Platforms may be unable to perform such cross-subsidization if both sides of
the market coordinate their purchases (the platform is in fact dealing with a
single party) or if pass-through and neutrality are possible. We have neutrality if,
even when end users on the two sides of the market act independently,
monetary transfers between them undo the redistributive impact and prevent
any cross-subsidization (e.g. value-added tax). If such neutrality holds, markets
with network externalities are one-sided, that is, only the total per transaction
price charged by the platform matters and not its decomposition between end
users.
In practice, however, neutrality does not hold because of three main
reasons:

1. Transaction costs refer to a broad range of frictions that make it

costly for one side of the market to pass through a redistribution of
charges to the other side. They can be associated with small
stakes for individual transactions (which can become substantial

9
 when applied to a large number of transactions), be related to the
absence of a low cost billing system or arise from the impossibility
of monitoring and recording the actual transaction or interaction.

2. Volume-insensitive costs exist when at least one side of the

market incurs costs that are influenced by the platform and are not
proportional to the number of transactions on the platform.

3. Platform-determined constraints on pass-through may also take

place.

10
 5. How are two-sided markets different?

The concept of two-sided markets is relatively new and, as such, it has not
yet been completely understood and explained. Recent research, however, has
helped to shed some light on this interesting topic; this paper now presents
some of the main findings that set two-sided markets apart from traditional
ones.

a. Endogenous competitive bottlenecks

Noticing that, in many two-sided market, agents on one or both
sides multihome and that platforms often charge little or nothing to
one side of the market, Armstrong and Wright (2007) investigate two-
sided markets in the case when one side views the platforms as
homogeneous, while the other views the platforms as heterogeneous.
They make the realistic assumption that sellers view the competing
platforms as more or less homogenous (controlling for the size of the
network benefits), while buyers have preferences for using one
particular platform over the other, and they allow agents to join a
single platform, to “singlehome”, or both, to “multihome”. Finally, they
consider the use of exclusive contracts that prevent agents from
multihoming.
Where there is strong product differentiation on each side of the
market, the model predicts all agents singlehome. If attracting one
group of agents (say, buyers) makes the platform particularly
attractive to the other group (sellers), then buyers will be “subsidized”.
In the case where product differentiation arises only on one side of
the market (say, buyers), an equilibrium exists where agents on the
other side (sellers) will multihome. This case represents a “
competitive bottleneck”: platforms compete aggressively to sign up

11
buyers, charging them less than cost (perhaps nothing), and make
their profits from sellers who want to reach these buyers and don’t
have a choice of which platform to join in order to reach them. In
equilibrium, sellers are left with zero surplus. A similar outcome can
also arise when there is no product differentiation on either side.
Finally, they show that competitive bottleneck equilibria can be
undermined when platforms can offer exclusive contracts to the seller
side, which work by making it easier for a platform to persuade
multihoming sellers to abandon the rival platform. A platform can set
arbitrarily high non-exclusive prices (so that sellers never choose to
multihome regardless of the rival platform’s offer) and then offer a
slight price cut relative to the rival platform to attract all sellers
exclusively. Even if the platforms are otherwise symmetric, this allows
a platform to attract all sellers, and therefore be able to charge a
premium to buyers. When network effects are strong, this can lead to
an equilibrium where all agents sign up exclusively to a single
platform even though it sets high prices to both sides. Competition in
such exclusive contracts can result in buyers having all their surplus
extracted.

b. Customer loyalty
Competing firms in any industry are likely to be asymmetric in their
customer loyalty as a result of differences in product positioning,
marketing effectiveness, and order-of-entry of the firms. Also, an
incumbent in an industry is more likely to enjoy higher customer
loyalty than a potential entrant: examining the impact of asymmetric
loyalty is thus also important in understanding firms’ entry strategies.
Firms in two-sided markets face competition in multiple
interdependent markets so that the installed user base and customer
loyalty in one market affect competition not only in that market but in

12
other markets as well. Moreover, loyalty build-up is especially
important among industries characterized by the cross-market
network effect because consumer commitments and switching costs
play very significant roles in competition. Finally, understanding the
competitive implications of asymmetric loyalty is practically relevant
for industries in two-sided markets as they are witnessing the entry of
new players.
Previous literature has suggested a positive effect of customer
loyalty on a firm’s competitive advantage. In order to test this
relationship in the contest of two-sided market, Chen and Xie (2007)
have developed a model composed of two competing firms, each
selling two products (a primary and a secondary product) in two
markets with a cross-market network effect, i.e., the value of the
secondary product depends on the demand for the primary product.
The firms differ in customer loyalty in the market of the primary
product.
They show that a mid-range loyalty advantage in the market of the
primary product may lead to a lower total profit for the firm compared
with its competitor. This is possible because a firm with a mid-range
loyalty advantage has an incentive to set a high price to target its
loyal segment, because its loyalty advantage is quite significant and
the existence of a price lower bound limits its ability to obtain non-
loyal customers by further undercutting the competitor in price. As a
result, this can lead to a disadvantage in market share in the primary
product market if the firm’s customer loyalty advantage is not high
enough to outnumber the non-loyal customers attracted by its
competitor. Consequently, its profit from the secondary product can
be lower than that of its competitor, and its total profit from both
markets can also be lower than that of its competitor.
Their main findings are the following:

13
 • Differently from traditional markets, where an advantage
in customer loyalty leads to an advantage in profit, in two-
sided markets a firm with an advantage in customer
loyalty can be leapfrogged by its rival in both profit and
market share if its advantage in loyalty is neither
sufficiently small nor sufficiently large.
• A cross-market network effect generates strategic
dependence between the two markets such that the more
competitive the secondary product market the more likely
it will be for the firms to adopt differentiated pricing
strategy in the primary product market, and the more
likely that the firm with a loyalty disadvantage will be the
market share leader in the primary product market.
• If the fixed cost of entry is low and the incumbent can only
build a mid-sized loyalty segment, a second mover
advantage may endogenously occur because the entry
cannot be deterred and the entrant may leapfrog the
incumbent in profit.

c. Price structure
Rochet and Tirole (2003) focus on the fact that, under
multisidedness, platforms must choose a price structure and not only
a price level for their service. Their work studies how the price
allocation between the two sides of the market is affected by: platform
governance (for-profit vs. not-for-profit), end users’ cost of
multihoming, platform differentiation, platforms’ ability to use volume-
based pricing, the presence of same-side externalities and platform
compatibility.

14
 They find that monopoly and competitive platforms design their
price structure so as to get both sides on board. Specifically,
• An increase in multihoming on the buyer side facilitates
steering on the seller side and results in a price structure
more favorable to sellers
• The presence of marquee buyers (buyers generating a
high surplus on the seller side) raises the seller price and
(in the absence of price discrimination on the buyer side)
lowers the buyer price
• Captive buyers tilt the price structure to the benefit of
sellers

15
 6. How to succeed in two-sided markets?

Platforms serving two-sided networks are not a new phenomenon, but,

thanks largely to technology, they have become more prevalent in recent years:
new platforms have been created and traditional businesses have been
reconceived as platforms. Yet, for all the potential they’ve spotted, platform
providers have struggled to establish and sustain their two-sided networks
mainly because, in creating strategies, managers have typically relied on
assumptions and paradigms that apply to products without network effects. This
paper is now going to present three unique challenges facing executives that
operate in two-sided networks as discussed in Eisenmann, Parker and Van
Alstyne (2006) and a model for assessing the lifetime value of a free customer
as presented by Gupta and Mela (2008).

a. Pricing the platform

Transactions in two-sided networks always entail a triangular set
of relationships. Two user groups – the network’s “sides”– interact
with each other through one or more intermediaries called platform
providers. Platforms exhibit two types of network effects, which may
be either positive or negative: a same-side effect, in which increasing
the number of users on one side of the network makes it either more
or less valuable to users on the same side; and a cross-side effect,
in which increasing the number of users on one side of the network
makes it either more or less valuable to the users on the other side.
For two-sided networks, pricing is a complicated affair. Platform
providers have to choose a price for each side, factoring in the
impact on the other side’s growth and willingness to pay. Typically,
two-sided networks have a “subsidy side,” that is, a group of users
who, when attracted in volume, are highly valued by the “money

16
side,” the other user group. Because the number of subsidy side
users is crucial to developing strong network effects, the platform
provider sets prices for that side below the level it would charge if it
viewed the subsidy side as an independent market. Conversely, the
money side pays more.
If the platform provider can attract enough subsidy side users,
money-side users will pay handsomely to reach them. Also, the
presence of money-side users makes the platform more attractive to
subsidy-side users, so they will sign up in greater numbers. Finally,
pricing is further complicated by “same-side” network effects.
The challenge for the platform provider with pricing power on both
sides is to determine the degree to which one group should be
encouraged to swell through subsidization and how much of a
premium the other side will pay for the privilege of gaining access to
it. When making pricing decisions, the provider should consider the
following factors:
• Ability to capture cross-side network effects: your
giveaway will be wasted if your network’s subsidy side
can transact with a rival platform provider’s money side.
• User sensitivity to price: it makes sense to subsidize the
network’s more price-sensitive side and to charge the
side that increases its demand more strongly in response
to the other side’s growth.
• User sensitivity to quality: rather than charge the side that
strongly demands quality, you charge the side that must
supply quality.
• Output costs. Pricing decisions are more straightforward
when each new subsidy-side user costs the platform
provider essentially nothing, like when the giveaway takes

17
 the form of a digital good. However, when a giveaway
product has appreciable unit costs, as with tangible
goods, platform providers must be more careful: If a
strong willingness to pay does not materialize on the
money side, a giveaway strategy with high variable costs
can quickly rack up large losses.
• Same-side network effects. Platform providers normally
welcome growth in the user base on either side, because
it encourages growth on the other side. However, in the
face of strongly negative same-side network effects,
platform providers should consider granting exclusive
rights to a single user in each transaction category and
extracting high rent for this concession (they must,
however, make sure that sellers do not abuse their
monopoly positions).
• Users’ brand value. The participation of “marquee users”,
which may be exceptionally big buyers or high profile
suppliers, can be especially important for attracting
participants to the other side of the network. A platform
provider can accelerate its growth if it can secure the
exclusive participation of marquee users in the form of a
commitment from them not to join rival platforms.
However, it can be expensive, especially for small
platforms, to convince marquee users to forfeit
opportunities in other networks. Also, when the
participation of a few large users is crucial for mobilizing a
network, conflict over the division of value between
platform providers and large users is common.

18
b. Winner-take-all dynamics
The prospect of increasing returns to scale in network industries
can lead to winner-take-all battles, so an aspiring platform provider
must consider whether to share its platform with rivals or fight to the
death. First, executives must determine whether their networked
market is destined to be served by a single platform. When this is the
case, the second step, that is, deciding whether to fight or share the
platform, is a bet-the company decision.
A networked market is likely to be served by a single platform
when:
• Multi-homing costs are high for at least one user side.
“Homing” costs comprise all the expenses network users
incur, including adoption, operation, and the opportunity
cost of time, in order to establish and maintain platform
affiliation. When users make a “home” on multiple
platforms, they increase their outlays accordingly; if multi-
homing costs are high, users need a good reason to
affiliate with multiple platforms.
• Network effects are positive and strong, at least for the
users on the side of the network with high multi-homing
costs. When cross-side network effects are positive and
strong, those network users will tend to converge on one
platform. The odds of a single platform prevailing also
increase when same-side network effects are positive.
• Neither side’s users have a strong preference for special
features. If certain users have unique needs, then
smaller, differentiated platforms can focus on those needs
and carve out niches in a larger rival’s shadow. In cases

19
 where special features are not important, however, users
will tend to converge on a single platform.
Even though proprietary control promises monopoly profits once
rivals are vanquished, there may be reasons to decide to share a
platform, like if senior managers believe that their company’s platform
is not likely to prevail. However, even those firms that have a fighting
chance of gaining proprietary control stand to realize benefits from
sharing: the total market size will be greater with a shared platform
(during a battle for dominance in a two-sided network, some users will
delay adoption, fearing that they will be stranded with obsolete
investments if they back the loser) and rivalry tends to be less intense
with a shared platform, reducing marketing outlays (since the stakes
are so high in battles for network dominance, firms spend enormous
amounts on upfront marketing).
• Winning the battle. To fight successfully, you will need, at
a minimum, cost or differentiation advantages. Three
other assets are important in establishing proprietary
control: platform providers gain an edge when they have
pre-existing relationships with prospective users, often in
related businesses; high expectations generate
momentum in platform wars, so a reputation for past
prowess helps a great deal; and in a war of attrition, deep
pockets matter. Moreover, first-mover advantages can
also be significant in platform battles, but they are not
always decisive: when the market evolves slowly, late
mover advantages may be more salient. Late movers
may, for example, avoid the pioneer’s positioning errors,
be better placed to incorporate the latest technology into
product designs, or be able to reverse engineer pioneers’
products and beat them on cost. Finally, in a battle for

20
 platform control, first and late movers alike will feel strong
pressure to amass users as quickly as possible; in most
cases, this urgency is appropriate and positive word-of-
mouth favors the early mover. But racing to acquire users
can be a mistake under two circumstances. First,
executives must ask whether their business is readily
scalable. Second, due to their explosive growth potential,
platform-mediated networks are prone to boom or bust
valuation cycles: when they launch cash-draining “get big
fast” strategies, therefore, top managers need to be sure
that funding will be forthcoming should capital-market
sentiment turn negative.

c. The threat of envelopment

Your platform may be “enveloped” by an adjacent platform
provider that enters your market. Platforms frequently have
overlapping user bases: leveraging these shared relationships can
make it easy and attractive for one platform provider to swallow the
network of another. The real damage comes when your new rival
offers your platform’s functionality as part of a multi-platform bundle.
Such bundling hurts the stand-alone platform provider when its
money side perceives that a rival’s bundle delivers more functionality
at a lower total price: the stand-alone platform provider cannot
respond to this value proposition because it cannot afford to cut the
price on its money side and it cannot assemble a comparable bundle.
Networked markets, especially those in which technology is
evolving rapidly, are rich with envelopment opportunities that can blur
market boundaries; this blurring is called “convergence.” In many
cases, a stand-alone business facing envelopment has little choice

21
but to sell out to the attacker or exit the field; some, however, manage
to survive.
Here is what a focused firm can do to survive envelopment:
• Change business model. It might be possible to switch
the money side leveraging existing relationships. Also, a
specialist can reinvigorate its business model by offering
services as a systems integrator, helping enterprises knit
together diverse systems and technologies. Facilitating
transactions across a two-sided network requires platform
providers to coordinate users’ activities; hence, managing
a platform builds system integration skills that can be
exploited.
• Find a “bigger brother”. When bullied on the playground, a
little guy needs a big friend: find allies through
partnerships.
• Sue. Firms facing envelopment are wise to consider legal
remedies, because antitrust law for two-sided networks is
still in dispute. Dominant platform providers that offer
bundles or pursue penetration pricing run the risk of being
charged with illegal tying or predation.
The threat of envelopment means that vigilance is crucial for a
focused platform provider: when market boundaries blur,
envelopment attacks can come from any direction. However, focused
firms are not without advantages when competing with large,
diversified companies. Big firms can be slow to recognize
envelopment opportunities and even slower to mobilize resources to
exploit them. Also, envelopment requires cross-business-unit
cooperation, a significant barrier in many diversified companies.

22
d. The lifetime value of a free customer
Customers who pay little or nothing and are subsidized by another
set of customers are essential to a vast array of businesses. The
rationale for this approach is that by charging one set of customers
little or nothing, the business will attract the critical mass of them
required to draw in large numbers of another set of customers, and
the income generated by the latter will handsomely exceed the cost of
acquiring and serving the former. Executives, however, tend to
underestimate the significance of free customers both because
managers naturally focus more on customers who generate the bulk
of revenues and because traditional customer-valuation models focus
exclusively on paying customers (estimating the net present value of
their purchases minus the cost of marketing to them).
This model considers the precise role that each customer segment
plays in growing the business and creating value: it takes into account
how the number of free customers influences the number of paying
customers and vice versa, and how both are affected by the firm’s
marketing efforts. The lifetime value of a free customer is thus defined
as his or her incremental effect on the net present value of cash flows
from the population of fee customers. It depends on the degree to
which a free customer attracts other fee and free customers and the
ripple effects those customers have on still other customers.
Direct network effects (how a buyer attracts more buyers or a
seller more sellers) can be positive or negative. When direct network
effects are strong and negative, a firm faces the challenge of building
a critical mass of players on the side in question. Indirect network
effects, between buyers and sellers, can be positive or negative as
well. When indirect network effects are strong and positive, the firm
benefits tremendously from the snowball effect and may eventually
become the sole industry standard. In such situations, free customers

23
in the early stages of the business are crucial, and the firm should be
willing to invest a lot of resources to get them on board.
Knowing the lifetime value of free customers is crucial to
determining:
• the optimal way to grow: how much a company should
spend at various points in time to acquire and retain free
or heavily subsidized customers.
• the real value of the enterprise: how much investors or
acquirers should pay for all or part of a business with
such customers.
• the best organizational design: how the business and its
incentive systems should be structured to encourage the
units responsible for the free and the paying customers to
work together.
Companies employ a variety of crude approaches to place a value
on free or heavily subsidized customers but, because these
techniques do not rigorously quantify the impact of network effects,
their valuations are wild guesses. One simple approach apportions
the prior period’s profits equally among free and paying customers; it
ignores the relative size of the two groups as well as the degree of
influence each has on the other.
Another approach assigns profits according to the proportion of
buyers to sellers; it can grossly miscalculate the value of buyers and
sellers because it ignores network effects and the changing value of
buyers and sellers over time.
The best of the common approaches is one employed by
publications whose subsidized customers (subscribers) pay
something: in valuing a subscriber, they typically take into account
both subscription fees and advertising revenues per reader. While

24
this is a reasonable approach, it, too, ignores the rippling impact that
readers’ referrals can have on circulation and ad revenues.
In analyzing a major international online auction house, Gupta and
Mela (2008) collected historical data on the number of sellers and
buyers, their growth rates, the prices charged (to sellers) and the
marketing expenses incurred. They then examined how the growth in
the number of both sellers and buyers was affected by the firm’s
marketing strategies, by direct network effects and by indirect network
effects and devised two related equations which were used to
determine the magnitude of the network and marketing effects.
Their model showed the growth patterns of buyers and sellers,
how the value of a newly acquired buyer changed over time and the
effect of pricing strategies on profits. This analysis also helped the
firm to strengthen its marketing operations, to cater more to buyers
and to make its case to investors.

25
 7. An example of two-sided markets: Payment cards
The payment card industry is a typical two-sided market where two different
groups of agents, the merchants and the cardholders, interact with each other
via a common network platform, the payment card network, and the value of
participating in a particular card network for agents in one group (say, the
merchants) depends on the number of participants from the other group (the
cardholders, correspondingly). For example, if more consumers carry a VISA
card, merchants accepting VISA cards will be able to capture higher sales
volume from these cardholders; on the other hand, if more merchants accept
VISA cards, it will be more convenient for VISA cardholders to pay for their
purchases.
We will now describe the payment cards network more in detail and then
present some research findings from Rochet and Tirole (2002) and Sun and
Tse (2007).

a. Payment cards network

In a two-sided market, the two sides interact with each other
through a common network platform; in the payment card network,
the electronic payment systems and equipment (e.g. point-of-sale
POS terminals) are the platforms via which consumers interact with
merchants. Besides the two sides, there is a third party who creates
and services the network: the network platform owner or sponsor:
VISA, MasterCard, American Express, and Discover are platform
owners of the U.S. payment card network.
Each merchant installs a POS terminal in his store, which is linked
to the electronic payment system owned by network platform owners
(e.g. VISA, MasterCard); consumers can then purchase goods or
services from any merchant in the network. The platform owners
operate the payment system and provide services to network

26
participants (e.g. clearing & settlements, fund transferring, fraud
protection).
In many two-sided markets, there is also a fourth type of agents:
the distributors of a network. They are the agents who produce and
sell network-specific products to participants on either or both sides of
the market; in the payment card network, banks such as Bank of
America, Wells Fargo, Chase, etc. issue VISA or MasterCard cards to
consumers and sign up merchants. They are neither the network
platform owner nor any side of the market: instead, they are the
distributors of the corresponding network (i.e. VISA or MasterCard).
Although inessential to a two-sided network, network distributors may
affect the diffusion speed of a network: their collective efforts in
signing up network participants and in improving the quality and
features of the network could have a critical impact on the growth and
even survival of a network.
The fee structure is also worth noticing. Since the network
platform provides added-value to both sides of the market, the
platform owner can charge both sides for its service, either on lump-
sum basis or on per-transaction basis. Payment card network owners
(e.g. VISA) charge merchants on per-transaction basis which is
usually 2-3% of the transaction value. They could also charge
cardholders a lump-sum membership fees, although most choose not
to do so or only charge cardholders of certain risk profiles (e.g. those
with low credit scores).
The defining characteristics of two-sided markets are the cross-
group network externalities: a consumer’s decision to use VISA card
imposes positive externalities to merchants, while a merchant’s
decision to accept VISA card imposes positive externalities to
consumers. There could also be within-group externalities, either
positive or negative, within either side of the market. In the payment

27
card network, negative externalities exist among merchants: given the
number of cardholders, more merchants in a particular card network
will lead to less incremental sales from accepting the card for an
individual merchant. This is because merchants are competing
against each other for businesses from the same cardholders. Such
negative within-group externality is called the congestion effect.

b. Interchange fee
Rochet and Tirole (2002) explore the workings of the payment
card industry from an economic perspective. They underline that, in a
payment card transaction, the consumer's bank, called the issuer,
and the merchant's bank, the acquirer, must cooperate to enable the
transaction. Two successful not-for-profit joint ventures, Visa and
MasterCard, have designed a set of rules to govern the
"interconnection" between their members:
• Interchange fee: the acquirer pays a collectively
determined interchange fee (the analog of an access
charge in telecommunications) to the issuer.
• Honor-all-cards rule: affiliated merchants must accept any
card of any issuing member.
• No-surcharge rule: affiliated merchants are not allowed to
impose surcharges on customers who pay with a card.
They base their model on three starting considerations.
First, when (at least some) consumers know which stores take
payment cards before they select which to patronize, or may leave
the store when they discover the card is not accepted, merchants use
card acceptance to attract customers. A merchant's total benefit, and
thus his decision whether to accept a card, then depends not only on
his technological benefit (fraud control, theft protection, speed of

28
transaction, customer information collection, etc.), but also on the
product of the increase in demand due to system membership and its
retail markup. Thus, they conclude that the earlier literature
overstated merchants' resistance to an increase in the merchant
discount and, therefore, to an increase in the interchange fee.
Second, when merchants are allowed to offer cash discounts, a
consumer's decision to use a card depends not only on the
technological benefit (convenience, theft and fraud control, etc.), but
also on the extra charge for using a payment card.
Third, when several payment card systems compete, a merchant's
opportunity cost for accepting a card is endogenous as long as some
customers hold cards on multiple systems. For example, a merchant
who turns down American Express (Amex) may see the customer pay
with Visa or MasterCard rather than with cash or a check. Thus, the
earlier literature understated merchants' resistance under system
competition.
They conclude that, in the absence of unobserved heterogeneity
among merchants, an increase in the interchange fee increases the
usage of payment cards, as long as the interchange fee does not
exceed a threshold level at which merchants no longer accept
payment cards. At this threshold level, the net cost for merchants of
accepting the card is equal to the average cardholder benefit. The
interchange fee selected by the payment card association either is
socially optimal or leads to an overprovision of payment card
services.

c. The “chicken-and-egg” problem

The cross-group network effect is a double-edge sword: it can
either lead to spiral growth of the network or create the “chicken-and-
egg problem”: without sufficient merchants accepting a particular card

29
network, few consumers are willing to apply for the card; without
sufficient cardholders, few merchants are willing to accept the card.
For example, if few consumers carry VISA cards, few merchants will
be willing to accept VISA, which further discourages consumers from
using this type of cards. Unless the network has reached a critical
mass in the number of participants, it cannot take off.
While economists have addressed the issue from a social welfare
perspective, Sun and Tse (2007) focus on business strategy
implications: modeling network externalities in dynamic systems, they
explore strategies for overcoming the chicken-and-egg problem.
The model developed shows that if a network starts with small
numbers of merchants and consumer members, it can never move
across the saddle path and its growth cannot be sustained;
eventually, the network will shrink to zero as the small number of
participants on one side of the market cannot provide large enough
value to attract or keep participants from the other side. However, if a
network can manage to gather enough participants on both sides of
the market at the very beginning, the network will be able to grow to
infinity on its own momentum. It is interesting to see that a network
needs not have large numbers of participants from both sides of the
market: instead, as long as it has sufficient participants from one side
of the market, it will be able to achieve sustainable growth.
Though the model is based on the market structure of the
payment card system, it is also applicable to other two-sided markets
with similar structures such as yellow page directory and PC
operating system. Therefore, although they discuss the findings using
the payment card industry as a background, the business insights in
the following propositions apply to many two-sided markets.

30
• Proposition 1: to overcome the chicken-and-egg problem,
firms entering two-sided markets as network platform
owners should leverage on their existing networks or
customer relationships from other businesses in order to
boost the number of initial participants of the network.
• Proposition 2: platform sponsors of two-sided networks
might overcome the chicken-and-egg problem by lowering
price/fee, increasing the benefit and/or decreasing the
potential risks faced by its participants.
• Proposition 3: platform sponsors of two-sided networks
can dynamically increase fees or lower the benefits they
provide to network participants after the chicken-and-egg
problem has been resolved.
• Proposition 4: two-sided networks with insufficient
participants from either or both sides of the market might
overcome the chicken-and-egg problem through merger
and acquisition, licensing or forming strategic alliances.
• Proposition 5: to overcome the chicken-and-egg problem
and/or increase the growth rate, two-sided networks
should leverage on the new information technology and
internet to reduce participant’s search/transportation cost.
• Proposition 6: to increase the growth rate of the network,
two-sided networks may resort to advertising, marketing
and promotion to mitigate the impact of incomplete
information and inertia to adoption.
• Proposition 7: to increase the rate of network growth, two-
sided network platform sponsors should allow and
encourage third-party distributors to distribute their
network.

31
 8. Conclusions
We first explained how two-sided markets tie together two distinct groups of
users in a network, how they are characterized by the existence of a cross-
group network effect (the net utility on one side increases with the number of
members on the other side) and how platforms provide infrastructure and rules
that facilitate the two groups’ transactions. We then more formally defined a
two-sided market as one in which the volume of transactions between end-
users depends on the structure and not only on the overall level of the fees
charged by the platform. We populated this definition with real world examples;
among the many, we highlighted the cases of portals and media, text
processing software, video games and PC operating systems.
The paper investigated why two-sided markets arise and explained the main
reasons because of which neutrality does not always hold (transaction costs,
volume-insensitive costs and platform-determined constraints). It then
presented some aspects that set two-sided markets apart from traditional ones;
namely, the possibility of competitive bottlenecks to arise endogenously, the
different relationship between customer loyalty and competitive advantage and
some findings on the price structure.
Taking on a more managerial approach, we presented the main research
findings on how to succeed in two-sided markets. Specifically, we presented the
factors to consider when pricing the platform: ability to capture cross-side
network effects, user sensitivity to price, user sensitivity to quality, output costs,
same-side network effects and users’ brand value. Investigating winner-take-all
dynamics, we explained that a networked market is likely to be served by a
single platform when multi-homing costs are high for at least one user side,
when network effects are positive and strong and when neither side’s users
have a strong preference for special features. Moreover, we investigated the
main assets important in establishing proprietary control. The threat of
envelopment, leading to convergence, was then explained and, even though we

32
recognize that a stand-alone business facing envelopment often has little choice
but to sell out to the attacker or exit the field, we underlined how a focused firm
can sometimes survive envelopment by changing business model, finding a
“bigger brother” and suing. Finally, we introduced a model for assessing the
lifetime value of a free customer which is crucial to determining the optimal way
to grow, the real value of an enterprise and the best organizational design.
Finally, we concluded with the case of a typical two-sided market: the
payment card industry. We explained its working, presented its distinguishing
elements (platform, platform owners, distributors, fee structure and network
externalities) and some considerations on the interchange fee from an
economic perspective. Lastly, we described the “chicken-and-egg problem”:
without sufficient merchants accepting a particular card network, few consumers
are willing to apply for the card and without sufficient cardholders, few
merchants are willing to accept the card. The case concludes with seven
propositions that, although developed specifically for the payment card industry,
apply to many other two-sided markets as well.
In conclusion, as new platforms are being created and traditional businesses
are being reconceived as platforms, two-sided markets are taking up an
increasingly important share of today’s economy. While this paper offers an
overall picture of the topic and presents relevant research findings, it appears
evident that much work is still to be done, especially in terms of managerial
implications.

33
References

Armstrong, M., & Wright, J. 2007. Two-sided markets, competitive bottlenecks

and exclusive contracts. Economic Theory

Chen, Y., & Xie, J. 2007. Cross-market network effect with asymmetric
customer loyalty: Implications for competitive advantage. Marketing Science

Eisenmann, T., Parker, G., & Van Alstyne, M. W. 2006. Strategies for two-sided
markets. Harvard business review

Eisenmann, T. 2007. Managing Networked Businesses. Harvard business

school note

Gupta, S., & Mela, C. F. 2008. What is a free customer worth? Harvard
business review

Parker, G. G., & Van Alstyne, M. W. 2005. Two-sided network effects: A theory
of information product design. Management Science

Rochet, J., & Tirole, J. 2002. Cooperation among competitors: Some economics
of payment card associations. RAND Journal of Economics

Rochet, J., & Tirole, J. 2003. Platform competition in two-sided markets.

Journal of the European Economic Association

Rochet, J., & Tirole, J. 2006. Two-sided markets: a progress report. RAND
Journal of Economics

34
Sun, M., & Tse, E. 2007. Sustainable growth of payment card networks: A two-
sided market approach. Journal of Business Strategies

35