In a two-sided network, members of each group exhibit a preference regarding the number of users in the other group; these are called cross-side network effects. Each group’s members may also have preferences regarding the number of users in their own group; these are called same-side network effects. Cross-side network effects are usually positive, but can be negative (as with consumer reactions to advertising). Same-side network effects may be either positive (e.g., the benefit from swapping video games with more peers) or negative (e.g., the desire to exclude direct rivals from an online business-to-business marketplace). Figure 1 depicts these relationships.
Figure 1: Cross-Side and Same-Side Network Effects in a Two-Sided Network.
In two-sided networks, users on each side typically require very different functionality from their common platform. In credit card networks, for example, consumers require a unique account, a plastic card, access to phone-based customer service, a monthly bill, etc. Merchants require terminals for authorizing transactions, procedures for submitting charges and receiving payment, “signage” (decals that show the card is accepted), etc. Given these different requirements, platform providers may specialize in serving users on just one side of a two-sided network. A key feature of two-sided markets is the novel pricing strategies and business models they employ. In order to attract one group of users, the network sponsor may subsidize the other group of users. Historically, for example, Adobe’s portable document format (PDF) did not succeed until Adobe priced the PDF reader at zero, substantially increasing sales of PDF writers. Relative to Apple computer’s initial pricing, Microsoft also steeply discounted systems developer toolkits (SDKs) leading to more rapid development of applications for MS Windows.
Figure 2–Traditional pricing logic seeks the biggest revenue rectangle (price × quantity) under each demand curve.
In two-sided networks, such pricing logic can be misguided. If firms account for the fact that adoption on one side of the network drives adoption on the other side, they can do better. Demand curves are not fixed: with positive cross-side network effects, demand curves shift outward in response to growth in the user base on the network's other side. When Adobe changed its pricing strategy and made its reader software freely available, its managers uncovered a key rule of two-sided network pricing. They subsidized the more price sensitive side, and charged the side whose demand increased more strongly in response to growth on the other side. As illustrated in Figure 3, giving consumers a free reader created demand for the document writer, the network's "money side."
Figure 3–So long as the revenue gained (red box) exceeds the revenue lost (light blue box), a discounting strategy is profitable. The subsidy largely changes network size.
Figure 4–In this market, consumers care more about access to critical features. The main effect of a subsidy is to change network value.
Which market represents the money side and which market represents the subsidy side depends on this critical tradeoff: increasing network size versus growing network value. The size rule lets you increase adoption relatively more while the value rule lets you increase price relatively more.
Although recently developed in terms of economic theory, two-sided networks help to explain many classic format battles, for example, Betamax vs. VHS, Mac vs. Windows, CBS vs. RCA in color TV, American Express vs. Visa, and more recently Blu-Ray vs. HD DVD.
In the case of color TV, CBS and RCA offered rival formats but initially neither gained market traction. Viewers had little reason to buy expensive color TVs in the absence of color programming. Likewise, broadcasters had little reason to develop color programming when households lacked color TVs. RCA won the battle in two ways. It flooded the market with low cost black-and-white TVs incompatible with the CBS format but compatible with its own. Broadcasters then needed to use the RCA format to reach established viewers. RCA also subsidized Walt Disney’s Wonderful World of Color, which gave consumers reason to buy the new technology.
Two-sided markets represent a refinement of the concept of network effects. They were conceived independently by Parker & Van Alstyne (2000) to explain behavior in information markets, and Rochet & Tirole (2001) to explain behavior in credit card markets.