Thursday, December 1, 2011

Economics of Two-Sided Markets and the Future of Newspapers

Warren Buffett recently announced the purchase of his hometown newspaper company, Omaha World-Herald. I have no opinion on the purchase, but I am going to use this occasion to talk about the economics of  business' that are like that of newspapers and apply these economic principles to the evolving newspaper business. Before I begin, I want to acknowledge that my thoughts on this topic absolutely not original, but come from a Boston University professor, Marshall Van Alstyne, one of the top researchers in this area.

The newspapers are an example of a "two-sided markets". Two-sided markets are economic platforms that bring together two different user groups that provide each other with network benefits. Other examples include credit cards (cardholders and merchants), HMOs (patients and doctors), operating systems (end-users and developers), video game consoles (gamers and game developers), web search engines (searchers and advertisers), and social networks (web "socializers" and advertisers).

First we'll begin by going back to your Econ 101 class. Usually for a market, the demand curve is downward sloping and you lower the price until value on the next unit sold makes up for the losses on sales you would have made at a higher prices. As you would expect, it makes no sense to give away your product for free because that gives up all profits on every unit sold. What makes two-sided markets special, despite what  your Econ 101 class tells you, is that sometimes it can make sense to give away your product for free (or subsidize them) because it could stimulate demand in an adjacent market you own that more than makes up for the subsidy.

Let me give you an example that you may not have thought of. Consider Abode's Portable Document Format (PDF) format, a standard used for universal document exchange. The PDF network consists of two sets of users - writers, who create documents using Adobe's Acrobat Distiller software that costs them $499, and readers, who view these documents using Abode's Acrobat Reader software that they can download for free. Writers, who greatly value the huge reader audience, are more than willing to pay a fee for their software. Adobe's subsidy of giving away the PDF reader for free is more than compensated by the higher demand in its writer software. Now here is an instance where giving away something for free makes sense!

Unlike the traditional markets, economics in the two-sided markets are more complicated. Dr. Alstyne prescribes a few factors to think about in order to make the network work correctly.

User Sensitivity to Price: Had Adobe started out charging even a small fee to the price sensitive reader group, the network would not have grown as big as it is today. Subsidize the group that is price sensitive ("subsidy side") and charge the side ("money side") that increases its demand more strongly in response to the other side's growth

User Sensitivity to Quality: Counter-intuitively, rather than charging the side that strongly demands quality, you charge the side that supplies quality. Think about the video game market. Gamers demand quality and game developers must incur huge fixed costs to deliver this quality. In order to amortize this cost, they must be ensured that the game console platform has many users. Hence the need to subsidize the gamers with a below cost subsidy.  Console providers ensure that game developers meet high quality standards by imposing strict licensing terms and high royalty rates. This "tax" is not passed to the consumers: the game developers charge the highest rates the gamers will bear, independent of the royalty rate. However, the royalty rate helps weed out games of marginal quality. Once the "tax" is added, titles with poor sales prospects cannot generate enough margin to cover their fixed costs, so they never get made in the first place. 

Ability to Capture Cross-Side Effects: Your giveaway will be wasted if your network's subsidy side can transact with a competitive network's money size. This was Netscape's mistake. Netscape gave away its browsers to individuals in hopes of selling Web servers to companies operating web sites. But web site operators didn't have to buy Netscape's servers in order to send web pages to Netscape's big browser user base; they could easily buy a rival's web server instead.

Output Costs: Don't subsidize the product when each unit has appreciable costs. If a strong willingness to pay from the money side does not materialize, a giveaway with high variable costs can quickly rack up large losses. FreePC learned this lesson in 1999 when it provided Compaq computers and internet access at no cost to consumers who agreed to view internet ads that could not be minimized or hidden. Not surprisingly, few marketers were eager to target consumers who were so cost conscious. The decision is much simpler when the product subsidized is a digital good such as a Google web search, where the marginal cost of serving an additional user web search costs Google nothing.

Value Added: Even though Apple's Mac platform always commanded a premium from consumers, Microsoft was a winner that essentially monopolized the desktop operating system market. Desktop customers were attracted to Microsoft's Windows operating system because of the large number of applications that were only Windows compatible. This came about partly due to Apple's missteps and partly Microsoft's foresight. When Mac was launched, Apple's grave error was to extract rent from the software developers who developed applications for the Mac operating system by charging them $10,000 for Mac's software development kit (SDK). In contrast, Microsoft was smart enough to give away the Windows' SDK for free. By the time Microsoft went to anti-trust trial, Windows had six times as many applications as Mac!

Interfering same-side effects: Sometimes it makes sense to exclude certain users from your network. For example, many auto part manufacturers, concerned about downward pricing pressure, refused to participate in Covisint, a B2B exchange organized by auto manufacturers. Covisint stalled, as did many B2B exchanges that failed to attract enough sellers. In the face of high negative same-side network effects, network providers should consider granting exclusive rights to single user in each transaction category - and in exchange extract high concession for this rent. The network provider must also ensure that sellers do not abuse their monopoly positions; otherwise, buyers will not be attracted to their platform. 

Marquee Providers: The participation of "marquee users" can be especially important for attracting participants to the other side of the network. A platform provider can accelerate growth if it can secure the exclusive participation of marquee users in the form of commitment from them not join rival platforms. For many years, this kind of exclusive arrangement was at the core of Visa's marketing campaigns - remember ads that said "...and they don't take American Express"

Microsoft learned the hard lesson of not to upset your platform's marquee customers when Electronic Arts (EA) - the largest developer of video games and thus a major potential money side user of Microsoft Xbox platform - refused to create online, multiplayer versions of its games for Xbox Live service. EA objected to Microsoft's refusal to share subscription fees from Xbox Live, among other issues. After an 18 month stalemate, EA finally agreed to offer Xbox Live games. Even though terms of the agreement weren't disclosed, you can bet that they were generously tilted in favor of EA.

Now that we understand the economics of two-sided markets, I'll describe Dr. Alstyne's application of these principles to the evolving business of newspapers in part II of this article to follow in the next few days. Your comments are always welcome. Feel free to email me at rgosalia at gmail dot com.

  • Information Business Models & The News: When Free Works and When it Doesn't, Marshall Van Alstyne, UC Berkeley Media Technology Summit 2009.
  • Strategies for Two-Sided Markets, Thomas Eisenmann, Geoffrey Parker, Marshall Van Alstyne, HBR

No comments:

Post a Comment