Platform Economics and What It Means for Litigation, Investigations, and Regulation

A multisided platform is a physical or virtual place at which participants can enter into beneficial exchanges, which the platform facilitates by helping participants find good matches and consummating an interaction. The participants form a community that has come together in the same place—the physical or virtual platform—for a common purpose: the subject of the beneficial interaction. To understand the basic economics of these businesses, consider platforms with two types of participants.

Two-sided platforms enable members of the two distinct types of participants to enter into beneficial interactions with each other, often involving exchange. Of course, two members of distinct groups could just meet and agree to interact. The platform, however, reduces the transaction costs, or frictions, between the two parties, thereby making it easier for parties to find each other and consummate a beneficial interaction.

For example, when OpenTable, the pioneering restaurant-reservation platform, started out in 1998, restaurants often had someone to answer the phone to take reservations, which were then written down in a book. Diners sometimes had to call several restaurants to find a table on a particularly busy night. Many tables went empty, and people went without reservations, because it was inefficient for diners and restaurants to make suitable matches. OpenTable reduced the transaction costs in making reservations for diners and restaurants. The diners saved time and had more choices, while the restaurants earned more profit from filling unused capacity.

Two-sided platforms have indirect network effects for at least one type of participant. An “indirect network effect” refers to a situation in which participants on one side of the platform (such as drivers on a ridesharing platform) value having more participants on the other side of the platform (such as passengers on a ridesharing platform) with whom they can have a mutually beneficial interaction (transport, for example).

Indirect network effects arise because, with more potential partners on the other side, there is a higher probability of finding a partner for a better value-increasing exchange. A passenger is more likely to find a driver and get picked up more quickly if more drivers are around. Indirect network effects refer to increasing the pool of relevant partners for each type of user (drivers near your home) and not the sheer number of participants in the platform (drivers in the whole metropolitan area).

Indirect network effects result in a positive feedback loop between the two sides. When more relevant members of one group (such as restaurants) join the platform, the platform becomes more valuable to the other group (such as diners), which leads more members of that group to join. Then the platform becomes even more valuable to the first group (the restaurants), leading even more of them to join. These positive feedback loops, which are sometimes referred to as the virtuous circle, drive the dynamics of platform businesses.

Studies of two-sided platforms typically find that managing these indirect network effects, and the resulting positive feedback loop, is a central part of starting and running their business. When a platform starts out, for example, it cannot provide a valuable service to members of either group unless it has members of both groups on board. This results in the “chicken-and-egg problem” for platform startups. A platform needs to figure out how to get enough of both types of participants to join. As they mature, platforms must balance the interests of both groups because business decisions that affect the value of one group in using the platform also affect the value of the other group.

The prices that different types of users pay for platform services are interrelated because of these feedback loops. Platforms have to select prices that balance the participation of each group against the profits from that group. A higher price for one group reduces the demand by that group, which makes the platform less valuable to the other group. The platform therefore has to juggle prices to find ones that maximize its profits, taking into account price and demand on both sides of the platform. The economic theory of two-sided platforms shows that the price charged to either group does not necessarily track the costs of serving that group, and this feature sets them apart from single-sided businesses. Ad-supported media platforms often provide their content at less than marginal cost, and some, including most digital platforms, do so for free.

Modern platforms, including digital ones, start by identifying frictions that prevent mutually beneficial interactions. They reduce those frictions by figuring out ways to agglomerate participants onto a platform. To do so, they try to persuade one type of participant that they will have more beneficial interactions with other participants if they join the platform. They use prices, sometimes including subsidies, to get more of each type of participants on board. They also employ methods such as search, matching, and payments to increase the expected value of the interactions for participants. Each participant who joins the platform as a result of these price and non-price strategies generates a positive externality for other members, which is the source of the indirect network effects. In effect, the two-sided business partly internalizes positive externalities by devising mechanisms to give people incentives to generate these externalities; the platform then makes money by taking a share of the increased value they create.

Businesses that account for an increasing part of the economy—particularly those resulting from the digital transformation—are platforms. When litigation, or other disputes, involves these businesses, it is often important, if not essential, to apply platform economics to study the merits. The Supreme Court affirmed this necessity in its seminal antitrust decision in American Express. Today, platform economics is part of the toolkit that economists apply when it comes to issues such as market definition in antitrust cases, the application of labor laws to gig economy firms, the calculation of damages in class actions involving platform participants, and the assessment of whether platforms are bottlenecks for market participants for regulation. As the digital economy expands the use of this specialized toolkit in litigation, investigations and regulation will grow. Lawyers, economists, and regulators all will need to know the new economics of multisided platforms.

 

For an introduction the multisided platforms and their role in the digital economy, see David S. Evans and Richard Schmalensee, Matchmakers: The New Economics of Multisided Platforms, Harvard Business School Press (2016).

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