This post originally appeared on The Finance Buff.
This is the first of a two-post series on two-sided markets, a relatively new idea in the economic theory of markets (developed circa 2000). Two-sided market theory more realistically models certain types of markets. In such markets empirical evidence is often inconsistent with conventional (one-sided) market theory but can be shown to reflect rational firm behavior with a two-sided perspective. This post explains the term and related concepts. The second post will explore the extent to which the idea can be applied to the market for health insurance.
We begin with a bit of plausible fiction. Dude, the proprietor of the new nightclub Dude’s Club, charges men and women the same price (parity pricing) to enter his establishment. One day, in going over his records, he noticed something. On the rare nights for which the numbers of women and men attending were roughly equal, he made a tremendous profit in bar sales. But typically the number of women was far below the number of men and he lost money.
Being a profit-maximizing sort of guy, Dude decided to try to attract more women to his club so that the typical night became profitable. After experimenting with the level of entry fee, he had a winning idea: let women enter for free and charge men twice the original price. This generated a gender mix that was roughly equal. Unbeknownst to Dude, he had discovered that his was a two-sided market. (In his (quite accessible) 2004 Review of Network Economics paper titled “One-sided Logic in Two-sided Markets“, Julian Wright also uses the heterosexual nightclub market to explore concepts in two-sided markets. He then proceeds to apply the concepts to credit card schemes.)
A two-sided market is one in which the volume of transactions is sensitive to how the total transaction price is allocated between two distinct groups of market participants (see definition 1 of this paper by Rochet and Tirole). Dude discovered that the true nature of his business was to match one-for-one members of one group of market participants (men) with those of another (women). Further, he discovered that the number of matches (transactions) was sensitive to how the total transaction price (the total price for one match, i.e. the entry price for one man and one woman) was allocated across genders. Specifically, holding the total price of a match constant, if women’s price decreased while men’s price increased then more women showed up relative to men and matches increased as did his profit.
To understand the phenomenon more deeply, Dude conducted some market studies. Using his background in polling research and applied statistics, Dude conducted and analyzed exit interviews. He learned that men’s satisfaction with their Dude’s Club experience increased as the number of women in attendance increased (holding the number of men constant). Conversely, women’s satisfaction increased as the number of men in attendance decreased (holding the number of women constant). Since the number of men was never less than the number of women these conclusions were consistent with the idea that overall satisfaction (and Dude’s profit) was maximized when the number of men and women were equal. Apparently, satisfied nightclub attendees buy more booze.
That the satisfaction of individuals in one group (e.g. men) depends on the number of individuals in the other group (e.g. women) is an example of an inter-group network effect (or network externality). A network externality is a favorable or unfavorable outcome that is related to the total number of participants. That your broadband service is frustratingly slower if more users are online is another example of a network externality. This is an example of a same-group externality because we’re only speaking of one group, all broadband users. The “inter-group” nature of the externality discovered by Dude is that the externality operates between groups: men’s numbers affect women’s satisfaction and vice versa. (There are likely also same-group externalities at play at Dude’s Club but they’re not the focus here.)
It is the very existence of these inter-group network externalities at Dude’s Club that gave rise to the fact that transaction volume was sensitive to relative group pricing. In fact, the existence of inter-group externalities is another definition of a two-sided market (see, again, Rochet and Tirole, Section 5.1.4, p. 21). Relative to the old parity pricing system, if women pay less than men to enter Dude’s Club, they are both more willing to attend and have a better time. While men are relatively less likely to attend as their price increases, this effect is somewhat offset by the anticipation of greater satisfaction with a 50-50 gender mix experience. Dude effectively “priced away” the negative inter-group externalities caused by an imbalance between men and women.
Dude’s new pricing scheme puts him in the role as mediator of a subsidy. Men pay twice the old rate and cross-subsidize women who pay nothing. Two-sided markets often involve cross-subsidies but subsidization is not a necessary feature. Some obvious two-sided markets with subsidies include broadcast TV, newspapers, and Google services (ad revenue subsidizes viewers, readers, and users, respectively). Many other examples are found in this Rochet and Tirole paper. Not mentioned there are health insurance plans. In at least two non-obvious ways one can view the market for health insurance as a two-sided one. That will be the subject of the next post in this series.