Two-sided markets are economic platforms having two distinct user groups that provide each other with network benefits. Example markets include credit cards (the issuing bank being the platform or intermediary between its cardholders and merchants) and yellow pages (mediating between advertisers and consumers).
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.
The distinguishing characteristic of the two-sided market is that the price structure is not neutral. Due to the presence of indirect network effects the structure of pricing will affect the extent of participation and usage in the market.
The allocation of the prices paid by the two parties to the transaction affects the sum of their respective benefits. Figure 1 below shows pricing without taking network effects into account.
Figure 1: Pricing ignoring network effects
Adobe initially used the approach above when it launched PDF and charged for both reader and writer software. But, demand curves are not fixed: with positive network effects, demand curves shift outward in response to growth in the user base on the network's other side. When Adobe gave consumers a free reader, this created demand for the document writer, the network's "money side", as shown in Figure 2.
Figure 2: Pricing for network effects
In Figure 2, so long as the revenue gained (red area) exceeds the revenue lost (dark blue box), a discounting strategy is profitable.
Two-sided network externality coupling is not traditional second-degree price discrimination. It differs from tying razors and blades because one market need never consume the service provided in the other market. It also differs from penetration pricing in which a good is subsidized initially on expectation of future exploitation. In both these cases, a single consumer internalises his own value calculation such that price changes affecting one matched item are reflected in willingness to pay for the other. This property fails for two-sided network markets. For example, consumers of a portable document reader may never buy the portable document creator.
The fact that it is the price structure that matters in a two-sided market, rather than the price level, has profound implications for regulation. In particular, pricing on either side of the market will not necessarily bear any relationship to marginal cost on each side of the market.
Firms in competitive two-sided markets do not set prices to maximise profits on each side of the market. Rather, the price structure and joint price level is set in order to reap the maximum benefit from the indirect network effects available on both sides of the market. When there are changes in price structure (allocation of total price), revenues cannot be allocated to either side of the market. Nor can there be any allocation of costs. Any change in price structure will impact on the number of transactions or the degree of usage from which each side jointly benefits.
Parker, Geoffrey and Van Alstyne, Marshall W.,Two-Sided Netowrk Effects: A Theory of Information Product Design, Management Science, Vol, 51, No. 10, pp. 1494–1504, 2005 http://ssrn.com/abstract=1177443
Stephen Esselaar and Keith Weeks, “The case for the regulation of call termination in South Africa: an Economic Evaluation”, Wikipedia http://en.wikipedia.org/wiki/Two-sided_market
Mark Armstrong (2006). "Competition in two-sided markets"