In honour of Jean Tirole, just announced as the Economics Nobel Laureate for this year, here is the introduction to my Masters Thesis from Spring 2008, which focused on his exploration of the theory of two-sided markets. This concept would come to dominate his research and ultimately lead to his Nobel prize win today.
A group of men are out on the town, looking for a place to go for the night. They come across two identical nightclubs, on different sides of the street. On the left side of the street, the entrance price is €3. On the right hand side, the entrance price is €5 for men, while women enter for free. Without hesitation, the group of men enter the bar on the right hand side and pay their €5.
From a traditional economic point of view, this choice is irrational. The nightclubs are identical, and therefore utility will be maximised by choosing the cheapest option. This analysis however would be to ignore the intent of the men completely. They are not looking for a nightclub at all- they want to meet women. The nightclub is simply a meeting place with little intrinsic value but as a designated area where men and women can meet each other in a relaxed environment. By charging women less, the nightclub on the right will attract more women and crucially- more men.
This nightclub example is the most accessible and used exposition of the notion of Two Sided Markets, an increasingly explored area in theoretical economics. A two sided market is said to exist if two different types of consumers interact over a common platform. This is easily applied to the opening example- men and women interact in the platform of the nightclub. This definition however is too broad. With creativity, the definition could be applied to almost all markets. For example, employees of a sausage factory could be said to interact with the end consumer over the platform of the sausage firm. Equally it could be said that politicians and voters interact over the platform of the state.
Blanchard and Tirole (2006) define a market as two sided if the platform can affect the volume of transactions by charging one side differently. Using our opening example, we can see that the nightclub on the right can attract more women by charging no entry fee. If men were not charged entry fee also, this could negatively affect the number of women, as the nightclub could be seen as lacking quality. This leads on to a further definition of two sided markets, which is that efficiency can actually be improved by charging one side of the market differently.
The world is full of other examples of two sided markets which discriminate against one side. Shopping malls charge a lease on storeowners, while shoppers can walk around the premises for no charge. Credit card companies charge higher interchange fees to banks in order to offer ‘no annual fee’ contracts to credit card holders. The key point is that even though one side is discriminated against, very often both sides are happy with the arrangement. Men want more women in the nightclub, and see the pricing system as an aid to this goal. Shopkeepers would see a severe drop in business if shoppers were required to pay an entry fee to visit the mall. Banks gain revenue from credit card use, and therefore any incentive created to increase usage would benefit them also.
The analysis of two sided markets is an emerging discipline in economics, with its uses and relevance still to be defined. The research that has been developed so far concentrates on the mishandling of two sided markets by national Competition Authorities when investigating anti-competitive claims in the sector. In these institutions, traditional economic analysis is held as law. It is easy to see how the analysis two sided markets could be misinterpreted in this way. What the nightclub on the right hand side is doing is blatant price discrimination.
To stop the investigation there and impose a fine would be erroneous however, as it would ignore the reason for the price discrimination, and ultimately lead to a suboptimal welfare allocation, where neither side of the market is satisfied, and therefore the platform suffers also.
The focus of this Master Thesis is on this problem, albeit with a focus on the media sector, an industry that is of particular interest to two-sided market theorists. The media industry exhibits a wide degree of examples of two sided markets. There are newspapers that charge a cover price while also charging spot rates to advertisers, while there are also newspapers with no cover price to the end consumer at all. The same goes with pay TV versus Free TV. Also the two sided market model exists in both the old economy of newspapers and magazines as well as the new economy of social networking sites and other Web 2.0 platforms.
Following this introduction, Chapter 2 is a literature review of two sided markets, with an emphasis on practical application in the media sector. Chapter 3 presents a number of processed media cases taken from different Competition Authorities. Chapter 4 offers a critique of these decisions based on the two sided market intuition developed in Chapter 2. This is followed by a conclusion detailing the competence of these Competition Authorities in analysing cases which exhibit characteristics of two sided markets.