DEFINING ANTITRUST MARKETS WHEN FIRMS OPERATE TWO-SIDED PLATFORMS

[Pages:34]A more recent version of this article has been accepted in: Columbia Business Law Review, 2005

DEFINING ANTITRUST MARKETS WHEN FIRMS OPERATE TWO-SIDED PLATFORMS

David S. Evans*

Michael Noel**

I. Introduction................................................................ 102 II. Economic Background on 2SPs ................................. 106

A. Exchanges ............................................................ 108 B. Advertising-Supported Media ............................. 109 C. Transaction Systems ........................................... 110 D. Software Platforms .............................................. 112 III. Economic Principles ................................................... 113 A. Pricing .................................................................. 114 B. Design Decisions.................................................. 117 C. Rules and Regulations......................................... 119 IV. Industrial Organization of Markets with 2SPs ........ 120 A. Determinants of Platform Size and Structure ... 120

1. Indirect Network Effects................................ 120 2. Economies and Diseconomies of Scale........... 121 3. Congestion and Search Optimization............ 122 4. Product Differentiation and Multihoming ... 123 B. Empirical Evidence on 2SP Industry Structure 124 V. The Analysis of Market Power .................................. 128 VI. Market Definition....................................................... 130 VII. Conclusion ............................................................... 134

*Vice Chairman, LECG Europe and Visiting Professor, Faculty of Laws, University College London. **Assistant Professor, Department of Economics, University of California, San Diego.

The authors thank Howard Chang, Andrei Hagiu, and Richard Schmalensee for valuable comments and Murtaza Akhter, Eri Budo, and Nese Nasif for exceptional research assistance.

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I. INTRODUCTION

Two-sided platforms (2SPs) cater to two or more distinct groups of customers. As we will explore, members of one customer group need members of the other group for a variety of reasons. The platform helps these customers get together in many ways and thereby creates value for these customers that they could not readily obtain without the coordination that the platform provides. The village market is one of the oldest examples of a 2SP. It is a place where buyers and sellers can get together and trade. A modern example is eBay. The village matchmaker is another old example. She tries to find marriage partners for men and women. A modern example is 8MinuteDating, which organizes speed dating events where men and women meet for short periods of time and decide whether they would like to see each other again.1 Today, 2SPs are the dominant form of business organization in a wide variety of industries, including many economically significant ones. Well-known examples are American Express (travelers' checks and charge cards), Google (search engine-based portal), the New York Stock Exchange (buyers and sellers), and Microsoft (software platforms).

Economists have shown that the economic principles that govern the diverse industries based on 2SPs differ from those that govern traditional industries in several important ways.2 First, profit-maximizing prices may require charging one side less than the marginal cost of serving that side. Empirical surveys of industries based on 2SPs find many examples of prices that are low or even negative so that customers on one side are incentivized to participate in the platform.3 Most malls do not make shoppers pay to enter,

1 8 Minute Dating, . 2 See, e.g, Jean-Charles Rochet & Jean Tirole, Platform Competition in Two-Sided Markets, 1 J. EUR. ECON. ASS'N, 990 (2003); Mark Armstrong, Competition in Two-Sided Markets (Indus. Org. Econ., Working Paper No. 0505009, 2005). 3 David S. Evans, The Antitrust Economics of Multi-Sided Platform Markets, 20 YALE J. ON REG. 325 (2003) [hereinafter Evans I]; David S.

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and they sometimes offer negative prices--through inducements such as free parking and entertainment--to subsidize shoppers' participation in the platform.4 More generally, 2SPs form systems in which there are feedback effects between the customer groups. Changes that affect the first customer group necessarily affect the second customer group and, in turn, affect the first customer group, and so on. For example, a recent effort in Australia to place a cap on the fees charged by credit card systems to merchants has resulted in an increase in annual fees (paid by consumers) for credit cards.5

Many antitrust cases have involved 2SPs. A few-- including several important ones--seem to have touched on two-sided issues before economists did.6 Notwithstanding whether the courts held correctly or not, their analyses of these markets and practices are not analytically correct in light of the recent 2SP literature.7 Table 1 presents an overview of antitrust cases in the European Community and the United States that concern 2SPs. We have not done a systematic review of cases, but rather have listed cases that have had high profiles in these jurisdictions and with which we are generally familiar. The cases span all of the major categories of 2SPs and involve the full spectrum of competition policy issues.

Table 1. Summary of Leading Cases by 2SP Type

Evans, Some Empirical Aspects of Multi-Sided Platform Industries, 2 REV. OF NETWORK ECON. 191 (2003) [hereinafter Evans II].

4 Evans I, supra note 3; Evans II, supra note 3. 5 See Howard H. Chang, et al., The Effect of Regulatory Intervention in Two-Sided Markets: An Assessment of Interchange-Fee Capping in Australia, REV. OF NETWORK ECON. (forthcoming), available at . 6 Nat'l Bancard Corp. v. Visa U.S.A., 779 F.2d 592, 602 (11th Cir. 1986); Times-Picayune Pub. Co. v. United States, 345 U.S. 594, 610 (1953); Joined Cases C-241/91 P & C-242/91 P ("Magill cases"), RTE & ITP v. Comm'n of the Eur. Cmtys. 1995 E.C.R. I-743. 7 Times-Picayune Pub. Co., 345 U.S. at 610; Nat'l Bancard Corp., 779 F.2d at 602.

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Media

Case Times Picayune

Magill

BT Yellow Pages

Lorain Journal

Sotheby'sChristies

Marsh McLennan

London Stock Exchange

Mobile operators

Case Type Monopolization

Refusal to supply

Monopolization Exclusive dealing Cartel

Cartel

Merger

Excessive Pricing

Software Platforms

Transaction Systems

Case

Case Type

NaBanco

Cartel

Wal-Mart

Tying

MicrosoftBrowser

MicrosoftMedia Player

Monopolization, Tying

Tying

Nintendo

Exclusivity

Exchanges

The antitrust issues that can arise for 2SPs are similar to those for traditional businesses. Members of these platforms can conspire to fix prices, to acquire market power through mergers, and attempt to obtain or to perpetuate monopoly power through the usual panoply of unilateral practices. However, the standard tools of analysis may need to be modified to fit these 2SP businesses. For example, there is no reason to presume for 2SPs that pricing below average variable cost indicates predatory pricing because such belowcost pricing is endemic to 2SPs regardless of competitive conditions.8 To take another example, in order to increase their profits through price fixing, competing 2SPs would have to fix prices to both customer groups. Otherwise they would shift the profits from customers on the side of lower,

8 Evans I, supra note 3, at 46-47; Rochet & Tirole, supra note 2, at 991; Julian Wright, One-Sided Logic in Two-Sided Markets, 3 REV. OF NETWORK ECON. 44, 44-64 (2004).

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fixed prices to customers on the other side, whose prices have not been fixed.9

This Article focuses on defining relevant markets and assessing market power when the subjects of the antitrust analysis include 2SPs. The fact that 2SPs compete simultaneously for two distinct customer groups has three ramifications. First, focusing on one dimension of this competition tends to distort the competition that actually exists among firms. An extreme case concerns heterosexual dating services. They compete for men and women customers, but it does not make sense to talk about separate markets for men and women. Second, market definition is supposed to identify the constraints on pricing and other business decisions. Changing the price for one set of customers affects the demand of the other set of customers, which in turn has a feedback effect on the demand from the first set of customers. The interdependencies between the two customer groups may provide an economically important constraint, yet this is ultimately an empirical issue. Third, the possibility of obtaining supracompetitive profits through certain business actions depends on the relationship between the two sides due to their interlinked demand and the nature of the competition on both sides. Profits on one side can be dissipated on the other side. That possibility affects the analysis of incentives and the sorts of anticompetitive practices that make business sense.

It is helpful to begin by clarifying a few terms that we will use throughout this Article and also to note some differences in how these terms are used occasionally in the literature. Many scholarly articles by economists refer to "two-sided markets." That term is sometimes applied to businesses that are 2SPs and sometimes to the markets in which they

9 For examples of price fixing allegations concerning 2SPs, see the

complaint in New York v. Marsh & McLennan Co., No. 04403342 (filed in

2004),

available

at

; Douglas

Frantz et al., Ex-Leaders of 2 Auction Giants Are Said to Initiate Price-

Fixing, N.Y. TIMES, Apr. 7, 2000, at A1.

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operate.10 Here, we use the term 2SP to refer to the entity-- the business, cooperative, standard, or government entity-- that provides a physical or virtual platform for distinct customer groups. 2SPs compete in what we will call 2SP industries. Thus, dating clubs are platforms that compete in the matchmaking industry. We try to avoid the term "twosided market" because the word "market" is a term of art for competition policy.

Although, for the most part, we will use the term "twosided platform," the reader should note that some platforms have more than two distinct groups of customers. Software platforms, such as Microsoft's Windows, have at least three: hardware manufacturers; application developers; and end users. 2SPs are a special case of nSPs where n>1. As most familiar platforms are two-sided, we stick with this case to simplify the exposition.

In the next section, we provide an introduction to 2SPs and discuss some of the most prominent examples. Section III reviews some basic economic principles about pricing and other decisions for 2SPs. Section IV then considers the factors that are important in determining the industrial organization of 2SPs. Next, Sections V and VI analyze market power and market definition for 2SPs and explain the issues that differ from the single-sided analysis. The final section offers our concluding thoughts.

II. ECONOMIC BACKGROUND ON 2SPS

A heterosexual singles-oriented club offers some intuition on the economics of 2SPs. A nightclub, such as Bungalow 8 in Manhattan, provides a platform where men and women can meet, interact, and search for potential dates. The club must have two groups of customers on board its platform to have a service to offer either one: it needs to get men and women to come. Moreover, the proportion of men and women matters. A singles club with few women will not

10 Rochet & Tirole, supra note 2, at 997 (citing to those papers for general discussion of two-sided markets).

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attract men, and a club with few men will not attract women. Pricing is one way to adjust the balance. The club might want to offer women a break if they are in short supply (through a lower price or free drinks). Or, it might want to ration the spots to ensure the appropriate number of women; popular clubs typically have queues waiting outside, and women are picked out of line disproportionately.

The dating club represents a platform according to the informal definition that we introduced at the start. There are two groups of customers: men and women. Members of each group value members of the other group, and the platform provides a way for them to get together.

Rochet and Tirole (2004) have proposed a formal definition11:

A market is two-sided if the platform can affect the volume of transactions by charging more to one side of the market and reducing the price paid by the other side by an equal amount; in other words, the price structure matters, and platforms must design it so as to bring both sides on board.12

In order to satisfy this definition, "the relationship between end-users must be fraught with residual externalities" that customers cannot sort out for themselves.13 That is clear in the case of the dating environment.

Men and women want the ability to search for dates among a large number of opposites. It is hard to conceive of a practical mechanism for women to reward men who come to a singles club but whom they ultimately reject. In the other 2SP industries we consider, it is difficult if not

11 Note that the word "market" above is being used in the loose manner that is the custom among economists.

12 Jean-Charles Rochet & Jean Tirole, Two-Sided Markets: An Overview 40 (IDEI-CEPR conference on Two-Sided Markets, Working Paper, 2004), available at .

13 As a result, a necessary condition for a market to be two-sided is that the Coase theorem does not apply to the transaction between the two sides. See id. at 13-14.

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impossible to imagine customers on one side of the platform making side payments to customers on the other side. As a result, the platform owner can institute a pricing structure to harness indirect network effects, and it is not feasible for customers to defeat this pricing structure through arbitrage.

It is helpful to distinguish four different types of 2SPs, although the boundaries between the types can be fuzzy: exchanges, advertiser-supported media, transaction devices, and software platforms.14

A. Exchanges

Exchanges have two groups of customers who can generally be considered "buyers" and "sellers."15 The exchange helps buyers and sellers search for feasible contracts--that is, where the buyer and seller could enter into a mutually advantageous trade and for the best prices. In these situations, the buyer pays as little as possible, and the seller receives as much as possible.16 It covers various matchmakers, such as dating services and employment agencies. It also covers traditional exchanges: auction houses; Internet sites for business-to-business, person-tobusiness, and person-to-person transactions; various kinds of brokers (insurance and real estate); and financial exchanges for bonds and equity. Finally, exchanges include a variety of

14 See David Evans et al., A Survey of the Economic Role of Software Platforms in Computer-Based Industries, INDUSTRIAL ORGANIZATION AND THE DIGITAL ECONOMY (G. Illing & M. Peitz eds., MIT Press) (forthcoming). In that paper, the authors refer to software platforms more generally as shared input facilities. Armstrong, supra note 2, uses the term "competitive bottlenecks" to refer to certain shared-input facilities. Although his discussion is analytically sound, his term is pejorative and has a meaning in competition law that differs from the one he assigns to it.

15 This Article will employ the terms "buyers" and "sellers" loosely. 16 Some securities exchanges, such as the New York Stock Exchange, also need to attract middlemen--specialists or market makers--who quote prices to both buyers and sellers and bring liquidity to the market. See FREDERIC S. MISHKIN & STANLEY G. EAKINS, FINANCIAL MARKETS AND INSTITUTIONS 17 (Addison-Wesley 2d ed. 1998).

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