In recent years, a significant role is given to the competitive regulations and competition law implementations to allow the full establishment of the competition in the market. The condition of the success of these arrangements and practices is the analysis of the markets fully and effectively.
In this context, two-sided markets are special kind of markets where two different customer groups that are dependent on each other’s demands are brought together by a mediator through being charged on platforms and the point of view towards these markets must be varied from the other markets. The presence of the network effects in two-sided markets has caused an approach to these markets as if they were monopoly or concentrated. Variation of the pricing strategy according to the indirect network externalities, structure of the demand flexibilities constitutes an important basis for this point of view. However, it should be known that analyzing these markets accurately and efficiently is not possible by isolating one side of the market from the other side because an application in one side of the market contributes to the presence and the benefit of the other party.
Two-sided markets differ from competitive and anti-competitive markets because of the demand relationship between customer groups, presence of intermediaries and their platforms, pricing conditions and network effects. In this study, the structural characteristics of two-sided these markets will be included after defining these markets, the rationale of the pricing policies in the market will be focused. Lastly, information about payment card systems which are one of the best-known examples of two-sided markets will be provided, the interchange fees which have been discussed very much in this market will be addressed.
Definition of Two-Sided Markets
In general, two-sided markets can be defined as markets with two different customer groups that have demands associated with each other and where one of the groups obtain positive external benefits as a result of the other group’s action due to this relationship (Veljonovski, 2006, p.34). The connection of the demands of the customer groups to each other can be interpreted not only by looking at the characteristics of the goods and services of the customers but also conferring the value to that good and service by reviewing the number of the customer groups. In two-sided markets, there are one or more mediators who ensure the interaction between these two groups by bringing these two different together customer groups. The mediator, charges both customer groups separately when ensuring this interaction (Rochet and Tirole, 2004, p.1).
Among one of the most well-known examples of two-sided markets are; video game platforms that aim to bring players and game developers together, software producers that aim to bring users and application developers, newspapers that aim to bring advertisers and readers together and card-based payment systems that aim to bring businesses and consumers together. The two main points that two-sided market theory is based on are the network externalities and the multi-product pricing. This means that there are externalities which haven’t internalized among end users and the pricing structure is remarkable rather than the price level in these markets (Rochet and Tirole, 2004, pp.1-2).
What is the Platform?
One of the concepts that should be addressed on two-sided markets is the concept of platform. Without any doubts, it is not possible to reach an agreement by directly coming together for customer groups that are in two different sides of the market. First of all, the transaction costs would be too high for such an agreement. In addition, the free rider problem is likely to be encountered with. That’s why any third group can ensure making agreements that will internalize the network externalities that exist between these groups by mediating. The place or the area where the intermediary establishes while doing so is called the platform (Veljonovski, 2006, p.35).
In the table there are examples of two-sided markets, the parties that form the market and the platform providers who mediate these parties to come together:
In all of these examples, the mediator group helps the realization of processes between customer groups and these platform providers can be reviewed in different categories:
The intermediary in this type of platform provides the agreement of two different customer groups by bringing them together by selling transaction. This type of brokerage trading platform available on the market agreements by provides. The buyers and sellers create these two different customer groups. Auction houses and eBay can be shown as an example of the type of platform (Veljonovski, 2006, p.36).
Audience (Target Market) Constructor Platforms
These platforms bring consumers with advertisers by selling message intended for the target group of customers. Television channels, newspapers and magazines are the best known examples of this type of platform. In these platforms that can be defined as media industries, advertisers are sellers and audience and readers are buyers. While the advertisers want to advertise on the most widely read newspapers and magazines or the most watched television channels in order to achieve their objectives more easily, the buyer group who is interested the content of the advertisement, will be directed to magazines, the newspapers or television channels with a wider range of advertisement (Evans, 2002, p15).
Demand Coordinating Platforms
Demand coordinating platforms do not get different customer groups together by selling transaction or message. These kinds of platforms coordinate the demands of different customer groups through indirect network externalities. The most typical example of these platforms are the computer operating systems that coordinate the demands of the hardware, software manufacturers and computer users (Veljonovski, 2006, pp.36-37).
Externalities in Two-Sided Markets
In two-sided markets, the presence of two different groups of customer cause that the externalities in these markets are seen in a variety of ways.
Firstly, the existence of externalities in the membership that seems as the participation of more consumers in the same platform due to the increase in the number of people on the platform can be mentioned. Membership externalities are positive in general and can be identified as classic network externalities. Websites like Facebook and Twitter are examples of this kind of externalities. Another type of externality in two-sided markets is the usage externalities that occur as a result of the interactions in between two different customer groups due to the usage decision. Usage externalities vary since the usage decisions depend on the cost that is decided for the usage by the platform. For example, the only way that the merchant benefits more from the card-based payment systems is that the consumers use the credit cards more than cash for purchases (Rochet and Tirole, 2008, p.544; Cortade, 2006, p.19).
As mentioned before, the main point that the two-sided markets are based on is that it contains positive network externalities. In the positive network externalities; the benefit of consumers in a specific market increases with the number of consumers buying that goods and services in that market. The effects created by the network externalities are not just about the impacts that arise directly. The main economic characteristic of two-sided markets is the existence of indirect network externalities in these markets. Indirect means that these effects of this network take place via complementary components. Accordingly, the benefit of the consumers in the presence of indirect network externalities does not depend on the number of consumers in the same side of the market but the increase in the demand for complementary goods by the consumers in the other side of the market. In two-sided markets where the indirect network effects are seen, the rising demand for the A product will cause an increase in the demand for a product which is complementary and as a result there will be an increase in the value attributed to A product. This is also seen as a positive feedback mechanism. Hardware and software platforms can be given as example for the two-sided markets where indirect network externalities are observed (Evans, 2002, p.32; Roson, 2005, p.144).
Pricing in Two-Sided Markets
In two-sided markets, the most important factor affecting the success of the market is the pricing policy. Pricing in these markets is more difficult than in one-sided markets since determination of the optimal price structure is equally important in addition to the determination of the optimal price level (Choi, 2007, p.2).
Pricing policies in two-sided markets is an issue that attracts attention in the economic literature and there are many studies made on this subject. The common point of all this work, the consideration is not only the demands of customer groups for goods and services or the costs of these goods and services while pricing in two-sided markets. In the price determination it must be known that the two sides of the market is related with each other in terms of price and demand. Because what decides the profit that the platform will obtain is that participation in one side of the market positively effects the participation to the other side (Rysman, 2009, p.49).
In general, the pricing type in two-sided markets is asymmetric pricing. The underlying principle of asymmetric pricing rationality in two-sided markets is the lower pricing of the mentioned side as a result of benefit provided by the increase of demand in one side of the market. In other words, one side of the market significantly pays less compared to the other side (Evans, 2002, p.40; Schiff, 2007, p.21).
The intricacies of this kind in two-sided markets cause that regulation policies for these markets contain intricacies. In a simple one-sided market, the only thing that the regulatory authority has to do to be able to maximize the welfare of society is to equalize the marginal cost to the price. The way to follow by the regulator in order to do this is to have full knowledge of the costs of the firms. However, this is not sufficient for two-sided markets. First of all, it is impossible to equalize the prices in both sides of the market to the marginal cost due to the asymmetric structure of the pricing. Therefore, as well as the cost structure of the regulator, it should know the demands of the sides in the market (Schiff, 2007, pp.21-22).
Pricing Strategies in Two-Sided Markets
Elasticity of Demand
The elasticity of demand is a measure of the degree of the sensitivity of consumers towards the changes in price. One of the most important factors that determine the pricing strategy in two-sided markets is the elasticity of demand because in two-sided markets, the platform providers can expand the scale of the platform with their pricing based on the elasticity of demand. Accordingly, the side with more elasticity of demand accesses the goods and services at a lower price so that it creates the maximum benefit in the other side. Maximum benefit means that provision of more contribution of the side that is charged lower increases the value of the other side. The reason for this effect is created by the side that pays less is the positive network externality. While increase in the elasticity of demand of the side in the market lowers the price, decrease in the elasticity of demand increases the price (Bolt and Tieman, 2005, p.1).
Indirect Network Externalities
Another determinant of pricing policy in two-sided markets is indirect network externalities. In two-sided markets, the party that takes advantage of indirect network effects more, pays more. For example, in yellow pages case readers can access other useful information, even if there is no advertising. But, advertisers cannot gain benefit in the absence of reader (Gündüz, 2009, p.16).
Platform Competition and Multi-Homing
The existence of a competitive platform in two-sided markets has significant consequences on the price level. Realization of the prices at a lower level in a competitive market compared to the non-competitive markets such as natural monopoly is a generally accepted rule in economics because firms in a competitive market price will avoid of increasing the price (Weyl, 2006, p.8-9).
In two-sided markets it is accepted that the competition reduces the level of price in the same way. But in this case the price range in sides is more important than the price level in two-sided markets. Because, even if the platform lead to a decline in the general level of competitive prices, in order the market to be successful, the competition in both sides of the market must be fully provided.
If there is a more intense competition in one side of the market compared to the other side, the price distribution deteriorates against the competitive side with less price range. As a result it is not clear that the competition of the platform will lead to effective price structure (Rochet and Tirole, 2008, p.550; Weyl, 2006,p.15).
Two-Sided Markets In Terms Of Competition
When the two-sided markets are subjected to an analysis in terms of competition and competition law, at first glance, it can be said that these markets include non-competitive practices. The reason of this is that single-sided approach is shown for two-sided markets. However, if these markets will be full analyzed, it is seen that these non-competitive practices are based on the competitive rationale (Veljonovski, 2006, p.37).
One of the fundamental economic characteristics of two-sided markets is the interdependence between the demands of different customer groups. Platform providers use this dependence to stimulate the total demand in the market. In doing so, they subject the customer groups on the market to different prices. The belief that the price discrimination practices reduce the competitive pressures is not realistic. In fact, what the competition is expected is not to eliminate the differences in price levels but to reduce the general level of prices (Veljonovski, 2006, p.37).
Predatory or Excessive Pricing
Predatory pricing is that a firm in dominant position in the market reduces the prices up to a point that it will lose in order to eliminate potential or actual competitors and prevent new firms from entering the market in this way. Since the predatory pricing restricts access to the market and causes the firm that adopts this pricing strategy to become the dominant force in the market it eliminates the competitive pressures (Evans, 2002, p.82).
Since the basic function of two-sided markets is to bring both sides of the market together, determination of the price as even lower than the marginal cost may be an optimal choice. Because in the two-sided markets, reflecting the costs to the customer groups that exist in the market is contrary to the nature of the market (Fletcher, 2007, p.221).
As a result of having a current pricing that is below the costs in one side of the market, a price much higher than the costs can be seen in the other side of the market. This situation is explained as excessive pricing in the theory. If the competition authority approaches to these parties separately, it may concluded that there is predatory pricing in one side of the market and excessive pricing in the other side. However, application of cross-subsidies that is in question here cannot be seen as a monopolistic behavior. Even if the profit that the platform has obtained as a result of the one-sided approach is at a competitive level, the existence of predatory or excessive pricing can be mentioned (OECD, 2009, p.13).
High Price-Cost Margins
As mentioned before, one of the most important factors determining the pricing policy in the two-sided markets is the sensibility of the sides in the market towards the changes in price. As a result that the side with less elasticity of demand makes higher pricing, observation of very high price-cost margins is natural (OECD, 2009, p.13).
To describe the high price-cost margins in one side of the market as market power, these rates must be valid for the other side of the market. However, the presence of a customer group in the other side of the market with high elasticity of demand causes a low price-cost margin. Here, necessity of analyzing the two sides of the market together gains importance(Schiff, 2007, p.22).
Payment Card Systems
In each transaction made a€‹a€‹with the card in two-sided markets, the card owners and business owner form the sides of the market. The way to detect the network effects is to ensure adequate participation in both sides of the market. Card holders will choose to be included in the platform only if the cards they use are accepted by a large group of operators and business owners will choose to be included in the platform if the customers use the card instead of cash when making payment. Upon the participation of the business owners and card holders, the membership and the user externalities will be internalized (Rochet and Tirole, 2008, p.572).
Payment cards are divided into two groups depending on the number of the groups in the card processing as with three party schemes and four party schemes:
Four Party Schemes
This kind of payment card systems is also known as an open payment card systems. Payment systems where two institutions such as the accepting bank such as Visa and MasterCard and the issuer bank act as intermediaries and where multiple banks are member of the network can be shown as examples for the systems with four scheme. The four groups in the payment system consist of the card holder, the business owner, the issuer bank and the accepting bank. The issuer bank means the bank that issues the card for use by the card holder in his transactions. The acquiring bank is the bank that places the POS device in businesses. A variety of payment flows is carried out between the four groups that form this system. Firstly, the card holder is responsible of the annual card fee payment type. In addition, if the card holder uses his card as a means of unsecured credit, he will have to pay interest as well as the annual card fee. Merchants pay for the services offered by the acquiring bank. Lastly, there is an interchange fee that the acquiring bank pays to the issuer bank (Veljonovski, 2006, p.40).
Three Party Schemes
Payment systems with three party schemes such as American Express and Diners Club are known as closed systems due to having a single mediator that carries out card issuance and acquiring. Intermediary organizations can directly contact with merchants and cardholders. Presence of a single intermediary organization limits the bank with two tasks such as marketing and distribution. No interchange fee is in question due to that the issuer and accepting banks are the same (Veljonovski, 2006, p.40).
Interchange fees consist of the payments made a€‹a€‹to the issuer bank by the acquiring bank. For example, as a result of the use of MasterCard by a consumer in his shopping, the acquiring bank that placed the POS device in the business is obliged to pay interchange fee to the issuer bank of the card holder. Card organizations with open system cannot directly determine the fees that will be received from the sides as in closed systems. Because there are multiple banks which are members of this system and these banks come together and determine the interchange fees together (Lerner et al, 2006, p.572).
Interchange fee is a payment affecting both merchants and consumers, particularly the acquiring bank because the exchange fee is of one of the highest cost items of the acquiring bank. The acquiring bank directly transfers these costs to merchant as merchant service fee. Merchants prices their goods and services at a higher level and pass a portion of their costs to the consumers. The interchange rates determined by the banks which are members of the payment systems with four party schemes show a very similar effect with horizontal agreements. As a result of this situation, the exchange rate has been exposed to criticism and complaints of many customer groups. According to the merchants, the interchange fee is an unfair payment and has a negative impact for consumers since it is reflected in the prices of goods and services. The interchange fee is defined as an unjust tax by a sector. Jointly determination of the interchange rate by the member banks forms a basis for the opinion that this fee is well above the competitive level. Interchange fee has formed the subject of monopoly lawsuits in many parts of the world and it has been even the regulatory justification of the government (Lerner et al, 2006, p.573).
Two-Sided Market Approach To Interchange Fees
Interchange fee is the one of the issues that should be considered differently in two-sided market theory. On the contrary of many competition authorities’ approach, interchange fees are not cartel agreement for determining the price aimed profit maximization. Because a price-fixing cartel restricts output in order to raise prices. As a result of this situation some consumers will deprive of the product and there will be a reduction in social welfare. Termination of the cartel will lead to a decrease in prices and an increase in output. But termination of four party schemes will lead to damage to both sides of market (Lerner et al, 2006, p.613; Muris, 2005, pp.15-16).
There is an opinion that the interchange commission stabilizes the demand. According to this, in order to increase the participation in the platform, facilities such has installment shopping, bonuses and delay in installments are offered to the card holders. The costs of caused by these facilities are reflected in the customer group that causes less network externality and with a low elasticity of demand due to the nature of the two-sided markets. These costs passed to one side of the market are compensated by the sales revenues increased as a result of the expansion of the scale of the platform (Muris, 2005, p.12).
Turkish Competition Authority to the Interchange Fees
Despite considering the exchange fee as an infringement, the Competition Authority did not opt for the complete prohibition with the reason that it acts as an intermediary in providing the interaction in both sides of the market. Instead, it has set the determination of an interchange rate by the industries that have not sufficient maturity and competence such as debit card yet of which at least they can bear the cost. However, it stipulated the removal of some cost items from the calculation items to prevent this application from producing excessive load on the merchants and consumers who do not use card (Gündüz, 2009, p.59).
Two-sided markets should be analyzed in detail in terms of competition since the structure of these markets is very complex. These complexities arise from interrelated demand between two sides and indirect network externalities. The way of internalizing indirect network externalities is getting two different customer groups on board via intermediaries.
Interrelated demand structure and network externalities affect pricing decisions. The price paid by parties is determined through network effects that are created by sides and demand elasticity of customer groups. In two-sided markets; the side that have higher elasticity of demand generates more network effects on the other side and as a result of this charges lower than the other side.
Competition authorities may detect two- sided markets anti-competitive due to their price structures. The reason of this is that single-sided approach is shown for two-sided markets. Instead of this both sides of the market should be considered together and interdependently.