Two-sided markets: why do they matter?
In a previous article we provided an introduction to what we believe is the template for future growth in telecoms: two-sided markets. Having got the basic facts laid out, now we can take a closer look at some of the consequences of moving from one-sided to two-sided markets.
Two-sided markets in a nutshell
A brief reminder of what we're talking about. In a one-sided market, merchants buy in equipment and services, taking on inventory risk. They combine them in some value-adding way, and sell the result on to end users (or other intermediaries in a value chain). The suppliers and customer do not interact directly. Most of telecoms works within a one-sided model today.
In a two-sided market, the middleman facilitates two groups on either side to interact with each other via some platform. This lowers transaction costs and builds scale. Critically, the price structure of using the platform is set to encourage participation from the most price-sensitive side, maximising platform revenues overall, rather than separately for the two groups. For example a newspaper typically charges a cover price well below that which would maximise reader revenue alone, because it needs a big audience to attract advertisers.
A good example of a company that moved from a one-sided to two-sided model is online bookie Betfair. Originally they only offered their own set of bets and odds online. They then allowed other bookies to offer bets in competition with one another, at which point Betfair's business took off very rapidly. (Another in-depth example on job sites is here.)
In telcoland, i-mode is an example of a two-sided market, joining application developers to users. Our hypothesis is that operators need to focus on developing capabilities and services that facilitate a much wider range of business processes than content retailing. In each case, 'upstream' parties wish to interact with the telecommunicating public in some way, and the telco takes friction out of this process. The data by-products of the current triple/quad play products are key enablers, along with assets in the 'edge' devices (handsets, home hubs, set top boxes, smart meters, etc).
Elephants are born big
The first observation we have about two-sided markets is that they always need scale. That means you need to kick-start the market in some way to make it attractive to your initial customers and users. Typically some kind of trend-setters or marquee users are used to pump prime the platform. For example, an upmarket shopping centre looking to attract both retailers and shoppers will want a John Lewis or Nordstrom as anchor tenant. Every music platform will wants the Universal Music Group catalogue. In telcos we see this effect with peering and interconnect sites, with large anchor tenants attracting the smaller players.
This leads us to conclude that telcos are better advised to try building new two-sided revenue streams off their existing core voice, messaging and broadband businesses. This contrasts with the current approach of building whole new propositions, particularly around entertainment media, from a base of zero. Ultimately a collection of transaction platforms -- for advertising, payments, and customer service -- will be converging from multiple industries, such as online search, e-commerce sites or banking. Better to compete off a strong base when engaging such powerful rivals.
Gasoline, girls and guys
It would be nice to think that users will appreciate your wonderful new entertainment products and gladly surrender some more money for value-added services. Sadly, they seem to have a budget in mind that they want to stick to, and you end up dissipating a lot of your profit in marketing expenses.
A more compelling proposition is through creating efficiency and cost savings in a broader range of industries. In particular, saving labour costs or energy are obvious targets. It is possible to create one-sided solutions for specific verticals, e.g. a fleet tracking solution using cellular location. However, we feel that a two-sided market offers a more defensible opportunity, which means business process services (e.g. advert targeting) that involve interacting with the mass retail customer base in some way.
This is not to disregard the traditional focus of telco platform efforts, which is to optimise the supply chain of purely digital applications and content to users. This is necessary, but ignores the wider opportunity, and the consequent chance of spreading the risk and cost of building the platform across a much larger range of revenue sources. It's the "analogue" world of people, trucks and raw resources where most of the economy still lives.
What do you know about the customer?
The 'upstream' party that wants to interact with the telco customer will have some data on that customer and their own relationship. However, this is likely to be significantly different from what the telco knows about the customer. The data assets of the telco, and the permission to use it derived from the customer relationship, are every bit as critical to optimising business processes as the ability to transmit data over distances via networks.
Where this data is most valuable is the 'real time' intelligence the telco can provide. Every time UPS delivers a yellow sticky 'sorry you were out' notice, instead of a parcel, resources are burnt to no productive end. The telco's role is to use customer information/data -- such as whether your mobile is associated with your home femtocell, if you're in the middle of a call, or are roaming abroad -- to help time interactions and facilitate transactions.
This is a common feature across two-sided markets: the more the middleman can help personalise the interaction, the more the platform can charge for its services. Operators need to reconsider how they manage such data assets, gather user consent, and extract value from them.
No bronze medals
Another property of two-sided markets is that they tend to follow 'winner-takes-all' economics, with a small number of dominant platforms: Windows and Mac OS; Visa, Mastercard and Amex; or Google and Yahoo!. In general, individual telcos will struggle to achieve scale in two-sided markets. The implication is that they will need to co-operate to either create clearing houses or hubs themselves, or work through existing aggregators or transaction networks (e.g. mBlox).
The goal for the platform must therefore be either to aim for general monopoly (in much the way the PSTN/PLMN voice network is the platform for all personal communications), or differentiate to dominate a niche.
The danger is that the telco is enveloped by other transaction and commerce platforms. A naive approach to exposing location, presence or other data could not only leave value on the table, but even worse have the telcos subservient to a small number of powerful external intermediaries.
A regulatory misfit
In competitive industries, and over the long run, prices reflect underlying costs. Competition will weed out inefficient players, making costs and prices converge.
Two-sided markets don't work this way, and this can cause serious regulatory and competition issues, as one-sided rules are applied to two-sided markets. The heart of the problem is the way the platform subsidises one side to get them 'on board' in order to more than make it up on the other side.
The classic case that's made its way through the courts in the EU's anti-trust action against interchange fees on the Mastercard network. What happens is that when you walk into a store and pay a merchant with your your credit card, the merchant's bank has to pay a fee to the bank that issued you the card. This fee doesn't reflect any specific operational cost being incurred. The contention of the EU was that this is anti-competitive and welfare-destroying. The reality is that it is necessary to 'bribe' the public with zero-fee cards, low introductory rates, cashback rewards etc. to adopt credit cards and use them. Without mass adoption, the cost of the interchange fee becomes moot, since merchants lose sales (as customers don't carry enough cash with them, or need credit the merchant doesn't offer), and costs rise (as you have to handle lots of cash).
We see the same dynamics in telecoms, with roaming and termination fees. These exhibit some of the properties of two-sided markets. Imagine there are two groups, businesswomen (who travel internationally) and househusbands (who don't). The high price of roaming could be seen as a 'tax' on the price-insensitive businesswomen, which can be used to subsidise pre-paid service for the househusbands, driving mutual benefit of service adoption. Likewise, calling-party-pays and high termination fees in Europe have driven adoption far higher than in the superficially more 'equitable' North American model.
Competition law concerns
These competition and regulatory issues will be a major battleground. You can charge more than cost, and it's not necessarily a sign of lack of platform competition. You can charge below cost, and it's not necessarily predatory. (You can read more on this in this academic paper.)
Indeed, even having competing platforms may end up dividing the market into two sub-scale platforms that ends up destroying value to all users. Whether platform predator or prey, it is common for a dominant platform to reach such scale that it starts to cause wider competition concern. We see this with Microsoft and Google, for example. But there may be no public welfare gain from breaking these platforms up or constraining the scope of their activities. Standard competition law doesn't apply here.
Where competition law does become more of an issue is where a successful platform adds on features and leverages its existing base to move into other areas. We've seen this with Microsoft (Windows plus browsers, media players and security suites), and it's an ongoing issue with companies like the BBC using distribution of public service broadcasting content to enter the pay-per-view market, much to the objection of commercial rival Sky.
Not a binary choice
You can have elements of both one- and two-sided business models, simultaneously. Wal-Mart acts as a retail platform (two-sided) as well as a traditional merchant that buys inventory at wholesale top resell (one-sided). The two-sided mode is favoured when the middleman can either eliminate uncertainty and risk for the upstream parties wishing to interact with the users, or has distribution economies of scale. The driver is a balance between inventory and risk of the one-sided merchant mode vs. the cost of affiliation to and use of the platform.
We see this in Blyk, which gives away a limited amount of free calling in return for receiving targeted adverts, but continues to charge for higher usage. Telco business models will be complex hybrids for the foreseeable future.
A pricing challenge
The pricing of platform services can be a tricky subject. The obvious question is how much to shift cost away from the price-sensitive side. You can't charge less than zero, but you can start to give away products and services (e.g. Google's search, mail, and other content sites). Where do you stop? Could all those service delivery platforms end up being used not to create new consumer value-added services, but instead to create the 'give away' services you can trade for customer data and permission?
There may also be a need for 'signalling' of commitment by one side or the other. Job sites for high-end positions can filter out under-qualified job applicants by charging to become a member. Normal dating sites typically charge both sexes, but adulterous men have to pay a huge premium to signal intent to wayward women. It remains to be seen how these kinds of exceptions might play out in identity, payment and content services offered by telcos, but collecting cash from people merely so they can signal intent sounds like a profitable proposition.
Finally, where you have competing platforms they typically need to follow opposite pricing models. So platform A charges end users and gives away service to the upstream parties, and platform B does the opposite. This lets them co-exist in two distinct segments, rather than over-dividing the pie.
A very different kind of business
As we've seen, two-sided markets require a very different way of thinking about telcos and their role in the economy. They have very different economics to most of today's telco products, and break the assumptions behind today's regulatory and competition rules. They require new skills, partners, channels and organisation structures. However, they also offer an escape route from the problems of today's one-sided telco business model, and since they principally re-sell data (packaged in special ways), they don't require masses of capex to implement and are often highly profitable.
For more information on the opportunity for telcos to build two-sided market business models, see our report The 2-Sided Telecoms Market Opportunity