Strategies for Two- Sided Markets

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A R T I C L E

Strategies for Two-

Sided Markets

by Thomas Eisenmann, Geoffrey Parker, and

Marshall W. Van Alstyne

Included with this full-text

Harvard Business Review

article:

The Idea in Brief—the core idea

The Idea in Practice—putting the idea to work

Article Summary

Strategies for Two-Sided Markets

A list of related materials, with annotations to guide further

exploration of the article’s ideas and applications

Further Reading

Product 1463

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Strategies for Two-Sided Markets

page 1

The Idea in Brief The Idea in Practice

If you listed the blockbuster offerings that

have redefined the global business land-

scape, you’d find that many tie together two

distinct groups of users. HMOs, for instance,

link patients to health-care providers. Search

engines join Web surfers and advertisers.

When successful, these

platforms

catalyze a

virtuous cycle: More demand from one user

group spurs more from the other. For exam-

ple, the more video games developers (one

user group) create for the Microsoft X-Box

platform, the more players (the other user

group) snap up the latest X-Box. Meanwhile,

the more players who use X-Box, the more

developers willing to pay Microsoft a licens-

ing fee to produce new games. And as user

bases grow, margins fatten.

But as Eisenmann, Parker, and Van Alstyne

contend, managing platforms is tricky:

Strategies that make traditional offerings

successful won’t work in these two-sided

markets. To capture the advantages that

platforms promise, you must address three

strategic challenges.

The key challenge? Get pricing right: “Subsi-

dize” one user group while charging the

other a premium for access to the subsi-

dized group. Adobe’s Acrobat PDF market

comprises document readers and writers.

Readers pay nothing for Acrobat software.

Document producers, who prize this 500-

million-strong audience, pay $299.

If you seize a platform opportunity but

don’t get it right the first time, someone

else will. By mastering platforms’ unique

strategic challenges, you’ll gain a head start

over your competition.

To ensure your platform’s success:

GET PRICING RIGHT

Consider these pricing strategies:

•

Subsidize quality- and price-sensitive us-

ers.

For example, if PDF document

readers

were charged even a tiny amount, Adobe

Acrobat Reader’s immense user base would

be much smaller, reducing document

pro-

ducers’

interest and their willingness to pay

a premium for access to readers. Readers,

much more price sensitive than document

producers, wouldn’t pay for access to a big-

ger base of writers.

•

Secure “marquee” users’ exclusive partici-

pation in your platform.

Providing incen-

tives for marquee users (for instance, an-

chor stores in a mall) to participate

exclusively in your platform (the mall) can

attract more users from the other user

group (retailers who lease space in malls

with prestigious anchor stores). Result? Your

platform’s growth accelerates.

COPE WITH WINNER-TAKE-ALL

COMPETITION

The prospect of fat margins in two-sided mar-

kets can fuel an intense desire among rivals to

become the

only

platform provider. To deal

with the competition:

•

Decide whether the two-sided market

you’re eyeing will eventually be served by

a single platform.

The answer’s “Yes” if

using more than one comparable platform

would be costly to users and if special fea-

tures don’t increase value to users.

Example:

The DVD industry meets these criteria:

Owning multiple DVD players would be ex-

pensive for consumers; providing multiple

formats, costly for movie studios. And DVD

players don’t lend themselves to distinctive

features, since they connect to TV sets that

would negate any DVD player’s unique pic-

ture and sound capabilities.

•

Decide whether to share the single plat-

form or fight for proprietary control.

Shar-

ing has benefits: Total market size expands

and rivalry lessens, reducing market outlays.

That’s why DVD industry contenders opted

to pool their technologies. They jointly cre-

ated the DVD format in 1995, avoiding a re-

play of the costly video players’ VHS-Beta

standards clash.

Want to fight for proprietary control? You’ll

need deep pockets, a reputation for past

prowess, and preexisting relationships with

prospective users. When launching Acrobat,

for instance, Adobe marketed to its existing

user base for PostScript printing products.

AVOID ENVELOPMENT

Many platforms have overlapping user

groups, tempting some related platform pro-

viders to swallow others’ users. Mobile

phones, for instance, now incorporate music

and video players, PCs, and credit cards. To

avoid being swallowed, consider changing

your business model.

Example:

Under attack from Microsoft, RealNetworks

(which pioneered streaming media soft-

ware) ceded the streaming media business.

It leveraged existing relationships with con-

sumers and music companies to launch

Rhapsody—a $10-per-month subscription

music service that offers unlimited stream-

ing to any PC from a library of a half-million

songs. It now profits from consumers ver-

sus subsidizing them.

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Strategies for Two-

Sided Markets

by Thomas Eisenmann, Geoffrey Parker, and

Marshall W. Van Alstyne

harvard business review • hbr.org

• october 2006 page 2

Companies in industries such as banking, software, and media make

money by linking markets from different sides of their customer

networks—audiences and advertisers, for example. The distinct

character of these businesses demands a new approach to strategy.

If you listed the blockbuster products and ser-

vices that have redeﬁned the global business

landscape, you’d ﬁnd that many of them tie to-

gether two distinct groups of users in a net-

work. Case in point: What has been the most

important innovation in ﬁnancial services since

World War II? Answer: almost certainly the

credit card, which links consumers and mer-

chants. Newspapers, HMOs, and computer op-

erating systems also serve what economists call

two-sided markets

two-sided networks

. News-

papers, for instance, join subscribers and adver-

tisers; HMOs link patients to a web of health

care providers, and vice versa; operating sys-

tems connect computer users and application

developers.

Products and services that bring together

groups of users in two-sided networks are

plat-

forms

. They provide infrastructure and rules

that facilitate the two groups’ transactions and

can take many guises. In some cases, platforms

rely on physical products, as with consumers’

credit cards and merchants’ authorization ter-

minals. In other cases, they are places provid-

ing services, like shopping malls or Web sites

such as Monster and eBay.

Two-sided networks can be found in many in-

dustries, sharing the space with traditional prod-

uct and service offerings. However, two-sided

networks differ from other offerings in a funda-

mental way. In the traditional value chain, value

moves from left to right: To the left of the com-

pany is cost; to the right is revenue. In two-sided

networks, cost and revenue are both to the left

and the right, because the platform has a dis-

tinct group of users on each side. The platform

incurs costs in serving both groups and can col-

lect revenue from each, although one side is

often subsidized, as we’ll see.

The two groups are attracted to each other—

a phenomenon that economists call the net-

work effect. With two-sided network effects,

the platform’s value to any given user largely

depends on the number of users on the net-

work’s other side. Value grows as the platform

matches demand from both sides. For exam-

ple, video game developers will create games

only for platforms that have a critical mass of

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Strategies for Two-Sided Markets

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• october 2006 page 3

players, because developers need a large

enough customer base to recover their upfront

programming costs. In turn, players favor plat-

forms with a greater variety of games.

Because of network effects, successful plat-

forms enjoy increasing returns to scale. Users

will pay more for access to a bigger network,

so margins improve as user bases grow. This

sets network platforms apart from most tra-

ditional manufacturing and service busi-

nesses. In traditional businesses, growth be-

yond some point usually leads to diminishing

returns: Acquiring new customers becomes

harder as fewer people, not more, ﬁnd the

ﬁrm’s value proposition appealing.

Fueled by the promise of increasing returns,

competition in two-sided network industries

can be ﬁerce. Platform leaders can leverage

their higher margins to invest more in R&D or

lower their prices, driving out weaker rivals. As

a result, mature two-sided network industries

are usually dominated by a handful of large

platforms, as is the case in the credit card in-

dustry. In extreme situations, such as PC oper-

ating systems, a single company emerges as the

winner, taking almost all of the market.

Platforms serving two-sided networks are

not a new phenomenon. Energy companies

and automakers, for example, link drivers of

gasoline-powered cars and refueling stations in

a well-established network. However, thanks

largely to technology, platforms have become

more prevalent in recent years. New platforms

have been created (Google, for example, links

advertisers and Web searchers) and traditional

businesses have been reconceived as platforms

(for instance, retail electricity markets are

evolving into platforms that match consumers

with speciﬁc power producers, allowing them

to express their preferences for cheaper coal or

more costly renewable power). Yet for all the

potential they’ve spotted, platform providers

have struggled to establish and sustain their

two-sided networks. Their failures are rooted

in a common mistake. In creating strategies for

two-sided networks, managers have typically

relied on assumptions and paradigms that

apply to products

without

network effects. As a

result, they have made many decisions that are

wholly inappropriate for the economics of

their industries.

In the following article, we draw on recent

theoretical work

to guide executives in negoti-

ating the challenges of two-sided networks. We

begin by looking at the factors that senior

managers must consider in designing their

platforms’ business models. The key decision

here is pricing. As we’ve noted, providers of

platforms for two-sided networks are able to

draw revenue from both sides. In most cases,

though, it makes sense to subsidize certain us-

ers. The crucial strategy question is, Which side

should you subsidize, and for how long?

The next step is to ﬁgure out how to man-

age winner-take-all dynamics. Many two-

sided network industries are served almost

entirely by a single platform. In some cases,

just one company controls that platform, as

with eBay’s auctions or Microsoft’s Windows.

In other cases, multiple companies share the

dominant platform, as with DVD and fax

standards or, in real estate, a regional multi-

ple listing service. (See the exhibit “Examples

of Two-Sided Networks.”) When a network

industry is likely to be served by a single plat-

form, aspiring providers must make a “bet the

company” decision. Should they ﬁght to gain

proprietary control over the platform or share

the spoils with rivals?

Platform providers that have vanquished

their immediate rivals can’t rest on their lau-

rels. Indeed, they face a signiﬁcant competitive

threat from large companies operating in adja-

cent markets that have the ability to offer a

multiplatform bundle. In our ﬁnal section, we

explore this challenge and offer prescriptions

for ﬁrms that face it. As we’ll see, moving ﬁrst

and getting big quickly aren’t necessarily the

right answers.

Challenge 1: Pricing the Platform

In competitive industries, prices are largely de-

termined by the marginal cost of producing an

extra unit, and margins tend to be thin. In in-

dustries with high barriers to entry, the price

ceiling is set by customers’ willingness to pay,

and margins are more likely to be fat.

For two-sided networks, pricing is a more

complicated affair. Platform providers have to

choose a price for each side, factoring in the

impact on the other side’s growth and willing-

ness to pay. Typically, two-sided networks have

a “subsidy side,” that is, a group of users who,

when attracted in volume, are highly valued by

the “money side,” the other user group. Because

the number of subsidy-side users is crucial to

developing strong network effects, the plat-

form provider sets prices for that side below

Thomas Eisenmann

(teisenmann@

hbs.edu) is an associate professor at

Harvard Business School in Boston.

Geoffrey Parker

(gparker@tulane

.edu) is an associate professor at Tulane

University’s A. B. Freeman School of

Business in New Orleans.

Marshall W.

Van Alstyne

([email protected]

) is an asso-

ciate professor at Boston University’s

School of Management and a visiting

scholar at MIT’s Center for eBusiness in

Cambridge, Massachusetts.

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Strategies for Two-Sided Markets

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• october 2006 page 4

the level it would charge if it viewed the sub-

sidy side as an independent market. Con-

versely, the money side pays more than it

would if it were viewed as an independent

market. The goal is to generate “cross-side” net-

work effects: If the platform provider can at-

tract enough subsidy-side users, money-side

users will pay handsomely to reach them.

Cross-side network effects also work in the re-

verse direction. The presence of money-side

users makes the platform more attractive to

subsidy-side users, so they will sign up in greater

numbers. The challenge for the platform pro-

vider with pricing power on both sides is to de-

termine the degree to which one group should

be encouraged to swell through subsidization

and how much of a premium the other side

will pay for the privilege of gaining access to it.

Pricing is further complicated by “same-

side” network effects, which are created when

drawing users to one side helps attract even

more users to that side. For example, as more

people buy PlayStation consoles, new users

will ﬁnd it easier to trade games with friends

or ﬁnd partners for online play. Economists

call this snowballing pattern a positive same-

side network effect. (Same-side network ef-

fects can also be negative. For a more detailed

explanation of how network effects attract or

deter users, see the sidebar, “The Dynamics of

Two-Sided Networks.”)

It is not always obvious which side—if

either—the platform should subsidize and

which it should charge. During the dot-com

boom, for example, nascent B2B exchanges ag-

onized over whether to charge fees to buyers,

Examples of Two-Sided Networks

Insights about the economics of two-sided

networks apply to a variety of industries. In

cases where platforms—the products and

sevices that bring together groups of users—

are proprietary, there invariably is a clear

subsidy side and a clear money side. For ex-

ample, doctors—in exchange for access to a

higher volume of patients—agree to rates

below those they could command if they

were not afﬁliated with an HMO.

Networks served by shared platforms tend

to lack a subsidy side. It is hard for platform

providers to recover subsidies if rivals share

the fees collected from the network’s money

side. Real estate brokers avoid this free-rider

problem by splitting the seller’s fee 50/50. Sub-

sidies also disappear when a shared platform’s

providers do not have pricing power on both

sides of the network, as in the case of gasoline-

powered transportation.

*Denotes network’s subsidy side

NETWORKED MARKET

PC operating systems

Online recruitment

Miami Yellow Pages

Web search

HMOs

Video games

Minneapolis shopping malls

Linux application servers

Wi-Fi equipment

DVD

Phoenix Realtors Association

Gasoline-powered engines

Universal Product Code

SIDE 1

Consumers

Job seekers*

Consumers*

Searchers*

Patients*

Players*

Shoppers*

Enterprises

Laptop users

Consumers

Home buyers*

Auto owners

Product suppliers

SIDE 2

Application developers*

Employers

Advertisers

Doctors

Developers

Retailers

Application developers

Access points

Studios

Home sellers

Fueling stations

Retailers

PLATFORM PROVIDERS

Rival Providers of Proprietary Platforms

Windows, Macintosh

Monster, CareerBuilder

BellSouth, Verizon

Google, Yahoo

Kaiser, WellPoint

PlayStation, Xbox

Mall of America, Southdale Center

Rival Providers of Shared Platforms

IBM, Hewlett-Packard, Dell

Linksys, Cisco, Dell

Sony, Toshiba, Samsung

100+ real estate brokerage ﬁrms

GM, Toyota, Exxon, Shell

NCR, Symbol Technologies

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sellers, or both, and how charges should be

split between ﬁxed subscription payments and

variable transaction fees. (See the sidebar “Simi-

lar Networks, Different Pricing” for an illustra-

tion of how two seemingly similar networks

may require very different pricing strategies.)

To make the right decisions about pricing,

executives of platform providers need to look

closely at the following factors:

Ability to capture cross-side network effects.

Your giveaway will be wasted if your network’s

subsidy side can transact with a rival platform

provider’s money side. That’s what happened

to Netscape, which subsidized its browser to

individuals in the hope of selling Web servers

to companies operating Web sites. However,

Web site operators didn’t have to buy Netscape’s

server in order to send pages to Netscape’s big

base of users; they could buy a rival’s Web

server instead.

User sensitivity to price.

Generally, it makes

sense to subsidize the network’s more price-

sensitive side and to charge the side that in-

creases its demand more strongly in response

to the other side’s growth. Adobe’s Acrobat

software follows this pricing rule. Acrobat pre-

sents any electronic document in Portable

Document Format (PDF), a universal stan-

dard that can be printed or viewed exactly as it

appeared in its original application. The PDF

network consists of two sets of users—writers,

who create documents, and readers, who view

them—using different software. Readers are

very price sensitive; they pay nothing for their

software. If readers were charged even a small

amount, Adobe Reader’s 500-million-person

user base would be much smaller. Writers,

who greatly value this huge audience, pay a

fee for their software. If Adobe reversed its ap-

proach, charging readers and subsidizing writ-

ers, its network would collapse. Writers are

less price sensitive, so free software would not

dramatically boost their numbers. More to the

point, readers would not pay much for access

to a bigger base of writers.

User sensitivity to quality.

High sensitivity to

quality also marks the side you should subsi-

dize. This pricing prescription can be counter-

intuitive: Rather than charge the side that

strongly

demands

quality, you charge the side

that must

supply

quality. Such a strategy is evi-

dent in video games. To deliver compelling

quality, game developers incur enormous ﬁxed

costs. To amortize these costs, they must be as-

sured that the platform has many users. Hence

the need for a consumer subsidy. Platform pro-

viders make sure game developers meet high

quality standards by imposing strict licensing

terms and charging a high royalty. This “tax” is

not passed through to consumers: Developers

charge the highest prices the market will bear,

regardless of the royalty rate. However, the roy-

alty helps weed out games of marginal quality.

Once the “tax” is added, titles with poor sales

prospects cannot generate enough contribu-

tion margin to cover their ﬁxed costs, so they

never get made in the ﬁrst place.

Output costs.

Pricing decisions are more

straightforward when each new subsidy-side

user costs the platform provider essentially

nothing. This will be the case when the give-

away takes the form of a digital good such as a

software program or a cheap service such as

otherwise-idle computer time. However, when

a giveaway product has appreciable unit costs,

as with tangible goods, platform providers

must be more careful. If a strong willingness

to pay does not materialize on the money

side, a giveaway strategy with high variable

costs can quickly rack up large losses.

FreePC learned this lesson in 1999 when it

provided computers and Internet access at no

cost to consumers who agreed to view Internet-

delivered ads that could not be minimized or

hidden. Unfortunately, few marketers were

eager to target consumers who were so cost

conscious. FreePC abandoned its offer after in-

curring $80 million in losses.

The Dynamics of Two-Sided Networks

Transactions in two-sided networks al-

ways entail a triangular set of relation-

ships. Two user groups—the network’s

“sides”—interact with each other

through one or more intermediaries

called

platform providers

. A

platform

em-

bodies an

architecture

—a design for

products, services, and infrastructure fa-

cilitating network users’ interactions—

plus a set of

rules;

that is, the protocols,

rights, and pricing terms that govern

transactions. These platforms exhibit

two types of network effects, which may

be either positive or negative: A same-

side effect, in which increasing the num-

ber of users on one side of the network

makes it either more or less valuable to

users on the same side; and a cross-side

effect, in which increasing the number

of users on one side of the network

makes it either more or less valuable to

the users on the other side. Cross-side

network effects are typically positive,

but they can be negative (TV viewers

preferring fewer ads). Same-side net-

work effects are often negative (sellers

preferring fewer rivals in a B2B ex-

change), but they may be positive (Mi-

crosoft Xbox owners valuing the fact that

they can play games with friends).

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Strategies for Two-Sided Markets

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Same-side network effects.

Surprisingly,

sometimes it makes sense to deliberately ex-

clude some users from the network. Platform

providers normally welcome growth in the

user base on either side, because it encourages

growth on the other side. In addition to posi-

tive cross-side network effects, however, plat-

form managers must assess the possibility of

negative same-side network effects, which can

be quite strong. In most markets, sellers would

be happy to see fewer direct rivals; the same

can be true for buyers when goods are scarce.

For example, many auto parts manufacturers,

concerned about downward pricing pressure,

refused to participate in Covisint, a B2B ex-

change organized by auto manufacturers. Cov-

isint stalled, as did many other B2B market

makers that failed to recruit enough sellers. In

the face of strongly negative same-side net-

work effects, platform providers should con-

sider granting exclusive rights to a single user

in each transaction category—and extracting

high rent for this concession. The platform

manager then must make sure that sellers do

not abuse their monopoly positions; other-

wise, buyers will avoid the network. Online

car-buying services like Autobytel, which for-

wards consumers’ queries to a single dealer in

any given geographic territory, have suc-

ceeded with this strategy. Autobytel has

earned a modest proﬁt over the past three

years; more to the point, it survived the dot-

com crash that extinguished many Internet

market makers with ﬂawed strategies.

Users’ brand value.

All users of two-sided

networks are not created equal. The participa-

tion of “marquee users” can be especially im-

portant for attracting participants to the other

side of the network. Marquee users may be

exceptionally big buyers, like the U.S. govern-

ment. Or they may be high proﬁle suppliers,

like anchor stores in malls. A platform pro-

vider can accelerate its growth if it can secure

the exclusive participation of marquee users in

the form of a commitment from them not to

join rival platforms. For many years, this kind

of exclusive arrangement was at the core of

Visa’s marketing campaigns (“…and they don’t

take American Express”). Of course, it can be

expensive—especially for small platforms—to

convince marquee users to forfeit opportuni-

ties in other networks. When the participation

of a few large users is crucial for mobilizing a

network, conﬂict over the division of value

Similar Networks, Different Pricing

On ﬁrst inspection, PC and video game net-

works look similar. In both cases, end users

on one side wishing to link to software or

games on the other side buy a platform con-

sisting of an operating system (OS) bundled

with hardware—a PC or a game console. The

two businesses exhibit similarly positive

cross-side network effects: End users favor

platforms that offer a wide variety of comple-

ments. Developers favor platforms with more

end users because this improves the odds

that they will recover the ﬁxed, upfront costs

of creating complements.

Notwithstanding these similarities, the PC

and game industries use very different pricing

models. In video games, end users are subsi-

dized. Platform providers like Sony PlaySta-

tion and Microsoft Xbox historically have

priced consoles at or below cost. Game devel-

opers are on the network’s money side; they

pay a royalty to console manufacturers of as

much as 20% of a game’s retail price. In the PC

industry, the money side and subsidy side are

reversed. End users are the money side, pay-

ing well above cost for the platform’s essential

element—its OS—which comes bundled with

PCs offered by OEMs like Gateway. Applica-

tion developers are the subsidy side. They pay

no royalties and receive free software develop-

ment kits from the OS vendors.

Why do these similar two-sided networks

have fundamentally different pricing struc-

tures? Video game consoles users—typically

teenagers—are both far more price sensitive

and quality conscious than typical PC users.

On average, each console owner buys just

eight games, which cost about $50 apiece.

Over the two- to three-year life of a console,

these precious titles are consumed sequen-

tially in intense bursts; gamers spend a great

deal of time—40 to 100 hours—with each title.

To deliver compelling quality, game devel-

opers incur enormous ﬁxed costs. To amortize

these costs, they must be assured that the con-

sole has many users: Hence the need for a con-

sumer subsidy. Console providers police qual-

ity by imposing strict licensing terms and

charging a high royalty. This “tax,” absorbed by

the developers, helps weed out games of mar-

ginal quality. Developers cannot afford to offer

titles with weak sales prospects, once the tax is

added to their price.

By contrast, PCs are often purchased for

work and are otherwise more likely viewed

as household necessities than game con-

soles are, so price sensitivity is lower. Over

their lives, PCs accumulate scores of applica-

tions, ranging from the indispensable (such

as word processing) to the disposable (for

example, some casual games). Accordingly,

we observe a huge range of price and qual-

ity levels for applications.

It’s true that both PC users and gamers

value variety and quality and that develop-

ers in both networks value the ability to

reach a large installed base. However, gam-

ers’ need for quality seems to be stronger, as

does game developers’ need for large num-

bers of consumers.

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between platform providers and large users is

common. Microsoft learned this when Elec-

tronic Arts (EA)—the largest developer of video

games and thus a major potential money-side

user of Microsoft’s Xbox platform—refused to

create online, multiplayer versions of its games

for the Xbox Live service. EA objected to Mi-

crosoft’s refusal to share subscription fees from

Xbox Live, among other issues. After an 18-

month stalemate, EA ﬁnally agreed to offer

Xbox Live games. Terms of the agreement were

not made public, but at the time, Microsoft an-

nounced that it would halt the in-house devel-

opment of new games that would compete

with EA’s ﬂagship sports titles.

Failing to recognize that two-sided network

pricing follows different rules than conven-

tional businesses can sink even the most attrac-

tive platforms. Apple provides a cautionary

tale about misapplied pricing logic. Apple’s

well-regarded Macintosh operating system has

always commanded a price premium from

consumers. When it launched the Mac, Apple

also tried to extract rent from the other side of

its network, charging third-party developers

$10,000 for the software development kits

(SDKs) required to create Macintosh applica-

tions. By contrast, Microsoft gave Windows

SDKs away for free. Tellingly, by the time of

Microsoft’s antitrust trial, Windows had six

times as many applications as Macintosh. This

made Windows far more attractive to consum-

ers, despite its functional shortcomings.

Challenge 2: Winner-Take-All

Dynamics

The prospect of increasing returns to scale in

network industries can lead to winner-take-all

battles, so an aspiring platform provider must

consider whether to share its platform with ri-

vals or ﬁght to the death. Companies some-

times get this decision wrong, as with Sony’s

futile battle to establish its Betamax videocas-

sette standard.

Coping with platform competition is a two-

step process. First, executives must determine

whether their networked market is destined

to be served by a single platform. When this

is the case, the second step—deciding whether

to ﬁght or share the platform—is a bet-the-

company decision. The stakes are much higher

when a networked market has room for fewer

rival platforms.

Turning to the ﬁrst step, a networked mar-

ket is likely to be served by a single platform

when the following three conditions apply:

•

Multi-homing costs are high for at least

one user side.

“Homing” costs comprise all the

expenses network users incur—including

adoption, operation, and the opportunity

cost of time—in order to establish and main-

tain platform afﬁliation. When users make a

“home” on multiple platforms, they increase

their outlays accordingly. For example, the

vast majority of PC users rely on a single op-

erating system—almost always Windows—

because using multiple operating systems is

expensive in terms of the additional hardware,

software, and training required. Similarly, dis-

tance limits the number of shopping malls that

consumers can visit at any one time, which in

turn limits the number of malls. When multi-

homing costs are high, users need a good rea-

son to afﬁliate with multiple platforms.

•

Network effects are positive and strong—

at least for the users on the side of the net-

work with high multi-homing costs.

When

cross-side network effects are positive and

strong, those network users will tend to con-

verge on one platform. A small-scale platform

will be of little interest to users unless it is

the only way to reach certain users on the

other side. The odds of a single platform pre-

vailing also increase when same-side network

effects are positive: for example, when users

of a software program need to share ﬁles with

one another.

•

Neither side’s users have a strong prefer-

ence for special features.

If certain users have

unique needs, then smaller, differentiated plat-

forms can focus on those needs and carve out

niches in a larger rival’s shadow. American Ex-

press, for example, earns high margins despite

having issued only 5% as many credit cards as

Visa. American Express cards have no preset

spending limit—a valuable feature for business

travelers, made possible because cardholders

must pay their full balance every month. Visa

cannot match this feature, because the loans it

extends to cardholders put an upper limit on

their spending. In cases where special features

are not important, however, users will tend to

converge on a single platform.

The DVD industry meets these three condi-

tions. First, multi-homing costs are high for

consumers because it would be expensive to

buy multiple players. Likewise, multi-homing

costs are high for studios: Having to provide

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• october 2006 page 8

the same content in multiple incompatible for-

mats would increase inventories and distribu-

tion costs. Second, cross-side network effects

are strong for both sides of the network. Most

consumers value access to a wide variety of ti-

tles, and studios realize scale economies when

they can sell to more consumers. Third, oppor-

tunities for technical differentiation are mod-

est, because DVD players connect to TV sets,

which are standardized in ways that intrinsi-

cally limit DVD picture and sound quality.

For these reasons, the DVD market was

bound to be served by a single platform. Poten-

tial platform providers anticipated this out-

come and faced a choice: They could ﬁght for

proprietary control of the platform or pool

their technologies. Industry participants chose

the latter approach, jointly creating the DVD

format in 1995 and avoiding a replay of the

VHS-Betamax standards battle.

Why share a network when proprietary

control promises monopoly proﬁts once rivals

are vanquished? The answer seems clear

enough if senior managers believe that their

company’s platform is not likely to prevail.

However, even those ﬁrms that have a ﬁght-

ing chance of gaining proprietary control

stand to realize beneﬁts from sharing. First,

the total market size will be greater with a

shared platform. During a battle for domi-

nance in a two-sided network, some users will

delay adoption, fearing that they will be

stranded with obsolete investments—like a

Betamax VCR—if they back the loser. Second,

since the stakes are so high in battles for net-

work dominance, ﬁrms spend enormous

amounts on upfront marketing. Rivalry tends

to be less intense with a shared platform, re-

ducing marketing outlays.

Winning the battle.

To ﬁght successfully, you

will need, at a minimum, cost or differentia-

tion advantages. Three other assets are im-

portant in establishing proprietary control:

First, platform providers gain an edge when

they have preexisting relationships with pro-

spective users—often in related businesses.

Adobe, for example, leveraged its user base

for PostScript printing products when launch-

ing PDF. Second, high expectations generate

momentum in platform wars, so a reputa-

tion for past prowess helps a great deal.

Having vanquished rival PC operating sys-

tems, Microsoft is feared and respected as a

ruthless and competent rival. Third, in a war

of attrition, deep pockets matter. Again, just

ask Microsoft!

First-mover advantages can also be signiﬁ-

cant in platform battles, but they are not al-

ways decisive. In fact, when the market

evolves slowly, late mover advantages may

be more salient. Late movers may, for exam-

ple, avoid the pioneer’s positioning errors, be

better placed to incorporate the latest tech-

nology into product designs, or be able to re-

verse engineer pioneers’ products and beat

them on cost. Google, which lagged Web-

search pioneers by several years, avoided por-

tals’ clutter in favor of a simple, fast-loading

home page. It also copied and then improved

on Overture’s paid-listing model for generat-

ing revenue from searches.

In a battle for platform control, ﬁrst and late

movers alike will feel strong pressure to amass

users as quickly as possible. In most cases, this

urgency is appropriate. Positive word-of-mouth

favors the early mover. But racing to acquire

users can be a mistake under two circum-

stances. First, executives must ask whether

their business is readily scalable. For exam-

ple, platforms that must support complex

customer-service interactions—like stop-loss

orders or margin trades at an online brokerage

ﬁrm—typically require skilled professionals.

The need to recruit and train such personnel

can put the brakes on rapid growth. Second,

due to their explosive growth potential,

platform-mediated networks are prone to

boom or bust valuation cycles. When they

launch cash-draining “get big fast” strategies,

therefore, top managers need to be sure that

funding will be forthcoming should capital-

market sentiment turn negative.

Challenge 3: The Threat of

Envelopment

You can do a great job addressing pricing and

winner-take-all challenges and establish a suc-

cessful new platform yet still face great dan-

ger. Why? Your platform may be “enveloped”

by an adjacent platform provider that enters

your market. Platforms frequently have over-

lapping user bases. Leveraging these shared re-

lationships can make it easy and attractive for

one platform provider to swallow the network

of another. The real damage comes when your

new rival offers your platform’s functionality

as part of a multiplatform bundle. Such bun-

dling hurts the stand-alone platform provider

In traditional value

chains, value moves from

left to right: To the left of

the company is cost; to

the right is revenue. In

two-sided networks, cost

and revenue are both to

the left and the right.

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• october 2006 page 9

when its money side perceives that a rival’s

bundle delivers more functionality at a lower

total price. The stand-alone platform provider

cannot respond to this value proposition be-

cause it cannot afford to cut the price on its

money side and it cannot assemble a compara-

ble bundle.

Networked markets—especially those in

which technology is evolving rapidly—are

rich with envelopment opportunities that

can blur market boundaries. This blurring is

called “convergence.” For example, mobile

phones now incorporate the functionality

of music and video players, PCs, and even

credit cards. Likewise, eBay—having acquired

PayPal and the voice-over-Internet protocol

(VoIP) start-up Skype, as well as equity in

Craigslist—is on a collision course with Goo-

gle, which also offers a payment service (Goo-

gle Checkout), VoIP (Google Talk), and a list-

ing service (Google Base).

In many cases, a stand-alone business facing

envelopment has little choice but to sell out to

the attacker or exit the ﬁeld. Some, however,

manage to survive. RealNetworks, the pioneer

of streaming media software, is—at least so

far—a case in point.

Real’s original business model was ideally

suited to the needs of its two-sided network:

Consumers downloaded its streaming media

player for free, and content companies paid for

its server software. As a result, the company

quickly dominated the new market and earned

modest proﬁts in 1999 and 2000. But as early

as 1998, Real’s streaming media franchise was

under attack from Microsoft. Like Real, Mi-

crosoft freely supplied its Windows Media

Player (WMP) to consumers. But Microsoft

also bundled its streaming software at no addi-

tional cost as a standard feature of its NT

Server—a multipurpose operating system that

also incorporated ﬁle, print, e-mail, and Web

servers, among other functions.

Since content companies—Real’s money

side—needed a multipurpose server anyway,

they could buy NT and receive a “free” stream-

ing media server. As content companies em-

braced this attractive proposition, consumers

switched with them, because Microsoft’s

streaming media servers worked only with its

own media players, and vice versa. By 2003,

42% of Internet users in North America identi-

ﬁed WMP as their primary media player, com-

pared with 19% for Real’s player.

Microsoft has not been the only threat.

Real’s Rhapsody subscription music service is

now threatened with envelopment by Yahoo

and ultimately by Apple. In 2005, Yahoo intro-

duced a subscription music service—including

downloads to portable music players—for $5

per month. Yahoo could afford to price ag-

gressively, because bundling subscription

music into its portal would increase user re-

tention rates and, through cross-marketing,

boost revenue from its other services. Like-

wise, Apple might choose to offer a subscrip-

tion version of iTunes, drawing on the very lu-

crative iPod—its money side—to subsidize an

envelopment attack. Real cannot match it ri-

vals’ bundles because it does not own a portal

or sell an MP3 player.

But Real is not without options. Its defense

against Microsoft and, more recently, Yahoo

and Apple shows what a focused ﬁrm can do to

survive envelopment.

Change business models.

Real’s response to

Microsoft’s envelopment attack was to switch

its money side. Ceding the streaming media

business, Real leveraged existing relationships

with consumers and music companies to

launch Rhapsody in 2003, charging $10 per

month for unlimited streaming to any PC

from a library of a half-million songs. Real now

proﬁted from consumers, rather than subsidiz-

ing them. Another common way for specialists

like Real to reinvigorate their business models

is to offer services as a systems integrator—

helping enterprises knit together diverse sys-

tems and technologies. Indeed, Real was doing

precisely that for a number of big music com-

panies even before it launched Rhapsody.

And it’s no accident that IBM—the dominant

provider of computing platforms through

the mid-1980s—has more recently focused

on systems integration. Facilitating transac-

tions across a two-sided network requires plat-

form providers to coordinate users’ activities.

Hence, managing a platform builds system in-

tegration skills that can be exploited.

Find a “bigger brother.”

When bullied on

the playground, a little guy needs a big friend.

Real has found allies through partnerships

with cable TV system operators and cellular

phone companies. Subscription music—

which requires a broadband connection—

makes cable modem service stickier: Once

consumers commit to a music service, they

face switching costs. Changing vendors would

For two-sided networks,

ricing is a complicated

affair. Platform providers

have to choose a price for

each side, factoring in the

impact on the other side’s

rowth and willingness

to pay.

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• october 2006 page 10

force them to conﬁgure new music players

and recreate playlists. Real also bundles its

Rhapsody Internet radio product with Sprint’s

wireless phone service and streaming video

with Cingular’s service. Cellular phone compa-

nies are attractive allies for Real, because they

can mount their own envelopment attacks if

Apple ever enters the subscription music mar-

ket. Cellular carriers can afford to subsidize

digital music playback on their phones, since

doing so would be likely to reduce cell phone

churn rates. That would present a big threat to

Apple’s money side.

Sue.

Firms facing envelopment are wise to

consider legal remedies, because antitrust law

for two-sided networks is still in dispute. Anti-

trust law was conceived to constrain the be-

havior of traditional manufacturing ﬁrms and

does not fully reﬂect the economic impera-

tives of platform-mediated networks. For this

reason, dominant platform providers that

offer bundles or pursue penetration pricing

run the risk of being charged with illegal tying

or predation. Exploiting this opportunity, Real

brought Microsoft to antitrust court and then

in 2005 received a $760 million payment from

Microsoft to end the lawsuit. Sun Microsys-

tems and Time Warner—Netscape’s current

owner—reaped similar bounties after they

challenged Microsoft’s anticompetitive be-

havior in court.

The threat of envelopment means that vigi-

lance is crucial for a focused platform provider.

Formulating strategy for platform-mediated

networks is like playing three-dimensional

chess: When market boundaries blur, envelop-

ment attacks can come from any direction.

However, focused ﬁrms are not without advan-

tages when competing with large, diversiﬁed

companies. Big ﬁrms can be slow to recognize

envelopment opportunities and even slower to

mobilize resources to exploit them. Also, envel-

opment requires cross-business-unit coopera-

tion, a signiﬁcant barrier in many diversiﬁed

companies. Sony, for example, has struggled to

coordinate strategy across its consumer elec-

tronics, video game, movie, and music busi-

nesses. Once the industry’s trailblazer with

products like the Walkman, Sony has seen

Apple usurp this role. Mistakes like this on the

part of established companies are precisely

why former upstarts like Google, eBay, and

Yahoo have grown into giants.

• • •

Despite the ubiquity of network industries

and the attractions of owning a successful plat-

form, the strategic implications of two-sided

networks have gone largely unexplored. In the

past, this lack of understanding was less prob-

lematic because executives usually had the

luxury of formulating strategies for two-sided

networks through trial and error. Markets

today are less forgiving. Many opportunities

for platform creation arise in high-tech sectors

with short product life cycles. Opportunities

also abound in traditional industries recon-

ceived as two-sided networks. And, thanks to

the Internet, ﬁrms have easy access to both

sides of new markets. In this environment, if

you draw attention to a platform opportunity

and don’t get it right the ﬁrst time, someone

else will. Thinking carefully through the stra-

tegic issues we’ve outlined here will give you a

head start.

1. See Geoffrey Parker and Marshall W. Van Alstyne,

“Two-Sided Networks: A Theory of Information Product

Design,”

Management Science

(2005) and Jean-Charles

Rochet and Jean Tirole, “Platform Competition in Two-

Sided Markets,”

Journal of the European Economic Associa-

tion

(2003).

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