Invisible Engines by David Evans, Andrei Hagiu and Richard Schmalensee was recently published by the MIT Press. All are leading economists and this book takes an in-depth look at software platforms as examples of two-sided markets. You can buy the book from Amazon here. Interestingly, the MIT Press has also made a pdf version of the book available for free download under a Creative Commons license. Therefore, I’m able to offer this book as a free download from my site here. I read the entire pdf version of the book on screen without printing it out. It was the first time that I read a whole book on my computer screen and it was an interesting experience that I’ll talk about later.

For now, I wanted to briefly review the book. As I said, it concentrates on software platforms. These are two-sided platforms that are based on some form of software (and often hardware too). Examples include computer operating systems, mobile phones, videogame platforms, and so on. Excluded are two-sided platforms like credit cards, shopping malls and real-estate agents, since these are not really based on software. The first three chapters provide background technical information on software platforms, and set out the basic economic issues. The authors do a good job of highlighting the key economic issues of information goods (high fixed costs and low marginal costs), and the key issues facing two-sided platforms — how to get both sides on board, what pricing strategies to choose, what features to offer, and how many ’sides’ the platform should have. These questions are illustrated with practical examples from various industries that show how different firms have tried to solve various problems.

The next five chapters give very detailed case-studies of five specific industries based on software platforms — Personal computers and operating systems, videogame consoles, PDAs, mobile phones, and digital media players. To be honest, I found the volume of facts about these industries in these chapters overwhelming, and I could only skim-read. It’s impossible to retain so many facts, so I didn’t see the value in reading carefully. These chapters would be a useful reference for anyone who wants to know the detailed history and business strategies that have been used in these industries. The chapters are well organised, but it reads a little like the authors got their research assistants to dig up every possible fact about these industries that they could find.

The book gets better again starting from chapter 9. Chapters 9-11 deal with the basic issues in two-sided platform strategy. The first question is whether to pursue a one-sided or two-sided strategy. A platform can be a one-sided business if it takes care of one side of the market itself. The most common example the authors cite is Apple’s iTunes and iPod system. Apple could have created a digital music platform but licensed the development and production of the portable players to others, but has instead chosen to create a closed system where it produces the hardware itself. Basically everything in the iPod + iTunes system comes from Apple, so it is not a two-sided platform. Other digital media services such as those offered by Real Networks have adopted different strategies, and these are true platforms that bring together hardware producers as well as music listeners and music publishers.

The second question is what pricing structure to use, what prices to charge the two sides, and how to get both sides on board through pricing. The authors discuss the various tradeoffs and constraints that affect these choices and again illustrate with examples from different industries. One theme that comes through here is that it is rarely the case that ‘one size fits all’. As in all markets, unique features need to be taken into account when setting prices in any particular market. The unique possibilities are compounded in two-sided markets, as factors on each side of the market affect decisions made on the other side. The authors do a good job here, although I would have liked to see a more explicit table or summary setting out exactly the implications of different factors.

The third question is the range of features to include in the software platform. The authors address this through standard economic arguments about bundling. Almost all goods and services can be thought of as a bundle of components. For example, a car contains many different components that could in principle be sold separately. The authors use the economic theory of bundling to explain why software platforms might choose to include some features and not others. They also explain why the number of features offered by platforms has increased over time, as a result of competition and technological progress.

The book concludes with a chapter that looks to the future and discusses how software platforms are likely to further shape industries such as retailing and traditional news media. There is also a fairly extensive bibliography of relevant economics and business literature.

I have a couple of minor complaints about the book. First, it seems like it was written in a little bit of a rush, and would have benefited from a bit more editing. I think it’s a bit bloated with industry facts, and there is some repetition in some places. Second, this might seem very picky but I found it annoying, the chapter titles are meaningless. For example, chapter seven is titled “Ba-BA-Ba-BAAAAH”, and is actually about the mobile phone industry. This is annoying because if I want to go back to the chapter about mobile phones later, I have no idea which chapter it actually was.

However, in all I think this is a very good book and I am recommending it. The material in the first three and last four chapters will be of interest to analysts, consultants and businesspeople in all markets that are based on two-sided platforms. Although the book is devoted to software platforms, most of the basic economic principles will apply equally well to other platform industries. If the book was a little more concise and there were fewer trivial facts, I would give it 4.5 stars out of 5, but because of those things and the other minor annoyances I’ll give it 4 stars.

Buy from Amazon here, or download a free pdf version here.

The US Census Bureau has been publishing quarterly statistics on e-commerce retail sales in the US since late 1999. There’s enough data now that some robust trends are emerging. I’ve taken the latest US Census Bureau data and stripped the effect of inflation out of it, so we can see the ‘real’ trends. First, this graph shows total e-commerce sales per quarter in billions of 2007 US dollars (ie today’s money). There’s been strong growth over time and total e-commerce sales in the most recent 12 month period were almost 120 billion US dollars. The real growth in e-commerce sales has averaged a bit under 900 million US dollars per quarter.

This next graph shows e-commerce sales as a percentage of all retail sales in the US. The growth in e-commerce has been strong, but it’s still only around 3% of total retail sales. However, e-commerce has been steadily displacing other sales channels in the US, and looks likely to continue to do so for the foreseeable future.

Next up is the annual growth rates of real e-commerce sales (in blue) and total retail sales (black). These are calculate as the percentage growth of sales in each quarter versus the same quarter in the previous year. So it’s growth over a 12 month period. On this basis, real total retail sales average 1.8% growth in any 12 month period, while real e-commerce sales have averaged about 25%. After a rapid start and then a decline caused by the dot-com crash, e-commerce growth has stabilised, and growth in the past two years has averaged 18.3% per year.

This last graph is an attempt at answering the question: To what extent is growth in e-commerce sales associated with growth in total retail sales? I’ve taken the quarterly growth rates of total sales and e-commerce sales and plotted them against each other. These are not the annual growth rates above, but the growth rate of each quarter compared to the previous quarter. This shows a positive but weak correlation between the two growth rates. There’s some positive relationship between growth in e-commerce sales and growth in total retail sales, but not a very strong one. This is some evidence in support of the idea that e-commerce growth is somewhat driven by total retail growth, but to a large extent represents sales shifting from traditional ‘offline’ channels to ‘online’ channels.

I read an interesting article on the Economist’s website about Facebook. Facebook is a social networking site like the infamous MySpace and Google’s Orkut, and so many others. It’s a pretty classic example of a business model that attempts to exploit ‘network effects’. This is the effect whereby the more people use a good or service, the more valuable it becomes to its users. A traditional example is fax machines — a fax machine is pretty useless by itself, but if other people have machines then it becomes useful. And it becomes more useful the more other people have fax machines, because the bigger the network that you can send faxes to or from.

Facebook and other social networking sites are similar. Their value comes from allowing people to connect and communicate with other people. A social networking site would be pretty useless without many members. Since Facebook has now amassed more than 30 million members, it’s quite a useful service to join. I myself found several long-lost friends on there. The biggest problem for a network business is how to get off the ground in the first place. Somehow, Facebook has achieved this, and is now exhibiting fast growth as it becomes increasingly valuable to its users as its user base increases.

The key issue for Facebook after getting off the ground is how to make money from its service. One obvious way is to put ads on its site, which will probably make them some money. But there seem to be other more interesting strategies. As described in The Economist article that I linked, what Facebook is creating is essentially a social ‘map’ showing who is connected to who. I’m sure studying this map would be highly interesting to sociologists and psychologists. But how can Facebook make money out of it? I’m not exactly sure of the answer to that. One possibility is again marketing. Facebook not only has a map of people’s social connections, but it also gets people to willingly share their preferences about music, movies, products, and so on, for their friends to see. It’s possible that all this information could be valuable for displaying customised advertising on the site and so on.

But just making money out of advertising seems a little mundane, though I’m sure that with an audience of 30 million, Facebook can more than cover its costs by selling advertising on its site. What the Economist article really talks about is Facebook’s recent move to open its platform up to outside software developers. Anyone with some programming skills can now develop Facebook ‘applications’ which run on its site. For example, you can play paper-rock-scissors with your friends via the site, or share lists of things that you like or dislike. Facebook has opened up to applications by providing an API (applications programming interface) which is a set of programming standards through which a customised application can interact with the basic Facebook site.

By allowing third-parties to develop applications, Facebook has added a new dimension to its platform. The existing groups were regular users of its site, and advertisers. Now Facebook has included software developers into the mix. Facebook is a valuable platform for software developers, because it has so many active users. And applications add some value to the experience of using Facebook for the regular users. I’m a bit puzzled by Facebook’s strategy in allowing applications though. Developing applications is time consuming and costly for programmers. Some will do it for fun, but Facebook has given them more incentive by allowing adverts (eg from Google’s adsense) to appear in the applications. Thus application developers can receive revenue from these adverts, if they make a popular application and if people click on the ads.

However, Facebook lets application developers keep all of their advertising revenue, and doesn’t charge the developers anything to use its site. So although Facebook has added a new ’side’ to its platform, it doesn’t seem to be making any money from that side (at the moment). I wonder why it is doing this. Is it just trying to drive more traffic to its site, to sell traditional advertising? Or maybe Facebook is using the applications as a way of outsourcing its R&D. It gets others to do the work of developing new uses for its site, and doesn’t have to bear the cost or risk of that itself. Then if applications become successful, Facebook can buy them out, I suppose.

In any case, it’s still early days, and it will be interesting to see how Facebook makes use of the platform that it has built. The Economist article suggests that the Facebook founder, Mark Zuckerberg, wants to ‘change the world’. So he might have other things on his mind than making money. Which is fine, but I’m sure his investors are most keen about how he can make money. If Facebook can figure out how to extract some of the value that its network has created, and can figure out how to balance sources of revenue across the different groups using its platform, it could become very valuable indeed.

I read an interesting article in the latest issue of The Review of Network Economics, “The Economics of Digital Business Models” by Eric Brousseau and Thierry Penard. The authors discuss how ‘digital’ businesses like Internet-related companies or software firms create economic value and how specific factors lead to different types of business model emerging. They talk about many things, so I just wanted to highlight their insights into how Internet-related businesses create economic value.

First of all, how is economic value created by businesses in general? There are basically two ways: by creating something new that people want, or by producing an existing thing more efficiently and cheaply than existing producers. The Internet enables both of these things. At its most fundamental level, the Internet is a technology for transmitting information in digital form. This enables both new products and services like blogs, and more efficient production of existing things, like online auctions (it’s cheaper to facilitate auctions online via a website than to do them in real life).

Brousseau and Penard go into this idea in more detail. They talk about three specific things that digital or Internet-related businesses can do to create value, that I’m going to summarise and discuss here.

1. Making markets / reducing transaction costs

Market makers stand in between buyers and sellers of goods and mediate transactions between them. A few specific examples are stockmarkets, wholesale food markets, and auction houses. Making markets is a very information intensive business. You have to know who wants to buy what, who wants to sell what, and the prices that people are willing to pay to buy or want to receive in order to sell. Information technology obviously helps to make these kinds of activities more efficient and cheaper.

In addition, buyers and sellers often face ‘transaction costs’ to do business with each other. For example, finding the person who sells the product most similar to what you want to buy can be time consuming and costly. The process of trading can be costly too. For example, running an auction in the ‘real world’ is an expensive process. You need an auctioneer, a room, a way for people to view the things being sold, and so on. Reducing these transaction costs explains much of the success of eBay. It creates value by allowing people to run auctions at much lower cost than they otherwise would. This results in cheaper trades, and opens up many more opportunities for trading that would not otherwise exist.

On top of this, making a market is a costly activity, regardless of whether it’s done online or in the ‘real world’. There needs to be a place (physical or virtual) for the market transactions to take place in, and the market maker has to supervise the trading that takes place. However, Internet-based market makers probably have more opportunities to exploit economies of scale compared to traditional market makers. Economies of scale occur when the average cost of producing something increases the more of it that you produce. Setting up a website is costly, and you need to spend more as your traffic grows, but the costs of supporting, say, an online auction market with 100 million members are almost certainly less than doing the same thing in the real world.

2. Packaging information goods together / customisation

‘Information goods’ are things that people consume that consist primarily of ‘information’ in some form. Examples include news, books, music, movies, and software. The Internet enables the transmission of these goods in digital form. Typically, information goods are highly modular. This means that they can be broken down into discrete pieces and combined in different ways. I’m not talking about bits and bytes. What I mean is that, say, a newspaper is composed of a number of discrete articles, each of which could stand on its own. A newspaper is valuable because it puts these discrete pieces together. However, newspapers are not very flexible — it’s too expensive to print customised newspapers for everyone.

With digital information goods, customisation is much easier and cheaper. A news website can easily offer the ability for readers to customise the categories of news that they see. This brings the product closer to what people want, and it’s valuable for that reason. The possibilities for customisation also explain some of the success of Apple’s iTunes service. By breaking albums down into individual songs and offering them for sale separately, iTunes allows music listeners to construct a customised bundle of their favourite songs. This is one way that iTunes creates economic value.

3. Knowledge management

Finally, knowledge is a valuable thing for several reasons. Without getting too philosophical, people value knowledge because it allows them to do things and understand how the world works. Knowledge can be represented in digital form, as words or other data, and can be transmitted between people via the Internet. Sites like Wikipedia are valuable because they collect and disseminate knowledge.

From a business point of view, knowledge about customers is also often valuable. Firms can make more money if they have better knowledge about what their customers want and what they are willing to pay. In a traditional retail business, say, the retailer has very little knowledge about their customers. If you go into a bookstore and buy a book, the shop doesn’t know who you are and probably won’t remember what you bought previously when you next come to the shop. An online retailer such as Amazon has much more information about its customers. Since you have to log in to the site to make purchases, they know your purchase history when you visit the site. They also probably know your address and some other personal information. They can use this information to improve the products and services that they offer.

Summary: Where the value comes from

Brousseau and Penard describe how Internet businesses create economic value through these channels:

• Improving efficiency in information-intensive activities like making markets and knowledge management.
• The modularity of digital products means they can be easily customised to suit people’s preferences.
• Reducing the costs of transacting and exploiting economies of scale in online market-making.
• Reduced costs and improved efficiency in knowledge management.
• Greater opportunities to gain knowledge about customers and their behaviour.

As I mentioned in the previous post, one of the key problems for a two-sided platform is to get both sides on board the platform. For example, an auction website is not valuable to buyers if there are no sellers, and it’s not valuable to sellers if there are no buyers. In technical terms, the value of the platform comes mainly or entirely from ‘network effects’ that operate across the platform. Users on each side of the platform find it valuable precisely because it allows them to interact with users on the other side.

One of the key things determining the platform’s success at getting both sides on board is expectations. If users on each side expect that a lot of users on the other side of the platform will join, it’s more likely that the thing will get off the ground in the first place. One way to manipulate expectations is through advertising. Another way is to charge a low price or even subsidise users on one side of the market. Then they may be persuaded to join the platform even if their expectations are a bit pessimistic. Two-sided platforms have the advantage that low prices on one side can be offset by high prices on the other side, so such a strategy doesn’t necessarily have to be a money-losing one overall.

Another way to help get things off the ground is to target ‘important’ users on one side of the market or the other. These ‘marquee buyers’ raise the value of the platform by proportionally more than the typical user. For example, for videogame platforms, some game studios have more popular and well-known games than others. Getting such important users to announce their commitment to your platform can be very beneficial. If possible, it may be in the platform’s interests to offer bigger than average incentives for marquee buyers to join the platform.

In some cases, like with videogame platforms, one side of the market may have to commit to the platform before the other side does. With videogames, since games take time to develop, game studios have to commit to a platform before game players have to buy the platform. The problem is that the number of game players that join will depend partly on the price that the game platform maker sets for the consoles. Game studios prefer that the console price be low, so that lots of game players will join and they will sell a lot of games. However, once game studios have committed to a platform and started developing games, they are somewhat at the mercy of the game platform if it decides to raise console prices. Anticipating this, game studios may be reluctant to support the platform in the first place. To solve this problem, the platform might want to commit to low prices for consoles before it starts selling them, by publicly announcing the price that it will charge. I’ll talk more about this issue again later.

[tags]network effects, network economics, game platforms, two-sided markets[/tags]