Two-sided markets are markets with two types of participants, where the benefit for one side depends on the number of participants on the other side of the market. This is also known as cross-side network externalities or cross-side network effects.

A network effect, or network externality, is the effect that one user of a product or service has on the value of that product to other people. It can be positive (more users, more value) or negative (more users decrease value).

Some examples of two-sided markets:

  • Credit card networks. The value of joining a credit card network is a function of the number of businesses that accept that credit card. For a small business, the value of joining a credit card network is a function of the number of customers who have such a credit card.
  • Gaming consoles. As a consumer, the value from a console is a function of the number of interesting games that are available on that console. As a game developer, the value of creating a game for a specific console is a function of the number of people who use that console.
  • Services like Uber. As a consumer, the value of being on Uber is a function of the number of taxi cabs available on that network. As a taxi cab driver, the value is a function of the number of consumers using that service.
  • Technology platforms are also a good example of cross-side network effects. For example, Apple’s iOS platform or Google’s Android platform where the value as a consumer is a function of the number of apps available on that platform. The value for a developer is a function of how many users use that platform.

When talking about two-sided markets one of the issues that need to be addressed is how are we going to build liquidity in the market?

Building a two-sided network involves solving the classic chicken-and-egg problem. Producers won’t show up without consumers and vice versa. Two-sided markets require synchronization of producers and consumers coming onto the platform for interactions to happen. Most marketplaces and platforms try to stage the seeding process getting one side in after the other.

One strategic lever is pricing.

Traditional pricing strategy seeks to set a price for a product so as to maximize revenue from the customers. One way to do this is to conduct a survey to assess consumer response to different product prices. With their responses, you can create something similar to a demand curve.

For example, for a technology platform, you will set a price that maximizes the revenue from consumers as well as for developers. But it could be that this pricing strategy is not the one that maximizes your overall revenues.

A better alternative pricing strategy is to subsidize one side of the market to increase profits from the other side.The number of subsidy side users is crucial to developing strong network effects, the platform provider sets prices for that side below the level it would charge if it viewed the subsidy side as an independent market. Conversely, the money side pays more. For example, for a technology platform, if you charge consumers a price of zero, you will get all potential consumers interested in your product. When this happens, the demand curve on the other side changes. Now developers will be more interested in building on that platform because it has more consumers. Now developers are willing to pay a higher price. Charging developers higher prices will increase your overall revenue.

Some examples of this strategy:

Adobe Acrobat Reader (free for readers) and Adobe Acrobat Writer (charges higher prices to publishers who are creating content)

Yellow pages. It is free to users and charges a high price for a business that wants to advertise there.

When designing a two-sided market, you need to decide which side of the market should you offer subsidies to. See what is the impact of providing a pricing subsidy.

  • You can subsidize the price sensitive side.
  • You can subsidize the side that generates the greater value to the other side of the network.

Besides price, there are other strategies to address liquidity challenges:

  • Obtaining supply from other marketplaces or other sources. For example. Airbnb originally obtained listings from Craiglist.
  • Leverage influencers with a large base of followers.
  • Manual matching of supply and demand.
  • Use one side to market the other side. For example, sites like Etsy where sellers bring many buyers.