Defining Antitrust Markets When Firms Operate Two-Sided Platforms DEFINING ANTITRUST MARKETS WHEN FIRMS OPERATE TWO-SIDED PLATFORMS David S. Evans* Michael Noel** I. Introduction ................................................................ 668 II. Economic Background on 2SPs ................................. 672 A . Exchanges ............................................................ 674 B. Advertising-Supported Media ............................. 675 C. Transaction System s ........................................... 676 D. Software Platform s .............................................. 678 III. Econom ic Principles ................................................... 679 A . P ricing .................................................................. 680 B. Design D ecisions .................................................. 683 C. Rules and Regulations ......................................... 685 IV. Industrial Organization of Markets with 2SPs ........ 686 A. Determinants of Platform Size and Structure ... 686 1. Indirect Network Effects ................................ 686 2. Economies and Diseconomies of Scale ........... 687 3. Congestion and Search Optimization ............ 688 4. Product Differentiation and Multihoming .... 689 B. Empirical Evidence on 2SP Industry Structure 690 V. The Analysis of Market Power .................................. 694 VI. M arket Definition ....................................................... 696 V II. C onclusion .................................................................. 700 * Vice Chairman, LECG Europe and Visiting Professor, Faculty of Laws, University College London. ** Assistant Professor, Department of Economics, University of California, San Diego. The authors thank Howard Chang, Andrei Hagiu, and Richard Schmalensee for valuable comments and Murtaza Akhter, Eri Budo, and Nese Nasif for exceptional research assistance. I. INTRODUCTION Two-sided platforms (2SPs) cater to two or more distinct groups of customers. As we will explore, members of one customer group need members of the other group for a variety of reasons. The platform helps these customers get together in many ways and thereby creates value for these customers that they could not readily obtain without the coordination that the platform provides. The village market is one of the oldest examples of a 2SP. It is a place where buyers and sellers can get together and trade. A modern example is eBay. The village matchmaker is another old example. She tries to find marriage partners for men and women. A modern example is 8MinuteDating, which organizes speed-dating events where men and women meet for short periods of time and decide whether they would like to see each other again.' Today, 2SPs are the dominant form of business organization in a wide variety of industries, including many economically significant ones. Well-known examples are American Express (travelers' checks and charge cards), Google (search engine-based portal), the New York Stock Exchange (buyers and sellers), and Microsoft (software platforms). Economists have shown that the economic principles that govern the diverse industries based on 2SPs differ from those that govern traditional industries in several important ways.2 First, profit-maximizing prices may require charging one side less than the marginal cost of serving that side. Empirical surveys of industries based on 2SPs find many examples of prices that are low, or even negative, so that customers on one side are incentivized to participate in the platform.' Most malls do not make shoppers pay to enter, 8 Minute Dating, http://www.8minutedating.coml. 2 See, e.g., Jean-Charles Rochet & Jean Tirole, Platform Competition in Two-Sided Markets, 1 J. EUR. ECON. ASS'N 990 (2003); Mark Armstrong, Competition in Two-Sided Markets (Indus. Org. Econ., Working Paper No. 0505009, 2005). ' David S. Evans, The Antitrust Economics of Multi-Sided Platform Markets, 20 YALE J. ON REG. 325 (2003) [hereinafter Evans I]; David S. COL UMBIA B USINESS LA W RE VIE W [Vol. 2005 DEFINING ANTITRUST MARKETS and they sometimes offer negative prices, through inducements such as free parking and entertainment, to subsidize shoppers' participation in the platform.' More generally, 2SPs form systems in which there are feedback effects between the customer groups. Changes that affect the first customer group necessarily affect the second customer group, which in turn affect the first customer group, and so on. For example, a recent effort in Australia to place a cap on the fees charged by credit card systems to merchants has resulted in an increase in annual fees (paid by consumers) for credit cards.5 Many antitrust cases have involved 2SPs. A few- including several important ones-seem to have touched on two-sided issues before economists did. Notwithstanding whether the courts held correctly or not, their analyses of these markets and practices are not analytically correct in light of the recent 2SP literature.7 Table 1 presents an overview of antitrust cases in the European Community and the United States that concern 2SPs. We have not done a systematic review of cases, but rather have listed cases that have had high profiles in these jurisdictions and with which we are generally familiar. The cases span all of the major categories of 2SPs and involve the full spectrum of competition policy issues. Evans, Some Empirical Aspects of Multi-Sided Platform Industries, 2 REV. OF NETWORK ECON. 191 (2003) [hereinafter Evans II]. Evans I, supra note 3; Evans 11, supra note 3. See Howard H. Chang, et al., The Effect of Regulatory Intervention in Two-Sided Markets: An Assessment of Interchange-Fee Capping in Australia, REV. OF NETWORK ECON. (forthcoming), available at http://ssrn.com/abstract=820044. 6 Nat'l Bancard Corp. v. Visa U.S.A, 779 F.2d 592, 602 (11th Cir. 1986); Times-Picayune Pub. Co. v. United States, 345 U.S. 594, 610 (1953); Joined Cases C-241/91 P & C-242/91 P ("Magill cases"), RTE & ITP v. Comm'n of the Eur. Cmtys. 1995 E.C.R. 1-743. ' Times-Picayune Pub. Co., 345 U.S. at 610; Nat'l Bancard Corp., 779 F.2d at 602. No. 3:667] Table 1. Summary of Leading Cases by 2SP Type Case Case Type Case Case Type Times Monopolization Picayune 4) NaBanco Cartel Refusal to Magill Supply BT YellowPYeo Monopolization 0 PagesWal-Mart Tying Lorain Exclusive Journal Dealing Sotheby's- Cartel Microsoft- Monopolization, Christies Browser Tying M hMicrosoft-Marsh M n Cartel Media Tying McLennan Player ' London Stock Merger Exchange Nintendo Exclusivity Mobile Excessive Operators Pricing The antitrust issues that can arise for 2SPs are similar to those for traditional businesses. Members of these platforms can conspire to fix prices, to acquire market power through mergers, and attempt to obtain or to perpetuate monopoly power through the usual panoply of unilateral practices. However, the standard tools of analysis may need to be modified to fit these 2SP businesses. For example, there is no reason to presume for 2SPs that pricing below average variable cost indicates predatory pricing because such below- cost pricing is endemic to 2SPs regardless of competitive conditions.' To take another example, in order to increase their profits through price fixing, competing 2SPs would have to fix prices to both customer groups. Otherwise they ' Evans I, supra note 3, at 46-47; Rochet & Tirole, supra note 2, at 991; Julian Wright, One-Sided Logic in Two-Sided Markets, 3 REv. OF NETWORK ECON. 44, 44-64 (2004). COL UMBIA B USINESS LA W RE VIE W [Vol. 2005 would shift the profits from customers on the side with lower, fixed prices to customers on the other side, whose prices have not been fixed.9 This Article focuses on defining relevant markets and assessing market power when the subjects of antitrust analysis include 2SPs. The fact that 2SPs compete simultaneously for two distinct customer groups has three ramifications. First, focusing on one dimension of this competition tends to distort the competition that actually exists among firms. An extreme case concerns heterosexual dating services. They compete for male and female customers, but it does not make sense to talk about separate markets for men and women. Second, market definition is supposed to identify the constraints on pricing and other business decisions. Changing the price for one set of customers affects the demand of the other set of customers, which in turn has a feedback effect on the demand of the first set of customers. The interdependencies between the two customer groups may provide an economically important constraint, yet this is ultimately an empirical issue. Third, the possibility of obtaining supracompetitive profits through certain business actions depends on the relationship between the two sides due to their interlinked demand and the nature of the competition on both sides. Profits on one side can be dissipated on the other side. That possibility affects the analysis of incentives and the sorts of anticompetitive practices that make business sense. It is helpful to begin by clarifying a few terms that we will use throughout this Article and also to note some differences in how these terms are used occasionally in the literature. Many scholarly articles by economists refer to "two-sided markets." That term is sometimes applied to businesses that are 2SPs and sometimes to the markets in which they ' For examples of price fixing allegations concerning 2SPs, see the complaint in New York v. Marsh & McLennan Co., No. 04403342 (filed in 2004), available at http://www.oag.state.ny.us/press/2004/oct/octl4a_04_ attachl.pdf; Douglas Frantz et al., Ex-Leaders of 2 Auction Giants Are Said to Initiate Price-Fixing, N.Y. TIMES, Apr. 7, 2000, at Al. No. 3:667] DEFINING ANTITRUST MRKETS operate. 10 Here, we use the term 2SP to refer to the entity- the business, cooperative, standard, or government entity- that provides a physical or virtual platform for distinct customer groups. 2SPs compete in what we will call 2SP industries. Thus, dating clubs are platforms that compete in the matchmaking industry. We try to avoid the term "two- sided market" because the word "market" is a term of art for competition policy. Although, for the most part, we will use the term "two- sided platform," the reader should note that some platforms have more than two distinct groups of customers. Software platforms, such as Microsoft's Windows, have at least three: hardware manufacturers; application developers; and end users. 2SPs are a special case of nSPs where n>1. As the most familiar platforms are two-sided, we stick with this case to simplify the exposition. In the next section, we provide an introduction to 2SPs and discuss some of the most prominent examples. Section III reviews some basic economic principles about pricing and other decisions for 2SPs. Section IV then considers the factors that are important in determining the industrial organization of 2SPs. Next, Sections V and VI analyze market power and market definition for 2SPs and explain the issues that differ from analysis of single-sided platforms. The final section offers our concluding thoughts. II. ECONOMIC BACKGROUND ON 2SPS A heterosexual, singles-oriented club offers some intuition on the economics of 2SPs. A nightclub, such as Bungalow 8 in Manhattan, provides a platform where men and women can meet, interact, and search for potential dates. The club must have two groups of customers on board its platform to have a service to offer either one; it needs men and women customers. Moreover, the proportion of men and women matters. A singles club with few women will not attract '0 Rochet & Tirole, supra note 2, at 997 (citing papers discussing two- sided markets generally). COL UMIA B USINESS LA W RE VIE W [Vol. 2005 men, and a club with few men will not attract women. Pricing is one way to adjust the balance. The club might want to offer women a break if they are in short supply (through a lower price or free drinks). Or, it might want to ration the spots to ensure the appropriate number of women; popular clubs typically have queues waiting outside, and women are picked out of line disproportionately. The dating club represents a platform according to the informal definition that we introduced at the start. There are two groups of customers: men and women. Members of each group value members of the other group, and the platform provides a way for them to get together. Rochet and Tirole (2004) have proposed a formal definition: A market is two-sided if the platform can affect the volume of transactions by charging more to one side of the market and reducing the price paid by the other side by an equal amount; in other words, the price structure matters, and platforms must design it so as to bring both sides on board." To satisfy this definition, "the relationship between end- users must be fraught with residual externalities" that customers cannot sort out for themselves. 2 That is clear in the case of the dating environment. Men and women want the ability to search for dates among a large number of opposites. It is hard to conceive of a practical mechanism for women to reward men who come to a singles club, but whom they ultimately reject. In the other 2SP industries we consider, it is difficult if not impossible to imagine customers on one side of the platform "1 Jean-Charles Rochet & Jean Tirole, Two-Sided Markets: An Overview 40 (IDEI-CEPR Conference on Two-Sided Markets, Working Paper, 2004), available at http://idei.fr/doc/by/tirole/rochet tirole.pdf. Note that the word "market" above is being used in the loose manner that is the custom among economists. 12 Id. As a result, a necessary condition for a market to be two-sided is that the Coase theorem does not apply to the transaction between the two sides. See id. at 13-14. No. 3:6671 DEFINING ANTITRUST MARKETS making side payments to customers on the other side. As a result, the platform owner can institute a pricing structure to harness indirect network effects, and it is not feasible for customers to defeat this pricing structure through arbitrage. It is helpful to distinguish four different types of 2SPs, although the boundaries between the types can be fuzzy: exchanges, advertiser-supported media, transaction devices, and software platforms. 3 A. Exchanges Exchanges have two groups of customers that generally can be considered "buyers" and "sellers."14 The exchange helps buyers and sellers search for feasible contracts-that is, where the buyer and seller could enter into a mutually advantageous trade and for the best prices. In these situations, the buyer pays as little as possible, and the seller receives as much as possible. 5 It covers various matchmakers, such as dating services and employment agencies. It also covers traditional exchanges: auction houses; Internet sites for business-to-business, person-to- business, and person-to-person transactions; various kinds of brokers (insurance and real estate); and financial exchanges for bonds and equity. Finally, exchanges include a variety of businesses that provide brokerage services, e.g., publishers (readers and authors), literary agents (authors and "3 See David Evans et al., A Survey of the Economic Role of Software Platforms in Computer-Based Industries, INDUSTRIAL ORGANIZATION AND THE DIGITAL ECONOMY (G. Illing & M. Peitz eds., MIT Press) (forthcoming). In that paper, the authors refer to software platforms more generally as shared-input facilities. Armstrong uses the term "competitive bottlenecks" to refer to certain shared-input facilities. Armstrong, supra note 2. Although his discussion is analytically sound, his term is pejorative and has a different meaning in competition law than the way he uses it. 14 This Article will employ the terms "buyers" and "sellers" loosely. 5 Some securities exchanges, such as the New York Stock Exchange, also need to attract middlemen-specialists or market makers-who quote prices to both buyers and sellers and bring liquidity to the market. See FREDERIC S. MISHKIN & STANLEY G. EAKINS, FINANCIAL MARKETS AND INSTITUTIONS 17 (Addison-Wesley, 2d ed. 1998). (Vol. 2005COL UMBIA B USINESS LA W RE VIE W DEFINING ANTITRUST MARKETS publishers), travel services (travelers and travel-related businesses), and ticket services (people who go to events and people who sponsor events). Exchanges provide participants with the ability to search among participants on the other side and the opportunity to consummate matches. Having large numbers of participants on both sides increases the probability that participants will find a match. However, depending on the type of exchange, a larger number of participants can lead to congestion. This is the case with physical platforms such as singles clubs or trading floors. Moreover, participants may derive some value from having the exchange prescreen participants to increase the likelihood and quality of matches. Some exchanges charge only one side. For example, only sellers pay directly for the services that eBay provides.16 This is also true for real estate sales in the United States: The seller pays. Other exchanges charge both sides, although the prices may bear little relation to side-specific marginal costs. For instance, Internet matchmaking services charge everyone the same, while, as we mentioned, physical dating environs sometimes charge men more than women. Auction houses charge commissions to buyers and sellers. Until the recent settlements in the United States, insurance brokers charged both insurance customers and insurance providers. 7 B. Advertising-Supported Media Advertising-supported media, such as magazines, newspapers, free television, and web portals, are based on a two-sided business model. The platform either creates content (newspapers) or buys content from others (free television). The content is used to attract viewers. The viewers are then used to attract advertisers. There is a clear, indirect network effect between advertisers and 16 See, e.g., eBay.com Fees, http://pages.ebay.com/help/sell/fees.html. 17 See the complaint filed in New York v. Marsh & McLennan Co., No. 04403342 (filed Oct. 14, 2004), available at http://www.oag.state.ny.us/ press/2004/oct/octl4a_04 attachl.pdf. No. 3:667] COLUMBIA BUSINESS LAW REVIEW viewers. Advertisers value platforms that have more viewers. The extent to which viewers value advertisers remains a subject of debate, but we suspect that viewers value advertisers more than they might admit.18 Most advertising-supported media businesses earn much of their revenues-and probably their entire gross margin- from advertisers. 9 Print media is often provided to readers at something close to or below the marginal cost of printing and distribution. In some cases, such as yellow page directories and some newspapers, they are provided for free. Most web portals, e.g., Google and Yahoo, receive revenue only from advertisers. C. Transaction Systems Particular methods of payment only work if buyers and sellers are willing to use them. Humans switched from a barter system when they agreed on a standard metric for exchange, such as metallic coins or seashells. Governments facilitated this switch by ensuring the integrity of coins (to various degrees) and by using government-issued coinage for buying and selling. Cash, which has no intrinsic value in most modern economies, provides a payment platform because buyers and sellers expect that other buyers and is See, e.g., Roger D. Blair & Richard E. Romano, Pricing Decisions of the Newspaper Monopolist, 59 S. ECON. J. 721, 731 (1993) (suggesting that "circulation demand rises with increases in the quantity of advertising"); James M. Ferguson, Daily Newspaper Advertising Rates, Local Media Cross-Ownership, Newspaper Chains, and Media Competition, 26 J.L. & ECON. 635, 653 (1983). Other studies have shown that, unlike Americans, readers in certain European countries are averse to advertising. See, e.g., Nathalie Sonnac, Readers' Attitudes Toward Press Advertising: Are They Ad-Lovers or Ad-Averse?, 13 J. MEDIA ECON. 249 (2000). On the other hand, TiVo and other related products that permit ad avoidance and deletion are currently very popular, as one study cites that TiVo viewers skip about 60% of commercials. See A Farewell to Ads?, ECONOMIST, Apr. 15, 2004, available at http://www.economist.com/business/display Story.cfm?storyid=2598890. is Lisa George & Joel Waldfogel, Who Benefits Whom in Daily Newspaper Markets? 11 (Nat'l Bureau of Econ. Research, Working Paper No. 7944, 2000). [Vol. 2005 DEFINING ANTITRUST MARKETS sellers will use it. Of course, the government facilitates these exchanges with various laws and through its own buying and selling activities. For-profit transaction systems are based on the same principles, although they have challenges that governments-which can create a platform by fiat-do not necessarily have.2" Although bank checks and travelers' checks illustrate examples of for-profit transaction systems, we focus on payment cards, which have been the subject of significant competition policy scrutiny in many countries. Diners Club started the first two-sided payment system in 1950.21 Before then, stores issued payment cards to their customers for use only at their stores.22 Diners Club began by getting a set of restaurants to agree to take its card for payment; that is, Diners Club would reimburse the restaurant for the meal tab and in turn collect the money from the cardholder.23 It also persuaded individuals to take its card and to use it for payment. Starting with a small base in Manhattan, it grew quickly throughout the United States and other countries.24 Diners Club charged restaurants seven percent of the meal tab. Cardholders had to pay an annual fee, which was offset in part by the float they received from having to pay their bills only once a month. As a result, Diners Club earned most of its revenue-and most likely all of its gross margin-from merchants. Other entrants into the charge and debit card businesses have followed this same approach.25 Determining who subsidizes the credit card system is a bit more complicated because the product bundles a transaction feature (for which the cardholder pays little) and a borrowing feature (for which the cardholder 20 DAVID S. EVANS & RICHARD SCHMALENSEE, PAYING WITH PLASTIC 1149-62 (MIT Press 2005). 21 Id. at 4. 22 Id. at 53. 23 Id. at 54. 24 Id. 25 Id. at 54-55. No. 3:667] COLUMBIA BUSINESS LAW REVIEW incurs finance charges). However, it is safe to say that merchants are the main source of revenue for credit cards held by people who do not revolve balances.26 American Express, Discover, and Diners Club (until its recent absorption into MasterCard) set prices for merchants, including the merchant discount, which gives rise to a positive, variable transaction price. 7 Similarly, they set prices for cardholders, such as annual fees and various records, which may give rise to negative variable transaction prices. Card associations, such as MasterCard and Visa, are examples of cooperative 2SPs. To consummate a transaction, the parties must agree on the division of profits and the allocation of various risks between the entity that services the merchant and the entity that services the cardholder. Most card associations set this centrally as, in effect, a standard contract between the businesses that service the two sides. Typically, they agree that the entity that services the merchant pays a percentage of the transaction-the "interchange fee"-to the entity that services the cardholder.28 This fee ultimately determines the relative prices for cardholders (issuers obtain a revenue stream for which they compete) and merchants (acquirers pass the cost of the interchange fee onto merchants). As we discuss below, this centrally set fee has been the subject of litigation and regulatory scrutiny.2 9 D. Software Platforms A software platform provides services for applications developers. These services help developers obtain access to the hardware for the computing device in question, as well as, other helpful services. Users can run these applications only if they have the same software platform as that relied on by the developers. Developers can sell their applications 26 Evans I, supra note 3, at 345. 27 EVANs & SCHMALENSEE, supra note 21, at 150-52. 28 Id. at 11. 29 Id. at 285-86. [Vol. 2005 only to users that have the same software platform that they used to write their applications. Software platforms are central to several important industries, including personal computers (e.g., Apple, Microsoft), personal digital assistants (e.g., Palm, Treo), 2.5G+ mobile telephones (e.g., Vodafone, DoCoMo), video games (e.g., Sony PlayStation, Xbox), and digital music systems (e.g., QuickTime/iTunes, MusicMatch, RealPlayer, and Windows MediaPlayer). With the exception of video games, software platform owners make most of their revenue, and their entire gross margin, from the user side." Developers generally obtain access to platform services for free, and they acquire various software products that facilitate writing applications at relatively low prices. Video game console manufacturers, on the other hand, typically receive most of their gross margin from licensing access to their software and hardware platforms to game developers. They sell the video game console at close to or below manufacturing cost. III. ECONOMIC PRINCIPLES The body of theoretical economics literature on 2SPs is relatively new. Economists have used stylized models to derive results that apply to some of the industries described above." The precise results are sensitive to assumptions 30 ANTHONY PICARDI ET AL., 1994 WORLDWIDE SOFTWARE REVIEW AND FORECAST, IDC Market Analysis No. 9,358 (Nov. 1994) (on file with the author); EVAN QUINN ET AL., 1995 WORLDWIDE SOFTWARE REVIEW AND FORECAST, IDC Market Analysis No. 10,460 (Nov. 1995) (on file with the author); STEVE GARONE ET AL., 1996 WORLDWIDE SOFTWARE REVIEW AND FORECAST, IDC Market Analysis No. 12,408 (Nov. 1996) (on file with the author); 1997 WORLDWIDE SOFTWARE REVIEW AND FORECAST, IDC Market Analysis No. 14,327 (Oct. 1997) (on file with the author); STEVE MCCLURE ET AL., 1999 WORLDWIDE SOFTWARE REVIEW AND FORECAST, IDC Market Analysis No. 20,161 (Oct. 1999) (on file with the author); RICHARD V. HEIMAN ET AL., WORLDWIDE SOFTWARE REVIEW AND FORECAST, 2001-2005, IDC Market Analysis No. 25,569 (Sept. 2001) (on file with the author). " For examples of models of the payment card and telecommunications industries, see Jean-Charles Rochet & Jean Tirole, No. 3:667] DEFINING ANTITR US T MA RKE TS COLUMBIA BUSINESS LAW REVIEW about the economic relationships among the various industry participants. Even for these special cases, it remains difficult to obtain results without making further assumptions about the precise nature of the relationships among demand, cost, and indirect network effects.32 Nevertheless, several principles have emerged from this literature that seem robust. They appear to rely on a few assumptions: the platform has two groups of customers; there are indirect network externalities; and customers cannot resolve these externalities themselves. A. Pricing To see the intuition behind pricing, consider a platform that serves two customer groups, A and B. It has already established prices for both groups and is considering changing them." If it raises the price for members of group A, then fewer As will join. If nothing else changed, the relationship between price and the number of As would depend on the price elasticity of demand for As. Because members of group B value the platform more if there are more As, fewer Bs will join the platform at the current price for Bs. That drop off depends on the indirect network externality that is measured by the value that Bs place on As. But with fewer Bs on the platform, As also value the Cooperation Among Competitors: Some Economics of Payment Card Associations, 33 RAND J. ECON 549 (2002); Julian Wright, Optimal Card Payment Systems, 47 EuR. ECON. REv. 587 (2003); Julian Wright, Access Pricing Under Competition: An Application to Cellular Networks, 50(3) J. INDUS. ECON. 289 (2002). " That is, the models are based on assuming particular functional forms-e.g., linear-for relationships. Rochet & Tirole, supra note 2, at 993; Julian Wright, The Determinants of Optimal Interchange Fees in Payment Systems, 52(1) J. INDUS. ECON. 295-96 (2004). " To keep matters simple, we consider the case where each side is charged a membership fee. See Mark Armstrong & Julian Wright, Two- Sided Markets, Competitive Bottlenecks and Exclusive Contracts (Social Science Research Network, Working Paper, 2004), available at http://ssm.comlabstract=654187. More generally, platforms are natural businesses for two-part tariffs involving an access fee and a usage fee. [Vol. 2005 platform less, leading to a further decline in their demand. Thus, there is a feedback loop between the two sides: The effect of an increase in price on one side results in a decrease in demand on the first side because of the direct effect of the price elasticity of demand; then, demand on both sides decreases as a result of the indirect effects from the externalities. The change in revenue from a change in price for As, therefore, depends on the price elasticity of demand for As and the indirect network effects between the two sides. 4 Of course, the platform would like to find the prices that maximize its profits by taking these same sorts of considerations into account. Single-sided businesses determine profit-maximizing profits by selecting the output level at which marginal revenue equals marginal cost and then charge the corresponding price for this quantity from the demand curve. 5 For 2SPs, three results appear to be robust: " The optimal prices depend in a complex way on the price elasticities of demand on both sides, the nature and intensity of the indirect network effects between each side, and the marginal costs that result from changing the output of each side. • The profit-maximizing, nonpredatory prices may be below the marginal cost of supply for that side or even negative. * An increase in marginal cost on one side does not necessarily result in an increase in price on that side relative to price on the other 14 Costs necessarily go down. As is always the case with profit maximization, the price increase is profitable if revenues do not decline more than costs decline. This equilibrium is often described by the standard Lerner formula that states that the price-cost margin equals the inverse of the elasticity of demand. " The standard Lerner formula addresses this equilibrium and provides that the price-cost margin equals the inverse of the elasticity of demand. See DENNIS W. CARLTON & JEFFREY M. PERLOFF, MODERN INDUSTRIAL ORGANIZATION 92 (Addison-Wesley, 3d ed. 1999). No. 3:667] DEFINING ANTITRULST MRKETS side. 6 More generally, the relationship between price and cost is complex, and the simple formulas used in single-sided markets do not apply. For many platforms it is sensible to charge two different kinds of prices: an access charge for joining the platform and a usage charge for using the platform. Although these costs are interdependent, one can think of the access charge as affecting how many customers join the platform and the usage charge as affecting the volume of interactions between members of the platform. Most software platforms levy access charges on users-who have to license the software platform but then can use it as much as they want-and impose neither access nor usage charges on developers. Videogame console vendors, however, charge a usage fee to game developers-a royalty based on the numbers of games that are sold. Users pay this usage fee indirectly when they purchase games for the console. Payment card systems also generally charge merchants a usage fee. Cardholders may pay an access fee (the annual card fee), but they pay either no usage fee or a negative one if they receive rewards. The profit-maximizing reliance on access versus usage fees depends on many factors, including the difficulty of monitoring usage and the nature of the externality between the two sides. Cardholders care about card acceptance, for instance, while merchants care about usage. Therefore, it seems sensible not to charge merchants for access and not to charge consumers for usage. The empirical evidence suggests that prices that are at or below marginal cost are common for 2SPs.38 Table 2 summarizes the evidence. 36 Under the particular demand assumption employed by Rochet and Tirole, the ratio of the profit-maximizing prices the two sides are charged is independent of side-specific marginal costs. An increase in the marginal cost on one side will raise both prices, keeping their ratio unchanged. This is not a general result, but it does illustrate a possibility that does not exist in single-sided markets. Rochet & Tirole, supra note 2, at 997. "' Evans et al., supra note 14, at 31. 38 Evans I, supra note 3, at 328. COL UMBIA B USINESS LA W RE VIE W [Vol. 2005 Table 2. Examples of 2SP Pricing Structures39 Industry Side Access Usage Heterosexual Dating Men / 4 Clubs Women 0 0 User / 4 DoCoMo i-Mode Content-Provider 0 '1 U.S. Real Estate Seller '1 0 Brokers Buyer 0 0 Reader 4i (=MC) 0Magazines Advertiser 0 41 Shopper - 0 Shopping Malls Store 0/ PC Operating User '1 0 Systems Developer '1 ( (industry share data); Newspaper Association of America, Top 20 U.S. Daily Newspapers by Circulation, http://www.naa.org/info/facts01/18- top20circ/index.html; Stephen Labaton, U.S. Backs Off Rules for Big Media, N.Y. TIMES, Jan. 28, 2005, at Cl; AL GILLEN & DAN KUSNETZKY, WORLDWIDE CLIENT AND SERVER OPERATING ENVIRONMENTS 2004-2008 FORECAST, IDC Market Analysis No. 32,452 (2004); NIELSEN MEDIA RESEARCH, THE NIELSEN REPORT NO. 828 (2005); NIELSEN MEDIA RESEARCH, THE NIELSEN REPORT No. 833 (2005); SCHELLEY OLHAVA, WORLDWIDE VIDEOGAME HARDWARE AND SOFTWARE 2004-2008 FORECAST AND ANALYSIS, IDC Market Analysis No. 31,260 (2004). COL UMBIA B USINESS LA W RE VIE W [Vol. 2005 DEFINING ANTITRUST M4RKETS Reader Advertiser Common: In 1996, the average number of magazine issues read per person per month was 12.3. Also common for advertisers: For example, AT&T Wireless advertised in the New York Times, The Wall Street Journal, and Chicago Tribune, among many other newspapers, on Aug. 26, 2003. Wall Street Journal had a 28% share of the five largest newspapers. (2001) I 4 + Viewer Advertiser Common: For example, viewers in many major metropolitan areas, have access to at least four main network television channels: ABC, CBS, FOX, and NBC. Also common for advertisers: For example, Sprint places television advertisements on the four main networks. U.S. law forbids broadcasters from owning TV stations reaching more than 35% of the nation's television audience. Uncommon for users: Microsoft has a Individuals typically 96% share of use only one operating revenue of client system. Common for operating End User developers: As noted systems. (2004) Operating earlier, the number of System Application developers that develop Developer for various operating systems indicates that developers engage in significant multihoming. Newspapers and Magazines Network Television No. 3:667] COLUMBIA BUSINESS LAW REVIEW Varies for players: The Sony PSi and average household that PS2 had a 63% owns at least one share in North console owns 1.4 America. (2003) Game consoles. Common for Video Game Player developers: For Console Game example, in 2003, Developer Electronic Arts, a game developer, developed for the Nintendo, Microsoft, and Sony platforms. Common: Most The Visa system American Express had an 45% cardholders also carry share of all at least one Visa or credit, charge, Payment Cardholder MasterCard. In and debit Pard addition, American purchase volume. Card Merchant Express cardholders (2004) can use Visa and MasterCard at almost all places that take American Express. V. THE ANALYSIS OF MARKET POWER It is useful to start with market power to clarify ideas. Economists generally care about determining whether an entity (a firm or a collection of firms) has market power for three reasons, which vary in importance across antitrust matters. First, entities that have or could obtain significant market power can, by definition, raise prices above the competitive level, restrict output, and reduce consumer and social welfare. Second, and related the first reason, entities that have significant market power generally have the ability to engage in business practices that could foreclose competition. Third, entities that obtain significant market power from using particular business practices may be able to recoup costs that they incur from investing in anticompetitive activities, such as predatory pricing and [Vol. 2005 DEFINING ANTITRUST MARKETS vertical foreclosure.56 The use of business practices by entities that either lack market power or are unlikely to acquire it are often presumed benign (except of course for naked price fixing and related cartel practices). The economics of 2SPs provides several insights into analysis of market power. It is of course an empirical question whether two-sidedness matters for a particular antitrust issue involving a particular two-sided platform business. The link between the customers on the two sides limits the extent to which a price increase on either side is profitable. Therefore, it necessarily limits market power, all else equal. Consider two sides A and B. An increase in the price for side A reduces the number of customers on side A, and therefore, reduces the value that customers on side B receive from the platform. The decrease in number of side A customers reduces the price that side B will pay and the number of customers on side B, which reduces the demand on side B. These positive feedback effects may take some time to work themselves out, but it is clear that the ordinary price elasticity on side A understates true price sensitivity. Competition on both sides limits profits. Suppose that in a market without multihoming, there is limited competition on side A because customers cannot easily switch between vendors on that side, but there is intense competition on side B because customers can and do switch between vendors based on price and quality. If competitors on side B cannot differentiate their products and otherwise compete on an equal footing, then the ability to raise prices on side A will not lead to an increase in profits. Any additional profits on side A will be wiped away by competition on side B. This point is especially relevant for assessing incentives and recoupment. It is also worth noting that the possibility of multihoming on side B will permit positive profits as it reduces the intensity of competition. 56 In contrast, economists and courts consider naked price fixing and related cartels as anticompetitive business practices, regardless of the amount of market power the entity holds. No. 3:667] For 2SPs, price equal to marginal cost (or average variable cost) on a particular side is not a relevant economic benchmark for evaluating either market power or claims of predatory pricing. As we saw above, the price on each side is a complex function of the elasticities of demand on both sides, indirect network effects, and marginal costs on both sides. Thus, it is incorrect to conclude, as a matter of economics, that deviations between price and marginal cost on one side indicate that 2SPs are pricing to exploit market power and drive out competition. 7 VI. MARKET DEFINITION Using market definition facilitates understanding of the constraints on business behavior and assessment of the contours of competition that are relevant for evaluating a practice.58 In some cases, the fact that a business could be considered a 2SP may be irrelevant, either because the indirect network effects, though present, are small or because nothing in the analysis of the practices really hinges on the interlinked demand. In other cases, the fact that a business is a 2SP will prove important both for identifying the real dimensions of competition and focusing on sources of constraints. As a general matter, antitrust market definition has been criticized.59 Although constraints on market power tend to " For the 2SP as a whole, a formula similar to the standard Lerner index emerges in the Rochet-Tirole model. This is not a general result, and thus, it suggests that the overall price-cost margin is somewhat less relevant for evaluating overall market power than in single-sided businesses. 5S MASSIMO MOTTA, COMPETITION POLICY: THEORY AND PRACTICE 40-41, 115-17 (Cambridge Univ. Press 2004). " For example, Michael Katz, former Deputy Assistant at the Department of Justice, said, "Formal market definition has taken on a life of its own and this formalism attempts to impose sharp boundaries even where they do not exist. Particularly in differentiated products markets, mechanical market definition risks weakening the analysis rather than strengthening it and there are risks of misleading conclusions." See EC Making Increasing Use of Merger Simulation Techniques in Antitrust COLUMBIA BUSINESS LAW REVIEW [Vot. 2005 DEFINING ANTITRUST MARKETS be a matter of degree, in practice, common approaches to market definition label a product as either in the market (and therefore a constraint) or outside the market (and therefore not a constraint). The role of products within this artificially defined market often is assessed according to shares of revenue received by products within the market, despite the fact that these products are imperfect substitutes for each other, and that other lesser, imperfect substitutes have been excluded altogether. Neither of these mechanical approaches to market definition has any basis in economics. Nevertheless, understanding constraints on business behavior and determining the contours of competition that are relevant for evaluating a practice are important steps in analyzing any antitrust matter. One can achieve this understanding through a looser form of market definition: one that is less insistent on defining sharp boundaries and that considers the degree of constraints than is often used in practice. In fact, industries with 2SPs are sufficiently complex that mechanical market definition exercises are particularly likely to obscure market realities. Figure 1 below shows potential sources of competition constraints for a two-sided platform denoted by A. It faces competition of some degree from other differentiated 2SPs that serve the same customer groups (e.g., the newspapers in a city). It also faces competition from single-sided businesses that provide competitive services to one side only (e.g., billboards). Moreover, the 2SP faces competition from other 2SPs that provide products that compete mainly with one side but not the other (e.g., advertising-supported television). Of course, the existence of these constraints does not mean that they are important, but only that they must be considered. Probes; Market Definition Taking Back Seat-Analysis, MERGERMARKET.COM, Jan. 31, 2005 (on file with the authors). No. 3:667] Figure 1. Types of Differentiated Platform Competition side 1 Ore it- sided Irtersectirg E side 3 F- Coincident One- Intersecting sided A B C D F 3 X X X X 2 X X X X 3 X Magill," the leading European Community case involving the compulsory licensing of intellectual property, provides an interesting example of differentiated 2SPs. The defendants were television stations (RTE, BBC, and ITV) whose broadcasts were received in Ireland. RTE and ITV were advertiser-supported media;61 BBC was a government- supported station with no advertising. RTV, ITV, and the BBC operated another 2SP. They also produced television guides that contained their own weekly listings. These guides charged a modest fee to readers, like most magazines, and earned significant revenues from advertisers. The stations benefited from subscribers both because they increased advertising revenue for the guides, and they increased the audiences for their stations. Magill TV Guide ("Magill") published a weekly advertising-supported guide that contained the listings of the three stations. The stations complained that this violated their copyrights, and Magill, with the Commission on its side, complained that this was anticompetitive. The 60 Joined Cases C-241/91 P and C-242/91 P (Magill cases), RTE and ITP v. Comm'n of the Eur. Cmtys. 1995 E.C.R. 1-743. 61 RTE also received revenue from assessments charged to owners of television sets. 62 Each station also provided their daily listings to newspapers-other 2SPs-that combined the listings. COL UMBIA B USINESS LA W RE VIE W [Vol. 2005 DEFINING ANTITRUST MARKETS European courts mandated that the stations provide a compulsory license to their copyrighted listings.63 The European Commission and the courts premised their decision on the existence of a market for weekly television guides for readers that contained listings of all three stations. 4 Analyzing market definition and power in such a case seems quite complicated given the two-sided nature of the television guide business and its link with the two-sided television broadcast business. Furthermore, it is not possible to analyze the competitive constraints on weekly television guides-the essence of the market definition and power examination-without considering the sale of advertising directly through the guides and indirectly (in the case of RTV and ITV) through the television stations. Nor for that matter is it possible to understand the motivation of the television stations in refusing to license their listings to others without considering the two-sided nature of their businesses. Taking two-sided features into account is important for the sorts of mechanical market definition exercises that have become popular in merger analysis. To illustrate this, we show how the existence of two separate customer groups affects critical loss analysis in the simple case where there are competing differentiated 2SPs.6 5 The same considerations apply to the SSNIP (small but significant non-transitory increase in price) analysis that is memorialized in the merger guidelines used by the United States and European authorities.6 Consider the standard single-sided critical loss approach to market definition. Given a small increase in price, the "critical loss" is the amount of output reduction that the " Magill, supra note 61, 1 134. 64 Id. IT 89-91. " As noted above, horizontal or vertical differentiation would be necessary for competing 2SPs to be viable. 6 DOJ & FTC, U.S. HORIZONTAL MERGER GUIDELINES, available at http://www.usdoj.gov/atr/public/guidelines/horizbook/hmgl.html; EU HORIZONTAL MERGER GUIDELINES, available at http://europa.eu.int/ scadplus/leg/en/lvb/126107.htm. No. 3:667] hypothetical monopolist needs for its reduced profits from lost sales to exceed its revenues from higher prices on retained sales. The "actual loss" is the output reduction that would actually result from the small increase in price. Under this approach, if the actual loss is greater than the critical loss, then the products sold by the hypothetical monopolist are a relevant market. One can undertake the same analysis in two-sided industries, but there are some important differences. The critical loss calculation must recognize that there are additional losses in two-sided industries. An increase in price on side A has the usual effect in reducing demand of side A. Moreover, the smaller side A is less attractive to side B, which causes a reduction in demand on side B. In turn, the smaller side B is now less attractive to side A, which leads to a reduction in demand on side A, and so on. This process results in two effects that increase the losses caused by a price increase. First, there is a multiplier effect-the overall reduction in demand on side A is greater than in single-sided industries because the platform is less attractive to side A consumers because side B is smaller. Second, in addition to losses on side A, there are now losses on side B, which are also subject to a multiplier effect. VII. CONCLUSION The indirect network effects among customer groups served by a single business are strong in many important industries. Businesses in these industries operate 2SPs. The economics of 2SPs provide insights into how these businesses and industries behave, which are relevant for competition analysis, including market definition, coordinated practices, and unilateral practices. The economic literature provides robust results-that is, results that are not dependent on only fragile assumptions-that can assist in this analysis. These results include the consequences of interlinked demand between customer sides for prices; prices do not, contrary to the standard model, have a tight relationship with cost. [Vol. 2005COL UMBIA B USINESS LA W RE VIE W No. 3:667] DEFINING ANTITRUST MA RKETS 701 As with almost any application of economics to policy, several cautions are prudent. First, many of the theoretical results in the literature to date are, like those in other areas of industrial organization, based on quite abstract models of how industries operate and on special assumptions regarding demand and cost. Second, presently there has been little rigorous empirical research on 2SPs or competition among them. Third, the existing theoretical and current empirical work suggest that 2SP businesses are highly dependent on the specific institutions and technologies within an industry. Accordingly, one must be careful not to generalize inappropriately.