Wikipedia Deep Dive

Two-sided market

13 min read

The Matchmaker's Dilemma

Here's a puzzle that haunted technology entrepreneurs for decades: How do you throw a party that nobody wants to attend until everyone else is already there?

This isn't a riddle. It's the fundamental challenge facing anyone who tries to build what economists call a two-sided market—a platform that only becomes valuable when it attracts two different groups of people who need each other but can't find each other on their own.

Think about it. A dating app with no women is useless to men. A job board with no employers is worthless to job seekers. A credit card that no stores accept might as well be a piece of plastic with your name on it. Each side needs the other side to show up first, but neither side has any reason to show up until the other side already has.

This chicken-and-egg problem has shaped the modern economy in ways most people never notice. It explains why you don't pay to use Google. It explains why Sony lost hundreds of dollars on every PlayStation 3 it sold. And it explains how a few companies—credit card networks, operating systems, social media platforms—have managed to dominate their industries so completely that competing with them seems almost impossible.

What Makes a Platform Different

A two-sided market is fundamentally an intermediary. It's a matchmaker. But not every business that connects buyers and sellers qualifies.

Consider your local supermarket. Shoppers want more products from more suppliers. Suppliers want access to more shoppers. Sounds like a two-sided market, right? But here's the crucial distinction: the supermarket doesn't let you interact directly with the supplier. You can't negotiate with the farmer who grew your tomatoes. You can't request that the bread company change its recipe. The supermarket buys from suppliers and sells to you. It's a traditional middleman, not a platform.

A true two-sided platform enables direct interaction between its two user groups. On eBay, buyers and sellers negotiate prices, ask questions, and build relationships. On Airbnb, guests communicate directly with hosts about everything from check-in times to restaurant recommendations. The platform provides the infrastructure and the rules, but the actual exchange happens between the participants themselves.

This distinction matters because it changes everything about how the business works—especially how it makes money.

The Economics of Network Effects

The magic of two-sided markets comes from something called network effects. The concept was first formally described in 1985 by economists Michael Katz and Carl Shapiro, and it explains why these businesses behave so differently from traditional companies.

Network effects come in two flavors.

Cross-side network effects describe what happens when growth on one side of the platform makes it more valuable to the other side. More sellers on eBay means more selection for buyers. More developers writing apps for iPhone means more reasons for consumers to buy iPhones. These effects are almost always positive—more people on the other side is almost always better.

Same-side network effects describe what happens when growth on one side affects other users on that same side. These can be positive or negative. Positive: more people using the same portable document format makes it easier to share files with colleagues. Negative: more sellers competing on Amazon means fiercer competition and thinner margins for each individual seller.

Here's where it gets interesting. Traditional businesses face diminishing returns to scale. The bigger you get, the harder it becomes to find new customers who find your product appealing. But platforms with strong network effects experience increasing returns to scale. The bigger you get, the more valuable you become, which makes it easier to get even bigger.

This is why mature platform industries tend to be dominated by a handful of giants, or sometimes just one. It's not just that Visa was better at operations than its competitors. It's that once Visa reached a certain size, the network effects made it almost impossible for anyone else to catch up.

The Art of Asymmetric Pricing

If you've ever wondered why so many internet services are free, the answer lies in the strange economics of two-sided markets.

In a traditional business, you charge each customer based on the value you provide them and the cost of serving them. Simple. But in a two-sided market, the value you provide to each side depends on how many people are on the other side. This creates opportunities for pricing strategies that would seem insane in any other context.

Adobe learned this lesson the hard way. When the company first launched the Portable Document Format—better known as PDF—it charged for both the software to create PDFs and the software to read them. The product flopped. Why would anyone create documents in a format that recipients would have to pay to read?

The breakthrough came when Adobe made the PDF reader free. Suddenly, anyone could open a PDF. This made the format actually useful, which made businesses willing to pay for the software to create PDFs. By giving away one product, Adobe created demand for another.

This strategy—subsidizing one side of the market to attract the other—has become the playbook for platform businesses. The subsidized side is sometimes called the "subsidy side" and the paying side is called the "money side." Figuring out which is which requires answering two questions: Which side is more price sensitive? And which side's growth creates more value for the other side?

Gaming consoles offer a dramatic example. Sony lost an estimated two hundred and fifty dollars on every PlayStation 3 it sold. Two hundred and fifty dollars! The company was essentially paying people to take its product. But this made sense because each new console owner became a potential customer for game developers, who paid Sony royalties on every game sold. The gamers were the subsidy side. The developers were the money side.

The Microsoft Lesson

In the early 1980s, two companies were racing to define personal computing: Apple and Microsoft. Both understood that an operating system was only as valuable as the software that ran on it. But they approached the two-sided market problem very differently.

Apple, following traditional business logic, charged substantial fees for its software development kits—the tools that programmers needed to create applications for Macintosh computers. If developers wanted access to Apple's customers, they would have to pay for the privilege.

Microsoft took the opposite approach. It priced its development tools so low that the barrier to entry practically disappeared. Any programmer with an idea could afford to try building software for Windows.

The result was an explosion of Windows applications. More applications made Windows more valuable to consumers. More consumers made Windows more valuable to developers. The virtuous cycle fed on itself until Microsoft dominated the personal computer market so completely that the United States government filed antitrust charges.

This illustrates a second pricing rule beyond "subsidize the price-sensitive side." Sometimes you should subsidize the side that adds the most value to the platform, even if that side isn't the most price-sensitive. Microsoft subsidized developers not just because developers were price-sensitive, but because each new application made the entire platform more valuable.

Standards Wars and the Winner-Take-All Dynamic

The history of technology is littered with format wars, and two-sided market economics explains why these battles are so vicious—and why the winner often takes everything.

Consider the legendary clash between VHS and Betamax in the home video market. By most technical measures, Betamax was the superior format. Its picture quality was better. Its tapes were more compact. Sony, its creator, was an engineering powerhouse.

None of that mattered.

VHS won because its backers understood the two-sided market dynamics. They licensed the technology more freely, allowing more manufacturers to produce VHS players, which drove down prices and increased adoption. They secured agreements with movie studios to release films on VHS. More movies meant more reason to buy VHS players. More VHS players meant more reason to release movies on VHS.

Once VHS gained a lead, the network effects became self-reinforcing. Video rental stores, facing limited shelf space, stocked more VHS tapes because more customers owned VHS players. This made VHS even more attractive to new customers. Betamax, despite its technical superiority, became a footnote.

The same pattern appeared in the color television wars of the 1950s. CBS and RCA promoted incompatible color broadcasting standards. RCA's master stroke was flooding the market with inexpensive black-and-white televisions that couldn't display CBS's color format but could display RCA's. Broadcasters, wanting to reach the largest possible audience, had to use RCA's format. RCA also subsidized "Walt Disney's Wonderful World of Color," giving consumers a reason to buy color sets. CBS's technically superior system never had a chance.

The Multihoming Question

Not every two-sided market ends with a single winner. Sometimes users participate in multiple competing platforms simultaneously—a behavior economists call "multihoming."

You probably multihome without thinking about it. Your wallet might contain both Visa and Mastercard. Your phone might have apps for Uber and Lyft. You might shop on both Amazon and eBay. Each platform serves slightly different needs, or you use whichever one offers a better deal for a particular transaction.

The tendency toward winner-take-all depends heavily on multihoming costs—all the expenses and hassles involved in maintaining relationships with multiple platforms. These costs include obvious things like subscription fees, but also the mental burden of learning different interfaces, the time spent managing multiple accounts, and the friction of switching between services.

When multihoming costs are low, multiple platforms can coexist. Credit cards survive as an oligopoly partly because carrying multiple cards in your wallet costs almost nothing. When multihoming costs are high, markets tend toward monopoly. Most people don't want to maintain expertise in multiple operating systems, which helps explain why Windows dominated for so long.

When Free Doesn't Work

The logic of subsidizing one side of the market has limits, and companies that forget this tend to learn expensive lessons.

In 1999, a company called Free-PC tried to take the subsidy model to its logical extreme. It would give away computers and internet access to consumers who agreed to view advertisements that couldn't be minimized or hidden. The theory was sound: attract a huge user base on the subsidy side, then monetize through advertisers on the money side.

The company lost eighty million dollars.

The problem was that advertisers weren't willing to pay premium rates to reach consumers who were, by definition, so cost-conscious that they would tolerate intrusive advertising to avoid paying for a computer. The money side simply didn't value access to the subsidy side enough to cover the costs.

This reveals an important caveat to two-sided market strategy: giving away physical goods with significant unit costs is far riskier than giving away digital goods with near-zero marginal costs. Adobe could give away unlimited PDF readers because each additional download cost essentially nothing. Free-PC had to actually manufacture and ship computers.

The Platform's Balancing Act

Running a two-sided market requires constant calibration. The platform must satisfy both sides well enough to keep them engaged, but each side often wants things that conflict with what the other side wants.

Buyers on eBay want low prices. Sellers want high prices. The platform's policies—auction rules, fee structures, buyer protection programs—inevitably favor one side or the other in any given situation. Tilt too far toward buyers and sellers flee to other marketplaces. Tilt too far toward sellers and buyers lose trust.

Airbnb faces similar tensions. Hosts want maximum flexibility to set their own rules, cancel reservations when convenient, and charge whatever the market will bear. Guests want reliability, standardized experiences, and protection when things go wrong. Every policy decision involves trade-offs.

This balancing act becomes especially fraught when platforms grow large enough to attract regulatory attention. Government intervention on one side of a two-sided market can create what economists call "waterbed effects"—pressure on one side causes changes to pop up on the other side.

If regulators cap the fees a credit card network can charge merchants, the network might respond by reducing rewards for cardholders or increasing annual fees. The total economics of the platform have to balance somehow, and restrictions on one side inevitably affect the other.

Cooperation as Strategy

Sometimes the smartest move in a two-sided market is to avoid fighting.

The history of the DVD format offers an instructive contrast to the VHS-Betamax war. In the early 1990s, two competing groups were developing optical disc technologies that could have led to another devastating format war. Sony and Philips backed one approach. Toshiba and Warner backed another.

But the companies had learned from history. They knew that a format war would be expensive, that consumers would wait to buy until a winner emerged, and that the losing side would face massive losses. In 1995, they negotiated a compromise. The DVD format incorporated elements from both approaches, and all the major players agreed to support a single standard.

The result was rapid adoption. Consumers didn't have to worry about backing the wrong horse. Studios didn't have to release movies in multiple formats. The entire industry grew faster because everyone cooperated.

Why This Matters Now

Two-sided markets have existed for centuries—medieval fairs connected buyers and sellers long before the internet—but digital technology has supercharged their importance.

The near-zero marginal cost of digital goods makes subsidy strategies more viable. The internet's global reach allows platforms to achieve scale that would have been impossible in physical marketplaces. And the increasing returns to scale create competitive dynamics that can feel almost unfair to newcomers.

Understanding these dynamics helps explain the rise of companies like Google, Facebook, Amazon, and Uber. Each built a platform connecting two or more user groups. Each used some form of cross-subsidization to bootstrap network effects. Each now enjoys competitive advantages that stem not just from superior products but from the sheer difficulty of replicating their networks.

It also helps explain why breaking into these markets is so hard. You can't just build a better product. You have to solve the chicken-and-egg problem that the incumbent has already solved. You have to convince both sides of the market to switch simultaneously, or figure out how to subsidize one side long enough to attract the other.

The French economists Jean-Charles Rochet and Jean Tirole, along with Americans Geoffrey Parker and Marshall Van Alstyne, developed much of the formal theory behind two-sided markets. Tirole won the Nobel Prize in Economics in 2014, with his work on platform competition cited among his contributions. These ideas have moved from academic journals to corporate strategy sessions to regulatory proceedings.

The next time you use a free app supported by advertising, or watch a streaming service subsidize original content to attract subscribers, or see a technology company lose billions to gain market share, you're watching two-sided market economics in action. The matchmaker's dilemma hasn't gotten any easier to solve. But the rewards for solving it have never been greater.