Platform Pricing Structure and Moral Hazard

• Author: Guillaume Roger,Luís Vasconcelos
• Date: 01 September 2014
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/jems.12059

Platform Pricing Structure and Moral Hazard

GUILLAUME ROGER

School of Economics

University of Sydney

Sydney, Australia

guillaume.roger72@gmail.com

LU´

IS VASCONCELOS

University of Essex, Colchester, UK

and Nova School of Business and Economics

Lisbon, Portugal

lvasco@essex.ac.uk

We study pricing by a two-sided platform when it faces moral hazard on the sellers’ side. In

doing so, we introduce an equilibrium notion of platform reputation in an infinite horizon model.

We find that with transaction fees only, the platform cannot eliminate the loss of reputation

induced by moral hazard. If registration fees can be levied, moral hazard can be overcome. The

registration fee determines the participation thresholdof sellers and extracts them, whereas (lower)

transaction fees provide incentives for good behavior. This providesa motivation for platforms to

use registration fees in addition to transaction fees.

1. Introduction

Marketplaces, stock exchanges, and Internet-based trading platforms bring together

sellers and buyers of all stripes. Typically it is difficult to control the behavior of these

traders as they transact not with the platform but directly with each other. Hence op-

portunistic behavior can reasonably be expected to arise, and evidently does.1Although

the trading parties are the ones directly injured, this is a problem for the platform as it

affects the value of the service it offers, and therefore its ability to extract surplus from

traders. That is, platforms face a problem of reputation, which they can govern only

indirectly through the behavior of the parties they host.

For concreteness, consider the example of Apple Inc. It acts as a platform by

providing a marketplace for applications, the App Store, where third-party developers

list their wares for Apple users to purchase. Apple does not carefully audit the quality

We would like to thank Juan Carrillo, Nancy Gallini, Iliyan Georgiev, Bob Gibbons, Steffen Hoernig, Bruno

Jullien, Gustavo Manso, Jean-Charles Rochet, RichardSchmalensee, and Romain de Nijs for helpful discussions

and comments, as well as seminar participants at Caltech, the University of Melbourne, the University of

Southern California, the University of New South Wales,the University of Essex, the Nova School of Business

and Economics, the Universidade de ´

Evora, and conference attendees at the 2008 North American Summer

Meeting of the Econometric Society, the 2008 International Industrial Organization Conference, the 2010

Conference of the European Association for Research in Industrial Economics, the 2010 Annual Meeting of

the Association of the Southern European Economic Theorists, and the 2nd Workshop on the Economics of

ICTs. Any errors that remain areours. Lu´

ıs Vasconcelos gratefully acknowledges financial support from the

Fundac¸˜

ao para a Ciˆ

encia e Tecnologia under grant POCI/EGE/58934/2004.

1. For example, AlibabaScam.com is an independent site dedicated to outing scammers that operate on

the popular Alibaba.com. In April 2008, a German court ordered eBay to take preventive measures to guard

against the sale of fake Rolex watches.

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 3, Fall 2014, 527–547

528 Journal of Economics & Management Strategy

of these (currently 500,000) products. Apple also cannot directly control the actions of

developers, whose lack of effort may result in applications with security flaws, poor

performance or that interfere with other software. Developers may even engage in

malicious behavior such as phishing or outright fraud. Clearly, these problems may

affect the credibility of the App Store, and therefore its ability to sell these applications.

In this paper, we analyze how the pricing structure of a platform (like the App

Store) affects the prevalenceof opportunistic behavior by traders. We show that the use of

registration fees (in addition to transaction fees) helps mitigate the moral hazard problem

to the point of overcoming it entirely in some instances. Building on the construct of

Rochet and Tirole (2003), we study a model of repeated interactions over an infinite

horizon. Buyers and sellers need an intermediary (the platform) to transact, which can

charge them fees for its intermediation services. Tocapture the problem of opportunistic

behavior, we let sellers pick one of a good and a bad action, which affects the buyer’s

payoff directly. The good action is more costly to sellers, but more valuable to buyers—

for example, developers exert effort to ensure their applications do not compromise

computer security. Buyers do not observe the action of their counterparty before the

transaction is completed.

At the heart of the paper is the following. Buyers hold some belief that a seller

they are matched with takes the good action. This belief is the reputation of the platform.

A good reputation is helpful in that the buyers’ expected value from a trade increases

with reputation, and so does their willingness to trade. Given the fees charged by the

platform and its reputation, buyers decide whether to trade. If taking the bad action,

sellers are detected ex post with positive probability and may be excluded from the

platform.2Hence a cheating seller runs the risk of foregoing future trades. The exact

cost of exclusion depends on the fees and the number of participating buyers, as it

affects the probability of future transactions. Given fees and the mass of buyers willing

to trade, sellers (i) decide whether to trade, and (ii) which action to choose if trading. In

equilibrium, given the fees charged by the platform, buyers anticipate sellers’ behavior

and optimally respond to it and sellers anticipate buyers’ behavior and optimally reply

to it.

We show that combined with the threat of exclusion, prices turn out to be simple

and effective tools to mitigate traders’ opportunistic behavior.3Our main result states

that with registration fees and transaction fees (a two-part tariff), the moral hazard

problem can be entirely overcomein the sense that the platform can implement equilibria

where all participating sellers choose the good action. Moreover, the optimal outcome

for the platform (in terms of reputation and profit) absent moral hazard can be fully

replicated, when the buyers’ valuation for the good action is high enough. None of this

can be achieved with transaction fees alone, and the latter requires a proper combination

of transaction and registration fees.

2. Most trading platforms reserve the right to exclude participants if they are harmful to others, as for ex-

ample eBay,MySpace, Yahoo!Stores,Match.com, GumTree.com.au, or even the more laissez-faire craigslist.com.

See their respective Termsand Conditions. This is also t he case with the App Store.For example, it is known

to have excluded developers and pulled down applications such as a fake driver-license app and “Process

Killer,” an app able to stop other apps running in the background.

3. Some platforms may use a broader set of instruments, such as vetting their members, or policing

them, as do securities exchanges such as the New York Stock Exchange (NYSE) or the Chicago Mercantile

Exchange (CME). For example, the CME regularly audits its own clearing members for financial viability.

Furthermore, the NYSE and the National Association of Securities Dealers (NASD) have become a Self-

Regulatory Organization (SRO) through their joint enforcement arm called the Financial Industry Regulatory

Authority (FINRA). An SRO is able to enact and enforce its own rules, as well as the broader rule of law,and

engages in dispute resolution between parties. However no Internet trading site qualifies as an SRO.