Price Discrimination in Two‐Sided Markets

• DOI: http://doi.org/10.1111/jems.12038
• Date: 01 December 2013
• Published date: 01 December 2013

Price Discrimination in Two-Sided Markets

QIHONG LIU

Department of Economics

University of Oklahoma

NormanOK

qliu@ou.edu

KONSTANTINOS SERFES

Department of Economics and International Business

Bennett S. LeBow College of Business

Drexel University

Philadelphia PA

ks346@drexel.edu

We examine the profitability and welfare implications of targeted price discrimination (PD) in

two-sided markets. First, we show that equilibrium discriminatory prices exhibit novel features

relative to discriminatory prices in one-sided models and uniform prices in two-sided models.

Second, we compare the profitability of perfect PD, relative to uniform prices in a two-sided

market. The conventional wisdom from one-sided horizontally differentiated markets is that PD

hurts the firms and benefits consumers, prisoners’ dilemma. We show that PD, in a two-sided

market, may actually soften the competition. Our results suggest that the conventional advice

that PD is good for competition based on one-sided markets may not carry over to two-sided

markets.

1. Introduction

The aim of this paper is to study the implications of price discrimination (PD) in two-

sided markets.1For example, TV stations target advertisers, the one side of the market,

Wewould like to thank a coeditor and two referees for very helpful comments and suggestions. We would also

like to thank Chris Adams, Christian Ahlin, Marcus Asplund, Lu´

ıs Cabral, Jay Pil Choi, Bob Hunt, Alessandro

Lizzeri, Steven Matusz, Leonard Nakamura and seminar participants at DrexelUniversity, the Federal Reserve

Bank of Philadelphia, Michigan State University, the 2008 International Industrial Organization Conference

(IIOC), the 2008 NET Institute conference (NYU-Stern), the 2007 European Summer Meeting of the Econo-

metric Society (ESEM), the 2007 Far Eastern Meeting of the Econometric Society (FEMES), the 2007 Society

for the Advancement of Economic Theory (SAET) meeting, the 2007 Conference on Research in Economic

Theory and Econometrics (CRETE), the 2007 Chinese Economists Society (CES) meeting and the 2007 Eastern

Economic Association (EEA) meeting for helpful comments and suggestions. We thank the NET Institute

(www.NETinst.org) for financial support.

1. Two-sided (or multiple-sided) markets are markets that areorganized around intermediaries or “plat-

forms” with two (or multiple) sides who should join a platform in order for successful exchanges (trade) to

take place, see Alexandrov et al. (2011), Armstrong (2006a), Caillaud and Jullien (2003), Rochet and Tirole

(2003,2006), and Spulber (1999). For example, videogame platforms (e.g., Nintendo, Sony, and Microsoft)

need to attract both gamers and game developers. Newspapers need to attract advertisers and readers. Credit

cards need merchants and users. Most media and advertising markets are two-sided markets, for example,

Anderson and Coate (2005) and Anderson and Gabszewicz (2006). Other examples of two-sided markets in-

clude, newspapers, scholarly journals, magazines, shopping malls, dating services and Business-to-Business

(B2B) markets. More formally,a two-sided market is defined as one where the volume of transactions between

end-users depends on the structure of the fees and not only on the overall level of fees charged by platforms

(Rochet and Tirole, 2006).

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 4, Winter 2013, 768–786

Price Discrimination in Two-Sided Markets 769

with different advertising fees and viewers, the other side, with different subscription

fees (Gil and Grichton, 2010), or newspapers offer low introductory rates to new sub-

scribers (Asplund et al., 2008) and different rates to advertisers.

There exists a relatively large literature on oligopolistic third-degree PD in “one-

sided” markets, but this paper is among the first ones that examine this problem in

the context of a two-sided market.2The main message of the one-sided literature is

that PD intensifies price competition (prisoners’ dilemma) and therefore it is beneficial

for the consumers (at least on average).3The advice then given to policymakers and

antitrust authorities is that they should not worry much about firms acquiring and

using consumer information with the intention to customize prices, because after all

firm competition for consumers dissipates profits and transfers most of the surplus to

consumers.

Furthermore, it is well known that the presence of indirect externalities in two-

sided markets can intensify competition, for example, Armstrong (2006a). Platforms

have strong incentives to lower prices in order to sign-up moreagents. Therefore, putting

together the results from one-sided models with PD and from two-sided models with

no PD, one would expect that price discrimination in a two-sided market will generate a

very competitive environment with low prices and profits. This is true, but not always.

We show that when the marginal cost is low relative to the cross-group network exter-

nalities (e.g., digital products), then PD increases platform profits and hurts consumer

welfare.

The intuition for this result is as follows. In two-sided markets, PD has two effects

on competition. First, and similar to one-sided markets, when platforms can price dis-

criminate, in equilibrium, any two prices charged by two platforms to an agent always

differ by the difference in transportation costs. This flexibility in pricing reduces profits,

anegative effect. However, PD also has a second effect through the cross-group external-

ity.In particular, it may render the cross-group externality irrelevant in equilibrium, and

thus to improve profits relative to that under uniform pricing, a positive effect.4This is

because, uniform equilibrium prices depend on the cross-group externality. A stronger

externality increases each platform’s incentives to cut prices and as a result equilib-

rium prices fall. Discriminatory prices, on the other hand, are, under certain conditions,

independent of the cross-group externality.5The presence of the indirect externality in-

tensifies competition and discriminatory prices fall. Under the reasonable assumption

that prices cannot become negative, each platform, in the symmetric equilibrium, will

charge zero price to the agents that are located closer to the rival platform and to its own

agents will charge a premium which only depends on the transportation cost. Due to the

“limit price” nature of the problem under perfect PD and the assumption of nonnegative

prices, the feedback effect disappears in equilibrium. Hence, strong externalities imply

that uniform prices will fall whereas discriminatory prices do not change, which further

implies that PD in such a case is more profitable. Price flexibility is a curse in one-sided

2. By “one-sided” markets we simply mean markets with no externalities. For a survey of the literature

on oligopolistic PD in one-sided markets we refer the reader to Armstrong (2006b)andStole(2007).

3. See, for example, Thisse and Vives (1988), Shaffer and Zhang (1995), Bester and Petrakis (1996), Chen

(1997), Corts (1998), Fudenberg and Tirole (2000), and Liu and Serfes (2004). For spatial PD using nonlinear

pricing see Spulber (1981,1989).

4. In one-sided markets, cross-group externality is absent so only the first effect exists. Therefore,targeted

PD intensifies competition relativeto uniform pricing (under the standard assumptions of uniform distribution

and linear transportation cost).

5. If, on the other hand, discriminatory prices depend on externality as well, then both effects are negative,

and targeted PD intensifies competition even more than in one-sided markets.