Not all marketplaces can increase prices after winning the market. Can yours?

Not all marketplaces can increase prices after winning the market. Can yours?

Any marketplace facilitates the exchange of value between the “producer (of the value) and the “consumer (of the same value). By easily matching the two sides in one place, the marketplace adds a lot of value to both.

Typically, the exchange of value is also accompanied by an exchange of cash. In such a case, the marketplace takes a small commission/tax in return for the value it adds. Let’s call the person paying with cash the “buyer”. Similarly, the party receiving the cash in the transaction will be labeled the “seller”.

To keep terminology straight, let’s recap the four members that potentially exist in the marketplace:

  • Producer: adds value into the marketplace.
  • Consumer: consumes the value from the marketplace.
  • Buyer: adds real money into the marketplace.
  • Seller: receives real money from the marketplace.

Note that each of the four parties above can be a person, group or corporation. Thus, this framework applies to all marketplaces, B2B, B2C, C2C, etc. Note also that exchange of cash is not a necessary requirement in all marketplaces.

As we shall see though, not all marketplaces are the same in their ability to reach monopoly status. Furthermore, even if some marketplaces are able to capture a significant portion of the market, they still do not have an ability to increase prices significantly.

There are three basic kinds of marketplaces based on the dynamics of the different parties involved.

Consumer = Buyer

This is the strict two-sided marketplace where the consumer is the same as the buyer, and is typically also accompanied with the fact that the producer is the same as the seller. This marketplace is the most common. Key examples are eBay, Amazon, Uber& AirBnb.

Let’s take Uber as the prime example. The drivers are producing the value of rides, and riders are consuming that value. The riders are also the buyers as they pay with cash into the marketplace. Uber takes a cut, and then passes on the rest of the money to the drivers (sellers). Since the commission taken by Uber is a strict tax on the system, the marketplace must continue to keep on adding value to keep it’s lead ahead of competitors (like Lyft). Furthermore, until they win a significant portion of the market, Uber must also keep lowering their prices across the board to aggregate demand and get more riders. See this tweet by David Sacks to understand how more rider demand leads to more drivers despite lower prices. The same logic applies to all the marketplaces in this category.

So, let’s consider what happens when Uber has a significant portion of the market and then raises prices? Unless Uber’s value in the matching algorithm is so high that it cannot be replicated by competitors, as soon as Uber increases prices to increase profitability beyond economic equilibrium, it opens the door for a competitor to come in and compete with similar value and lower prices. Thus, to maintain the lead, Uber will be better off with lower prices and a larger market share, and will not increase prices for riders. Economists call this “perfect competition”, and companies in perfect competition in the long run are both productively and allocatively efficient. In the short-run, Uber might give incentives to drivers to flock to their marketplace in order to increase supply, but in the long-run, drivers will have no power left and must compete with each other to find equilibrium in prices.

These marketplaces benefit the consumers/buyers, but producers/suppliers typically have no power, and hence, hate them. From a societal perspective, that is a good thing.

Such marketplaces can enable the exchange of value through services (Uber, Instacart, Postmates, Doordash) or products (Amazon, eBay). In case of services, sometimes there is an additional 5th party that is involved — typically the party providing the underlying product. In such cases, the marketplace can expand the underlying market, and thus, demand $$ from the underlying market itself as an additional source of revenue. Example: Instacart can get a kick-back from Whole Foods for increasing their total sales. But from a consumer perspective, Instacart will raise prices only at their own peril.

Consumer = Producer

Ah, this is the kind of marketplace that dreams are made of. In this kind of marketplace, the consumer and the producer belong to the same group. Because of this, it has the additional effect that the marketplace itself becomes the seller. Because there is only one seller, if the marketplace reaches massive scale, by definition, it becomes a monopoly.

A good example is Facebook. Since all the users are both producing and consuming content, Facebook continues to add value through network effects, new features and superior feed updates for user engagement. Facebook tries very very hard to add value and keep all the people on their marketplace. Once scale is reached, the activity itself is monetized primarily through ads — typically through the entrance of 3rd party buyers. Facebook then takes this increased activity and attracts buyers into the system. Thus, Facebook is the seller of the user attention and advertisers become the buyers. Facebook does not share this cash with anyone, certainly not the users who are both producing and consuming the value (content). Furthermore, there is no competition and hence no incentive for Facebook to decrease prices from the buyers. The only competition exists from the outside world via companies like Google, which are also similar monopolies. Economists call this “monopolistic competition”. In such cases, the two products are not interchangeable, and thus, the companies compete more on features than on price. It actually serves both companies really well to add more features and keep increasing prices. Even if all advertising were to move to only Google and Facebook, the price/click for both platforms will continue to go up without the two companies actively colluding with each other.

In general, if the buyers do not have better alternatives anywhere, they are forced to pay the prices commanded by the marketplace. Such marketplaces can quickly become monopolies and use their position to set prices. Beware though, such marketplaces are very tough to build and require massive scale to succeed. Most successful communication apps fall in this category.

On the flip side, if the total volume of transactions (exchange of value) in such marketplaces is low, buyers have many more opportunities outside of this marketplace, and thus are in a much better position to dictate prices. For example, smaller websites with a tenth of the traffic of Facebook typically earn less than one hundredth the cash.

Producer = Buyer

This kind of marketplace is very tough to build — perhaps, the toughest to build. In such cases, the marketplace has to entice the producers first. To do that, the marketplace works very very hard to build the supply first, and once the consumers are aggregated, the burden of building up the supply moves to the producers. At that point, the producers also compete with each other and thus must pay the marketplace for listing or ads. Craigslist is a great example of such marketplaces. In case of Craigslist, the producer of value (party adding the listings) also has to buy listings for special kinds of listings — homes, rentals, jobs, etc. Thus, the producer is also the buyer (not of the rental, but rather adding money into the marketplace).

Such marketplaces tend to be the hallmark of a highly fragmented producer market. Additionally, marketplaces also need to control/monopolize distribution and access to the consumers at scale. The fragmentation of producers makes it very difficult to have enough liquidity initially (think listings for Craigslist), but also adds enough competition between producers that they have to become net buyers (typically of ads) to promote themselves, primarily because of the wild fragmentation. Once built successfully, such marketplaces are the most defensible.

Yelp is an example of a hybrid of this style of marketplace and the other monopolistic one (consumer=producer). In terms of reviews, the producer and consumer belong to the same group. However, a large part of Yelp’s value comes from having complete and accurate listings, and thus, Yelp provides a lot of tools to businesses to maintain their own page and even showcase flattering reviews and delete negative ones. Because Yelp’s business model lies firmly in this style of marketplace design, they are forced to provide these toolsets to the producers of the content and cannot contend with simply selling user activity on their platform.

There are additional combinations possible, but the economics are such that they don’t play out. I have listed them below for completion.

Producer = Seller

Same as consumer=buyer above. In such cases, the consumer also belongs to the same group as the buyer. Not a different scenario.

Consumer = Seller

This is not a valid scenario, as the consumer of the value in the system cannot be selling and getting money in return. In theory, this can work where the consumer=producer and hence is adding all the value in the system. Again, theoretically, all consumers can revolt together and ask the marketplace to share part of their bounty. But, in practice, this kind of organization is not present on the consumer side, and hence, the consumers never become sellers.

Buyer = Seller

This is not a valid scenario. If buyer=seller, then there is no reason for the marketplace to exist, and the transaction takes place outside.

Well, there it is. A fun way to look at the different kinds of marketplaces, and what business models can work in each dynamic. Some of them are definitely harder to build than others. All of them want to be larger to get network effects and aggregate the consumers, but payout at the end of that road is not the same in all cases. Some of the marketplaces will reach the end and take all the available cash, while others will have to contend with a tax in the system and only take a small commission. It is very important to keep this in mind so one can accurately plan for the size it will take for the marketplace to be wildly successful like Etsy versus Instagram.

This essay is a follow-up to 10+ factors to evaluate online marketplaces.

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