10+ factors to evaluate strict two-sided marketplaces

I have recently been giving a lot of thought to the product considerations in building two-sided marketplaces. A lot has been written about this topic, and some of the posts have been excellent. However, despite the plethora of articles out there, I have noticed that in all the discussions that I have had with other strong product designers, we tend to go around in circles while describing some of the key concepts and how they fit into the exact problem we are trying to solve. In other words, there isn’t a cohesive framework that lists the underlying metrics or key variables that can help a product designer quickly evaluate the merit of an idea for a two-sided marketplace.

This post by the great Bill Gurley details some of the most important considerations while evaluating marketplaces. It is a fantastic post with lots of great nuggets that reveal themselves over and over again, and I urge all who are interested in this topic to read the post and extract the learnings for themselves.

Before we get into the specifics, let’s first understand the nature of the space itself. From Wikipedia:

Two-sided markets, also called two-sided networks, are economic platformshaving two distinct user groups that provide each other with network benefits.

The wikipedia article then provides examples of companies like Facebook, Match.com and eBay as two-sided marketplaces. While technically true, there is a subtle-yet-important distinction between a service like Facebook and a service like eBay when it comes to the two-sidedness of the marketplace. Specifically, it matters greatly whether the consumer of the service is also the buyer of the service. In case of eBay, the consumer and the buyer are the same person as the buyer is paying with real money in return for the value provided by the seller (supplier). In Facebook’s case, the consumer consumes information provided by suppliers (publishers) and pays for it with attention, but not money. This attention is then monetized through the Facebook platform and paid for, in real money, by the buyers (advertisers). Thus, Facebook is serving three different entities: suppliers, consumers and buyers, and can be considered to be a three-sided marketplace. This distinction matters greatly in how the incentives are structured for the supply side (adding value) and demand side (consuming value).

Since the distinction is important, but not clearly vocalized, I am going to define the term “strict two-sided marketplace” to mean two-sided marketplaces where there is an explicit monetary transaction between the consumer and the seller, and thus, the consumer is also the buyer. In short, marketplaces like eBay, Uber and AirBnb, and not like Facebook, Google or even Medium.

In this article, Ben Thompson talks specifically about innovation, Apple and Clayton Christensen, but the core point of his thesis is that it matters greatly whether the consumer and the buyer are the same versus not. The main point here is that the distinction is vastly important, and as such, it manifests itself greatly in the specific actions that designers must take to solve the two most important considerations in marketplace design — viz. trust and liquidity.

The authoritative article on building trust in such marketplaces is written by Anand Iyer and is available here. Anand has done such a good job that everyone who is thinking about building marketplaces must read that article at least a few times to grok the fine points. Most people intuitively understand the importance of trust and as consumers, we all make decisions based on trust (or lack thereof) when we decide whether or not to consume products and services. Product designers will thus do well to keep the idea of trust first and foremost in their minds. Ultimately, the key question behind building trust is whether or not the marketplace delivers on the promise of the use case for the consumer in a consistent, timely and predictable manner. To make good on this promise, the marketplace must provide the right set of tools for the supplier and enable them to deliver on said promise. This leads us directly to the other important consideration: liquidity.

I am going to focus the rest of this essay on specific considerations in evaluating a strict two-sided marketplace and understanding the key variables that can expand or shrink the total addressable market (TAM). Some of these can be controlled, while others are dictated by the nature of the goods/services being exchanged.

Evaluating Marketplaces

As mentioned above, Bill Gurley does a fantastic job in detailing some of the key considerations while evaluating marketplaces. The key point is that a lot of these variables are dictated by the nature of the goods/services being exchanged and product designers have very little control over them. However, while thinking through the design and specific decisions, one can target the marketplace to have the most chance of success in building liquidity.

To be comprehensive, I am going to list all the points made by Bill Gurley in his post, but am also going to add a few others that I think that he missed. While possibly less important for the kind of marketplaces that he had in mind, they keep coming up whenever I have discussions or am thinking about newer ideas. Here are the ones listed by Bill, in order, with my own thoughts for each of them:

  1. New experience versus Status Quo
    – whether or not the experience is a significant improvement over current use case. For example, the Uber experience is vastly better than that of a taxi.
  2. Economic Advantage versus Status Quo
    – To me, this advantage must be on the demand side. i.e. whether the marketplace offers a cheaper alternative. Again, UberX is cheaper than a taxi for comparable distances.
  3. Opportunity for technology to add value
    – For most discussions, this is a given. If this does not exist, the rest of the discussion is usually moot.
  4. High Fragmentation
    – Here is one where I disagree with Bill’s thesis, and subscribe more to Ben Thompson’s Aggregation Theory. Bill makes the point that high fragmentation is good as it provides easier entry into the market with less resistance from incumbents. I would argue that this was true when the suppliers still had a lot of control over distribution. But the internet has driven the marginal cost of distribution to zero, and as such, if the other factors are in favor, then marketplaces can, and will, take on concentrated incumbent suppliers and modularize them. In other words, high fragmentation is not necessary if the marketplace does a good job of aggregating demand. Even in highly controlled supplier markets, there are examples of hacking this kind of supply liquidity, and while initially challenging, these can deliver great results over the long run (e.g. Netflix).
  5. Friction of supplier sign-up
    – Again, this is a lot more tactical. Whether there is low or high friction, there are different strategies that can solve either problem. Bill does correctly surmise that the critical part is not supplier aggregation, but demand aggregation.
  6. Size of the market opportunity (TAM analysis)
    – Obviously, bigger is better. But yeah, no vanity here. Examine the TAM with optimism and paranoia.
  7. Expand the market
    – This is one of the points that I am yet to grasp in its entirety. While doing TAM analysis, one has to look at the factors today and what part of the market is addressable by the addition of the new service. The analysis to figure out new use cases and whether the marketplace expands the market is much harder to do, but also captures a lot of the value. Most entrepreneurs come up with far-fetched scenarios that expand their market. A realistic yet optimistic analysis is very difficult, but separates the good entrepreneurs, product designers and venture capitalists from everyone else.
  8. Frequency of transaction
    – Obviously, higher frequency is better. The flip side is to consider how low can the frequency get before the marketplace starts losing value to the consumer. In other words, at what frequency will the consumer go back to the status quo? For example, if the AirBnb experience was only marginally better and cheaper than comparable hotels, then demand stickiness would be a much tougher problem to solve because the frequency of transaction is very low.
  9. Payment flow
    – Excellent point that if the marketplace is part of the payment flow, then it can dictate some terms of commissions (and also, as we will see, liquidity). Some marketplaces simply match buyers and sellers, while the transaction takes place outside the marketplace (e.g. autos). In this respect, one must follow design principles for aggregation theory. In general, strict two-sided marketplaces have a lot more opportunity to be part of the payment flow, unlike the aforementioned three-sided ones. For example, Yelp is not part of the payment flow, and as such even though it is widely used to make consumer choices with high frequency of transaction + high average cost, it had to define itself as a slightly different marketplace where the supplier is also the advertiser/buyer.
  10. Network effects
    – Most successful marketplaces have some kind of network effects, but they are not all the same. All strict two-sided marketplaces have network effects on the supply-side where greater demand increases incentives for supplier (higher utilization and thus lower cost for services-based supply, or economies of scale for goods-based supply).

The above list is excellent. In addition, I keep coming back to a few more:

  1. Cumulative nature of supply
    – It matters greatly whether the supply is cumulative in nature, or is transient. There is always some ingress and egress of supply as new suppliers come in and old ones go out, some marketplaces have a more-or-less cumulative supply. For example, a house listed on AirBnb is much more likely to remain there. To some extent, that is less true for an Uber driver. For marketplaces selling goods, like Etsy, each seller listed adds greatly to the cumulative nature. This has benefits for all parties involved: buyer, seller and the marketplace.
  2. Size of transaction
    – Yes, this has to go in concert with the frequency of transaction. All things being equal, bigger is better. The key question though is how these two variables relate to each other. For example, AirBnb has low frequency, but a large size of transaction (rumored to be ~$400 on average). Thus, even if the AirBnb transaction occurs once a year, the fee collected (~$58) is very high ARPU (average revenue per user). The rest of the $400 is passed on to the seller. Uber, on the other hand, has a lower average transaction size, but the frequency is much higher. If the product of the two numbers is the same, higher frequency trumps larger size, as it also begets brand loyalty. Consumers are less likely to switch if they are already using one marketplace more often. On the other hand, if the product of size times the frequency is larger because of a larger average transaction size, then the marketplace must be designed with that in mind.
  3. Temporal nature of supply
    – Is the supply transient in nature, or mostly there? This is slightly different from the cumulative nature of supply. For example, a restaurant added to a marketplace is cumulative, but events at the same restaurant are transient in nature. Once the event has already transpired, it does not add any value for future liquidity. All transactions are ephemeral in nature, but if the underlying supply is transient itself, then it shrinks the marketplace liquidity. The marketplace designers will then have to keep adding new supply constantly, and this presents a significant challenge while balancing liquidity and demand.
  4. Local or global nature of the transaction
    – The Internet has done a wonderful job in bringing information about global supply to local areas. AirBnb is a great example of this, and even though supply is local in nature, the demand it spurs is global. Uber, on the other hand, is very much of a local player, and as such, can be looked at as the collection of many different local marketplaces. Yes, there is crossover where some consumers (riders) will travel and use Uber in other markets, but the large part of the design has to account for both supply and demand locally. This is why the marketplace dynamics for Uber is different in each city. As the product designer thinks about this issue, it is important to keep in mind that a strictly local marketplace shrinks the potential supply for demand. Over time, it can be built and exploited, but the job is much harder than building the whole network at once. Thus, for purely local marketplaces, a city-by-city (also called market-by-market) approach usually works best, even if it all happens at the same time.
  5. Single player mode
    – This is a really important concept from the demand side. Imagine Uber where there is no other rider in the system. The service will still be immensely useful to a single rider. In fact, a single rider does not care whether other riders are present in the system as long as the supply is liquid enough. So, while network effects will make the system more powerful, this concept allows the marketplace designer to employ growth techniques for demand that are somewhat independent of the supply-side. In the absence of the single player mode, the designer has to balance both supply and demand together, a much more challenging prospect.
  6. Seller/Buyer ratio
    – This is a rarely talked about concept, but for increased utilization of supply, the lower this ratio, the better for the marketplace. Lower ratio means that there are many more buyers, and thus, each seller has to service a number of buyers. This increases the utilization of supply, and incentivizes sellers to make marketplace supply their primary occupation. If sellers are professionally tied to the marketplace for their income, they are much less likely to leave the marketplace. Said another way and with the lens of aggregation theory, as the marketplace controls demand, the supply side loses power and gets modularized and interchangeable.
  7. Cross-over between buyer and seller
    – In some marketplaces, increased activity by the buyer also moves the buyer towards becoming a seller. For example, people who buy things on eBay also tend to sell things on eBay. Sure, eBay has professional sellers that forms the backbone of the supply, but the initial growth in liquidity comes from these very important buyers who tend to be sellers. However, even in these circumstances, the considerations for the buyers and the sellers are different, and the marketplace design should keep that in mind. Some marketplaces are just not suited for this. e.g. Uber drivers are actually less likely to be riders.

I realize that this list is far from complete, but I find myself coming back to these considerations in multiple discussions.

Product design is highly subjective by nature, but our job as product managers/designers/thinkers is to balance the different forces and come up with valid frameworks that enable predictable action.

In future essays, I want to tackle the question of how to systematically add and improve liquidity if the TAM is big-enough. And once there is enough liquidity in the marketplace, how to employ specific marketing techniques for scale. And while the considerations above are meaningful in my own analysis, there is a lot of potential to formulate a theory and understand/quantify the relative value of the different variables.

If you have any questions, or comments, you can find me at anuragmjain — at — gmail.com

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