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Economics of the Internet A-Karim Lalani

Fragmentation in Mobile Payment Platforms: A Case Study on East Africa
The success of M-Pesa in Kenya has been celebrated as one of Africa’s greatest success stories. The service was introduced in 2007 and within five years M-Pesa has attracted fourteen million subscribers and in the last year processed $14.2 Billion in transactions1. M-Pesa is a mobile payment platform deployed by Kenya’s largest telecom operator, Safaricom. The payment platform functions as a mobile wallet, an individual can deposit cash through an affiliated agent and then use their balance to pay and receive payments from other individuals using the platform. Individuals can also withdraw cash from their electronic account through an agent. M-Pesa is a household name in Kenya, however, the same payment platform has struggled in a neighboring country. The Vodafone group is a multinational firm that owns telecom operators globally. This paper is particularly interested in the fact that the firm owns 40% of Safaricom and has a majority share in Vodacom Tanzania. In 2003, Vodafone contracted a firm to develop what would become the M-Pesa platform and began to implement it in Kenya, Tanzania and Afghanistan post 2007. Despite the many economic and political differences between Kenya and Tanzania, we can argue that they have many similarities that make them comparable target markets. Both countries have similar population sizes (41 to 43 million people), population age structures, economic composition (both have approximately 75% of the labor force in agriculture) and both countries have experienced similar surges in mobile phone penetration rates. It is reasonable to expect the successes of M-Pesa in Kenya to be comparable to the successes of M-Pesa in Tanzania, however this is not the case. In May 2009 Vodacom Tanzania’s implementation of M-Pesa is said to have attracted 280,000 users compared to Safaricom’s 6.5 Million and had processed 3% the amount of money in transactions that year (IFC)2. The question that remains unanswered is: why is M-Pesa so much more successful in Kenya than it is in Tanzania? Having witnessed the potential of a mobile payment platform, many organizations are keen to replicate the success of M-Pesa in other parts of the world but it seems as though the Kenyan example is an outlier when compared to the deployment of similar platforms in other countries. There have been attempts to answer why M-Pesa has worked better in Kenya than in Tanzania, but these hypotheses have been stated and not verified through empirical data nor have they been based on the predictions of a formal economic framework3. In this paper I present my own hypothesis for M-Pesa’s user adoption, I describe a model that applies to the M-Pesa in and then compare the predictions of the model to our observations in both Kenya and Tanzania.

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Kenya’s GDP is $70.6 Billion, their transaction volume is very high relative to GDP The most recent statistics are less drastic and they will be evaluated later in the paper.

B can withdraw money from an agent of platform 1 and then deposit it their account. These agents allow users to deposit and withdraw money from their accounts and are paid for each transaction5. payment platforms differ because their accounts are not connected to an underlying bank account.2 Economics of the Internet A-Karim Lalani Section 1: Background and Hypothesis Mobile payment platforms as they have been developed in emerging markets are structurally different from similar platforms in the developing world. . the Square Card Case and Google Wallet) are tied to an underlying bank account and all payments made on the platform withdraw money from the account of the payer and deposit money into the account of the recipient. The telecom markets in both Kenya and Tanzania are also structured differently. has a market share of almost 70% whereas the leading operator in Tanzania (also owned by Vodafone) has a market share of 45%. if A uses platform 1 and B uses platform 2. In emerging markets. Payment platforms in East Africa employ individual ‘agents’ to convert physical currency to the platform-specific virtual currency and vice versa. They are vital to the success of the platform because they collect the money underlying their virtual currency and provide liquidity to the users who can withdraw their money at any time. We expect that as the number of users increases there will be more trust in the virtual currency and transactions with other users on the platform will become vastly more popular than transacting with agents (Mas). Each one of these platforms operates a different virtual currency. Safaricom. True compatibility doesn’t exist among the various payment platforms in East Africa and one virtual currency has to be converted to cash before it can be converted into another virtual currency. for example if A pays B who is on platform 2. For example. also known as an e-money. and each virtual currency is incompatible with the others. There is a much higher level of fragmentation in the Tanzanian telecom market than there is in Kenya as depicted in Figures 1 and 2. shop owners. instead the accounts are registered with the platform operator who takes on the responsibility of providing the user the ability to deposit and withdraw money. Once the user has debited their platform account they are free to transact with other users on the platform using a virtual currency that is backed by actual cash. Most payment platforms in the United States (this includes credit cards. The operators earn revenue on each transaction on their platform and the individual making the payment is charged according to a tiered payment schedule4. Competition is also much greater in Tanzania 4 5 Traditionally lower transaction values have had a higher percentage cost With the exception of ATMs that are not capable of letting the users deposit money. Agents are generally entrepreneurial individuals. or even ATMs. they have developed measures for weak compatibility. As the payment platforms have evolved. the leading operator in Kenya. In Tanzania there are four different telecom operators and each has their own mobile payment platform that is similar to M-Pesa. A cannot pay B using platform 1 and expect B’s account balance to increase by the transaction amount.

625 Vodacom Airtel Tigo 6.75 4.993 Zantel Figure 2: Tanzanian Telecom Subscribers (as of March 2012) The differences in market fragmentation may significantly reduce the value proposition to an M-Pesa subscriber in Tanzania. Assuming a users transactions are mainly domestic. The fragmentation of these markets may be a key predictor in the user adoption rates of M-Pesa in the respective countries.63 2. the combined market share of Safaricom’s competitors is less than half their market share. Kenyan Subscribers (Millions of People) 1.45 11.17 17.524 5.95 Safaricom Airtel Orange yuMobile Figure 1: Kenyan Telecom Subscribers (as of Jan 2012) Tanzanian Subscribers (Millions of People) 1.3 Economics of the Internet A-Karim Lalani whereas in Kenya. an M-Pesa subscriber in Kenya can transact with 70% of the mobile phone using population whereas an M-Pesa user in Tanzania can transact with less than .

a technology exhibits network effects when the value of that technology to a potential customer increases with the number of other people currently using it6. Banks are the entities that support the credit card system. Direct network effects refers to a simple increase in the value of a product as the number of people using it increases. It is the level of market fragmentation that I believe has caused such a large discrepancy in M-Pesa’s success in the two East African countries. a consumer makes the decision whether or not to join the network. However. and this is present in payment platforms as a larger user base provides customers more users to transact with. the network effect ceases to be an externality. which are the Western analogous of payment platforms. if we take the example of credit cards. In further analysis I consider mobile payment platforms as being one-sided. but with the constraint that 6 An alternate way of viewing network effects is to consider them as positive externalities. However. agents act as supporters to the system and both merchants and cardholders have their own accounts on the platform. The technology this paper is concerned with. With regards to the adoption of M-Pesa. Higher fragmentation reduces the value for the payment platforms because there are fewer users on any given network. the two sides of the platforms are cardholders and merchants. Network effects exist in a platform when the value of using that platform increases with the number of other people using it. exhibits direct network effects and is arguably one-sided. the number of users joining a social network is a spillover benefit to current users of that network because there is no mutually defined way of compensating the new users who are contributing to the surplus of old users. in network terminology. In the next section I propose a model to test this hypothesis and analyze the extent to which this hypothesis predicts the user adoption rates and relative revenues of M-Pesa in the two countries. For example. This is true in mobile payment platforms with respect to agents. it is less obvious the extent to which the network is one-sided. I hypothesize that in a market for platforms. I believe this is the case in payment platforms where the providers are able to charge higher prices for larger networks and capture the consumer surplus. as a higher number of agents can attract more users to the network. Section 2: A Model of Network Effects As previously defined. a greater degree of fragmentation will cause lower total user adoption at a given price level and that prices will have to drop significantly in order to attract more users. if the added surplus is compensated for.4 Economics of the Internet A-Karim Lalani half of all telecom subscribers. In two-sided networks. This is analogous to buying a good. making the platform one-sided for financial transactions. . Similarly. However. the increase of users for one technology increases the demand for another. This is the case in mobile payment platforms where the intrinsic value of the platform is lower if there is no one to transact with. It is more attractive to use M-Pesa in Kenya because of the existence of network effects.

In both cases. In the case of mobile payment platforms. Adding an additional person should increase the total value of the platform. where the value is dependent on n. similar to distributed reservation prices that users have for goods in a traditional market. If the network size was to be held fixed. their valuations differed due to factors that were unrelated to the size of the network. but there will be diminishing returns for each additional person. to choose an unbiased value we choose the midpoint of that range and assign: ! ! =   !! 7 ! Other functions also fulfill the previously stated conditions but we choose nx for simplicity of calculation.5 Economics of the Internet A-Karim Lalani the consumer can purchase one good at most. In the original model of one-sided networks. This can be restated as: ! 0 =  0 In making the decision to join a network. Mathematically we can say: !" ! ! >  0 !" !!! ! ! <  0 !! ! !" ! ! =0 !→! !" lim Any value of ! ! where 0 < ! < 1 fulfills such these three conditions7. Let us consider the nature of the relationship between total value and size of network. individuals can have different valuations for the platform for a given network size. and hence there is no inherent value in joining the network. Katz and Shapiro (1985) consider a model where the good has an intrinsic value independent of the size of the network. The consumer decides to join the network only if the value of joining the network exceeds the cost to join it. we can say the total value to the user is given by the function !(!). If n is the number of user using the network. a restaurant owner may value the platform more than a civil servant because the restaurant owner appreciates the ability to streamline a large volume of transactions whereas a civil servant who has to be frugal and makes few transactions doesn’t value joining the platform as much. we have to ask whether there is any value to the first adopter of the network given there is no one else to transact with? The platform is provides no utility to a user if he or she cannot transact with anyone else. These random valuations suggest the total value function is composed of two separate functions: ! ! =  !(!)!(!) The first function ! ! accounts for the random variation in values for each user. The second function !(!) describes the relationship between total value of the platform and the size of the network. .

We see the shape of this curve in Figure 3 to be parabolic. Then if the price of the good is p. we know that everyone with a higher value for !(!) will want to buy the good. For a mobile payment platform a user can decide to join or not. where ! measures the reservation price for a good by person !. … . the platform provider can set a price equal to the total value function such that: ! = (100 − !)!! This equation gives us the relationship between price and size of the network. we can define ! ! as: ! ! =  100 − ! Shapiro and Varian apply this same function for reservation prices to a market with network effects to model the different values a population has for a good at a given network size8. they go on to say that they typically expect to see a function of similar form . If this individual is indifferent to buying the good.6 Economics of the Internet A-Karim Lalani We borrow the functional form of ! !  from work done by Shapiro and Varian (1999) as follows: Lets take the example of the demand for a good that does not have network effects. The consumer decides to buy that good if ! < !(!) and if 1 ≤ ! ≤ 100. so we know that: ! = 100 − !(!) Rearranging. 100 and define !. which is analogous to buying at most one good. In such a scenario there will be a person who is indifferent to buying the good. For example. We index 100 people by ! = 1. Hence we can take the total number of users to be the same as total quantities sold and the above equation represents an inverse demand curve. however. there will be 50 people for which ! >  50 and hence 50 people will buy the good. the total value to an individual is defined by: ! ! = ! ! ! ! = (100 − !)!! In equilibrium. the number of people who think the good is worth at least p is 100 − !. So if we consider the market of 100 people for a good that does exhibit network effects. if ! = 50. ! ! 8 Easley and Kleinberg (2010) suggest that the general function for r(x) need not look like the way defined by Shapiro and Varian.

If we were to assume there is fragmentation. In the example we have considered so far. we expect competition to decrease profit margins for firms and increase welfare. the demand curve would look different. the platform will reach equilibrium A and expect !! number of users when making their valuation decision. hence this user will join the network. the platform will have reached a critical mass. We observe that fragmenting the market reduces prices. This is a self-fulfilling expectations equilibrium where if !! number of users expect as many people to join. As most markets. So the first user may expect that at a price of 200.7 Economics of the Internet A-Karim Lalani Figure 3: Demand for a Mobile Payment Platform The parabolic shape of the demand curve describes three unique equilibriums when the price is set to 200. each with equal market share. A is not a stable equilibrium because once a platform reaches equilibrium A. there will be “upward pressure” for the size of the network to reach equilibrium B. It is important to note that the process of moving from A to B is not instantaneous and requires time. then all individuals will derive no utility from the joining the network and no users will choose to join the network. The first of which is if ! = 0. In that sense. We see on the graph that for the !! + 1 user. We see this is true for many users who will continue to join the network until we reach equilibrium B. his willingness to pay is higher than the price. Figure 4 describes the demand curves for a single mobile payment platform where there are 1. in which case we must ask why does the first user ever join a platform? We can answer this if we assume the user is forward looking and makes their valuation decisions based on their expected size of network. This equilibrium exists in all platforms with similar demand curves. they all join and fulfill their expectation. If there is currently no one on the network. Once the platform gets to equilibrium A. 2 and 4 total platforms in the market. we assume there is only one mobile payment platform in a market of 100 potential consumers. however in .

The predictions are described as follows: 1. the potential market share of each platform is given before the platforms compete. This model of network effects has several powerful predictions about the East African market for mobile payment platforms that shed light on the current state of the industry. We assume no costs for simplicity. . where there exist multiple firms who do not compete on prices and have no costs.8 Economics of the Internet A-Karim Lalani a market with network externalities. Farrell and Saloner (1985) show this is not the case for differentiated products and that welfare can potentially increase if the dominant product is inferior to a competitive product. we can assume that mobile payment platforms do not compete with each other with prices. If we assume there is a significantly high cost of switching between telecom operators because a customer would have to change their phone number. This example corresponds to percentages. p is the price they are charged and ! is the total size of their telecom subscriber base. In a market with network effects. ask their network to update their contact information and potentially miss calls that were directed to their old number. so the monopolist would want to charge a price at which 60% of his potential consumers join the platform. Figure 4: Demand Curves in a Fragmented Market Given the mobile payment platforms we consider in East Africa. the aggregate number of subscribers will be the same regardless of the number of competitors. So we can think of each platform provider as a profit-maximizing monopolist given within the subscribers of their telecom services. Telecom operators were already selling voice and text message services to their subscribers before they began selling financial services. welfare may decrease with competition for identical platforms9. We solve the profit function when ! = 100 to find ! = 60. so the monopolist solves the profit function: ! = !" = ! ∗ !!  (! − !) Where n is the number of users that join the platform. 9 ! We assume the different platforms are identical for this to be true.

if we assume they all have equal market share then each firm has ! ! potential customers. we would expect they would attract the same proportion of their total subscriber base. which means that they set their prices to sell a certain quantity. and there are m number of firms. The firm maximizes ! = ! ∗ !!  ( We find the maximum of this function when: 0.6! ∗ ! = 0. However. Introducing a new product to a new market is challenging for a monopolist who yet to learn the preferences of their potential customers and it takes much learning by doing to learn their what the demand curve looks like a new market. then the aggregate number of users is equal to: 0. We see that this is empirically the case for M-Pesa in both Kenya and Tanzania. Figure 5: 2009 Price Schedules for M-Pesa in Kenya and Tanzania . and they all have equal market share.6 ! =! ! ! ! − !) ! If all firms m maximize their profits. Hence if we assume that platform providers have the same pricing strategy.9 Economics of the Internet A-Karim Lalani If ! is the total size of the market. The implications for this is that in both Tanzania and Kenya we would expect telecom operators to have 60% of their total subscriber base join their networks if they are profit-maximizing.6! ! This result still applies when firms don’t have equal market share but only in an industry where all the platforms are identical and don’t compete on price. the assumption of all operators being profit maximizing may not be reasonable.

We can see this more simply when: ! = !!  ( ! ! − !) ! As ! is fixed in a market. In a market where firms offer identical platforms and aren’t competing with each other through prices. then the firm with lower market share will have to charge a lower profitmaximizing price. . if we assume each firm maximizes profits then the total revenues for each firm have been depicted in Figure 6. which is comparable to their Kenyan counterpart10. If there are two firms offering identical platforms and aren’t competing with prices. only m can increase which causes prices to decrease (as long as !/! is greater than !). then we would expect the conversion rate of subscribers to M-Pesa users to be the same in both countries. If we assume over time M-Pesa has adopted a unified pricing strategy to induct the profit maximizing number of users across countries. it is a reasonable hypothesis that after several years of learning by doing the parent company has issued its subsidiaries to implement the best practices they have learned. We see that doubling market share for a firm increases revenues by 566% and quadrupling market 10 There was no credible resource suggesting that the countries have adopted a uniform pricing strategy and this was just a hypothesis. This shows that as the number of firms increase. However. which means there is a greater degree of market fragmentation. In December 2011 Safaricom reported that approximately 81% of its 22 Million subscribers at the time had created accounts on M-Pesa. 11 The decrease in prices charged by Vodacom for M-Pesa Tanzania supports this prediction. However. with a parabolic demand curve the drop in maximum profits is disproportionately greater. we would expect significantly lower users of M-Pesa Tanzania as a proportion of Vodacom’s customers. In Figure 4 we see that when a firm has lower market share it shifts the firm’s demand curve downward so the firm is forced to reduce prices. Due to the differences in market share. 3. We can reinterpret a greater degree of fragmentation as a downward shift of the demand curve. in a market for platforms the greater the degree of fragmentation the lower the prices charged will be. a greater degree of fragmentation will lower the aggregate revenues earned in that market. This can be restated as. In the example so far. That means Vodacom had attracted close to 78% of their total user base to subscribe to M-Pesa. the prices charged by a platform provider will decrease11. 2. These price schedules have changed over time and in early 2012 Vodacom recently reduced M-Pesa prices by 75%. In 2009 Safaricom had converted 50% of their subscriber base to M-Pesa users whereas Vodacom had converted only 5% (IFC). Later in February 2012 Vodacom reported that roughly 9 of their 11. I was unable to collect data on the most recent price schedules and platform user statistics for M-Pesa and other mobile payment platforms at the time of writing this paper to make further comparisons. This result is the basis for the next prediction that revenues also fall with fragmentation.6 Million users had created accounts on M-Pesa (though they did claim only 3 Million were active users).10 Economics of the Internet A-Karim Lalani Figure 5 shows the 2009 price schedules for M-Pesa in both Kenya and Tanzania and we see they are very similar.

almost a third of their transaction volume while they have 25% less market share. Similarly. Figure 6: Revenue for Firms in Fragmented Markets We can begin to compare this prediction to what we observe in the mobile payment markets. The effect of compatibility is that consumer will make their decision to join a platform if ! − ! !!   > ! where ! is the total number of users in the market and it is constant regardless of the number of platforms that arise. We observe in Figure 6. For example.8 Billion in transactions. Due to a scarcity of comparable revenue data for M-Pesa in both Kenya and Tanzania. M-Pesa Tanzania has less reported data but has claimed to process over $400 Million in December 2011.11 Economics of the Internet A-Karim Lalani share increases revenues by 3200%. This leads to a key prediction for incompatible networks: 4. In December 2011 M-Pesa in Kenya had reported processing $14. the firms would generate higher aggregate revenues if they operated a compatible platform. This general result of disproportionate changes in revenue for a linear increase in quantity sold should hold for any firm with a parabolic demand function. aggregate revenues are greater in a market with one payment platform rather than a fragmented market. The market operates as if there is effectively a single payment platform provider and the various platform owners can share the profits fairly. in a market where there are 12 ! This is because each individual firm earns 581 units and there are four firms. for example a market with four firms with equal market share will earn in aggregate 232412 units of revenue whereas that same market with just a single firm will earn 18590 units of revenue.2 Billion in transactions. approximately 8 times as much. we consider transaction amounts processed as a proxy for revenues. In a fragmented market where firms offer identical platforms and that aren’t compatible. if we assume they had similar transaction volumes for each month then they would have managed to process $4. The difference is quite large at an aggregate level. a fragmented market can choose to make their platforms compatible. so the aggregate revenue is 581 * 4 = 2324 units .

For example. or any other fragmented market. . Conclusion and Further Analysis This paper tried to evaluate the initial hypothesis that a fragmented market for platforms reduces the total user adoption rates for a give price level and that for a platform to induce a higher number of adopters they will have to lower prices. I would like to have specific data on the user growth of each East African mobile payment platform with respect to the total subscriber base of the telecom operator since its inception. For further analysis. Ideally the dataset would include all similar mobile payment platforms globally. I’d like to begin to look at how these platforms provide individuals with a measure for accountability and how it can further enhance accountability in countries with few transaction records. making them compatible with each other will generate 8 times the aggregate revenue and each firm should rationally be willing to switch to such a platform if they receive a share of the increased revenue. It suggests that the payment platforms in East Africa. and we see the claim of lower user adoption rates being invalidated in theory but we still see that firms in fragmented markets have to significantly reduce prices to attract users. however there are many predictions that could have been tested more rigorously with more data. Several other areas on enquiry would be how exactly mobile payment platforms add value to a consumer. The model seems to predict many of the empirical observations in the growth of M-Pesa in both Kenya and Tanzania. Such a change in the payment platforms could potentially have a significant impact on the GDP as more users discover the value of using an electronic payment platform instead of just transacting with cash. With such data we could test whether firms that operated in multiple countries yet had the same pricing policy achieved similar user adoption rates as a percentage of the total subscriber base. develop a compatible payment platform and share the profits fairly. The model of network effects put forward is applied to mobile payment platforms in both Kenya and Tanzania. And if I could also get the monthly revenue data I would compare the total revenue numbers for firms with larger market share with those with lower market share and see if the former firms have disproportionately larger revenues. If I could also get the price schedules of each firm I could test whether the average price is lower for networks with fewer subscribers in a specific country.12 Economics of the Internet A-Karim Lalani four platforms with equal market share. One of the most significant predictions of the model was that of compatibility.

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