Industrial Organisation / Matěj Bajgar

Lecture 9: Intermediaries and

platforms
Intermediaries
• Most products and services are not sold directly from producer to
customer
• Instead, they pass through intermediaries
Dealer
• Buys goods and resells them
Platform
• Provides a space (physical or virtual) where buyers and sellers interact
Infomediary
• Provides information about prices and match value of products or
services
• E.g. review systems, personalised recommendations…
Trusted third party
• Certifies quality
Lecture roadmap
1. Intermediated vs. non-intermediated trade
2. Intermediaries as two-sided platforms
Intermediated vs. non-intermediated trade
• Several reasons why buyers and sellers often do not trade directly
• Logistics
• Storage
• Inventory
• But
• These reasons apply mostly to physical goods
• Even these producers could, and sometimes do, directly ship to customers
• What are other reasons for existence of intermediaries?
Centralised exchange
• Consider a simple market where
• 50% buyers have high valuation (WTP) vH and 50% have low valuation vL
• 50% sellers have low costs cL and 50% have high costs cH
• Buyers and sellers are randomly matched
• E.g. you call the first washing machine repair person you find
• First assume that vH > cH > vL > cL so the only match with negative gains from trade
is when low-valuation buyer meets high-cost seller
• Gains from trade are evenly split between buyer and seller
Centralised exchange
• The expected net surpluses of each agent are
• High-valuation buyer:
• Low-valuation buyer:
• Low-cost seller:
• High-cost seller:
• The market outcome is socially inefficient:
• Optimally, all high-valuation buyers would buy from low cost sellers
• The amount traded would be 0.5 and social welfare
• In reality, the amount traded is 0.75 and social welfare is the sum of the surpluses
above, which equals
 There is too much trade
Centralised exchange
• Introduce an intermediary into the market
• It sets bid (wholesale) price w and ask (retail) price p
• The prices are such that high-valuation buyers and low-cost sellers self-sort into
the intermediated market, while the other don’t
• High-valuation buyers know they only meet high-cost sellers in the non-
intermediated market, which would give surplus , so they are indifferent between
the markets if
• Similarly, low-cost sellers indifferent between the markets if
• So the intermediary sets prices and
• The low-valuation buyers and high-cost sellers do not have incentive to join the
intermediated market because and .
Centralised exchange
• Example: groceries in a developing country
• There are rich and poor consumers and low and high cost food producers
• Initially, everyone buys and sells in the market
• Then a supermarket joins and attracts rich customers and low-cost producers
• If a rich customer wanted to go shopping in the market, they would only find high-
cost sellers there.
• Similarly, a low-cost seller would only find poor customers in the market.
Centralised exchange
Summary
• An intermediary is able to make a positive profit by setting centralised
prices and allowing buyers and sellers to sort into the intermediated
market
• By doing this the intermediary increases welfare
• But note that all buyers and sellers are worse off – the surplus is
redistributed towards the intermediary!
• What if ?
• Then all matches lead to trade and market is efficient even without intermediary
• But the intermediary can again enter, generate market segmentation and make
positive profits
Dealer vs. pure platform
• Intermediaries make a choice between being
• A dealer – buys and sells goods
• A platform – charges fees for using the infrastructure

• Some intermediaries combine the two roles

• e.g. Amazon, supermarkets’ own brands
Dealer vs. pure platform
• We have a simple model to illustrate the choice
• Sellers produce differentiated products with c uniformly distributed
• Each buyer has unit demand over each good
• Buyers have valuation v of the products that is also uniformly distributed
• Here we assume all trades go through the intermediary
Dealer vs. pure platform
• Dealer intermediation
• The dealer first sets p and w, then buyers and sellers decide to buy/sell
• Demand is given by nb=1-p, supply by ns= w
• The intermediary profit is
• The profit maximisation gives
• Retail price p = 2/3
• Wholesales price w = 1/3
• Bid-ask spread P = p-w = 1/3
• Number of buyers = 1/3 and number of sellers = 1/3
• Intermediary profit 1/27
Dealer vs. pure platform
• Platform intermediation
• Here the intermediary sets a transaction fee P and lets buyers and sellers interact
• Assume the transaction fee borne by the seller (without a loss of generality)
• Also assume sellers set the price (in procurement markets it could be the buyers)
• First intermediary sets P, then sellers set p
• Sellers maximise profit
• The profit maximising price is
• Sellers actually sell if or equivalently
• The quantity exchanged on the market is .
• In the first stage, the intermediary maximises profit given by
• The optimal P is given by 1/3 and the intermediary profit again by 1/27
Dealer vs. pure platform
Summary
• In the special case with uniform distributions of valuations and costs, the
dealer and platform business models give the same results
• In the dealer case, the quantity traded is below social optimum because
the dealer applies monopoly/monopsony power to both sides of the
market
• In the platform case, sellers apply monopoly power, prices are higher but
also more sellers participate. These two effects on welfare cancel out (in
the special case) so the welfare is the same
• But in more general cases one or the other model can be preferred (both
for the intermediary and for welfare)
Dealer vs. pure platform
Summary (continued)
• Other reasons can also play a role in the decision of dealer vs. platform
• If being the dealer involves other functions such as storage and logistics, relative
costs of the intermediary at these functions matter
• Example: Logistics a key comparative advantage of Amazon
• With (indirect) network effects that lead to multiple equilibria, becoming a dealer
may allow the intermediary to ensure co-ordination on the high equilibrium
• Example: Amazon (again) – size built as dealer helped build the platform
Other advantages of big intermediaries
• Competitive pressure – large intermediaries lead to greater variety and
more intense competition between shops
• Example: Large malls shopping centres, large supermarkets
• Liquidity – ensures buyers can easily find matching sellers even for large
quantities at any point in time
• Example: Most stocks traded at a single exchange
Two-sided platforms with indirect network
effects
• Agents on one side of platform benefit from more agents on the other
side of the platform
• Examples
• Credit cards
• Operating system
• Shopping malls
• Real estate websites (e.g. Sreality.cz)
• Uber
• We talk about buyers and sellers, but can be other types of agents
• e.g. men and women in dating apps, viewers and advertisers
Fee structure
• Membership (aka access) fees M
• Transaction (aka usage) fees P
• Does it matter who pays the fees?
• If buyers and sellers internalise structure of fees in their contracts, only the total
level of fees matters
• But it need not be the case
• Example: “No surcharge rule” for payment cards
• Sellers must charge the same price independent of whether a customers pay in
cash or by card
• If most people pay cash, the sellers set prices based on these people and carry
most of the costs of credit card transaction fees
• If they could charge different prices, it would not matter who pays the fee
Price-setting by the platform
• Assume
• There is only a single platform
• The platform charges only membership fees, for buyers and for sellers
• Each buyer has potential relationship with each seller
• Terms of buyer-supplier deal independent of the membership fees (membership
fees are sunk costs at the time of transaction
• Each seller gets profit per buyer and each buyer gets utility u per seller
• A seller gets surplus nb𝜋-Ms and a buyer gets surplus nsu-Mb
• The platform has fixed costs per buyer Cb and fixed costs per seller Cs
Price-setting by the platform
• The platform maximises profit ns(Ms-Cs)+ nb(Mb-Cb)
• It can be shown (see textbook) that profit maximisation gives Lerner ratios
given by

•,
where is a demand elasticity for seller access with respect to the seller
membership fee, keeping the number of sellers fixed
• The formulas differ from the standard Lerner index by the network externality
generated by a new seller joining the network () or a new buyer joining the
network ()
Price-setting by the platform

• Intuitively, if the elasticities were constant and identical, then the group exerting
stronger network effects would have lower membership fees
• If the network effects associated with one group sufficiently exceed the costs, the
membership fee may even be negative
• Example: Entrance fees to clubs are often lower for women than for men. Why?
• Socially optimal membership fees would be and , i.e. lower than with the monopoly
platform
Competition between platforms
• So far we had a monopoly platform. What if multiple platforms compete?
• Assume there are two horizontally-differentiated platforms.
• We know that network effects can lead to winner-take all equilibria
• Under what conditions will there be more than one platform in the
equilibrium?
Singlehoming vs. multihoming
• Singlehoming
• Each buyer and seller is only with a single intermerdiary
• Multiple reasons for single-homing
• Physical indivisibility - a family-run business only at one location at a time
• Exclusive contracts (e.g. taxi drivers and call centres in Germany)
• Exclusive content for a particular streaming networks
• Convenience - consumers only using a single flight search engine out of habit
• Multihoming
• Buyers or sellers are with multiple intermediaries
• Rational if allowed and membership fees not too high
• Examples
• Many accommodations on both Booking.com and Airbnb
• Customers using both Uber and Lyft
• Hiring multiple real-estate agents
Singlehoming vs. multihoming
• The single/multihoming can differ between the sides of the markets
• Multihoming on the seller side only
• Most users have only one operating system but software often developed for
multiple OS
• If malls far from each other, there can be H&M in both but a customer only goes to
one
• Multihoming on the buyer side only
• Flea markets in Bruxelles close to each other – buyers can visit both but sellers
only have a stand at one of them
• Any situation where sellers sign exclusivity but buyers can cross-shop
• Multihoming on both sides
• Ride-hailing – both drivers and customers often on multiple platforms
Platform competition with singlehoming
• Assume
• Two platforms with Hotelling-style horizontal differentiation between them
• Platforms sufficiently attractive – all agents on one of the platforms
• Both platforms operate as long as the network effects not too strong relative
to the horizontal differentiation
• The Lerner indices are twice as sensitive to the network effects compared to
the monopolist platform

• Intuition: a seller that leaves platform 1 is not only lost to platfom 1 but but
goes to platform 2, making it more attractive to buyers (some of whom now
want to move to platform 2 unless platform one reduces fees)
Platform competition with multihoming
• Assume sellers multihome but buyers singlehome (e.g. accommodation
platforms)
• Now a seller lost to platform 1 is not a seller gained by platform 2
 platforms relatively more sensitive to buyer network effects
 platforms reduce fees for buyers and increase them for sellers
• Note this is somewhat counter-intuitive: it might seem that being able to
multihome is advantageous, but the opposite if true
Two-sided platforms with network effects:
Implications for anti-trust policy
• Two-sided platforms with network effects behave in many ways differently
from standard markets, with implications for anti-trust policy
 Two-sided platforms with network effects:
Implications for anti-trust policy
Definition of a market
• In normal markets, the SSNIP (whether a hypothetical monopolist can
profitably sustain a small but significant non-transitory increase in price) test
used to determine a product market
• In the case of a platform, which price should be considered? Buyer price, seller
price, their difference…?
• Which profits should be considered?
• Example: a 2007 merger of the two US satellite digital radio services
• One-side logic would imply the merger is a problem, because from consumer
perspective the two services don’t have a good substitute
• But they fiercely compete with other broadcasters for content and advertisers
• This also supported by a National Association of Broadcasters lobbying against the deal
 Two-sided platforms with network effects:
Implications for anti-trust policy
Analysis of market power
• In one-sided markets
• Price above marginal costs signals market power
• Price below marginal costs may indicate predatory behaviour
• In two-side markets
• Price above or below marginal costs may just be compensating for network effects
Standard Lerner index no longer adequate
Cost-based regulation hard to implement
May be misleading to talk of cross-subsidisation – a “cross-subsidy” to buyers also
benefits sellers through network effects
• E.g. Freely distributed newspapers – advertisers would not necessarily be better off if the
newspapers became paid and price of advertising went down
 More competition may lead to more asymmetric pricing structure
 Two-sided platforms with network effects:
Implications for anti-trust policy
Mergers
• As discussed above, definition of market difficult
• Market power and competition effects on both sides of the market need to be considered
Cartels and price-fixing
• More difficult because it requires co-ordination on both sides of the market
• Price-fixing may enhance efficiency by internalising the network externalities (note this is
similar to R&D collaboration in the presence of spillovers)
Regulation
• Regulation that may be neutral in one-sided markets may not be such in two-sided
• Forcing a company to reduce prices does not help rivals, but regulating one price of a two-
sided platform may put it at a disadvantage (e.g. forcing a club to charge the same entry
fees to women and men
 Two-sided platforms with network effects:
Implications for anti-trust policy
Two-sided aspects of markets have to be carefully considered
One-sided logic can be very misleading
Problem 1
Firms 1 and 2 compete in a market for homogenous products. The firms differ in their productivity (i.e. marginal
costs). Firm 1 has marginal costs c1 = 1, and firm 2 has marginals costs c2 = 2.
a) First assume the firms compete in prices, and the market demand is Q = 10 – P. What will be the Nash equilibrium
prices, market shares, profits and consumer surplus? (Assume that if p 1 = p2, firm 1 has market share 100% and
firm 2 has market share 0%.) [10 points]
b) Imagine a new firm enters in the market. How will it affect the price and firms‘ market shares, depending on the
entrant’s marginal costs? (Assume that if p 1 = pe, firm 1 has market share 100% and the entrant has market share
0%.) [10 points]
c) Now assume firms 1 and 2 compete in quantities (ignore the entry mentioned in (b)), and the inverse demand for
the good is given by P = 10 – q1 – q2. For each firm, calculate the reaction curve q i*(qj). Then solve for the
asymmetric Nash equilibrium. What will be the market price and quantities sold by each firm? [10 points]
d) Show for firm 1 that under quantity competition, the Lerner index equals the firm’s market share divided by the
price elasticity . What does this imply for a relationship between market concentration and market power? [10
points]
e) Comment on the relationship between firm marginal costs and market shares. What do solutions to (a) and (c) have
in common and how do they differ? [10 points]
f) Given the analysis in subquestions (a) to (e), why should one be careful before concluding that high concentration
or high market shares of some firms indicate a lack of competition and inefficient markets? (Hint: compare prices
in subquestions (a) and (c).) [10 points]
Problem 2
• Initially, there is only one construction company building family houses in a town (firm 1). There are two time
periods, and in the first time period, the incumbent construction company is a monopolist. But seeing how
profitable the company is, one of the senior workers at the construction company considers starting her own
construction company (firm 2). If she does so, the two construction companies will compete in quantities in the
second period. In each period, the inverse demand for building houses in the town is p = 20 – q 1 – q2, and the cost
costs of each firm (in each period) are Ci = 9 + 4qi.
a) First assume that there is no risk of entry. How many houses will the incumbent company build in the first period,
and what will it charge for bulding a house? What will be its per-period profits? [10 points]
b) Now assume that it is hard to hire/let go workers and buy/sell machinery, so the incumbent firm has to build the
same number of houses in period 1 and period 2. Observing the number of houses the firm 1 has built in the first
period (and will build in period 2), how many houses will firm 2 build in the second period if it decides to enter
the market? [10 points]
c) Assume that firm 1 expects firm 2 to enter in the second period. How many houses will it build? What will be the
equilibrium price and profits? [10 points]
d) How many houses would firm 1 need to build in period 1 (and in period 2) to deter entry from firm 2? Will the
incumbent construction company choose to deter entry? [10 points]
e) Would the deterral be more or less likely if firm 1 was impatient, i.e. if it discounted period 2 profits using
discount factor δ? [10 points]
f) Could advertising be used as a strategy to deter entry? Give an example how such strategy might work. [10 points]
Short essay question 3
How is market concentration measured? What are the different decisions that one must
make when measuring market concentration. Name at least 4 and explain why these
decisions can have large impact on the measured concentration, using examples from
different markets. What is the key economic concept used when defining a „market“?
[20 points]
Short essay question 4
Governments often treat firm investment in research and development differently from
other firm activities. Two examples include (a) allowing R&D co-ordination between
competing companies (where a similar co-ordination with respect to, for example, prices
would be illegal) and (b) subsidising firm R&D through grants and tax incentives. Is the
differential treatment of R&D justified? On what theoretical and empirical grounds?
How do the policies in (a) and (b) make markets more efficient. [20 points]
Short essay question 5
Korean car manufacturer Kia is known for offering a 7-year warranty, while most other
car manufacturers offer only 3 years. Why would Kia do that? What does Kia have in
common with university students? [20 points]