Platforms

Economic Characteristics of Platforms

Knowledge of some economics concepts such as ones discussed in this volume is useful to understand how platforms differ from more traditional firms.

1. Externalities

We can all benefit from and be harmed by things that are not within our control. When people join networks (be it social networks or telecoms networks), all the other network users benefit since the network’s reach—and therefore overall value—is increased. This is a positive externality since all network users are better off as a result.

If a company were to dump toxic wastes in the water next to a village, the villagers would suffer a strong negative externality. Villagers are not responsible for the behavior of the firm, yet their lives are impacted by it. This is a negative externality, and the company is not incurring the real cost of its actions (unless it is caught).

Many examples of externalities can be found in everyday life. Things as simple as the pleasant scent of a perfume worn by a stranger in the underground can be seen as a positive externality.

A negative externality has the same properties, but with a negative impact imposed by somebody else’s actions. A smoker would be imposing a negative externality on people around him.

Clearly, externalities go far beyond personal inconvenience, and the toxic waste of our factory in our previous example is a strong negative externality on the people living nearby.

Externalities can also change over time. The rather disturbing noises made by the builders next door excavating a basement as these lines are being written are not helping with concentration in the short term. However, once completed, an extended and renovated house next door will have a positive impact on the valuation of the street and therefore represent a positive externality for nearby homeowners.

One reason why such negative externalities occur is that economic agents may not be able (or willing) to internalize the effect they have on third parties. If a factory were economically responsible for the well-being of the nearby population, it would have strong incentivesOpens in new window not to pollute as much.

Positive externalities are important for platformsOpens in new window, since when a platform grows, both in terms of number of transactions and participants, it becomes more valuable to all.

For example, the more applications available on an app store, the more attractive it becomes for users. Of course, the more users join and interact on the platform, the more attractive the platform becomes for app developers trying to reach users.

As in the Apple App Store example, when positive externalities exist on both sides of a platform, positive feedback loops appear and amplify growth. Enabling and enhancing these loops with a frictionless customer experience and the right features for users is a key objective of platform businessesOpens in new window.

The term internalizing the externalities is sometimes used, and sounds more complicated than it is. It simply means that some firms and organizations may need or want to take into account these externalities in their businesses. So a pollution tax can help firms internalize the negative externalities associated with pollution because it gives them an incentive to pollute less.

2. Economies of Scale

Many businesses requiring significant upfront investments benefit from economies of scale since the more units are produced by a factory or plant, the lower the unit costs.

The cost of production of car is highly dependent upon how many cars can be manufactured by a given factory/car plant. If the production is very small, say 10 cars, the total cost of the factory will have to be covered by these very few cars and result in a very high unit cost.

Car production is therefore said to benefit from economies of scale, as more cars produced will allow for the shared cost of production (including R & D) to be spread across more cars and will therefore be lower on a per car basis.

The logical strategic implication of industries with economies of scale is that you need to become the largest company in the sector in order to enjoy the lowest cost base per unit.

These economies of scale affect the supply side, that is to say the company producing the goods. Recently, however, the concept of demand-side economies of scale has become quite widespread. In networks, the value of the service provided increases with the number of users because of the positive externalities we discussed earlier.

Economists therefore describe network businessesOpens in new window as benefitting from demand-side economies of scale. Strictly speaking, this is no longer about the cost of production (supply) going down with volume, but about the value created for users (demand) going up with the number of users.

The concept of demand-side economies of scale is also referred to as network effectsOpens in new window. It is so central to the economics of platforms that we develop it further in a designated volumeOpens in new window.

3. Price Elasticity

We all know that the demand for products and services change depending on their price. If the price of baked beans goes up, people will buy fewer cans — and vice versa, if the price goes down, more baked beans are sold.

The price elasticity of demand reflects this by giving the percentage change in quantity demanded for a 1% change in price. It is the quantitative articulation of the question “How many more cans of baked beans will I sell if I decrease the price by 1%?”

A small change in price of some goods sometimes results in a large change in demand. Traditional baked beans or chocolate bars would be in this category and are therefore said to have a high price elasticity.

The demand for other types of goods doesn’t change much when prices change. This is the case for cigarettes or petrol, where customers are either addicted or really need to buy in order to go from A to B. These goods have a low price elasticity.

Often, the decision to not buy something because the price has increased is driven by the fact that other, cheaper alternatives may exist. So if you are no longer buying baked beans because their prices have increased, you may be buying black-eyed beans instead.

When that is the case, the products are said to be substitutes and the relationship between the increase of price of one product and the increase of demand of the other one is called “cross-price elasticity”.