Consumer Demand in Two-Sided Markets and the Platform-Specific Nature of Externalities

We propose a general framework for consumer demand in two-sided markets, modelling the way externalities between customer groups affect the price sensitivity of demand on both sides of the market. We define a measure for the strength of the externalities and establish the conditions for the existence of critical mass. The outstanding feature that distinguishes two-sided market demand from normal demand is that services on different sides of the market are complementary when offered by the same platform, but substitutes when offered by different platforms. This is attributable to the platform-specific nature of the externalities. It is this platform-specific nature that makes skewed pricing profitable. When externalities are market-wide, skewed pricing is self-defeating. The internalization of externalities is only a by-product of skewed pricing, not its motivation. We show that the mechanism triggering skewed pricing in two-sided markets is the same as in markets with firm-specific complements even though business strategies may be entirely different.