Platform's Rake:
If you're in the process of starting a virtual two-sided marketplace, there's plenty of information out there on how much to charge and who should pay. For example, Bill Gurley's article called "A Rake Too Far" illustrates how much existing platforms skim off the top (termed "rake" to follow casinos' syntax) to formulate their revenue. Marketplace Academy's Juho Makkonen expounds on Gurley's findings with his own data to contend that the average rake among virtual marketplaces is 9.2%. Makkonen then gives guidance on figuring out how much rake you should charge for your own marketplace, using variables such as marginal costs, competition, network effects, and transaction size.
Secondly, there's also plenty of advice on which side to subsidize. Eisenmann et al demonstrate in their paper "Strategies for Two-Sided Markets" that in a two-sided network, there is typically a "subsidy" side, which is a group of users, who, when attracted in volume, are highly valued by the "money side", the other group. Because the strength of the network hinges on the subsidy side, that side ends up paying little to nothing. Eisenmann et al suggested that factors used to determine which side ought to be subsidized should be figuring out which side is more sensitive to price and quality. The following table, from the paper mentioned herein, depicts different two-sided markets and highlights the subsidy-side of the market with a star.
Marketplace Transactions:
That said, I'm interested in exploring pricing structures for individual transactions within a marketplace. I don't think there's as much thought given to structures of individual transactions, and for that reason, there may be room for optimization. Structures of individual transactions, as I've observed, fall into the following four categories:
1. The platform sets the transaction price. Ride-sharing apps such as Uber and Lyft, as well as Handy, practice this method of pricing their transactions. I view these platforms as psuedo-resellers: they buy a service/product from provider and sell it at a higher price to users. These platforms facilitate the transaction and the meeting of buyer and seller.
2. The seller of the product or service determines the price. Airbnb, Kayak, and Amazon Marketplace fall into this category. These marketplaces mimic a traditional physical market where sellers sell their goods at their prices, and buyers choose what to buy based on prices and other factors.
3. Auctions establish pricing in this case. Ebay is the prime example of this, but other marketplaces make use of auctions as well, such as Priceline for travel, Beepi for cars,and Ubid for electronics.
4. No dollars are exchanged in this marketplace. Marketplaces such as Opentable and Yelp have no pricing at the transaction level, but there is still a "money side" who pays the platform fee.
Avoiding Auctions:
If we take a look at Gurley's list of how platforms charge, it becomes apparent that not many marketplaces use auction style pricing for their transactions. There could be a few reasons for that:
2. Platform's marginal costs. The platform wants to make sure that it covers its costs, and the easiest way to ensure that might be by setting the transaction prices and basing its commission off the transaction price. For example, if Uber knows that it's marginal cost for a particular ride is $1, it might charge $10 for the ride and take a 20% commission. That way, the company would make a $1 profit ($2 commission -$1 marginal cost). If there were an auction instead and the ride only went for $5, Uber's commission would only be $1 and profit would be $0.
3. Consistency. The platform may not want to have dynamic pricing for the sake of offering consistent prices and quality. Handy, for example, may want to make sure that you get a consistent quality of cleaning done for the same price, hence setting the transaction price each time.
4. Sellers' marginal costs. In this scenario, the platform may permit sellers to elect their own prices to protect the sellers' marginal costs. Etsy serves as a good example here since craftsmen on the site may have vastly different costs, requiring them to charge varying amounts. They may also have varying levels of quality of workmanship, allowing them to charge higher or lower prices than their competitors. The Etsy platform wants to cater to that kind of variability in quality and competition by sanctioning sellers to establish their own pricing.
Types of Auctions:
Auctions have the benefit of allowing price to be close to where supply meets demand without the platform's intervention (more on that below). There are lots of different types of auctions, and I won't go through all of them, but they are English, Dutch, First Price Sealed, Second Price Sealed, and Reverse Auction. You can learn more about all of them here. The two most relevant ones for our purposes are the Second Price, Sealed Bid Auction (used by Ebay) and the Reverse Auction (used by Priceline).
A Second Price, Sealed Bid Auction is where bidders submit what they are willing to pay. Their bids remain undisclosed to other bidders. The highest bidder wins the auction, but pays the price offered by the second-highest bidder (in Ebay's case, a premium is added to the second-highest bid). Therefore, the buyer still ends up having a consumer surplus. It is important to leave some consumer surplus on the table to keep customers coming back to the platform. The seller can set a minimum starting point to cover his costs, so issue #4 from above is solved.
A Reverse Auction requires that the buyer name his own price and the seller either accepts or denies that price. In this case, the buyer starts with a price that is much lower than the maximum that he is willing to pay and then gradually moves higher. Priceline uses this for its travel, which makes the buyers to feel like they got a great deal, but also ensures that sellers are able to get some producer surplus.
Why Auctions Are Important:
Even though there's a myriad of reasons for eschewing auctions, they might be the best way for sellers to discover the right price, and therefore, for a platform to build momentum over its competitors. In my opinion, the auction strategy works best when the outcome of the transaction is not time-sensitive.
As I discussed in my previous post on Ride-Sharing Apps, it is difficult to know how much a customer would be willing to pay for a product or service. In economics terms, it is difficult to draw a demand curve (how much of something would be sold for each price level) in real life. Therefore, it is difficult to price where supply and demand would meet. What happens if you can't price where supply meets demand? Let's look at the following graph:
In the third scenario, EP, which stands for Equilibrium Price, is where supply would meet demand. In this case, the right price could be $75, and you might end up with 8 lessors and renters. It's tough to know where to price, however, and it could become a guessing game. Here, supply meets demand, the number of transactions is 8 and revenue is $600 (higher than if you had over-priced).
Let's look at a fourth scenario, where price isn't set by the platform. Each individual apartment owner puts up his apartment for a reverse auction, sort of like Priceline, where the prospective renter submits the daily rent she'd be willing to pay. She'll start off lower than the maximum that she's willing to pay, and he will either accept or reject. That is, she'll submit a bid closer to P2 and move higher if he rejects the bid. There's no guarantee that they'll end up at EP, but if they agree on a price, it will likely be lower than the maximum that she's willing to pay and higher than the lowest amount that he's willing to accept. In large quantities and with free-flowing information (how much did similar apartments rent for on the same day?), prices will move towards EP naturally, without the platform having to do the guesswork.
At P1, the price is too high and supply exceeds demand. For example, you are setting prices for renting out apartments for a night, and you set the price at $100 (P1). You get 10 owners willing to lease out their apartments for the night, but you only get 5 renters. This results in excess supply. The number of transactions is 5, revenue is $500.
In the second scenario, you see the excess supply and decide to lower prices to increase quantity demanded. The next night, you set the price at $50 (P2). The scenario flips, and you get only 5 owners willing to lease out their apartments, but 10 renters. The renters get the apartments on a first-come-first-served basis. Pricing at P2 results in excess demand. The number of transactions is 5, revenue is $250. For this reason (lower revenue), most platforms are more likely to overprice than underprice.
Let's look at a fourth scenario, where price isn't set by the platform. Each individual apartment owner puts up his apartment for a reverse auction, sort of like Priceline, where the prospective renter submits the daily rent she'd be willing to pay. She'll start off lower than the maximum that she's willing to pay, and he will either accept or reject. That is, she'll submit a bid closer to P2 and move higher if he rejects the bid. There's no guarantee that they'll end up at EP, but if they agree on a price, it will likely be lower than the maximum that she's willing to pay and higher than the lowest amount that he's willing to accept. In large quantities and with free-flowing information (how much did similar apartments rent for on the same day?), prices will move towards EP naturally, without the platform having to do the guesswork.
Auctions can be a very powerful way to grow the marketplace precisely because they allow prices to be set dynamically through supply/demand. Especially for commodity services and products, buyers may be able to pick up what they need for very cheap, giving them the incentive to keep coming back. For example, Handy's cleaners may be willing to work for less on weekdays during school hours, which, if Handy were an auction, would be reflected in the pricing. Or, someone who only needs a sub-par writer should be able to bid a much lower amount for my writing skills on Fiverr than for an excellent writer. Were some of these platforms' prices auction-based rather than pre-set, I'd surmise that prices would be lower in many instances, resulting in higher consumer surpluses and a higher number of transactions.
From sellers' point of view, price discovery becomes easy since they can price discriminate. Apartments will demand a higher rent price on July 4th weekend, for example, but owners shouldn't have to guess how much higher. Moreover, apartments on July 4th weekend can then be allocated to those who are willing to pay for them instead of on a first-come-first-served basis, which is what would happen if rents were set arbitrarily than through an auction.
While platforms may fear that dynamic pricing may result in variable or lower commission (rake), I believe that the higher growth (from greater transactions) and the network effects that come with it will make up for that. Furthermore, Gurley gives good reasons for keeping the rake low, which is what may happen if overall prices are low and the platform takes a low percent of transaction as its rake. He states, "If your objective is to build a winner-take-all marketplace over a very long term, you want to build a platform that has the least amount of friction (both product and pricing). High rakes are a form of friction precisely because your rake becomes part of the landed price for the consumer. If you charge an excessive rake, the pricing of items in your marketplace are now unnaturally high (relative to anything outside your marketplace). In order for your platform to be the “definitive” place to transact, you want industry leading pricing – which is impossible if your rake is the de facto cause of excessive pricing. High rakes also create a natural impetus for suppliers to look elsewhere, which endangers sustainability."
And while having high consumer surplus and low prices is imperative for building the demand side, Mike Russell of Paintzen talks about building the supply side of the marketplace on the Traction podcast. A good marketplace will strive to know and solve for the sellers' pain points in a specific industry, but reducing friction in terms of pricing (rake), as well as providing an avenue for sellers to price discriminate and enlarge producer surplus will make the platform sticky for the sellers. Therefore, auctions can be an elegant way to solve for price discovery where time is not of the essence, and they can help expand a new marketplace by attracting buyers due to higher consumer surplus.
