# Pipes, Platforms, the Internet and Zero Rating

My friend Sangeet Paul Chaudary, who runs Platform Thinking Labs, likes to describe the world in terms of “pipes” and “platforms”. One of the themes of his work is that we are moving away from a situation of “dumb pipes”, which simply connect things without intelligence, to that of “smart platforms”. Read the entire Wired piece (liked above) to appreciate it fully.

So I was reading this excellent paper on Two-Sided Markets by Jean-Charles Rochet and Jean Tirole (both associated with the Toulouse School of Economics) earlier today, and I found their definition of two-sided markets (the same as platform business) striking. This is something I’d struggled with in the past (I admit to saying things like “every market is two-sided. There’s a buyer and a seller”), especially given the buzzword status accorded to the phrase, but it is unlikely I’ll struggle again. The paper says:

A necessary condition for a market to be two-sided is that the Coase theorem does not apply to the relation between the two sides of the markets: The gain from trade between the two parties generated by the interaction depends only on the total charge levied by the platform, and so in a Coase (1960) world the price structure is neutral.

This is an absolutely brilliant way to define two-sided markets. The paper elaborates:

Definition 1: Consider a platform charging per-interaction charges $a^B$ and $a^S$ to the buyer and seller sides. The market for interactions between the two sides is one-sided if the volume V of transactions realized on the platform depends only on the aggregate price level

$a=a^B +a^S$

i.e., is insensitive to reallocations of this total price a between the buyer and the seller. If by contrast V varies with $a^B$ while a is kept constant, the market is said to be two-sided.

So for a market to be two-sided, i.e. for it to be intermediated by an “intelligent platform” rather than a “dumb pipe”, the volume of transactions should depend not only on the sum of prices paid by the buyer and seller, but on each price independently.

The “traditional” neutral internet, by this definition, is a platform. The amount of content I consume on Youtube, for example, is a function of my internet plan – the agreement between my internet service provider and me on how much I get charged as a function of what I consume. It doesn’t depend on the total cost of transmitting that content from Youtube to me. In other words, I don’t care what Youtube pays its internet service provider for the content it streams. Transaction costs (large number of small transactions) also mean that it is not practically possible for Youtube to subsidise my use of their service in this model.

Note that if buyers and sellers on a platform can make deals “on the side”, it ceases to be a platform, for now only the total price charged to the two matters (side deals can take care of any “adjustments”). The reason this can’t take place for a Youtube like scenario is that you have a large number of small transactions, accounting for which imposes massive transaction costs.

The example that Rochet and Tirole take while explaining this concept in their paper is very interesting (note that the paper was written in 2004):

…As the variable charge for outgoing traffic increases, websites would like to pass this cost increase through to the users who request content downloads…

..an increase in their cost of Internet traffic could induce websites that post content for the convenience of other users or that are cash-strapped, to not produce or else reduce the amount of content posted on the web, as they are unable to pass the cost increase onto the other side.

Note how nicely this argument mirrors what Indian telecom companies are saying on the Zero Rating issue. That a general increase in cost of internet access for consumers can result in small “poor” consumers to not consume on the internet at all, as they are unable to pass on the cost to the other side!

Fascinating stuff!