Predatory pricing in multi-sided platforms

Over the last few days, living and commuting in Nuremberg, I realised that I was not missing Uber. While just about a month ago, commuting for a week in suburban Paris, I was completely dependent on Uber for even the shortest of distances. The penetration of public transport and my familiarity with the city of Nuremberg aside, I began wondering how would Uber price its services in a city like Nuremberg (when it enters here, which I doubt very much would happen in the next few years), where public transport is omni-present, efficient, and affordable. It surely should adopt predatory pricing.

In this post, I will elaborate on the concept of predatory pricing in the context of multi-sided platforms.

Theory alert! If you are uncomfortable with theory, skip directly to the illustration and come back to read the theory.

What is predatory pricing?

Economists and policy makers concerned about market efficiencies and fair competition have been obsessed with the concept of predatory pricing for a long time. The most common definition of predatory pricing is through the application of the conventional Areeda-Turner test. Published way back in 1975, in spite of its limitations, most countries and courts have used it consistently, due to, in some ways, lack of any credible alternative.

The Areeda-Turner test is based on two basic premises. The recoupment premise states that the firm indulging in predatory pricing should be able to predict and be confident of its ability to recoup the losses through higher profits as competition exits the market. The assumption is that the firm could reasonably anticipate the (opportunity) costs of predatory pricing, as well as have an estimate of the future value of monopoly profits; and the net present value of such predatory pricing to push competition out of the market should be positive and attractive. In plain English, the firm should be able to project the effect of lower prices in terms of lower competition and higher profits in the future.

How low can this predatory price be? That is the subject of the second premise – the AVC premise. The firm’s prices (at business as usual volumes) should be below its average variable costs (AVC), or marginal costs in the short run. If the prices were indeed above the AVC, the firm would argue that they are indeed more efficient than competition, due to any of their resources, processes, or organisational arrangements. It is when the price falls below the AVC that the question of unfair competition arises – the firm might be subsidising its losses.

Take for instance, a start-up that is piloting an innovative technology. It may price its products/ services at a price below the AVC to gain valuable feedback from its lead users, but in the absence of a recoupment premise such pricing might not qualify as predatory pricing. On the other hand, imagine a new entrant with superior technology who can bring costs down to a level where the prices fall below the marginal costs of the competitors but stay well above the firm’s AVC, it is just disrupting the market.

Only when both the conditions are met, i.e., when the predator’s prices are below the AVC and the firm could project the extent of recoupment due to monopoly profits as competition exits the market, that we call it predatory pricing.

Predatory pricing in MSPs

There has been a lot of discussion about how ecommerce firms in India have been indulging in predatory pricing and how various platforms have been going under. I had written about subsidies and freebies from a consumer perspective a few months ago (Free… continue hoyenga). Let us discuss how and why it is difficult to assess if a lower-than-competition price is indeed predatory in the context of multi-sided platforms (MSPs).

  1. Multi-sided platforms have a unique problem to solve in their early days, that of network mobilisation. A situation that is like a chicken-egg problem, or a Penguin problem, where “nobody joins unless everyone joins” is prevalent in establishing a two-sided or multi-sided platform (for more details about the Penguin problem and network mobilisation strategies, read my earlier post here). In order to build a sufficient user base on one side, a common strategy is to subsidise, even provide the services free.
  2. Another common feature of MSPs is the existence of subsidy-sides and money-sides of users. The platform might subsidise one side of users and make money from the other side, while incurring costs of providing services to both sides, depending on the relative price elasticities and willingness to affiliate with the other side of the platform. And the prices for the subsidy side would surely below costs for that side. It is imperative that the overall costs and prices are considered while analysing these pricing strategies.
  3. These cross-side network effects will surely force the platforms to price their services most efficiently across both the sides. Even for the money side, the platform might not be able to charge extraordinary prices as such prices would themselves act against the sustenance of these cross-side network effects. It is likely that these extra-normal profits would evaporate through subsidies on the other side to keep the network effects active. Imagine a situation where a B2B marketplace charged the sellers higher than normal prices, only large (and desperate) sellers would affiliate with the marketplace, leading to buyers (the subsidy side) leaving the platform. In order to keep the buyers interested, the marketplace might either have to broaden the base of sellers by optimising the prices, or provide extraordinary subsidies to the buyers to keep them interested. So in order to maintain the equilibrium, the platform would have to price the sides efficiently.
  4. Finally, in a competitive situation, not all competitors might follow the same price structure. So, a reduction of prices by one competitor for one side of the market may not force all other competitors to reduce prices; they may just encourage multi-homing (allowing users to use competitive products simultaneously) or manipulate the price on the other side of users.

So, a direct application of the Areeda-Turner test might not be appropriate while studying predatory pricing in the context of MSPs.

An illustration

Let us imagine a market for home tutors supporting school students. The market is inherently geographically constrained; it is very unlikely that either the teacher or the student would travel across cities for this purpose. For the time being, let us assume that there is no technology (like video conferencing) being used.

This market is apt for the entry of a multi-sided platform, like LocalTutor. This firm provides a platform for the discovery and matching of freelance tutors with students. LocalTutor monetises the student side by charging a monthly fee (that includes a platform commission), and passes on the fees to the tutor. We need to make two assumptions before we proceed with competitive entry and predatory pricing: the market is fully penetrated (all the students who are looking for tutors and tutors looking for students are all in the market) and there are no new students and tutors entering the market; and there are no special preferences between student-tutor matches, i.e., the student-tutor pair does not form a bond like a sportsperson-coach, where they begin working like a team. In other words, the tutor is seamlessly (with no loss of efficiency) replaceable.

Now imagine a new competitor enters the market and engages in predatory pricing to kick-in network effects. The new entrant, let’s call it GlobalTutor (a fictitious name), drops the student-side prices to half. In order to attract the right number and quality of tutors, GlobalTutor has to sustain the same fees that LocalTutor provides its tutors, if not more. So, it starts dipping into its capital reserves and begins paying the tutors the market rates while reducing the student fees. Anticipating a larger surge in student numbers, more tutors sign up to GlobalTutor, and seeing the number and quality of tutors on GlobalTutor (at least if it is not inferior to LocalTutor), students first start multi-homing (use both services for their different needs, like LocalTutor for mathematics and GlobalTutor for music classes), and some of them begin switching.

In a fully penetrated market, the only way for LocalTutor to compete is to respond with its price structure. It has two options – reduce the student-side prices to restrain switching and multi-homing behaviour; and tweak the tutor-side prices and incentives. The first option is straightforward; it is cost-enhancing and profit-reducing. The second option (which is not available for pipeline businesses) is interesting in the context of platform businesses.

There are various ways of responding to this threat. The intent is to arrest switching and multi-homing behaviour of tutors and students from LocalTutor to GlobalTutor.

  1. Increasing multi-homing costs of tutors by providing them with incentives based on exclusivity/ volume: Like what Uber/ Ola provides its drivers – the incentives kick-in at what the company believes is the most a driver can do when they do not multi-home. In other words, if you multi-homed, drove your car with both Ola and Uber, you would never reach those volumes required to earn your incentives in either of your platforms.
  2. Contractual exclusion: This might not be tenable in most courts of law, if these freelance tutors were not your ‘employees’. Given the tone of most courts on Uber’s relations with its driver-partners (drivers’ lack of control in most of the transaction decisions including choice of destination, pricing, and passenger choice), any such contracting would imply that the tutors would be employees, and that would significantly increase the platform’s costs (paying for employee benefits are always more expensive than outsourcing to independent service providers).
  3. Increase contract tenure: LocalTutor may increase multi-homing and switching costs by increasing the tenure of the contracting from monthly to annual. Annual contracting will reduce the flexibility that students and tutors have, and might result in reduction in volume.
  4. The next options for LocalTutor are to work at the two restraining assumptions we made at the beginning – penetration and perpetual matching. LocalTutor might want to add in more and more students and tutors and expand the market, providing unique and differentiated services like art & craft classes, preparation for science Olympiads, or other competitive tests. LocalTutor might also communicate the value of teaming of student-tutor pairs in its success stories, in a bid to dis-incentivise switching and multi-homing.

To predate or not to predate is not the question

Given the differences between pipeline and platform businesses new entrants seeking to mobilize network effects have very little option but to resort to predatory pricing. The choice is not if, but how. And as an incumbent, should you be prepared for a new entrant who would resort to predatory pricing? Surely, yes! And how? By being ready to expand the market and increasing switching and multi-homing costs. Unlike in the tutoring business that is inherently geographically constrained, a lot of businesses could span across markets. Even tutoring could leverage technology to reach a global audience.

Just one comforting thought, predatory pricing as a strategy to eliminate competition is inefficient in the long run. The new entrant might adopt predatory pricing to eliminate competition in the short run, but the act of predatory pricing breaks down most barriers to entry, and sends signals to others that there is a market that is easy to enter. It might attract a more highly capitalised competitor to enter the market with the same strategies … making the market a ‘contestable market’. And no one wants to make a fortune in a contestable market, right? More on competing in contestable markets, subsequently.

Cheers

© 2017. R Srinivasan

 

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Free … continue hoyenga?

Well, writing here after a really long time. Finished teaching three courses, two mentoring assignments, and two cycles of a customised executive education programme for a client in the interim. A bad throat induced rest (well-deserved, that’s what I would like to believe for myself) gets me to write this short post.

Let them eat FREE

The title is inspired by the advertising tagline of India’s latest entry into the already crowded (dozens of competitors) in a highly penetrated market, Relinace Jio (see here).

Today morning’s story from Rohin Dharmakumar at The Ken is titled Let them eat free! His basic argument is that as regulators and governments are discouraging service and convenience fees, consumers are getting used to free services; which will eventually kill the free markets by taking away the pricing power of enterprises (especially in a highly competitive market).

Over the past few years, I have been studying platform business firms where one of the first concepts one learns in multi-sided platforms is that at least one of the sides of the platform (either the demand side or the supply side) needs to be subsidised to leverage network effects (or mobilise the network from scratch). Is subsidy therefore any different from free? I would say no. There are free lunches, for at least some people in a business. The business may therefore decided to charge someone else for giving these free lunches.

Think free food in temples and gurdwaras… prasads or langars. In fact the mess food at most military establishments in India is called a langar. In a society where there are a lot of people struggling to earn two meals a day, a free lunch provider was a celebrity. The village elder, the temple management, the birthday girl, or just about a casual visitor. Oh, this is religion and philanthropy, you argue. Business is different. Business is for-profit.

Subsidies

Businesses subsidise one side and make money from another side (think Internet search, where search is free, listing is free, and SEO/ Ad is paid); subsidise one product and make money from another product (think Gillette’s razors and blades, HP’s printers and cartridges); subsidise today and charge you tomorrow (think airline dynamic pricing); and/ or subsidise one segment of customers to charge from another segment (Aravind eye hospitals, Robin Hood). Remember, Skype is free (well almost); this WordPress blog is hosted on a free plan; so does your email (well almost all of it).

Is subsidy bad? No, as long as the “customer” who receives the subsidy knows where it comes from. If the business model is clear, and the subsidy receiver knows that she is receiving the “free lunch” because someone values giving it to her for free, it should not be a problem.

Subsidy is bad when someone receives a subsidy in return for particularly nothing. It is inefficient for the entire market when the customers do not know where the free is coming from, what the firm is going to do with all those intangibles (information about me, my behaviour, my preferences, and my network) I provided with them when I signed up.

Government subsidies

What happens when the government gives you something for free? Like the social security? Do you know why it is free? And how is it financed? In countries like India, the annual presentation of the government book of accounts is a celebrated ritual. See the official website here, and the Bloomberg “live” reporting here.

For long, successive governments in the Indian state of Tamil Nadu have been providing freebies to the citizens both as an electoral gift as well as a welfare measure. Most of these have been funded by the state monopoly liquor retail shops, the TASMAC (read here). But when these shops close/ scale down, the state government has to find new sources of funds and/ or scale down welfare spends.

Enjoy it till it lasts

A lot of my friends enjoy these subsidies (for instance a discount from ecommerce companies) knowing very well that the provider is giving it to them from their investors’ wallet. Like the Reliance Jio offer, like the cheap OLA ride to the Bangalore airport, or just the discounted products on the Flipkart’s sale day! They say, enjoy it till it lasts! The assumption is that they would attrition out when the prices rise, or the firms begin charging for whatever was hitherto free. Don’t the firms know this … they are trying to build and leverage multi-homing costs for your products/ services.

Be aware

I would therefore say, be aware; enjoy it till it lasts; use it as a trial; choose whether you want to multi-home and retain the flexibility to signout, and have fun.

Cheers.

(C) 2017. R Srinivasan.

Regulating Platforms

Over the past few months, there have been a lot of disputes between platform businesses, governments, and a lot of these have gone to courts as well. Last Friday (26 August 2016) issue of the Mint newspaper carried an opinion piece titled “the tricky business of regulating disruptors” (read it here). The editorial while labeling almost all platform businesses as disruptors, just stopped short of calling all of them disruptors. In this blog post, I dig deep into the issue of if and how platform businesses need to be regulated with respect to consumer protection, without impeding innovation and thence providing fair business opportunities to businesses (and returns to investors).

Defining the industry boundaries

One of the key determinants of “competitive” behavior is the definition of the relevant industry. What is competitive and what is anti-competitive can depend on how narrow or broad you cast your net while defining the industry. For instance, the Mint editorial explains in detail how in a 1953 verdict on DuPont’s monopoly on the cellophane as a result of “result, business skill, and competitive activity”, despite having over 75% market share in the cellophane market, because the courts defined the “relevant” market as flexible packaging material, and not cellophane, the product. However, in most cases against platform businesses like Uber, the competition commissions and other regulators have defined the market as app-based taxi services, and therefore looked at the market being usurped by monopolies (Didi-Uber combine in China) or a duopoly comprising of Uber and a local operator (like Grab in SE Asia, OLA in India, Lyft in the USA).

Is Uber a competitor or substitute to Taxi?

In a detailed response to Prof. Aswath Damodaran’s 2014 article on Uber’s valuation (read it here), Bill Gurley (a series A investor and board member of Uber) defined three things (read Bill Gurley’s blog post here).

  1. He argues that Uber has since transformed the industry so much that one’s market size estimates based on current taxi market sizes is flawed. In other words, Uber was providing customers with far more value and a very different set of value propositions than a traditional taxi service – quick discovery, easy payment, predictability of service, quality (dual rating of riders and drivers), and trust/ safety. He talked about how Uber’s customers are using it to transport young adults/ children or older parents in the “comfort and safety” of an Uber, rather than a taxi.
  2. He argued that given the economies of scale that arose due to the positive cross-side network effects, more and more drivers and riders adopted Uber, and Uber expanded to more and more geographies, and the prices fell. And the price elasticity contributed to more demand and therefore more network effects. The economics of Uber (and therefore other ride-hailing app-based services) are very different from the city Taxi services.
  3. Uber is not a taxi alternative – it is a car-ownership (or a car-rental) alternative. When the liquidity (availability + density) of Uber vehicles is so high in every geography you want to travel to, you would rather not rent/ buy a car, but use Uber. The convenience and reduced cost of Uber as an alternative to ownership is something that he substantiates with data and analysis.

In other words, Uber was indeed a disruptor, and therefore was entitled to be treated as a separate industry. It is not a competitor to the for-hire taxi, it is an alternative; much the same way Kodak was bankrupted by digital photography (and not by competitors like Fuji).

Creative destruction and Schumpeterian waves of technology innovation

The Mint editorial called for Honorable Judges to not set taxi fares, simply because these disruptors would transform the industry through their technology innovation, and any restraining regulation would hinder these Schumpeterian waves. It is therefore an indirect call for letting these disruptors alone, let the waves of Schumpeterian technology innovation hit the markets, before we arrive at a stability of sorts. Regulation can wait.

Can regulation wait, and allow for a disruptor, in the excuse that the market is a “winner-takes-all” market monopolize the market? The popular arguments against monopolies is that of consumer protection, and that when monopolies rule, consumers suffer – prices rise, service levels fall, and there may be no alternatives. This is exactly the case for another wave of creative destruction.

My primary thesis is that when such disruptions happen on the basis of network effects, leading to economies and scale, and the disruption is based on parameters like improved customer service, lower prices, and transparent/ fair transactions (trust/ safety and the like), monopolies are not necessarily bad. When such monopolies emerge and the customer experiences deteriorate, as dictated by traditional industrial economics theory, the market will be ripe for another wave of Schumpeterian technology innovation. The waves of market entry in the Indian airlines market is testimony to these (1990s – privatization and shake-up leaving two state-owned and two private competitors; 2000s – entry of low-cost carriers leading to the demise/ consolidation of all stuck-in-the middle competitors; 2010s – entry and strengthening of regional airlines, is it?) waves of creative destruction.

Yes, there is space for other competitors, but not so much for Uber replicas. The market is indeed a winner-takes-all market (as I have argued in the past), and therefore there is just enough room for small, losing replicators. Look around the markets for Uber competitors, you do not find any market fragmented. While differentiation and creating niches is the prescription for firms competing with Uber, I request the regulators to begin treating such platform businesses as an independent market and let the inefficient product-markets fail, if required. No one cried when the offline ticket counters of Indian Railways are declining sales, thanks to the volumes garnered by IRCTC (some claim that this is the world’s largest ecommerce platform, is that true?). No one complains about bookmyshow.com garnering huge market shares in the app-based movie seat booking market, claiming that the livelihoods of the ticket clerks are under threat. Why cry about Uber, or for that matter, OLA, Grab, or Lyft?

There is already sufficient discrimination against these disruptors. In a recent visit to San Francisco, I made an extra effort (okay, walked down a flight of escalators) to click a picture at the SFO airport that read, “app-based taxis to pick-up from departures level”. Honorable Judges, please leave them alone, enjoy your ride/ movies/ every other service, contribute to the economies of scale, and let the market be disrupted.

Cheers.

 

100% FDI in e-commerce – will prices fall?

On the 29th March 2016, the Government of India allowed 100% FDI in Indian e-commerce firms. While there is reason to cheer about the fast-growing sector getting more access to much needed funds for fuelling growth, there are three interesting developments in the notification.

  1. The Government has explicitly defined what is a marketplace model, as different from an inventory model.
  2. The consequence of this definition means that marketplace ecommerce firms cannot have a single retailer selling more than 25% of the retailer’s sales.
  3. The definition also means that the retailer cannot provide discounts and promotional offers on their own, directly or indirectly.

The impact of these three definitional changes would in the short run, require marketplace e-commerce firms to discontinue price discounts they offer directly or indirectly. Amazon’s promotional funding to sellers, PayTM’s cash back offers, or Flipkart’s big billion sale have to end. Will this mean they would stop offering discounts? I do not believe they will. They will find other ingenious ways of providing the customer with discounts, given that they would have access to larger source of funding through the FDI investments. More on that below.

It’s the sellers that matter

This definition of the marketplace model would clearly lead to interesting dynamics on the seller side. For instance, an SMB seller who would otherwise be listing his goods across multiple e-commerce companies would now be wooed by more and more marketplaces, as they seek to expand their base of sellers. Do you realize that the firm that owns the site www.amazon.in is actually called Amazon Seller Services India Pvt. Ltd.? In order to expand and sustain their broad base of sellers, these marketplaces would now have to offer discounts and freebies to the seller side, rather than the buyer side as it was apparent in all these years of growth. These seller-side offers would eventually translate into lower prices for buyers in two ways.

One, in the traditional sense of the word, the seller bargaining power would go up; sellers’ multi-homing costs (costs of simultaneously offering their products and services across multiple marketplaces) would come down; and the volumes would go up. Larger sellers therefore, would invest in technology to manage their multi-homing costs, automate a lot of processes, outsource specialised functions like last-mile delivery to focused service providers, and would grow their own sourcing networks. Smaller sellers on these marketplaces would have no incentive to be remain small, and would either get gobbled up in a consolidation game or become second-tier sellers to the larger sellers operating on the marketplace e-commerce retail. This consolidation and growth of sellers on the marketplace would result in lower costs through economies of scale and scope, which the seller would eventually pass on to the buyers.

Two, the consolidation of the seller market would lead to fierce competition across sellers; and the basis of competition between the sellers is likely to be only price. Other differentiators like product variety/ features and brand are likely to be owned by manufacturers/ marketers (like Samsung), whereas service differentiators like distribution network, logistics and related customer service are likely to be managed by the marketplace. The only bases of competition for the sellers to compete would be (a) optimisation of inventory to reap appropriate economies of scale and scope, (b) managing distributed inventory through accurate prediction and forecasting of demand and supply, and (c) reducing costs through faster inventory turns as well as leveraging their bargaining power with manufacturers as well as retailers/ ecommerce firms.

Good times are here to stay (for the consumers)!

So, in effect these regulations do not necessarily mean that the prices in the ecommerce retail would rise and match the offline prices. There may be small adjustments; but in the long run, the discounting would shift from the retailer to the supplier. And the consumer would continue to enjoy lower prices (offered by the sellers) along with superior customer service (provided by the retailer, as this would be the only basis of competition across  marketplace e-commerce competitors).