Tag Archives: downward spiral

Fragility of two-sided markets

Two-sided markets are inherently fragile for participation of each side depends on a certain degree of confidence in participation on the other side. Thus, small negative shocks can lead to quick downward spirals.

Following the ill-advised ban on Uber and other taxi aggregators in four Indian states (Delhi, Karnataka, Andhra Pradesh, Telangana), business for drivers who ply their services via such apps has dropped significantly. While on first inspection you might expect it to go to zero (given their services have been banned), the fact that enforcement is tough (there is nothing to identify a cab as “belonging to Uber”) means that apart from Delhi (where Uber has pulled its services) these cabs continue to ply.

In the days after the ban, various news reports have interviewed drivers who ply for Uber who complain about drastically reduced services. While numbers vary from report to report, the general sense is that so far the number of trips per driver per day has fallen by half. And I expect this to fall further unless drastic steps are taken – such as issuance of new regulations or removal of the ban.

In a “normal” market (where the owner of the market is also a participant), when demand for a particular good drops, price is expected to fall and availability is expected to increase. If demand for a particular item that you have in stock drops, you need to take steps to get rid of the excess inventory that you have. You are most likely to indulge in discounting or other such promotional activities, in order to make it more attractive for the buyers to buy, and thus take the inventory off your shelves.

In a “two-sided market” (one where the owner of the market is not a participant), however, things work differently. It is a popular saying that in such markets “demand creates its own supply”. A corollary to that is that “lack of demand creates lack of supply”. Let us take the case of Uber itself. Over the last few days, irrespective of whether the ban on the service is official or not, legal or not, the number of people who have been requesting for the service has dropped.

Now, if you are a driver using the app, you realise that your potential revenues and profits from continuing to use the app are not as high as they used to be. Thus, if there are other avenues for you to make money, you are now more likely to take those avenues rather than logging on to Uber (since the “hurdle rate” for such a switch is now lower thanks to lower Uber revenues). As many of you take the same route, the availability of cabs on Uber also drops – something that I’ve seen anecdotally over the last few days. And when availability of Uber cabs drops beyond a point, I start questioning my trust in the service – a week ago I would be confident that I would be able to hail an Uber from anywhere in Bangalore with very high confidence; that confidence has now dropped. And when my trust in the service drops, I start using it less, and when many of us do that, drivers see less demand and more of them pull away from the market. And this results in a vicious cycle.

Notice that things would work very differently had Uber been a “traditional” taxi service which owned its cabs and employed its drivers. In that case, falling demand would have been met with a response that would have made it easier for customers to buy – price cuts, perks, etc.

The point is that platforms or two-sided markets are inherently fragile, and highly dependent on confident in the system. I leave my car at home only if I have enough trust in the taxi platforms that I’ll be able to get a cab when I need one. A driver will forsake other trips and switch on his Uber app only if he is confident that he can get enough rides through the app.

The same network effects that can lead to a rapid ramp-up in two-sided markets can also lead to its downfall. All it takes is a small trigger that leads to loss of confidence in the service from one side. Unless that loss of confidence is quickly addressed, the “positive feedback” from it can quickly escalate and the market grinds to a halt!

Another good example of lack of confidence killing two-sided markets is in the market for CDOs and associated derivatives in 2007-08. There were standardised pricing models for such products and a vibrant market existed (between sophisticated financial institutions) in 2007. When house prices started coming down, some people started expressing doubts in such models. Soon, this led to massive loss of trust in the pricing models that underpinned such markets and people stopped trading. This meant companies were unable to mark their securities to market or rationalise their portfolios, and this led to the full-blown 2008 financial crisis!

So when you build a platform, you need to make sure that both sides of the market retain confidence in your platform. For in the platforms business loss of confidence can lead to a much quicker fall than in “traditional” markets. This dependence on confidence thus makes such markets fragile.