Monday, December 15, 2008

Google's two sided markets

I was thinking about Google last week. One of my student teams did their report on Google (a popular topic around here). And the author of a Google book wanted to interview me about platform issues.

The students did an analysis of the search industry. Oversimplifying, they concluded that Google would have trouble making money because Google’s customers have high bargaining power due to low switching costs — because they can switch to another search engine at any time.

I had three problems with this. The obvious one is that Google is making money: last year, $4.2b net on income of $16.6b, or 25.3% net after. There are possible explanations for this contradiction, the first being that you can’t use the industry’s market share leader (and most profitable firm) as a proxy for the entire industry. We don't know what MS or AOL are making in search, because they’re too diversified, and Yahoo’s profits has shown wild swings in the past 4 quarters, from 3% to 30% net after.

Still, I always tell my students to check their industry analysis against industry profitability for consistency, so this big discrepancy was unsatisfying without being a conclusive proof of something wrong.

The second problem was that people could switch, but they don’t. Why not? Habituation — psychic switching costs — is an explanation, one consistent with the psychic costs I saw in my dissertation. But the switching costs between Google and Yahoo are 100x lower than between Microsoft and the Mac, and yet Apple is gaining share and Yahoo is not.

Which brings me to my third issue — the only one that produced a satisfying answer. Suppose users could switch — and they did? Would it affect Google’s profitablity? Of course not.

Google gets its revenues from advertisers, not users. It has a two-sided market (or, perhaps more accurate, a two-sided platform) supplying content to users and user eyeballs (or clicks) to advertisers.

So as long as Google does a very good job of delivering the right users to advertisers, the advertisers will have high switching costs and will stick with Google. So Google will continue to monetize its users better than its rivals.

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