TCS Daily

The Real Explanation for Google's Success

By David S. Evans - May 24, 2004 12:00 AM

What's left to say, now that Google's plans to go public has evoked the predictable reactions -- everything from encomiums for the principals' decision to spread the wealth beyond the usual investment banker suspects to contrarian predictions that the masters of the search engine universe will meet their match in Yahoo or Microsoft?

Actually, quite a lot. For while the company did initially distinguish itself with superior technology, that fleeting advantage hardly explains how it managed to break out of the dot-com pack. Google's most impressive achievement, we would argue, was to use its technology edge to create a balanced, "multisided" market -- that is, to satisfy very different classes of customers whose demand is nonetheless interdependent.

The above may read suspiciously like the worst sort of business school babble. In fact, it follows from striking new research at the intersection of classical microeconomics and game theory. Look closely, and you'll see that businesses as disparate as singles bars, electronic game console makers and credit card companies all face the core problems that Google has so profitably solved.

Think for a moment about a (heterosexual) singles bar. The bar is really selling services to two sets of customers -- men and women. Without the right numbers and mix of the sexes, no one will pay the outrageous cover charge. Hence, all the gimmicks. Not enough women? Offer free margaritas to the fair sex. Not enough men? A wet t-shirt contest is in order.

The same sorts of calculations drive strategic planning at some very serious businesses. Sony sells Playstation game consoles below cost, expecting to make the investment back in royalties from their other customers -- game makers. American Express offers endless incentives to attract high-spending cardholders, thereby making it possible to collect hefty transactions fees from merchants. NTT DoCoMo, the big Japanese wireless company, gives content providers free access to the network in order to attract consumers who pay to download everything from sports scores to restaurant reviews.

Note that getting the prices right can be very difficult. In traditional competitive markets, prices must more or less reflect costs; in multi-sided markets, one set of customers typically pays extra while another gets a free (or, at least, a cheap) ride. Note, too, that establishing a foothold in a multi-sided market is typically very difficult because the markets are subject to powerful positive feedback -- what economists call "network effects." The first charge cards (issued by Diners Club) weren't worth much to holders because so few restaurants would accept them. And they weren't worth much to restaurants because so few diners carried them.

Thus success in a multi-sided market takes more than a good product or an edge in costs. It takes exceptional insight into how the demand from each side of the market affects the other -- and, more often than not, the patience and capital to survive until you get the prices right and reach the scale needed to capture the network effects.

From this perspective, the fact that the vast majority of Internet companies crashed and burned is understandable -- indeed, perhaps inevitable. Yes, many wasted money on frills, and many more seemed to have based their business models on insights worthy of fortune cookies. But large numbers with reasonable cost structures and worthy products failed, too -- and often because they either didn't understand that they faced the problem of balancing demand in a multi-sided market, or simply ran out of money in the process of solving it.

Which brings us back to Google. Good technology was certainly a prerequisite to success. And in light of Web surfers' notorious reluctance to pay for anything, it's no shock that the search engine users' side of Google get the service at no charge. The company's singular achievement was linking search results to advertising in a way that was both productive to advertisers and inoffensive to users of the search engine.

Google is now gearing up to extend the model to e-mail. And there's even talk of challenging Microsoft on its own turf by offering Web-based applications software along with targeted advertising. Can the two sides of these markets be balanced in ways that make the services profitable?

We don't know. What we do know is that those who, one way or another, fail to come to grips with the problems of balancing demand in multi-sided markets are courting failure.

David Evans is vice chairman of LECG Europe, an economics consulting firm. Peter Passell is a senior fellow at the Milken Institute in Santa Monica, CA.


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