A two-sided market is one where an intermediary acts to bring two distinct groups together. The wikipedia definition is pretty good:

Two-sided markets, also called two-sided networks, are economic networks having two distinct user groups that provide each other with network benefits. Example markets include credit cards, composed of cardholders and merchants; HMOs (patients and doctors); operating systems (end-users and developers), travel reservation services (travelers and airlines); yellow pages (advertisers and consumers); video games (gamers and game developers); and communication networks, such as the Internet. Benefits to each group exhibit demand economies of scale. Consumers, for example, prefer credit cards honored by more merchants, while merchants prefer cards carried by more consumers.

The economics of these markets are explained very well in the book Invisible Engines: How Software Platforms Drive Innovation and Transform Industries by David S. Evans, Andrei Hagiu and Richard Schmalensee (and I just noticed today that the book is available as a free download at that link!). In many of these types of markets, the intermediaries get a pretty good chunk of the money – this has been true in markets like software and the media in particular. In others, like mobile telephony, the money gets spread more widely.

The internet is breaking down some of these two-sided markets in two different ways. One way is that it can make it easier for the two groups to connect up with each other – driving down the profits of the intermediaries or even cutting them out completely. This is what is happening with travel. Online fare finders have driven the marginal cost of comparing flights and prices down near zero, putting pressure on travel agents. On top of that, many airlines now do a substantial amount of their own booking through direct websites, cutting out both online and offline intermediaries.

Bob Garfield explains how the other way these two-sided markets break down in his book The Chaos Scenario. This video summarises the main points of the book pretty well (it runs for 35 minutes, and is pretty entertaining, but the critical points come up in the first few minutes):

The Chaos Scenario from Greg Stielstra on Vimeo.

All of the advertising-based mass media are two-sided markets. They create content that they essentially give away free to consumers to create a large audience. They then sell access to this audience to advertisers. As Garfield points out, there are basically two problems now with this model – the first is that widespread access to content has driven down the price that consumers are willing to pay for it, and more importantly they have fragmented the audience. The second issue is that the explosion in available content has also driven down the prices that advertisers are willing to pay for access to any one particular segment of the market.

This has led to a collapse in advertising revenue for the major players, including newspapers, magazine publishers, and television networks (both free-to-air and cable).

This leads to the real problem in these business models – filtering is a critical part of creating value for consumers, and the fundamentals of that part of the business model haven’t changed much. The problem is that it is impossible to replace this advertising revenue – the other side of the value creation equation has changed enormously. The key point is that being a platform in a two-sided market can be incredibly lucrative (think Microsoft – where their operating system connects software developers to users), but it requires two business models – one for each side of the market.

Problems arise when the value generation equation changes in one of the business models. This usually requires changes in the other side of the business model as well – which is a very complex business model innovation problem!

Note: Greg Satell, who writes Digitaltonto one of my favourite blogs, doesn’t agree with Garfield’s stats, and consequently disagrees with my conclusions here. Be sure to read his response in the comments.