1. Soumya Sen Dept. of Electrical & Systems Engineering University of Pennsylvania ssoumya@seas.upenn.edu www.seas.upenn.edu/~ssoumya Joint Work with: R. Guerin, K. Hosanagar 9 th December, 2010. University of Minnesota. Exploring the Trade-offs between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis

2. Success of new network technologies depends on: – Technological factors – Economic factors (e.g. price, costs, demand) Design choices should reflect our understanding of these factors – Analytical frameworks – What are the ‘qualitative’ insights from the model? Some Dimensions for Assessing Network Technologies: – Topic 1: Network Technology Adoption/ Migration (NetEcon’08, ToN’10) – How can a provider help its technology (service) to succeed? – Topic 2: Network Infrastructure Choice (ReArch’09, WEB’10, ISR) – What infrastructure should the new technology (service) be deployed on? – Understanding Trade-offs between Shared and Dedicated networks – Topic 3: Trade-offs between Functionality-rich versus Minimalist Designs S. Sen On the Adoption and Deployment of New Network Technologies: An Economic Perspective Background 2

3. Exploring the Trade-offs between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 1. Research Motivation 2. Review of Two-sided Markets 3. Problem Formulation 4. Model 5. Solution Methodology 6. Results 7. Conclusions S. Sen On the Adoption and Deployment of New Network Technologies: An Economic Perspective Talk Outline 3

4. Networks are becoming akin to services – Evolving from physical to virtual infrastructures – Helped by progress in new technologies e.g. Virtualization, Cloud computing, IP Multimedia Subsystem platform – Network platforms to serve as software ecosystems – Growing number of Internet intermediaries are providing different kinds of development platforms Google and Microsoft want to build web platform -the powerful layer of basic services on top of which everyone else builds their web sites and services Network Platforms are characterized by two customer segments or market sides – Application (Service) Developers – Consumers Platforms providers have to provide built-in functionalities in the platform – e.g., API, tool boxes, software modules – Availability of these software modules, APIs help to reduce app development costs of developers – But adding functionalities comes at a cost – A trade-off between functionality-rich versus minimalist design exists S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Research Motivation 4

5. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Related Work: Two-sided Markets (1) 5 Platform Infrastructure Service Providers Users Network Provider F bdbd pcpc ndnd xcxc

6. Network externalities: Katz and Shapiro (1985), Farrell and Saloner (1985) Two-sided markets definition – Cross-side externality: Bakos and Katsamakas (2008) – focus on design and ownership of platforms – Two-side externalities: Yoo (2002) -focus on B2B markets – Violation of Coase Theorem: Rochet-Tirole (2004)- “ A market is two-sided if, holding constant the total of prices faced by the two parties, any change in the price structure would affect participation levels and the number of interactions on the platform” Two-sided platforms: Economides and Tag (2009) – focus on net neutrality debate Pricing and Social Efficiency: Hagiu (2006) Competition in two-sided markets: Armstrong (2004) Pricing, subsidies: Armstrong and Wright (2004) Most closely related to our work: – Bakos and Katsamakas (2008) – Two-side externalities: Yoo (2002) Our focus on the interaction of how investments in functionalities by platform affect the application development costs, and therefore the platform’s design S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Related Work: Two-sided Markets (2) 6

7. Monopolist Platform Provider Two-sides: Application Developers and Consumers Each market sides benefits from the participation of the other side – Cross-side externality benefits (e.g., Android, Xbox) Platform provider invests in platform functionalities – basic functionalities to `niche’ functionalities Trade-offs between platforms with functionality-rich and minimalist designs Charges flat-fees to both market sides Functionality Rich Design: – Pros: Attractive to developers Indirect benefits to consumers Allows platform to charge higher fees – Cons: Expensive to build Minimalist Design: – Pros: Cheaper to build – Cons: Less attractive to developers Indirectly less attractive to consumers Lowers the platform’s profit potential S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Problem Formulation (1) 7

8. Developers create Applications (services) and generate advertisement revenues Services can be differentiated but they use the same set of underlying functionalities Note: Competition among developer apps can be allowed in the model – Can be captured through negative network externalities among developers – These negative network externalities will be proportional to the number of other developers present – Quantitative values change, but not the qualitative findings Platform provider knows about this set of functionalities needed by the apps – But may or may not provide all of them: The design decision (functionality-rich/minimalist) S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Problem Formulation (2) 8

9. In innovating apps, Developers will: – Use the functionality as is, if already provided by the platform – Otherwise, write their own software code to enable that functionality for their service – The latter comes at an application development cost for developers (presence of cost heterogeneity) Consumers are application (service) users – Benefit from the number of available applications (developers) on the platform (can be heterogeneous) – Are oblivious to who provided the code for the functionality (i.e. do not experience any difference in the quality of platform provided verses developer provided functionalities) – App downloads are transaction free S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Problem Formulation (3) 9

10. Timeline for a three stage sequential decision process is considered: Design Stage Platform decides the level of functionalities, F Pricing Stage Platform decides on the flat fees (prices) to be charged to the two sides, p c (consumers) and b d (developers) Adoption Stage A x c fraction of consumers and a n d fraction of developers join the network Consumers and developers who join are those that enjoy positive utility from joining the platform S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Model Formulation 10 Design Stage (Platform provider chooses F) Pricing Stage (platform chooses flat fees p c and b d ) Adoption Stage (n d developers and x c consumers join the platform) Decision Timeline Direction of solution

11. Platform charges flat fees to both market sides – Users pay subscription fees – Developers pay certification and licensing fees Platform provider incurs a functionality development cost, C(F) – Functionalities are added from most basic to `niche’ ones – C(F) is monotonically increasing in F – C(F) is convex (concave) if the marginal cost of adding sophisticated (niche) functionalities is increasing (decreasing) Consider F to be large, so the set of F is mapped onto an interval [0, F max ] such that C(F) is continuous on the interval S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Model : Platform Utility (1) 11

12. α captures value that a consumer generates for the developer (cross-externality) It accounts for advertising revenue (e.g. Facebook app iLike gets revenue from iTunes, Ticketmaster) b d is the flat fee developers pay to the platform – Android charges $25 market developer fee, Apple charges $99 licensing fee to distribute apps and $299 for ‘enterprise programmers’ (iOS developer program) K(F) captures the baseline app development cost when F functionalities are provided by the platform (developers have similar baseline expertise in developing apps) φτ captures the heterogeneity among developers in development cost for apps (e.g., fixed costs, employee benefits) All system parameters are normalized w.r.t. τ Assume Development cost, K(F) – More built-in functionalities, lower is this cost – K(F) is monotonically decreasing in F – K(F) is concave (convex) if the marginal cost of developing sophisticated (niche) functionalities is increasing (decreasing) Developer utility when same side externalities are considered S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Model : Developer Utility (2) 12

13. q captures stand-alone benefits the platform provides to consumer β captures the value that a developer generates for the consumer (cross-externality) θ captures the heterogeneity among consumers in how much they value the available apps, p c is the flat fee consumers pay to the platform All system parameters are normalized In some platforms, consumers may value the stand-alone qualities or brand name more We consider the following alternative utility function to account for the case where users are heterogeneous in their evaluation of stand-alone benefits, while valuing their cross-externalities equally e.g. most players of games platform value the available number of games but can be more subjective about the console characteristics and hardware features (captured by q) S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Model : Consumer Utility (3) 13

14. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Model: C(F) and K(F) 14

15. Amazon Web Services provides a variety of functionalities with available APIs – EC2 (computing), SimpleDB (database) Amazon S3 (storage), CloudFront (content delivery) API complexity is a proxy for platform’s cost of building-in the functionality Forum Activity levels is a proxy for usefulness of the functionalities Functionalities that are most useful to developers are most difficult for platform to provide, `niche’ functionalities can be added at decreasing marginal cost to the platform. – Note the correlation in EC2, FPS, SimpleDB, RDS, SQS, SNS, DevPay S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 15 Source: http://www.elastician.com/2010/06/aws-by-numbers.html Model : Examples (1)- Amazon Web Services

16. IP Multimedia Subsystems Platform provides a way for delivering integrataed voice, video, data services in a reliable standardized services Low level APIs are developed by the platform first at high marginal costs, but low-level APIs are too complex for app developers to work with, and involves complexity of learning the platform architecture As High-level APIs are made available by the platform, the developers costs decrease significantly S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 16 Model : Examples (2)- IMS Platform

17. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 17 Solution Methodology: Adoption Stage Consumers and developers are assumed to be: Rational Incentive compatible Make simultaneous adoption decision, given p c, b d and F At equilibrium: Design Stage (Platform provider chooses F) Pricing Stage (platform chooses flat fees p c and b d ) Adoption Stage (n d developers and x c consumers join the platform) Decision Timeline Direction of solution

18. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 18 Solution Methodology: Pricing Stage Interior Solution: Design Stage (Platform provider chooses F) Pricing Stage (platform chooses flat fees p c and b d ) Adoption Stage (n d developers and x c consumers join the platform) Decision Timeline Direction of solution Proposition 1: The optimal price levels ( p* c, b* d ) and the optimal adoption levels of consumers and developers ( x* c, n* d ) of the two-sided market, which maximizes the platform provider’s profit are given by: Only Boundary constraints need to be satisfied, second order conditions are satisfied

19. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 19 Solution Methodology: Design Stage Proposition 2: The optimal level of built-in functionalities (F * ) for the platform which maximizes its profit is given by: Design Stage (Platform provider chooses F) Pricing Stage (platform chooses flat fees p c and b d ) Adoption Stage (n d developers and x c consumers join the platform) Decision Timeline Direction of solution Second order condition needs to satisfy: At the optima, the participation level of developers equals the ratio of rate of change in the costs to the platform and the developers.

20. Using the conjugate pair theorem, we have: Proposition 3: Increase in cross-externality benefits provides incentives for the platform to invest in built-in functionalities How does F* change with the cost functions C(F) and K(F), i.e. when should a platform create a functionality-rich / minimalist design? S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Analysis (1): Impact of cross-externalities on platform design 20 Impact of α and β on F*

21. AWS example scenario K(F) convex, C(F) concave Basic functionalities help developers a lot (K’(F) is large -ve), marginal value to developers from ‘niche’ functionalities is decreasing (K’(F) is small -ve →0 as F increases) Cost of adding basic functionality is large, marginal cost of adding ‘niche’ functionality decreases Multiple maxima (Depending on K(F), the design should be minimalist or functionality rich) Counterintuitive: For the K’(F) that initially decreases faster and slowly later on (i.e. K(F)=0.25e -0. 43*F ) the platform will invest in higher functionality level S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Analysis (2): Presence of Multiple Maxima 21

22. K(F) convex, C(F) convex Basic functionalities help developers a lot (K’(F) is large -ve), marginal value to developers from ‘niche’ functionalities is decreasing (K’(F) is small -ve →0 as F increases) Multiple maxima (Depending on K(F), the design should be minimalist or functionality rich) Counterintuitive: For the K’(F) that initially decreases faster and slowly later on (i.e. K(F)=0.5e -0.194*F ) the platform will invest in higher functionality level S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Analysis (3): Presence of Multiple Maxima 22

23. K(F) concave, C(F) convex Design depends upon boundary values as well as the rate of change of K(F) Non-intuitive platform functionality design outcome S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Analysis (4): Complex design decisions 23

24. IMS scenario K(F) concave, C(F) concave F* is on the boundary, platform will be either minimalist or functionality-rich depending on the F max S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Analysis (5): Boundary values 24

25. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 25 Alternative Utility Function: Robustness Interior Solution: Proposition 1: The optimal price levels ( p* c, b* d ) and the optimal adoption levels of consumers and developers ( x* c, n* d ) of the two-sided market, which maximizes the platform provider’s profit are given by: Boundary constraints need to be satisfied, second order conditions require Design Solution:

26. S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis 26 Alternative Utility Function: Robustness (1) Using the conjugate pair theorem, we again have: Proposition 3: Increase in cross-externality benefits provides incentives to the platform to invest in built-in functionalities Proposition 4: Increase in platform’s stand-alone benefits decreases platform’s need to invest in higher levels of built-in functionalities

27. K(F) convex, C(F) convex Non-intuitive behaviors still present For the K’(F) that initially decreases faster and slowly later on (i.e. K(F)=0.5e -0. 35*F ) the platform will invest in higher functionality level S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Alternative Utility Function: Robustness (2) 27

28. We provide an analytical framework to investigate trade-offs in platform design Multiple design optima may arise The design decision can be complex and non-intuitive Design decision is based not only on the rate of change in costs from adding functionalities, but also the relative rate of change in platform’s and developer’s costs, as well as boundary values Robustness analysis: – Alternative demand function – Non-linear externality functions The model can help in providing design guidelines for network platforms Potential for future exploration S. Sen Exploring the Trade-offs Between Functionality-rich Versus Minimalist Design: A Two-sided Market Analysis Conclusions 28 Thank you!