Matchmakers: Lowering Transaction Costs through Technological Advancement

Richard Schmalensee, coauthor of Matchmakers: The New Economics of Multisided Platforms, on the importance of friction, critical mass, and pricing strategy for matchmaking businesses

By Christ Ponderosa
Friday, May 18, 2018

Not to be confused with dating sites or apps, matchmakers are businesses such as AirBnb, Uber, the successful restaurant reservation platform OpenTable, and other similar multisided platforms, that connect members of different groups and facilitate transactions and/or interactions among them.

The United States-Indonesia Society (USINDO), in collaboration with GTech Digital Asia, Asia School of Business, and MIT Sloan School of Management, held an open forum titled “Matchmakers: The New Economics of Multisided Platforms,” which featured a talk by Professor Richard Schmalensee, who is a Howard W Johnson Professor of Economics and Management Emeritus from MIT Sloan School of Management.

The forum, which took place on March 22 at the GTech Digital Asia office in Jakarta, allocated around 45 minutes for the talk by the professor, followed by another 30 minutes of Q&A. While Schmalensee’s talk centered around three main components — frictions, critical mass, and pricing strategy — that a matchmaker needs to pay particular attention to, it also covered his observation that the business model of matchmakers can be traced back to the past, and that a matchmaker’s business model is not “one size fits all.” 

Schmalensee began by introducing the basic business model of matchmakers, which he said is not a new model. Classic examples include the traditional marketplace, such as shopping malls, and social media platforms, where users interact with each other. The appeal of the matchmaking business is that it supplies access, lowering frictions and transaction costs. This implies that in order for this business model to work, there has to be a difficulty in getting transactions and/or interactions done between groups of customers or users.

Schmalensee said that the difference between the classic matchmakers and today’s matchmakers lies in the technology that powers the transactions and/or interactions. The implication of the use of modern technological advances in facilitating transactions and/or interactions is that this basic business model of matchmakers is a lot more powerful today than it used to be.

The main challenge matchmakers face is in building critical mass to get the business off the ground. Addressing this main challenge means addressing the question of how to deal with the tricky balance between groups of (prospective) customers.

A reinforcing loop is in play at this stage; the more vendors a platform has, the more attractive the platform becomes from the perspective of the customers, and thus, the more customers the platform will have, which eventually attracts even more vendors to join the platform, which then attracts even more customers, and so the cycle repeats.

This also applies vice versa, and thus, the reinforcing loop can easily become a vicious circle when one small component goes wrong in the process. While such a critical mass is required not only to ignite the business, but also to sustain the growth of the platform, building a critical mass is very costly to do, and most matchmakers run out of money before they can even get their business off the ground.

There is also the question of pricing strategy. Partial or full subsidy of one or more groups of customers helps overcome the costs associated with switching from using another or no platform to a particular matchmaker’s platform. This price subsidy strategy is often employed by matchmakers, and in deciding which group to subsidize, the price sensitivity of each group of customers needs to be considered. Which group is subsidizing others depends a lot on who needs who. In Schmalensee’s words, it is important that “some groups of customers get served at less than marginal cost, and then keep them on board, because their presence on the platform is crucial.” Such a pricing strategy could contribute to a matchmaker’s efforts to build the necessary critical mass to get the business off the ground.

Another puzzle that is commonly faced by matchmakers is the observation that while their business models work in one place or context, they may not work in others. Schmalensee emphasized the importance of understanding local markets and said that cultural/local contexts often become the missing piece to the puzzle.

He cited the example of how business-to-business (B2B) exchange platforms in the US do not work, while Alibaba is widely successful in China. In the US, B2B exchange platforms increase competition among sellers, because it makes it easier for buyers to compare prices. This essentially means that buyers have higher power, and the players are prone to price wars, which ultimately led to the demise of those platforms.

In contrast, Alibaba worked because it addressed what used to be a massive friction in China. Being a cash-based society with poor and uneven development of transportation and communications infrastructure, and a poor commercial legal system, making huge payments to a distant supplier was problematic. Alibaba solved all those problems, essentially lowering transaction costs.

The professor also said that blockchain technology may not be suitable to be used as the basis of a matchmaking business due to its complexity and huge cost of mining. The complexity of the technology and huge blockchain mining costs are likely to translate into high sustenance costs on a large scale.

Schmalensee ended his talk by proposing a set of five questions for business developers to examine before going forward with their business plans.

First, it is important to know what problem the business is solving, and for whom they are solving it. Second, it is also important that matchmakers know their solution to the problem they are trying to address. Also very critical is the question of the ignition plan and market entry strategy, which will likely determine if the business will survive. Matchmakers also need to examine their pricing strategy to see if it is appropriate for their target customers. Finally, they need to ask themselves if their platform can adapt quickly.

Schmalensee said he hoped that by answering each of these questions, matchmakers could fend off anticipated risks.

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