Yearly Archives: 2020

There is a growing worry that digital platforms (multi-sided markets that offer digital services to customers, often for free, in exchange for data) might be gaining market power, distorting competition, and slowing innovation. A specific concern is that such platforms might acquire any potential competitors, dissuading others from entering, and thus preventing innovation from serving as the competitive threat that is traditionally believed to keep monopoly incumbents on their toes. In a sense, such platforms create a “Kill Zone” around their areas of activity. Yet, this decline in the raw numbers could be driven by other concurrent factors. Most importantly, the idea that acquisitions discourage new investments is at odds with a standard economic argument; if incumbents pay handsomely to acquire new entrants, why should entry be curtailed? Why would the prospect of an acquisition not be an extra incentive for entrepreneurs to enter the space, in the hope of being acquired at hefty multiples?

In this paper we argue that this standard economic argument relies critically on the value at which firms are acquired being adequate compensation for innovation. This may not hold in the context of acquisitions by digital platforms, because the economics of digital platforms differ significantly from the neoclassical economics of firms taught in standard textbooks.  To show this, we build a simple model of platform competition that contains the key novel ingredients present in this space: First, they are two-sided in that one side faces advertisers while the other side provides customers a service, which is often priced at zero. As a result, there isn’t any price competition on the customer side. Second, there are important network externalities on the customer side of the market. Third, some customers face switching costs.

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