Book Review: Evans, Hagiu & Schmalensee, Invisible Engines: How Software Platforms Drive Innovation and Transform Industries.

What makes the PlayStation 3 tick? The Apple iPod? Your BlackBerry? Software, or, more precisely—and much more interestingly—a software platform makes the hardware sing and sits in the middle of a business ecosystem of users, hardware makers and software developers. An invisible engine.

David S. Evans, Andrei Hagiu and Richard Schmalensee hold a mix—individually and collectively—of high-end academic and consulting positions. They are nicely-situated to bring to bear sophisticated theory—here, the rapidly developing economics of multi-sided markets—and a substantial amount of real-world contact. They do exactly that in their new book Invisible Engines: How Software Platforms Drive Innovation and Transform Industries.

Invisible Engines focuses on the software engines that sit at the center of many of our high-tech markets. Software is at the core of personal computers, games, cell phones, the BlackBerry, MP3 players (dominated by the iPod (quick name another MP3 player and then for double-score, a third)) and the fading category of personal digital assistants such as the Palm organizer. For most who will read the book, these are familiar, everyday devices and part of the fun of the book is learning more about the sophisticated market strategies that lie behind them.

If you are a day-to-day participant in one of these markets, you will likely find much that is familiar in the book, but you will also benefit from seeing the same dynamics at work in other software-platform markets. That said, as befits an MIT Press book, the core audience for the book is probably an academic one. For practicing lawyers, this book will be something of a long-term investment, as, as the book notes in its preface, it “does not cover government policies that affect software platforms.” So no law and, one step up, no real discussion of policy. Most lawyers will approach Invisible Engines as Toyota does its inventory: on a just-in-time basis. Buy it or read it just when you need it but not a moment before (but, if you do that, download it now: it is a free download from the MIT Press website; yippee, and it is a delight to be able to both read and search the book).

The book centers on software platforms, one example of a two-sided market. But the notion of a two-sided market—more generally, a multi-sided market—is more general than just software platforms; indeed, the classic example is an advertising market. Consider newspaper competition in Chicago. The Chicago Tribune is a standard morning daily, with a mix of advertising and news stories. The Trib is 50 cents each day, more on Sundays. The Chicago Reader is a free weekly “alternative” newspaper (that means more interesting personals). Each Friday, you can pick up the Chicago Reader in bookstore and restaurant alcoves.

Consumers pay nothing for the Reader. Does the Tribune have a good action for predatory pricing against the Reader? After all, the newspaper is free and yet it costs money to print it and authors have to be paid. Consumers are clearly paying below whatever measure of cost is the right one for predatory pricing purposes. But we know that analysis misses something important about newspapers: newspapers are middlemen situated between advertisers on the one side and readers on the other. Newspapers deliver readers to advertisers. Newspapers price ads based on the number and kind of eyeballs that will see them. It can be perfectly sensible for a newspaper to charge very little to readers if doing so attracts readers that advertisers value highly. Indeed, other than the moral hazard problem, one could imagine newspapers paying readers to take their papers. (The moral hazard problem of course is that you can pay consumers to take the newspaper but, short of pop quizzes, it is hard to monitor whether they have actually read it.) In two-sided markets, we have to resist applying our one-sided market intuitions. Two-sided markets are an example of joint production, and, as our experience with multi-product firms in regulated industries makes clear, moving from one product to more than one product is quite complicated.

The newspaper advertising example is a good starting point, but it doesn’t give the full flavor of how software operates as a platform. Switch to game consoles (the PlayStation 3, the Xbox and more recently Nintendo’s Wii). The game console sits between game developers on the one hand and game players on the other. This is an interesting coordination problem:  game players want a console with many choices, while game developers want to write to a platform with many customers. The console manufacturer coordinates these two sides.

How? Game consoles are a razors-and-blades business. Sell the console below cost — lose money on each one sold—and make money off of each game sold. Console makers achieve critical mass by selling the console below cost. Again, we can see how a naïve application of predatory pricing doctrine might miss how below-cost pricing helps solve the coordination game among game developers and consumers.

But this pricing structure creates a problem: how does Microsoft make money if it loses money each time it sells an Xbox? This gets us to a critical issue for software platforms, namely, how open (closed) is the platform? Our newspaper example is the extreme case of the closed platform. This review will appear in the Tribune only if the Tribune consents and I can’t otherwise distribute it to the eyeballs the Tribune has amassed. I need to Tribune’s permission to reach its readers. In contrast, the Wintel platform—Microsoft Windows and an Intel x-86 instruction-set compatible CPU—is an open platform. You can write a new program that runs on Windows tomorrow—without Microsoft’s or Intel’s permission—and any consumer on the Wintel platform can buy it and run it.

Open or closed? That is the core question in two-sided markets. That turns importantly but not necessarily decisively on the pricing approach of the platform. If the platform is sold at a substantial loss, money has to be made somewhere. It is hard to sell the platform at a loss and open it fully for third-parties. The platform either needs to be bundled with something else—cell phones sold below cost bundled with service plans—or the platform needs to be locked and participants need to be charged for unlocking it.

Game console manufacturers charge game producers a royalty for each game they sell, typically, Invisible Engines tells us, of $7 per game. This “tax” is how the fixed cost of producing the system is recovered. But note how this pricing structure creates boundary issues and the need to draw property lines. If a game developer can write for the console free of royalties, the economics of the game console are broken. If each developer could pursue this strategy successfully, the console producer would need to charge full prices for the console itself, and that would make it more difficult to coordinate game developers and consumers in this two-sided setting. So the game consoles are locked to developers: they need to purchase an access key and they do so by paying royalties.

As I hope this brief analysis suggests, multi-sided markets are rich places, and we need to master new rules of the road to navigate there. Our simple one-market understandings will not map easily to this new, richer space. Invisible Engines sets all of this is out in a comprehensive and interesting way. If you are ready to jump in to better understand these markets, Invisible Engines is a very good place to start.

Comments

[c&d]

"If a game developer can write for the console free of royalties, the economics of the game console are broken."

I would say "broken" is a strong word. As it is now, console makers compete with each other in an environment where consumers are not completely rational, life-cycle-aware purchasers. In such a situation it makes sense to subsidize the initial purchase in order to get a greater marketshare and increase the network effects of being a popular console.

If a law were passed tomorrow requiring all manufactures to have open systems (or at least not allow them to use the law to restrict access to their systems), all consuls would increase in price and games would get cheaper. It is hardly evident that this would be harmful to consumers or break the market.

[Doug Lay]

> If a law were passed tomorrow requiring all manufactures to have open systems (or at least not allow them to use the law to restrict access to their systems), all consuls would increase in price and games would get cheaper. It is hardly evident that this would be harmful to consumers or break the market.

I agree with you, though in general I would rather see laws that protect reverse engineering, as opposed to laws that mandate open architectures.

We should see this debate play out in the upcoming 700 mhz spectrum auction. Commissioner Martin, apparently with the support of some members of Congress, is pushing a plan to reserve some of the spectrum for organizations that allow open access across their entire set of offerings. Existing carriers don't like this plan one bit, while Google is backing it strongly. Let's get ready to see some regulatory fireworks over the next few months!

[wii]

"If a law were passed tomorrow requiring all manufactures to have open systems (or at least not allow them to use the law to restrict access to their systems), all consuls would increase in price and games would get cheaper. It is hardly evident that this would be harmful to consumers or break the market."

I agree with this and actual think it would help the marketplace to have an open ended system for development. An initially high console purchase would in theory deter likely buyers but would be offset but the actual amount of cheaper games provided for the consumer