Platform Subsidy with Endogenous Network Effects

This paper examines a monopoly platform’s strategy in offering subsidies based on a microfoundation of trades on the two-sided platform. A key feature is the endogenous network effects that arise from sellers’ and buyers’ entry and trading decisions. The model also captures both horizontal and vertical dimensions of product differentiation, which directly affect these decisions. The results illustrate that the platform substitutes differentiation in the horizontal dimension for that in the vertical dimension in its optimal decision. We show that it is never optimal for the platform to subsidize sellers in the absence of vertical differentiation. When products are vertically differentiated, the platform may subsidize sellers if the market is sufficiently liquid. Vertical differentiation and characteristics of a liquid market mitigate the negative same-side network effect among sellers and allow the platform to internalize higher gains to offset the subsidy. Regardless of vertical differentiation, buyer-side subsidy is possible given an illiquid market, in which seller competition is less severe. However, the degree of vertical differentiation works against the buyer-side subsidy. Our findings connect platform pricing strategies to market and user characteristics, which applies directly to managerial decisions and deepens theoretical understanding.