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22 May

Understanding what makes marketplaces tick

There are two simple reasons why marketplaces can be such a lucrative business model.

1. Marketplaces have fairly high margins. Once the platform is built, your workload is relatively easier. You only have to host and maintain the venue for trading. Craigslist is a marketplace business with 50 employees, an annual revenue of close to a billion dollars and a valuation of ~$3-4 bn.

2. Once a marketplace hits network effects, they tend to be sticky for both buyers and sellers as both benefit from its scale in different ways.

And there are four things successful marketplaces crack to take hold of the markets they're in.

1. Aggregating Supply and Demand

For a marketplace to take root, it must help aggregate and standardize a yet-unconsolidated or fragmented market. By that I mean: it must successfully bring a large pool of sellers and buyers to transact under a single roof.

How does aggregation benefit sellers? It helps them cater to newer customers that they wouldn't have been able to cater to before. Not only that, it helps them discover what other competing products exist in the market and gives them visibility into their strategies.

For buyers, an aggregated marketplace not only serves as a good place for discovering new stuff, but it also helps bring prices down. Buyers now have more visibility around market-wide prices and can thus negotiate better. In some sense, marketplace competition itself indirectly negotiates prices, standardizes them, and brings them down for the buyer.

2. Increasing Liquidity

In the process of aggregation, the marketplace can also end up creating new supply and new demand — both of which didn't exist before the marketplace existed. They can help individuals who previously couldn't find an avenue to buy certain niche products or buy them within the budget they had. And they can help certain businesses sell inventory that was previously lying dormant.

Generally, the best marketplaces connect nonconsumers to nonproducers as a second-order effect.

Examples of nonproducers:

Before Airbnb, most people's apartments were unused assets. Airbnb made it possible for these people to monetize these unused assets.

Before Swiggy and Zomato, restaurant kitchen capacity was an underutilized asset. These food delivery marketplaces helped restaurants monetize this unused capacity. To understand this in depth, read this essay.

Examples of nonconsumers:

Before Apple Music, a music listener had to buy an entire album, just to enjoy a particular song. With Apple Music, such buyers could now easily afford to listen to their favorite tracks from a hundred different albums, without having to pay the equivalent of buying 100 albums.

Before businesses like Fitternity's OnePass aggregated different gym memberships into a single pass, individuals had to buy expensive memberships at individual gyms and were stuck to them. Now, they could buy a single pass that would allow them to try multiple fitness programs and studios all over the country, without burning through their pockets.

Before Hostelworld, people were stuck to expensive hotel rooms, even if they didn't need the luxury. Hostelworld opened up a market for owners of smaller spaces to set up dorm rooms with bunk beds and cater to low-budget customers.

3. Providing Infrastructure

Before Amazon, to sell online, any business owner would have to build their own online sales and logistics stack from scratch.

Likewise with Gumroad, that allowed small creators to easily sell their creations online, without having to build their own tech stack.

This infrastructure provided by marketplaces allowed many new nonproducers to enter the market, leading to increased choices for consumers.

4. Building Trust

Before Airbnb started, many people doubted that others would be okay with letting complete strangers live with them in their homes. Likewise, many travelers were hesitant to live in a stranger's apartment.

But with its digital photography, style of listings, the content on those listings, and a healthy and fleshed out review system, Airbnb helped both parties build trust in each other.

Uber worked because of helping riders know where their assigned drivers currently were, disincentivizing bad players, and having a reputation system — all ways of fostering trust in random drivers beyond just 'standardizing' a ride.

Generally, when you can generate new levels of trust that didn't exist previously, you promote new trades to happen. And you can build new markets, like Uber did. More than capturing an existing market, Uber helped create an entirely new one. Same for Airbnb. And all this would not be possible if these platforms didn't manage to build trust between buyers and sellers.

A large number of possible transactions simply do not exist or are highly concentrated in a few parties because a trust barrier prevents demand from engaging with supply. Hence, marketplaces that crack trust do well.

Now that you understand what successful marketplaces do, how do you identify if a particular market is fertile for consolidation and building a marketplace on?

The simple answer is incentives.

Yes, you should be deeply aware of both buyer and seller incentives driving any market.

And before thinking of building a marketplace, you should find out all the reasons why the current market is fragmented. Are there any strong reasons for why the market is the way it is?

Let's take the example of the wedding market in India, which is for the large part, mostly fragmented with little-to-no consolidation.

It is an ineffient and informal market with incomplete information about sellers. There is no standardization in pricing, either. But if you were to dive deep into the incentives that drove this marketplace, you would realize the following:

On the buyer side:

1. A wedding is one of the biggest occasions in a person's life. They want to make it special. They want to make it unique and customized. In short, they do not necessarily want to buy what everyone else is buying — be it in terms of the wedding venue, the jewelry, the decor, the food, or the apparel. They young generation wants to differentiate itself. The buyers do not want standardization.

2. A lot of the purchases and expenditures made in a wedding are culturally dictated. It's hard to standardize a cultural event like a wedding in a country with hundreds of different cultures and customs.

3. Big bash weddings are fueled by black money. The demand is driven by cash-rich tax evaders with wealth in undisclosed assets like cash or gold. A standardized and transparent marketplace goes directly against their interests.

On the seller side:

1. Service providers are incentivized to keep the markets informal and inefficient because they want to drive buyers towards customization. Customization allows service providers to charge their own prices and dictate their own margins. When the service is fully customized and there is no one to compare to, you automatically avoid price comparisons with the competition, because there is none.

2. The demand is driven by word-of-mouth based on referrals that hinge on the quality of service and trust built with customers, more than prices. There is no incentive for the seller here to promote price transparency and compete on that axis, because price is not a consideration for growth, only trust and quality of service is.

3. The aggregation in this market happens hyperlocally: the push for customization from both ends means the service provider usually becomes the buyer's trusted source of value-added services. The wedding planners act like an aggregator for other related service providers.

Would you try building a marketplace in such a market where both buyer and seller incentives are aligned against standardization?

Now compare this to a marketplace that aggregates human capital where service providers and creators need more business and exposure while recruiters are always on the lookout for better talent.

In short, both parties will benefit from all 4 factors discussed above: aggregation, liquidity, infrastructure, and trust. The incentives are aligned and the market is ripe to take advantage of a marketplace that cracks all 4 of these factors well.

The lesson

Marketplaces are lucrative once they reach a certain scale, but they're difficult to crack because understanding buyer and seller incentives that dictate market behaviour isn't a trivial problem.

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