Designing Online Platforms for Customized Goods and Services: A Market Frictions–Based Perspective

Abstract

Through digitalization, online platforms facilitate suppliers to meet market demand with customized offerings, but this business model’s value-creation potential is often hampered by market frictions. Consequently, suppliers may avoid exerting effort and so customers may be unwilling to pay a premium. This article develops an analytical model to address market frictions. We identify circumstances where the classic reputation mechanism is insufficient and then propose a new strategy whereby the platform accepts only a subset of suppliers. We demonstrate that this supplier-restriction strategy can support a welfare-enhancing equilibrium and accelerate evolution even if all the suppliers are homogeneous and the customers can costlessly transact with suppliers outside the platform. At equilibrium, suppliers on the platform enjoy a higher market share than those outside and are motivated to exert effort; customers prefer to pay suppliers on the platform a premium and seek outside suppliers only if the former are unavailable. We evaluate platform profitability and social welfare, compare different payment structures, and extend the model to accommodate issues regarding verifiability, imperfect signals, and matching costs. Our work enriches the market frictions–based perspective by showing how it can guide platform design in governing economic exchanges.