Definition of waterbed effect

A ‘waterbed effect’ occurs in two-sided markets when prices are pushed down, say through regulation, on only one side of the market, resulting in a re-balancing of prices on the other side - much like a waterbed would react if you were to push down one side of it.

Understanding and quantifying this “waterbed” phenomenon has important consequences for designing and implementing effective regulatory interventions for any two-sided market.

Example

Newspapers charge high prices to advertisers and subsidise the price of the paper to readers. Forcing newspapers to charge advertisers only the actual costs incurred to print the copy would inevitably force up the price of newspapers to readers, and possibly reduce the number of papers sold.

Regulations of this type are rare among newspapers, but are quite common in other industries. In particular, it is found in telecommunications, where fixed-to-mobile termination rates – the charges mobile operators levy on fixed network operators for call termination – are perceived to be high both in absolute terms and in relation to similar prices charged by fixed network operators. If the market for mobile calling was ‘one-sided’, then forcing the termination price down would be likely to result in a reduction in retail charges. But the greater the extent to which cross-net calling subsidises on-net calling, the greater the likelihood that reducing termination charges will result in increased charges for on-net calls.

The point to take from this is that regulation may have unintended consequences in that for some customers prices could rise, not fall, as planned – because of the waterbed effect. [1][/ref]

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