The network effect is when a product becomes more valuable as its scales, users, and volume are fantastic. Network effects arise in the communication system where users directly benefit or value other users’ presence. There are two types of network effects. There are direct network effects and indirect network effects. Indirect network effects the benefit increases with each additional user in the network.
In economic terms, direct network effects create a positive externality through the presence of other users. Indirect network effects would be when people don’t necessarily care about other users’ presence.
We have a world of digital businesses and physical businesses. In the digital business world, they’re strongly dominated by network effects. Network effects are when people congregate together and feed essentially on themselves. A good example is Google Search. Everyone searches on Google because everything’s on Google.
What is Network Effect?
The network effect occurs when the value of a networked product or service depends on the number of other users or participants within that network.
Here are a few key points to understand the network effect:
Increased Adoption: The network effect suggests that as more individuals or entities join a network or use a particular product or service, the value of that network or product increases. This increased value can be attributed to improved communication, enhanced functionality, or a larger user base.
Positive Feedback Loop: The network effect creates a positive feedback loop. As more users join, the network becomes more valuable, which attracts additional users, further enhancing the network’s value. This cycle continues, leading to exponential growth and amplification of the network effect.
Barriers to Entry: The network effect can create significant barriers to entry for potential competitors. Once a network effect is established, it becomes increasingly challenging for new entrants to attract users away from the existing network, as the value lies in the number of existing users.
Widely Observed: The network effect is a common phenomenon in various industries and sectors, including technology, social media, telecommunications, online marketplaces, and more.
The network effect means that the more users start buying products, and the more people use services, the better. It is for the best business model. The absolute best example of network effect in recent days has to be the blockchain.
Network effects are significant because, in the digital age, there are only four defense abilities left. A network is a way of describing how things are connected to social media sites like Twitter. Twitter has so many users that the value of Twitter is vast. At this point, the more customers that store has, the more money they make.
As they get more customers, they incur more costs. However, the customer’s value doesn’t change as the business becomes more successful and grows. As the store becomes more successful, its value to its customers doesn’t grow much, but the cost of running the sure store increases.
Scale: The first is scale. A company like Amazon has spent billions of dollars to get to the size where they produce. Their prices can be lower than people who want to use their service. It’s a great defensive ability, and it works.
Embedding: Companies like Oracle or Workday use embedding. People are embedding their software into enterprise behaviors. It’s tough to rip them out. So Oracle charges more and more every year, and there’s not much you can do about it. It’s hard to replace them.
Brand: The third is brand. Google or Uber is sustainable for everyone. People get in the habit of using something they know and trust. So brand still works in the digital age.
Network effect: The fourth defensibility is the greatest of them all. That’s the network effect because it’s native to the digital environment. Network effects are super important because they’re cheaper and easier to get than scale or brand. They’re available to founders, and they’re more powerful. It’s a nice duality. So people tend to focus on startups looking at network effects because they tend to get a bigger longer term, and it’s easier for them to get going.
So if you’re a founder and not using network effects, it’s probably not a great decision. You should be looking at how you add network effects to the design of your business. They’re powerful because of math. Sarnoff was one of the first to talk about this network effect.
He noticed that if you have a network increased with every new node on the network. The value would be proportional to the number of nodes on the network. Metcalfe said it’s better than that because you connect all of them once you get your network.
Network effect formula
The network’s value increased as a square of the network’s number of nodes. It means that instead of the value going up linearly, as Sarnoff said, it was going up geometrically. Those powerful networks add value to each other in a way that’s even denser than a broad category.
Metcalfe’s law: Metcalfe’s law states that a network’s value is proportional to the square of the number of users in that network.
- Square of nodes, n².
That’s why communication-driven platforms like Skype or Whatsapp can be compelling.
Reed’s law: Reed says the value is 2 to the n. The actual value goes almost vertical because of these mathematical relationships.
- Subgroups, 2^n.
It is based on the permutations of the subgroups. The network effect is about retention by adding value to users. Every new user adds more value to the other users already there. A smaller network will not add as much value to the new user as a bigger network. So it’s about value-adding and defensibility. Competition with other networks would be smaller. The value of Facebook is based on the multitude of subgroups gaps that can emerge.
Network Effect on Business/Startup
The companies need to reach a critical mass. Critical mass is the specific number of people a company needs to reach to succeed in the market. If the user growth rate is prolonged and the company fails to reach critical mass, it will eventually fail. For example, What is the service Airbnb offers? People worldwide will rent out one or two rooms as a service.
If their marketing were not strong enough and not many people provided their rooms to be rented on Airbnb as a service, Airbnb would have failed as a business. That is because they are trying to provide this service worldwide. If they have 150 providers in London and no providers in Paris, it will not work. They are not going to be able to do their business worldwide.
The first movers in any industry can heavily get benefited from network effects. That way, they will have a significant advantage over the competition. But if another company improves upon every aspect of the business in the industry, the network effect will not help the first mover. That is because the users are going to move. So new companies can steal customers if they improve upon every aspect of the business.
For example, Facebook was not the first mover in Myspace’s social media industry. But think about it where Myspace is right now? But Facebook is the largest social media platform on the internet. How can a new company with better infrastructure defeat the first mover and gain a competitive advantage?
How does the network effect work? Let’s say Uber is doing business and gaining new customers every day. They will be reaching critical mass pretty soon and will be successful. But what happens if another company with better infrastructure? This sector has a huge opportunity to earn a lot of money. They can spend much money and bring hundreds more cars on the streets.
The next day that way, they can provide a reduced waiting time. When you order a car from Uber, you must wait for a while now. If another super company gives you half the Uber wait times, you will likely switch to super. That way, bigger companies with established infrastructure can capture the market of smaller startups.
- The first part of the business is the launch of the business companies trying to create a lot of hype around the products.
The hype can get so big that the company lacks the infrastructure to support the number of users at launch. So for online services, many users can log in at the time of launch and, as a result, crash the whole system.
The most recent example is Disney Plus. Many users experienced error messages instead of the service at the launch date. They did not anticipate the number of people using their service correctly. That might be why their servers could not handle the load. It could not be because they did not have the capability. They assumed that many people would use the service but, in reality, a lot more tuned into the service.
Types of Network Effects
Different types of network effects can occur. Some common examples include:
Direct Network Effects: The value of a product or service increases as more users join. Examples include social media platforms, messaging apps, and telephone networks.
Indirect Network Effects: The value of a product or service increases as more complementary products or services become available. For instance, the value of a video game console increases as more game developers create games for that console.
Two-Sided Network Effects: The value of a platform depends on the interaction and participation of two distinct user groups. An example is a credit card network where the value increases for cardholders and merchants as more participants join.
There are 13 different types of network effects.
Physical: Comcast & AT&T with actual physical nodes in the network.
Protocol: Bitcoin, Ethernet, Fax.
Personal utility: Facebook, Messenger, and WhatsApp.
Personal: Like Facebook or Twitter.
Market network: Honeybook or AngelList, where people add value for transactions.
Marketplace: Two-sided marketplaces like eBay or Craigslist.
Platform: Two-sided platform network effects like Microsoft OS or iOS.
Asymptotic marketplace: Here, the value doesn’t grow as over time as Uber or Lyft.
Data: There are many different types of data network effects.
Tech Performance: BitTorrent or Skype, where the more nodes on the network, the faster the network moves.
Language: This network effects, for instance, using the word Google.
Bandwagon: Apple is getting us not to want to be left out and use their products.
Belief: Bitcoin, religion, or gold, or the more we believe in it, the more value for everyone.
Network effect examples
A telephone network where one person has a telephone it’s useless because they can’t call anyone else. The second person has a telephone. They can now call one other person in one link. The third person can now call two different people. By adding more numbers, the value of all the connections increases dramatically and geometrically. The value of the overall network increases without doing anything. It is the fundamental unit of how value is created using network effects.
Let’s talk about Amazon eCommerce websites where people buy from vendors. The more people start to use the service of Amazon. More vendors are likely to be attracted to this service and sell it. More vendors have started selling on this website. The more people will want to buy from them.
It creates a positive feedback loop that more vendors will enter the service and sell their products on Amazon. Newer and newer buyers will go into the market and start buying from them. The more new users there are for Amazon, the better it is for them.
There are many topologies of how different network effects happen with facts. There are 15 other network effects, different playbooks different ways of approaching it. But they all have this fundamental principle: the more people use a product or service, the more valuable it gets for everybody else. The company has network effects, and its core has produced over 70% of the value.
The new Palgrave dictionary of economics. Jones, Garett (Third ed.). London. ISBN 978-1-349-95189-5.
Klemperer. The New Palgrave Dictionary of Economics. London: Macmillan Publishers Ltd.
Hagiui, Andrei. The Palgrave Encyclopedia of Strategic Management. Cambridge, MA: Macmillan Publishers Ltd.
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