Science Facts

What Is Network Effect? – Successful Business Formula

Network Effect

The network effect is when a product becomes more valuable as its scales, users, and product volume, which is a fantastic thing. Network effects arise in the communication system where users direct benefit or value from 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 a situation where 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 quite simply the situation where people congregate together, and they 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 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, the value they provide to their customers doesn’t grow all that much, but the cost of running the store sure increases.

Scale: The first is scale. It’s a company like Amazon, which has spent billions of dollars to get to the size where they prod. Their prices can be so much lower than people all want to go there and 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 that was on the network. The value would be proportional to the number and 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 comes along and says the value is 2 to the n. It means that the actual value goes almost vertical like that 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 who comes on adds more value to the other users who are already there. And a smaller network isn’t going to add as much value to the new user as the bigger network. So it’s about value-adding and defensibility. Competition with other networks would be smaller. The value of Facebook is based on all the multitude of subgroups gaps that can emerge.

Network effect in 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? People all around the world are going to rent out one or two rooms as a service.

If their marketing was not strong enough and not many people provided their rooms to be rented in Airbnb as a service, Airbnb would have failed as a business. That is because they are trying to provide this service all around the world. 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 all around the world.

The first movers in any industry can heavily get benefited from network effects. That way, they are going to 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 the customers if they improve upon every aspect of the business.

For example, Facebook was not the first mover in the social media industry Myspace was. But think about it where is Myspace 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 their business and gaining new and new customers every single day. They will be reaching critical mass pretty soon, and they will be successful. But what happens if another company with better infrastructure. There is a huge opportunity to earn a lot of money in this sector. They can spend a lot of money and bring out hundreds of 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 have to wait for a while now. If another probably super company gives you half the uber wait times, you are likely to 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.

And the hype can get so big that the company does not have the necessary 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, crashed the whole system.

The most recent example being Disney Plus. At the launch date, a lot of users experienced error messages instead of the service. 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

There are 13 different types of network effects.

Physical: Comcast & AT&T with actually 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 are there adding value to each other 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 much overtime as Uber or Lyft.

Data: There are many different types of data network effects.

Tech Performance: BitTorrent or a 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 to these people. And the more vendors start selling on this website, the more and 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. And newer and newer buyers are going to 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 fact. 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 that product or service gets for everybody else. The company has network effects that their core has produced more than 70% of all the value.


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Sources:

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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