Facebook, Twitter, Airbnb, LinkedIn, and Uber are all well-known names that almost everyone recognizes. Much of their success can be directly linked to the network effect these social networking services have derived.
With so many startups out there for VCs to invest in, it’s those that have the business model that leverages network effects that catch their eye. Let’s go into what a network effect is, why they are so powerful, and how you might be able to create or pivot to a product or service that can harness its power.
What are Network Effects?
In simple terms, the network effect refers to when a product or service becomes more valuable when you have more people use it. It is also sometimes called the network externality or demand-side economics of scale.
An example of this is the internet. Launching in 1991, the World Wide Web was thought to have been a technology that would have vanished after a few years. Netscape, Internet Explorer, AOL, and other web browsers helped make it easy and simple for people to hope on the internet.
It grew in popularity through the mid-90s. Amazon.com and eBay started up with their online stores and over 28 million online users received or sent an email once every few weeks.
Today, the entire world is connected through the internet and the younger generations don’t know of anything before its existence. It’d almost be an underestimation to say that the internet is valuable.
Is the Network Effect the same as Growth?
Growth is a term that is often used when the subject of network effects comes up. So let’s discuss it to ensure that there is no confusion between the two.
What’s important to understand about growth is not equal to the network effect. There are different types of growth out there.
For example, virality is one that often causes growth. This is that word-of-mouth marketing that happens among your friends and family. Take Facebook for example. In the early days when it first launched on the campus of Harvard, it used the school directory to launch the social media platform. As people started to invite other friends to use the platform, it increased in its usefulness for other users.
How the Network Effect Works
There are two economic values that provide a product with the network effect:
- Inherent value – When the user is using the product, this is the value that is derived
- Network value – When the network is using the product, this is the value that is derived by the user
For a business to achieve a network effect, it has to gain both of these. So basically the company must focus on getting initial users to achieve inherent value and increase its value by using the network value.
The business must also reach what is called critical mass for its network effect to become significant. This is the percentage of subscribers on board that it takes (inherent value). The network value will only come into play once it has reached this critical mass.
This network value provides more value to the user than he or she had originally paid for it. All of this works in a positive loop where when a new user that joins the network increases its value, then as a result, more users are attracted, and that further increases the value of the network.
As you may have guessed, this can happen really fast. But to make the network effect happen successfully, focusing on the loop once it has begun is the answer. After all, once the clock starts winding, it becomes easy to get more users.
Getting the product to critical mass by obtaining enough users is what’s the most challenging. You have probably come across many examples of companies offering up an incentive for signing up, waiving the initial fee, or asking that you invite your friends to sign up too.
Other companies have developed a product that by itself is valuable enough to get early adopters to use it. This is obviously a more efficient and effective way to develop a product’s inherent value to reach critical mass.
Be careful of the Potential of a Negative Network Effect
What you must be cautious of are problems that occur from saturation or congestion. Each user adds value to the network until it reaches its congestion point. This is caused by overuse. From this point on, every other user will actually lower the value of the network.
Imagine what sometimes happens when you go to a huge sporting event such as a pro football game. We may use our cell phones to try to make a call out or upload an image of yourselves at the game to a social networking platform.
However, because there are so many people that are on this cell phone network, it causes it to get overloaded and reach its congestion point. If more people continue to try to make phone calls, texts, etc., the network will eventually it will reach saturation.
At this point, you won’t be able to make an outgoing call, receive incoming calls, etc. The positive effect of the network effect ceases when this happens and it is all negative from here on out.
Types of Network Effect
If you are seeking to build a business model that uses the positive network effects to create value, there are many ways to do this. There are different types of network effect business models. They don’t all work the same or have the same results. Here are the types that you should know about:
Direct Network Effect
In the direct network effect, an increase in usage is directly linked to an increase in the value of the product offering. This type of network effect is also known as the same-side network effect.
Online games are a good example of a direct network effect. As you have more gamers participate in an online game like League of Legends, the more valuable it becomes.
Indirect Network Effect
In the indirect network effect, an increase in usage of one product will lead to the increased value in a complementary product or network. The original product finds its value increased as a result of this. This type of network effect is also known as the cross-side network effect.
We can think about iOS and Android operating systems that power many of the smartphones out there. The popularity of the iPhone (iOS) and Samsung Galaxy (Android) increases the value of the apps that are created on these platforms. These operating systems derive more value from this too.
Two-Sided Network Effect
In the two-sided network effect, a two-sided market will exhibit the properties of both the direct and indirect network effects. There are two distinct user groups in a two-sided market.
You can think of eBay as an example of this. eBay is the middleman that connects the buyers to the sellers and vice versa. Amazon is another company that experiences a two-sided network effect.
Here’s what’s important to know about how a two-sided network effect can have positive and negative effects for these user groups: When it experiences an increase in buyers, the sellers increase. This results in a positive indirect network effect. However, if there is an increase in sellers, the competition gets fiercer and that results in a negative direct network effect.
Local Network Effect
The local network effect is when a user’s gain is affected by a small group of users, rather than a whole set of members.
A great example of the local network effect is the use of instant messenger. If your friends and family sign up to use the same instant messenger app, you will benefit from using the product. Hover if the instant messenger app increases its overall users in general, there’s no benefit that you’ll gain from it.
Why is Network Effects Important?
The principles that you find behind the network effects imply that if a business, platform, or website achieves the highest market share, it will be more successful in the long run. Basically what this means is that this organization’s market share is likely to grow much bigger.
If you can effectively leverage network effects in your business, you’re likely to experience rapid rates of growth. And once you’ve become #1, you tend to stay ahead of your competitors.
eBay is again a great real-world example of this. The company tends to win big in a given country because of its prominence over the local competition.
Examples of Companies and Startups that used Network Effects
A lot of the most popular companies were influenced heavily by the network effects to become what they are now. The value of hat they provide customers also increases as they scale and acquire additional users. Here are some names that you’ve probably heard of before:
Another good example of how the network effect has worked (both positively and negatively) is when you look at the modern stock exchanges. The volatile nature of stock prices is how the effect will arise.
The number of users that participate in the stock exchange will heavily determine prices that are set by the forces of supply and demand.
Let’s say that demand is low. As a result, prices will fall, which in turn will attract more investors to invest. Their investments will cause the price of the stock to price, which will invite even more people. Now, when there is a downfall, that causes people to lose their confidence in the stock. They will begin to sell it off and cause the price to fall. When more people buy a certain stock, everyone benefits from its rising price, which is the network effect doing its magic.
Ways to Measure Network Effects
Being able to track your numbers so you can see how the network effects are affecting your business is worthwhile. This is challenging however because the product, audience, and environment of a single network effect business are different.
Let’s look at some metrics that could help measure the network effect of your business as defined by whether your product has become more valuable with more people using it. These 16 methods are divided into 5 main categories:
- Acquisition-Related Metrics
- Organic vs paid users
- Sources of traffic
- Time series of paid CAC (customer acquisition cost)
- Competitor-Related Metrics
- Prevalence of multi-tenanting
- Switching or multi-homing costs
- Engagement-related metrics
- User retention cohorts
- Core action retention cohorts
- Dollar retention & paid user retention cohorts
- Retention by location/geography
- Power user curves
- Marketplace Metrics
- Match rate
- Market depth
- Time to find a match (or inventory turnover, or days to turn)
- Concentration or fragmentation of supply and demand
- Economic-related metrics
- Pricing power
- Unit economics
Are you a network, a marketplace, or a platform?
If you are a founder that’s building a network, this is the most important question that you should be asking yourself according to Anu Hariharan. She goes on to say in an interview with Y Combinator that “Not to be super academic about it, but the reason why you have to understand whether you’re one of those three is that the questions you ask are really different depending on who you are.”
Anu thinks of Facebook and WhatsApp as a network because it’s a group of connected users that share information, where the company is trying to drive the product.
Etsy is an example of a marketplace because it has both sellers and buyers.
When you have users and developers, then you have a platform. Both these groups help build the platform and it can be customized. Microsoft’s operating system is an example of a platform.
Pricing and Network Effects
Understanding whether your market is subject to network effects is critical before you price your product, service, or platform. This is due to the fact that the typical pricing strategy that uses underlying logic will reverse itself in markets that the network effects are the strongest.
When a business typically prices its products, they charge the highest price possible that doesn’t exceed their customers’ willingness to pay. That allows the business to maximize its profit margin.
But this is not the main focus when a market is subject to network effects. Maximizing profit is not the driving concern for the business in these cases. It’s about gaining as much market share as possible. This is especially important early on.
Why is this the case? Well, your future customers’ willingness to pay for your product largely depends on how many existing users there are. You can always raise prices on your products later on, but only after you have grown your market share early and can leverage the network effects to drive the adoption of your offering. That is why many companies will either lowball their prices in the beginning or even give them away.
This is the method that Facebook has used to become so successful for example. Launched in 2004 as a free social media platform, the platform became increasingly popular. Eventually, it was able to dethrone its primary competitor at the time – Myspace. Facebook only started to monetize its user base in 2007 when it introduced ads.