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Network Effects

Definition

Network effects are the often positive value and sometimes negative impact existing users experience when other users join a service or product.

Also known as demand-side economies of scale or network externalities, when a network adds a new user, it can increase the value for everyone using it and concurrently motivate non-users to join.

Why Use It

Services and platforms across industries contain network effects, and it delivers exponential value when it’s a primary driver. As networks grow, they become more useful, attracting more users to the product, and can ultimately tip a market in that business’s favor.

Several industries that exemplify the use of network effects are:

  • Social media with platforms like Instagram, TikTok, LinkedIn, and Twitter
  • Home-sharing via Airbnb and VRBO
  • E-commerce giants such as Amazon and Alibaba

Amazon’s third-party marketplace drives its bottom line and adds more products to its selection. Airbnb and VRBO provide millions of unique experiences globally via its hosts who rent their homes to others on the platform. Social media connects users to friends and near-endless variety, utilizing attention as a commodity.

When to Use It

For a business, it’s strategic to focus on network effects as it yields a defensible position in the market.

However, networks need active users who find the platform valuable:

  • A mailman has a job because they deliver the mail from one person to another.
  • Someone with a phone needs to be able to call another person.
  • An auction occurs because there are buyers and sellers.
  • Social media exists to scale communication between groups of people.

In these cases, without widespread usage, the product will fail. This is especially true of software applications, where network effects have played an outsized role in their success. How many organizations have become unicorns is disrupting existing industries and producing entirely new verticals by following a rapid growth playbook?

Once an organization has the highest market share, new entrants are less likely to best them. Demand for a service or product increases as the business grows, and it forms a moat that leaves competitors at a significant disadvantage. The network protects the organization’s market position by existing. Once built, the network allows for the company to be self-sustaining.

How to Use It

If there’s only one person in a social network, the application has no value because there’s nothing for that person to do or see. If a second person joins, the first person can engage with them and vice versa. If that interaction is helpful to both parties, then the network has value. A platform’s global network is often the focus, but micro-networks within the product’s larger ecosystem are where folks derive the most benefit.

Network effects can be direct where an increase in usage correlates to a rise in value. There are also indirect effects where complementary products or services form around that original business. As the network grows, third-party companies benefit from that larger pool of potential customers.

When starting a network from the ground up, the main challenge is gaining traction—attracting a critical mass of users who find the product or service worthwhile.

Growing a network is strategic:

  • Own a niche market by focusing on a specific group within a market or creatively seeking a new market altogether.
  • Come for the tool; stay for the network by offering a utility that makes someone’s life easier. Then introduce them to a robust network within the platform that adds to their experience.
  • Congestion occurs as a network grows, causing the product or service to slow down, making a user’s experience worse, and diminishing the network’s value. Planning and scaling capacity with one’s user base must be a strategic priority.
  • Networks overlap with others, and what might have seemed like an entirely new market might be adjacent to a giant multinational company’s market. There is a risk they might enter the market with an even larger network. Keep an eye on how others might engage in the same market because owning a niche does not grant complete immunity.
  • Low switching costs to rivals can decrease a network’s value. As a market matures, users might co-exist on multiple platforms.
  • A user might be multi-tenant (use several competitive products) if they cannot achieve their objectives on one platform and can pressure the market to reduce prices as a whole.

How to Misuse It

Some businesses do not require a network and can incur significant unnecessary expenses. Conversely, a product or service might stop innovating after successfully building a network, opening it to new entrants.

Next Step

Network effects play a massive role in exponential growth for companies and are increasingly important. Where they make sense, a network can be the way to dominate a market. Discover how an organization can build a defensible moat by using this strategy.

Where it Came From

Theodore Vail, the first post-patent president of Bell Telephone, coined the term in 1908 as a central theme in how they would gain a monopoly in the U.S. Later, it was popularized by Robert Metcalfe, the creator of the ethernet, when he introduced Metcalfe’s Law in 1980.

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