What's The Network Effect? The Crash Course we're offering for 2023 |
If you have a product which relies on the acquisition of a critical mass of users for example, a rideshare service, then your service becomes worth more when more people use it. Why? because the greater number of people who use your services means that you are able to reduce costs, improve accessibility, and keep a large demand.
This is the effect of networks. In this article, we'll introduce you to the idea of the network effect. We'll discuss the background of the network effect and explain how tech companies use it to hit billion dollar valuations.
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The effect of networks at an encapsulated view
What exactly is a network effect?
Examples of the effect network
Direct vs indirect network impact
What exactly is an effect of a network that is direct?
What is an indirect effect of a network?
The network effect aids tech companies to rise.
How the network effect can benefit human-centered companies
The network effects as well as community flywheels
An example of the effect network the community flywheel.
A History of the Network Effect
Strategies to create the network effect
Advantages and disadvantages from the Network Effect
The effect of network at a glance
- The effect of network is that the value of a platform increases because more and more people utilize it.
- Many of the biggest and most profitable firms of the last century have grown due to the network effect which has affected everything from telephones to trains and social media, to eCommerce.
- The network effect is what makes community businesses so powerful, as they see rapid member led growth to create a flywheel of community that rapidly creates profit.
What is a network effect?
Network effects refer to the way in which the value of a product, platform or service grows when more users use it; according to the economists Michael Katz and Carl Shapiro this is the reason why popular products are inherently more valuable.
They observed that just as certain products don't have value by themselves (e.g. nuts without bolts) similarly, in the same way, some platforms won't be as useful (or in any way) without users.
A social media site in and of itself is a piece of software. If nobody uses it is useless. The presence and interaction of their users that make platforms such as Facebook, Instagram, LinkedIn and others. their importance. It is possible to assign an exact value to any user who joins the platform: for example the year 2021 was Facebook averaged $43.39 in revenues per user, and $13.89 net income.
The network effect can add value to a firm in different ways:
- By user actions or generated content by users: For instance, YouTube would be worthless if people didn't show up and upload videos. In many social media networks an effective network effect can only occur if the users make use of the software. Meta's latest Threads release had 100 million people joining for the initial month, only to have the number of active users reach 10 million a month later. This isn't yet a complete picture and it's a sign that value isn't in sign-ups, it's in active users.
- Through monetizing the network. Social media platforms can monetize the attention of their users (selling advertisements) They can also make use of the size and scope of their network to charge more for specific targeting, demographics, etc.
- They also produce data that can be monetized too. The more data a collection becomes, the more valuable it becomes for data scientists to draw data from.
Source: Katz, Michael L., and Carl Shapiro. 1994. "Systems Competition and Network Effects." Journal of Economic Perspectives, 8 (2) (93-115).
Some examples of the network effect
Here are a few examples of the effect network working in a variety of different sectors:
- Communications: Landlines cable TV, land lines, email - These devices become more valuable the more users they have. A land line can be more useful if you can call anyone who is connected to it.
- Tools for scheduling: Calendly, Google Calendar - Calendar tools expand quickly due to the network impact, as when you send someone an invite and they're required to have a calendar to accept.
- Social Media: Facebook, X (Twitter), LinkedIn, Instagram The social media giants make billions off the effect of networks, turning user growth into ad revenues (and sometimes directly selling premium services). For example, the only reason that a job-seeker would pay for LinkedIn Premium is that the number of employers using LinkedIn.
- Discussion Forums like Reddit and Quora and Reddit. These sites function because of the network effect. If people show up and participate, you can have powerful discussions.
- Video Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you have a few people uploading videos to YouTube, you have something to look at as a fun distraction. If you're in the position of having millions of users, you've got a service that can replace traditional TV.
- AI tools: ChatGPT - It's still new, but ChatGPT quickly grew to 100 million customers through the help of word-of-mouth The more users it has it has, the faster the machine can learn information.
- Delivery apps: DoorDash, Uber Eats, Grubhub - It's only due to the huge number of customers ordering food that delivery drivers are able to earn money from these apps. That's the network effect!
- eCommerce platform: Amazon, eBay - Amazon did not grow as fast as it did because it had a mass of customers. Others online bookstores slowed. Once it had millions of readers, it could expand into merchandise other than books.
- Communities for customers: Apple Community, Quickbooks Online Community, Lego Community Communities like these are valuable because customers log on and share their knowledge, usually for fun. If you're an Apple user having trouble using a particular product, you can usually find the answer in the Apple Community. And it would be worthless for people to not jump in the bandwagon and get it done at no cost!
- Subscription companies: Netflix, Amazon Prime Video, Disney+ - With these platforms growing, they earn greater subscription revenue. The money can be put back to create entertainment.
What do all these aspects have to do with each other? All of them become useful the more users they have, for various motives.
- In some cases it is possible that the technology improves with the number of users (e.g. ChatGPT)
- In certain instances there is content on the platform that users can interact with due to the presence of more users (e.g. Facebook, reddit)
- In other situations, the greater audience allows a company to advertise at a higher price (e.g. Facebook, LinkedIn)
- In some cases, there's a "real world" advantage to the network effect (e.g. LinkedIn helps you find jobs that ).
- In certain cases the effect of network creates an adequate number of customers that individuals and businesses can offer a particular service (e.g. Uber). We refer to this as indirect network result.
Example:
Airbnb: Airbnb has quickly became the preferred platform for property owners looking to rent their properties for short-term stay to clients. It is a prime instance of a network effect, as the benefit of the platform increases as increasing numbers of people sign up to the site looking to rent, which provides property owners with a steady flow of business. Additionally, value is created also for renters, since more homeowners open their properties for rental, it gives renters with more choices to select from. The value of the network increases as renters as well as homeowners join the network.
Direct or indirect network result
All of the examples above included what economists refer to as both indirect and direct network effects. But the difference between these two types of network effects is crucial to understand.
Here's a really easy way to understand the differences between an indirect and a direct network result:
What exactly is an effect of a network that is direct?
An immediate network effect often referred to as an "same-side" or "one-sided" impact of networks occurs when more people of the same kind of members join a particular platform. This means that network value is generated directly as a consequence of the increased number of users joining.
In the example above, if I want to send you a message on WhatsApp but you don't have the app, there's a simple solution. There's a chance to try downloading WhatsApp! And the app just became more valuable because now we're both on WhatsApp!
The network effect is seen constantly in online communities. Communities have a direct network effect as members produce content and create quality, while people from the outside would like to join to get that worth! This means communities can sell memberships, courses exclusive content, as well as activities - and they are all based on the number of members.
This is how the network effect can also result in a community flywheel enterprise, which we'll get to below.
What is an indirect network effect?
Indirect network effects are also called an "two-sided" network effect happen when growth in one network results in benefits for another. In the case of Uber, for example, an expanding network of customers using Uber generates advantages for a different system: drivers. As more Uber customers are there, the more opportunity there are for driver. While drivers and users on Uber are different kinds of people and are looking for different things, the two platforms affect each other: The indirect effect of the network.
Complementary network effects
There's one more term you could encounter in this article called the effect of a complementarity network. The term "complementary network effect" is used when a related product or service increases in value due to the growth of networks within a community that isn't the company's. As an example, LinkedIn grows because of hiring and job seekers joining. But these enormous networks also hold value for recruiters; LinkedIn acts as an alternative network.
The network effect helps tech companies soar
Many digital businesses we engage in daily interactions make use of the network effect to their advantage. Indeed, if you look at the top businesses in the world by market capitalization most of them have used the network effect to soar to enormous expansion. As an example:
- Amazon (plus $1 Trillion) - It's used the effect of networks to propel an online store to become one of the biggest stores in the history of mankind. In addition, Amazon is using the network effect to launch profitable businesses, for example, AWS provides cloud computing and web-based services to application suppliers and for vendors to service their clients.
- Alphabet (plus $1.5 Trillion) Alphabet (+ $1.5 Trillion) Alphabet includes a plethora of firms within it however, it was founded by creating the world's best search engine (Google) which grew rapidly thanks to the network effect. The searchers who used it made Google into the business that it is now.
The network effect has helped technology businesses become some of the highest-valued firms on earth. The reason is externalities.
Externalities can be described as the positive or negative outcomes of networks and they may limit network growth. In the past, externalities grew with the network. Railway companies, for instance, grew thanks to the network effect, with increased riders and more cash. BUT there was still massive expenses to keep the system going. They had to maintain rail networks, bridges tunnels, stations, and bridges in addition to keeping fuel for the engines up to date.
Externalities like these slowed the development of the network.
The network effect helps tech companies.
Tech firms have few externalities. If Amazon has the infrastructure in place, anyone around the globe can sign on and shop. It would cost a railway millions of dollars in additional externalities to be able to accommodate more customers; they'd need more trains, vehicles as well as stations. The only cost is Amazon an additional server, which can be as low as pennies.
Tech companies can grow nearly endless networks with no additional costs. This is why the network effect has helped push several tech giants to the top of the stock exchange.
The network effect can benefit human-centered companies
We've been really excited about the way that network effects work with human-centered software. Online communities grow exponentially and transform into lucrative businesses thanks to the effect of networks. So we've seen thousands of thriving communities-large and small-become businesses thanks to this phenomenon.
When it comes to community development, the network effect is a phenomenon where the value of a group increases when new members join. Every new member who joins the community brings the unique viewpoints as well as experiences and knowledge which creates additional value for you, your brand, and the members you have.
This could be of direct value of membership sales. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).
The effect of the network isn't only about membership fees though. It also explains how the value of companies increases because of the activities of members.
Members create content and inspire others to join, that adds value to the overall community. It creates a chain reaction where additional users create additional value. This in turn draws other members who provide even more value.
It's known as member-led growth, and once you experience it, it's life-changing. Member-led growth uses the effect of networks to shift your customers, subscribers or customers, towards being members. The members are part of the network. When your business is able to prosper through member-driven growth, you'll be able to see the effect of networks working.
Being a creator you can benefit from the network effect extremely beneficial because when you establish a network of relationships between members of your community, you will be able to focus in creating content. With a vibrant community you will benefit from the ideas and expertise your members bring to each other keeps the dialogue continuing long after the release of new content to them.
The effects of network are typically positive and stem from the potential buyer gaining higher value from your item or service due to the others they know using it.
The network effects and community flywheels
The year before, McKinsey identified a type of business that they predicted will dominate in the years 2020. They called these businesses community flywheels. A community flywheel starts as a brand expands into by forming a community through the effects of networks. Usually, there's a powerful brand story that ties the community together. This leads to your supermembers creating content and getting involved-which makes your community grow by itself.
THEN McKinsey says that These brands offer hero items which are suitable for their customers, and sales are a breeze because supermembers are primed and excited to shop. There's no funnels. No pressure.
Just awesome, organic, member-led growth thanks to the network effect.
An example of the network effect with the community flywheel.
In the Cut: Rae Benjamin In the Cut was created by Rae Benjamin In the Cut to be an online community centered around providing resources and connections for marginalized artists to get into the TV and film business. In the Cut has quickly grown in its size since its debut in 2020 and now boasts over 1000 members. On Their Mighty Network, they offer free webinars, job ads and a community of similar-minded artists, and host online occasions.
Sktchy Art School: Jordan Melnick established Sktchy Art School as a art school for those interested in portraiture to learn new skills, share their artwork, and gain feedback about their art. Since launching in 2018 Melnick's group has grown to more than 14,000 people. The members of the community are able to attend art classes, take part in art competitions for groups, and interact in an ever-growing art community.
A History of the Network Effect
Here are a few of the main ways in which the effect of network has been working across the years:
- Telephone networks (19th C.) In the years that increasing numbers of users had access to phones as they grew in popularity, the importance of the whole network grew exponentially. Because of this, it was the fact that, the year 1908 saw Theodore Vail, president of Bell Telephone, presented the concept of the network effect in Bell Telephone's annual conference.
- Radio Networks (1920s) : As increasing numbers of people had radios and broadcasting became more profitable and powerful.
- Television Networks (1950s up to) : Much like radio, televisions' widespread use by households led to greater prices for programming and advertising.
- Computers for Fax (1970s-80s) In the 1970s and 1980s, Fax machines would only expand as networks as more people bought them. They required a send and receive side similar to telephones. In the year 1980, Robert Metcalfe brought the theory of network effects to mainstream when he recognized that the worth of a communication network (e.g. telephone lines) did not come from the price of the equipment, it was rather an exponential cost for each additional user. The ethernet card had to hit a critical volume to realize their full potential as networks.
- Personal Computers (1980s-90s): As increasing numbers of households purchased a Mac or a Windows-based computer, software that runs these computers became increasingly valuable. This is the reason that made Microsoft and Apple the companies they have become now.
- Internet along with Email (1990s) Internet and Email (1990s) two merged in the 1990s as communication via digital technology increased. Between 1985 and 1995 Michael L. Katz, Carl Shapiro, Joseph Farrell, and Garth Saloner did an extensive amount of the initial work on the concept of network effects as an economic theory.
- Social Media Platforms (2000s to): Social media platforms utilized the effect of networks to generate mass amounts of users, who also created their own content. Do you remember Myspace? It was one of the first!
- Share Economy Applications (2010s) The impact of the network was that sharing platforms would grow to become a major part of our lives, as things such as Airbnb and Uber could be made.
- Cryptocurrencies and Blockchain (2020s): The valuations have taken a hit however the technology behind both crypto as well as blockchain is based on a network effect and it's not going to change. The promise of Web3 is the ultimate in a network effect: a decentralized internet.
Tips to generate the effect of network
If you're creating a business that's going to profit by the impact of networks Here are a few tips to follow:
- Harness the power of user-generated content. The huge growth that of social media businesses came from creating platforms and then letting human creativity loose.
- Use platforms that empower users to create, join and share their experiences with others (ie. communities platforms). Giving ownership of platforms (getting away from the process) will allow for the platform to grow organically.
- Develop a service or product that, in its nature, stimulates growth by invite others to join (e.g. Calendly).
- Niche down. People join and contribute to networks (esp. social networks) which allows them to connect with people who share their interests. Even though the social media giants boast huge users but they thrive in independent networks. For example, Facebook thrives on family and friends. LinkedIn has a presence in workplaces and industry. Twitter is a way to connect people who share interest (e.g. politics)
Advantages and Disadvantages from the Network Effect
Benefits
- companies can expect rapid growth and profits.
- Human brands can gain from having more people engaged and contributing (e.g. an online community works by leveraging human creative ).
- The increased number of users lets brands to create superior products and experiences.
Advantages and Disadvantages
- Social media can have negative externalities. A high volume of users using social media websites can open potential for predators.