What are Network Effects?

“Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small.”

— Peter Thiel

 

Network Effect is not a very old phenomena. In fact, it was first discovered around the early 20th century itself after the invention of the Telephone. Theodore Vail, the post patent president of Bell Telephone, used the concept of Network Effect to establish a monopoly of Bell Telephone among all other telephone networks. 

 

After him came the Metcalfe’s Law given by the ethernet creator, Robert Metcalfe who said that the telephone network is directly proportional to the square of its users. But if we talk about the current use of Network Effect then it is seen everyday by us and we are a part of it.

 

We are on social media sites like Facebook, Twitter, Instagram and their whole model is based on Network Effects. The more users on it, the more valuable the application and its services become. In this blog, you will learn more about Network Effects.

 

Also Read | Network Marketing

 

Concept of Network Effect

 

Network Effect occurs when the existing users of the products or a service gain advantage when new users are added to it. This way value is added to the product/service whenever new users connect to it. The Internet is one of the best examples of network effect as we call it “network of networks”. 

 

The basic idea behind this effect is that whenever a new user is added to an existing network it increases the value for every user associated with it. Network effect also affects businesses by increasing sales. 

 

It is a known fact that whenever the value of any commodity is higher than its price, users are attracted and buy it without thinking. This way the consumers of the commodity increase. Once the business has a certain high number of consumers it starts attracting new users. 

 

Companies use multiple ways to add users to their networks like discounts, fee waivers, free trials, coupons etc. In simple language, Network effect is the additional or incremental benefit that an existing customer gets whenever a new customer joins the network. 

 

Network effect is widely used by companies to develop an entry barrier for the competitors to protect their profits and long term sustenance. In the present age where technological developments are on the rise, network effects play a vital role.

 

Also Read | Product Market Fit (PMF)

 

Example of Network Effects

 

“Facebook is quite entrenched and has a network effect. It’s hard to break into a network once it’s formed.”

— Elon Musk

 

Some of the leading tech companies, startups are using Network Effects. Here are some examples in each category:

 

1. Social Media

 

Twitter, TikTok, Pinterest, Reddit are some examples of companies that use Network Effects.

 

2. Food Delivery

 

Postmates, Doordash, Ubereats are some examples of companies that use Network Effects.

 

3. Delivery Service

 

Instacart, Shiprocket, DHL are some examples of companies that use Network Effects.

 

4. User Reviews

 

Tripadvisor is a very famous company that uses Network Effects.

 

5. Recruiting

 

Glassdoor, Indeed, Linkedin are some examples of companies that use Network Effects.

 

6. E-Commerce

 

Shopify, Etsy, Amazon are some examples of companies that use Network Effects.

 

Another example of Network Effects is the stock market. The stocks are volatile in nature. The work on the demand and supply principle and the prices are determined based on them. It is based on the number of people buying and selling the stocks. 

 

If the demand of a particular share is low, its prices will fall and ultimately more people will invest in that share. Because of this the demand will increase and the price will start rising. 

 

Once the utmost level is reached, people start selling the shares and prices again decline and stock demand diminishes once more. All these fluctuations are due to network effects.

 

Case Study on Network Effects

 

When we talk about transportation services or cab services two popular names immediately strike our mind- Uber and Lyft. Let us look at how these two companies have used Network Effects to grow and expand.

 

Just buying assets and investing in marketing is not sufficient for platforms like Uber and Lyft to grow and economically boom. The main model for these two is customer acquisition. Only this way they can make profits and sustain in such a competitive market where the burn rates are very high. 

 

These companies have to invest a lot of time and money for customer acquisition. If they treat one customer wrong then that one customer will spread the word and new customers will not be easily appealed. 

 

For Uber and Lyft word-of-mouth marketing done by customers plays a significant role. They both have developed an application where customers make an account by registering and booking a ride. 

 

For this user interface they have spent a fortune of money which they either funded through venture capital or equity sharing. Since they were successful in revenue generation they were able to minimize their Marginal Costs. 

 

The main question is how they increased their customers and profits? The answer is via Network effects. There whole model of Network Effects cycle is based on 5 elements:

 

1. Increasing the supply of drivers. Now here the main point is that by recruiting more drivers you cannot guarantee more customers. But if you have more customers then you need to increase the supply of drivers.

 

2. They worked on reducing the waiting time for customers and fares.

 

3. Increased rider signups.

 

4. Increase in the earnings. When the customers increase, rides per hour also increase and drivers get to earn more.

 

5. When all the above elements go well, more drivers will automatically join.

 

So, this is the whole cycle, where more customers means more drivers and more drivers means less waiting time for customers. This is the whole network effect in Uber and Lyft. 

 

For these platforms if the number of customers do not match with the number of drivers then the whole model would have collapsed. But not both have crossed the risk barrier and established a big network of customers and drivers.

 

Types of Network Effects

 

Network Effects are broadly categorized into- Direct Network Effects  and Indirect Network Effects. Both these have multiple types of Network Effects in them. First let us understand both of them.

 

In Direct Network Effects the growth in network and usage has a positive impact on the value of a commodity or the entire platform. These are much easier to understand. Whereas in Indirect Network Effects the advantage on users and platform is shown after some time. We can say it has cross side effects.

 

Now let us look at multiple types of Network Effects :

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Types of Network Effects

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1. Marketplace Effect

 

Marketplace Network Effect is a kind of indirect network effect. It is also a 2-sided effect where both sides are complementing. It is not as strong and beneficial as the direct network effect. It is a complex process to form such a network. 

 

If you wish to break such a network then you need to have better options for both sides. In a marketplace network effect customers want vendors and vendors are present for customers. 

 

No one will abandon until and unless a better deal is available for both the parties. Examples of Marketplace effect are: Alibaba, Amazon, Wikipedia, American Express, Visa etc. The top companies in this network for more than 15 years are Craigslist and eBay. 

 

The only limitation of this network effect is multi-tenancy. Because of multi-tenancy it becomes vulnerable. People can easily shift to other sites for better deals. Hence stopping the entry of new competition is tough here. Otherwise it is a great model for revenue generation.  

 

 

2. Data Network Effect

 

Data Network effect is when the value of your products increases because of data and an additional use of the product gives you more data. Data is very important now. Everything is based on data. 

 

If data is based on how the product will benefit the customers then it is very useful. A very relatable example can be Netflix. When you watch any movie, Netflix recommends you new shows based on your viewing. 

 

But this algorithm is marginal. The main attraction is the content it has. Therefore, we can say that it has Data Network Effect but marginally. Some other examples of Data network effects are Amazon, Google,Yelp etc.

 

 

3. Platform Network Effect

 

Platform Network Effect is another two sided model and is quite similar to marketplace network effects. In this too, we have two sides which interests each other and benefit directly from one another. 

 

The only difference is that the selling side has to collaborate or integrate with the platform to sell the products. In short, the supplier is not independent. The issue of multi-tenancy is a challenge in this network effect too. 

 

Eliminating competition is not easy.  The buying side can buy both playstation and Xbox whereas the selling side can create multiple platforms for Android and IOS. Some examples of Platform Network effect are- Android, Microsoft OS, FaceBook, Sony, Xbox etc.

 

 

4. Physical Network Effect

 

Physical Network effects are a type of direct network effects which are tied to nodes and physical links. For example- telephones and the cables. Companies that have a physical network effect have a strong foothold in the market and it is very difficult to compete with such companies. 

 

One might need a lot of capital and investments to deal with such competition. There are three industries that have physical network effects- Telecommunications, Transportation and Infrastructure companies. 

 

The biggest advantage of having a physical network effect is that you create a monopoly and become the biggest competitor in the market. The end result is that you become nationalized.

 

In this digital age, network effects are very important considering globalization. We discussed the advantages it has for companies and users. But we cannot ignore certain limitations it has like network congestion, poor product/service quality etc. 

 

Since we are moving towards a huge technologically changing world we need to adapt ourselves with all the changes happening around us.