The Power of Network Effects: Why they make such Valuable Companies, and how to Harness them

Eric Jorgenson
Jun 22, 2015 · 12 min read
  • What Network Effects are Not — don’t get it twisted
  • Why Network Effects are powerful
  • How to Create Network Effects

What Exactly are Network Effects?

Network Effects were not really ‘a thing’ until we started to build a layer of technology for communication around our planet. It was coined in the early 1970's as academics began to study the growth of the telephone network.

A product displays positive network effects when more usage of the product by any user increases the product’s value for other users (and sometimes all users).

This is a more precise definition than many others floating around because of a few key concepts:

  • ‘Usage’ rather than ‘adding a user’ (which implies all users are identical)

Types of Network Effects

There are different ways that Network Effects can exist, and their dynamics change depending on the application. These concepts are often mistakenly conflated into ‘Network Effects’. Work to understand the differences, because they are not conceived the same way, and they don’t create the same results. This short breakdown from the Stern School of Business (NYU) defines the types of Network Effects:

What Network Effects are Not

In addition to being conflated amongst themselves, Network Effects are also conflated with other adjacent concepts in business. To understand any concept well, it’s helpful to understand what it is Not.

Network Effects are Not Virality

A viral product is one whose rate of adoption increases with each additional user. The more people join, the faster it grows — until a certain point. They’re often confused because both Network Effects and Virality increase growth of a business and it’s value as new users join. However, they are completely independent concepts, as we see here:

Network Effects are Not Economies of Scale

Economies of Scale arise (and there’s a whole separate Edition to come on this) when there’s sufficient volume of production to massively reduce the costs, so the largest player can maintain the best margin of profitability.

Why Network Effects are Powerful

To the fun part — how to create Network Effects, and benefit from their incredible power to extract value. Let’s start with the Endgame.

Why Networks create so much value

There is one graphic that conveys the full concept of Network Effects. It was contributed by Ray Stern, who created it when he was training employees as CMO of Intuit. Take it all in…

“You can suck at everything and still make money”

Another reason that Network Effects are so valuable is that they don’t require a ton of maintenance. Once they’re built, they tend to perpetuate themselves. Even if they’re managed completely incompetently. To paraphrase Warren Buffett: “It’s great to own a business that a monkey could run — because sooner or later, one will.”

How to create Network Effects

Not all businesses can create Network Effects, and not all businesses should. There are a lot of approaches to this strategy, and it’ll look very different depending on your company and your industry.

Come for the Tool, stay for the Network

It seems like in many cases, strategic openings to create Network Effects only become available after certain levels of success with simpler products.

Dominating Extremely Tiny Markets

Another option is to create Network Effects in minuscule markets. We saw this as Facebook got started at Harvard. They had to start with a tight social group, like a class or group of friends — and grow quickly within a small and well-defined group, until they had a meaningful network to that demographic.

Product/Market Fit in Network Effect Products

If you’re relying on a Network Effect as your competitive advantage, it’s not as easy to test your value proposition and get early feedback from customers. Sean Ellis has some great slides about how different it is to find Product/Market Fit for a Network Effect Product:

Content Networks vs. Connection Networks

So far we’ve only talked about Networks of people. The Network Effect Playbook, by Sangeet Choudary (which was suggested by Eric Wilson and Itamar Goldminz) proposes that there are two ways to solve the problem of creating a Network — connection and content.


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Thank you

Massive appreciation for who suggested pieces of content (or wrote something new) for this Edition of Evergreen: David Duckworth, Itamar Goldminz, Aaron Wolfson, Karthik Rajeshwaran, Eric Wilson, David Barnes, Karan Khandpur and Ray Stern.

Never Enough

As my Father always says: “There’s always room for the best.” There’s always a better resource out there. These collections can always get better, and I hope that they do. If you can think of anything that was missed, I welcome you to share it.

If you liked this, check out other Editions of Evergreen:Building and Managing a Team:How to Find and Recruit the Team you Need
How Not to Hire like a Clownshow
Compensation Rules Everything Around Me
Why Employee Onboarding is holding you back
How to Boost Employee Retention
How Performance Reviews are being Reinvented
Secrets to Perfecting Organizational Communication
How to Manage Scale, and Operate in Scaling Organizations
How to Fire an Employee
What you actually need to know about Company Culture
How to Interview Prospective Hires
Strategy and Competitive Advantage:How to Master the Craft of Strategy
Competitive Advantage: How to Build a Winning Business
The Power of Network Effects
How Cost Leadership Builds Powerful Businesses
Why the Best Brands Stand Out
Scale as Competitive Advantage
Barriers to Entry are Confusing
Flywheel Effect: Meta-Competitive Advantage
Building the Business:How to get good business Ideas: Mental Alchemy of Ideation
How to Choose the Right Business Ideas
Product/Market Fit: What it really means & How to Measure it
How to Failure-proof your business with Customer Development
How Strategy and Psychology Work Together to Perfect Pricing
The Most Important Equations in Business - CAC (Part 1)
The Simple Math Behind Every Profitable Business - CLV (Part 2)
How Psychology behind Word-of-Mouth Works
The Secret Core of Every Successful Business--Distribution
The Most Important Lessons in Sales
Why Value Creation is the Foundation of Business
Why Value Capture is the most important idea you haven't read about
The Misunderstood and Underestimated Genius of Advertising
How to be a Great Human:How to Start a New Job: Handling Career Transitions like a Boss
How to Master the Discipline of Product Management
The Ancient Origins of Storytelling, and how to Apply Them
I've also written about How & Why we started Evergreen:How a prototype's failure created the next iteration
Mission & Method of Evergreen
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Eric Jorgenson

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Read and write. Listen and speak. Think and unthink. Fixing the biggest broken market in the world at Zaarly. I am a Terrible Investor. Tw: @EricJorgenson

Evergreen Business Fortnightly

Timeless Wisdom on Business Topics, created from the best resources suggested by our readers. Each week there’s a new topic and a new Edition of Evergreen Business Weekly. Become a member at Evergreen.instapage.com