Belfast — The Home of Network Effects
Few people in Northern Ireland will have heard of W Brian Arthur. Yet he is one of the most important thinkers in Silicon Valley who realised the ascent of technology would upend the economic model of diminishing returns — that is, products or companies that get ahead in a market eventually run into limitations. Instead, as the shift in enterprise goes towards a service oriented economy, behaviours now reward increasing returns. In principle what this means is that if a company gets ahead it will go further ahead. Excuse the textbook economics but what this implies is W Brian Arthur was the originator of the understanding of network effects. He predicted the dominance of Microsoft, Amazon, Uber, Airbnb et al.
Why should you care? For most people, where this thinking comes from and who conceptualised it doesn’t worry them. For me, it was interesting. Why? Because W Brian Arthur was born and raised in Belfast. He received an Electrical Engineering degree from Queen’s University Belfast before taking his research career across the Atlantic where he eventually landed in Stanford. As one of the most prominent academic leaders in Silicon Valley, I wondered why his name was not more well known back in his home country.
In my recent work with hundreds of Northern Irish based startup companies the term network effects get thrown around and, if I am being honest, very few people have a good understanding of it. So to help out, I started to write my thoughts down. This is my take on understanding the demand side economies of scale (another term for network effects) through the guidance of a much more learned Northern Irishman, W Brian Arthur.
So what exactly are network effects?
“Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate — within markets, businesses, and industries — to reinforce that which gains success or aggravate that which suffers loss.”
In even simpler terms, a network effect occurs when a product or service becomes more valuable to it’s users the more people use it. More value to users or consumers equals more value to the business. It is also a strong reinforcing feedback loop which not only keeps increasing growth but also locks out competitors.
Understanding the different terms around network effects is important as it will dictate the strategies required when attempting to grow your own business. Different types of businesses exhibit network effects — a network (Facebook), a Marketplace (airbnb) or platform (Wechat). These examples all exhibit the economic model of positive returns on scale. The correct categorisation of your own business in this context will allow you to adopt the correct appropriate strategy hence increasing your user base and chances of success. Some businesses can have all three – platform, network and marketplace economics but they always start with a focus on one of three elements.
Facebook is the ultimate example of a networks effects business but a more relevant example for most company founders is a marketplace. As such, it is interesting to look at AirBnB as an example of network effects, tactics for growth and how to take an idea to a global product.
Airbnb is a traditional two sided marketplace. Each host they add will increase the value of the network to all the other participants and each guest they add will also increase the value for the hosts. It is the very definition of a positive return business. So how did they go about this?
They started small — the founders had a problem finding affordable accommodation as there is limited hotel space which can also be very expensive, especially in periods of high demand. There is a lot of underutilised capacity in peoples homes and some of these homeowners would like to benefit from this. They would happily rent out space for a night to someone. So Airbnb would be able to provide cheaper, more available accommodation to travellers and create value for the host.
To achieve growth the team focused on high demand periods where supply of hotel rooms would be constrained. This early strategy allowed them to achieve basic growth which they then capitalised on by helping hosts create high quality imagery for their accommodation. They then added mutual social connections which started to build trust in the marketplace. Finally, the wheel began to spin and more guests started to come on which led to more hosts and the supply increased exponentially. One very clever strategy was that the guest who used the service was encouraged to be a host and many took this up. This sped up the flywheel.
This process, while sounding clever and straightforward, took a long time. It took almost 3 years to build enough liquidity in the marketplace to enable the network effects that have created a $10 billion business. My personal take on this is that airbnb did something that most marketplaces fail at, they commoditised trust. Trust is at the centre of most marketplace transactions and will be the single biggest influence of achieving network effects for a marketplace business.
So, network effects are important. They are not easy to attain and often will result in a business sector producing a single winner. This requires patience and often money, a lot of money. However the rewards are plentiful. You may need to run your business for several years, backed by private capital, to grow a large enough user base that it starts to create a positive feedback loop which leads to exponential growth.
W. Brian Arthur recognised this before most others. He also predicts it will continue and grow further and faster with the adoption of artificial intelligence. He suggests there could be two new economies with the traditional and automation economies competing with or complementing each other for growth. Algorithms talking to algorithms with no human intervention. Sounds futuristic but so did network effects when they were predicted in the early 1980s. Maybe this time we can start to realise the opportunity that W Brian Arthur is forecasting, I wouldn’t bet against his view of the future coming true again.
