What are Network Effects? A Minimum Viable Explanation:
Network effects have been a defining aspect of dominant software companies over the last decade. Despite being a major driver for technology we use every day, it still isn’t a widely understood.
A Network Effect occurs when you have a shared resource that gains in value with every new person using it.
Startups driven by Network Effects:
1) Take a group of people or things
2) Build a customizable platform for connecting this network
3) Host a marketplace on this platform where parties within the network can exchange resources
We’ll boil these three qualities down into a general equation:
“A platform for A, built on upon network of B, to build a marketplace between C and D”
Network Effect driven startups take these separate groups of people or things and puts the building blocks together in a new way. This often creates new incentives for the members of each group. The startup’s product, then, is a marketplace for acting on those incentives.
When we talk about the value of a shared resource we’re referring to how valuable the platform offered by the startup is to its users. These platforms become entrenched in a user’s life. Each new user that joins alongside them is another node in the marketplace they can exchange value with.
This concept can be a little hard to understand in the abstract. Let’s look at AirBNB as a great model of the power of Network Effects.
AirBNB: A Case Study
The idea of AirBNB doesn’t seem wild now that it has grown to be worth $30 billion. In August 2017, AirBNB claimed to have 4 million listings, in over 191 countries, with 200 million guests since their launch in 2008. But let’s take ourselves back to 2008 and really examine this idea.
AirBNB takes two distinct groups:
- Guests. A Guest could be attending a conference, touring Rome, or visiting their children. They all have a common need: Temporary housing.
- Hosts. Hosts can be renters with a spare room or homeowners. They have extra space and are open to renting it out for short periods of time.
AirBNB takes the concept of crashing on a friend’s couch and formalizes it. Their platform asks the question: What if this relationship could exist between anyone?
This is the fundamental question of all Network Effect driven technology.
In the beginning, our Guests and Hosts are two separate groups. On occasion, there may be an informal payment for a spare room, but this is still rare. This doesn’t imply there is any natural opposition to the concept of room-sharing. It implies that no one has asked the question before. The resource is abundant, but so are the blindfolds stopping everyone from seeing it.
AirBNB took this disconnected network and offered a platform to connect each side. This platform, with AirBNB in the middle, now offered a way to exchange value between Guests and Hosts.
Everyone received value from everyone else. Hosts get paid for offering their spare room. Guests get access to cheaper, or more interesting housing choices. AirBNB makes its profit as a cut of the payment for the temporary room.
For the very first interactions on the app, AirBNB’s model would look like this:
This is where we start to have a “Chicken and the Egg” problem. How does AirBNB get more Hosts for their platform if there aren’t enough Guests to fill the rooms? Guests need Hosts where they’re traveling, otherwise, they can’t use the platform. Which comes firsts?
For those who have read our article on Critical Mass, you know the answer. AirBNB must expand both groups at the same time until they reach the point of Critical Mass. The point of Critical Mass is when the growth of AirBNB’s platform becomes self-sustaining.
Before reaching this point, the platform still resembles the straight line diagram above. The platform still hasn’t become valuable enough to its users yet for it to replace their old habits. There hasn’t been a wider level of adoption yet to allow users to be a Host or Guest in any city. Because of this, AirBNB is primarily expanding through promotions, unique growth tactics, and marketing. There is a direct relationship between the work they put in to expand the network and the amount of new users.
Each new user brings added value to everyone else on the platform. Each new Guest is a new opportunity to earn money for a Host. Each new Host opens up opportunities for new or veteran Guests to use the platform again.
A bond between the two user types begins to build. As this bond strengthens, the platform gains the ability to grow without direct efforts from AirBNB. Once the bond is strong enough, we hit our point of Critical Mass. After crossing this point, we get a very dramatic change to our platform model.
The above model is a perfect example of Network Effects at work. Let’s dig into it.
At this point, AirBNB’s users start to promote the platform on their own. Guests may love the platform and evangelize it to their friends and family. Hosts may do the same, or begin keeping their rooms open for longer. The blindfolds are off; the resource isn’t hidden anymore. Everyone starts to see the value that AirBNB saw when they first built the platform.
This creates a self-fulfilling prophecy of growth. Guests and Hosts beget more new Guests and Hosts. Guests have more options of where to stay in an increasing amount of cities; Hosts have more steady streams of Guests. With each addition, the value of the platform increases and the strength of the relationship between both user types deepens.
It’s this deepening of the relationship between users types that give Network Effect driven technologies their strength. Value and strong relationships create an ever-expanding moat for the company and user alike.
Once AirBNB reaches Critical Mass and Network Effects take over, it becomes exponentially harder to challenge their platform. A new challenger doesn’t have to convince the market of the value of room-sharing, they have a harder sale. They have to convince customers that their platform is better for them, even though its value is magnitudes lower. A newcomer isn’t fighting just AirBNB when promoting themselves, they’re also fighting the entire platform of Guests and Hosts.
With AirBNB in mind, let’s return to our equation:
“A platform for A, built on upon network of B, to build a marketplace between C and D”.
AirBNB is “a platform for room-sharing, built upon a network of homeowners and travelers, to build a marketplace for exchanging capital for cheaper or more unique temporary housing”.
Network Effects drive all sort of technologies and startups. Here a few other examples of this in other startups and technologies:
A platform for publishing content, built upon a network of writers and their readers, to build a marketplace for exchanging content for attention.
A platform for responsive transportation, built upon a network of commuters and drivers, to build a marketplace for exchanging rides for capital.
A platform for team communication, built upon a network of teams within an organization, to build a medium to exchange information.
A platform for exchanging symbolic value, built upon a network of individuals with resources, to build a marketplace for exchanging resources without bartering.
If you’d like to read more about Critical Mass and its importance in Network Effects driven systems, read our Critical Mass Mental Model and walk through our thought experiment comparing the growth of a Network Effects driven startup to a more conventional counterpart.
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