What Are Network Effects?

And How To Leverage Them

Take a second, and think of three large companies that are booming right now.

Have them?

Chances are that all of them are tech companies. And probably one of the following: Apple, Google, Microsoft, Facebook, Uber, Airbnb or Amazon. All are in fact are business driven and highly benefited by network effects.

In a sentence, network effects are: when a product or service becomes more valuable to its users as more people use it…

Since the consolidation of the internet, around 1994, 70 percent of the value in tech is driven by network effects [1]. Think telecom companies, software companies, social media platforms, blockchain businesses and so on. If you understand how network effects work, you appreciate companies’ rapid growth. And ideally can embrace them and utilize them to build better products and businesses.

Many people know network effects are important. However, they don’t fully grasp what network effects entail. Simply said, very few people know the functioning of network effects and how to use them for their advantage.

Network effects refer to: the positive effect where an additional user (of a good, service, platform or market places), adds more value for existing users (to the product, the service, or the platform). By virtue of network effects, the value of a product or service increases according to the number of customers using it. A classic example is that of a telephone. If only one individual has it, it’s useless. However, as more people have telephones, each line has a higher value. Each telephone then offers the possibility of connecting to more and more people. A more contemporary example is Facebook and social networks in general. As value for each member increases as more members join. Which creates a positive feedback loop.

The key of network effects is the added value to the network each time there is a new user. The added value can take diverse forms. Such as cost reduction (in user acquisition), higher liquidity (in a marketplace), stronger community or deeper relationships (in social networks). Furthermore, network effects create a higher exit threshold for users and a higher lever for new entrants. Many of us are still on Facebook because by leaving it we lose connections to people whom we cannot find elsewhere.

Workings’ of Networks

Not all networks are created in the same way. There are different types of networks, some stronger than others. As such, each network works differently. Still, all types of networks have the same components and share several common characteristics which will be explained below.
At the basic level, networks are formed by nodes and links. Nodes are each individual network participant. Buyers, sellers, consumers, devices, any individual user is a node. Different types of nodes can have very different roles within the same network. One same node can have multiple roles within the network. A central node has a high number of links and tends to have a high value, than marginal nodes, which tend to have fewer links and less value. Though it’s important to note, the strength and the value of the nodes to which node it is connected influences its value. For instance, marginal nodes with links to few but powerful nodes have an increased value. are the connections between nodes or groups of nodes in a network. Not all links are equal, as they vary in terms of strength, closeness, and activity between nodes.

The direction of the interaction between nodes is also important. Directionality can be directed/unidirectional (exclusively from node A to node B) or unidirected/bidirectional (from node A to node B and from node B to node A). This is determined depending on which way the interaction between nodes goes. For example, on Facebook, one person (node A) sends a friend request (link) to another person (node B) when it is accepted a bidirectional connection is established. Whereas on Twitter a person (node A) follows (link) another person (node B), when node B does not follow node A back the connection becomes unidirectional, also creating an asymmetric connection.

The network size can be measured by the total number of nodes in a network, however, the size does not fully determine the value of the network. For example, consider your LinkedIn network; your connections who can provide you business opportunities or new leads are more valuable than the links to your college acquaintance who is a homestay parent. Both are connections but their worth is quite different.

Another factor that should be considered in a network is the network density. It is determined by its ratio of links and nodes. A higher ratio = denser network. The interconnectivity of links serve to reinforce and strengthen the connections between other nodes. The higher the density of a network, the more powerful its network effects are. Density tends to be unevenly distributed within the network, which is what leads to clustering. The images below shows evenly distributed networks.

In networks, nodes are likely to be dispersed unevenly and will cluster in different groups, some more closely than others. Clustering can exist in any network, sometimes subgroupings are more active than the broader network. The networks with higher degrees of clustering can have very powerful network effects as described by Reed’s Law. Reed’s Law explains that cluster prone networks scale value faster than other networks. Reed argues they increase in value a rate of 2N, where N is the total number of nodes on the network. The total number of connections in the network is not just a function of the total number of nodes. It’s a function of the total number of nodes plus the total number of possible clusters. This tends to scale at a much faster rate with the addition of more users to the network. In relation to marketplaces, most online networks allow for the formation of clusters. They are likely to behave in the manner suggested by Reed’s Law, growing in value at a fast rate. A network with a high clustering coefficient will increase exponentially in value while it grows. The image below shows how networks are irregular and how clustering works.

Generally speaking, network effects are categorized into two types: direct and indirect.

• Direct network effects: refer to an increase in usage leads to a direct increase in value for all other users. In a marketplace, there is a two-sided network effect, with the buyers on one side and the sellers on the other. In some cases, one same person can be a buyer and a seller. This overlap can initially add defensibility to a marketplace since there is a higher level of fragmentation.
• Indirect network effects: the more people that use a product or network, the more production of complementary goods or products will take place, which in turn increases the value of the original product. For instance, in terms of hardware and software, the more people use a hardware product the more people will develop software for it, giving the hardware higher value. Think of a mobile phone and its app store. The presence of more users indirectly benefits other users by attracting complementary goods. Indirect network effects generally are pecuniary nature and therefore should not be internalized.

In the literature and colloquial conversation, the terms of network externality and network effects are used interchangeably. However, their meaning refers to different phenomena, thus, should be avoided. In network externality, one individual’s utility for a good depends on the number of other people who have that same good. Whereas, with network effects, the utility of the good or product does not depend on the number of users. In network externalities, there are two values at play. One, the autarky value, generated by the product itself regardless of the number of users. Two, the synchronization value, refers to the value derived from the number of users of the product. It is the synchronization value, which is the essence of network effects.

An additional advantage of network effects is defensibility. In the digital age, next to brand, embedding and scale is one of the four defensibilities. In the past business created defensibility with unique access to raw materials, patents, licenses, favourable geographic location and government regulations like tariffs. In the digital world, network effects have emerged as a native defence. For many businesses’ geographic location and access to raw material are irrelevant. Moving past competitive advantages will lead to true defensibility. We consider network effects the most important type of defensibility, and thus, the surest route to value creation which is why we choose to focus on them.

Types of Network Effects

As mentioned, not all network effects are created equal. There are many types and categories, we will like to cover five of them for their relevance in business.

• Direct: The strongest and simplest network effects. The telephone example, increased usage of a product leads to a direct increase in the value of that product to its users.
• Two-sided network effects: are distinguished in having two different classes of users: supply-side and demand-side users. Each joins the network with distinct motivation and produce complementary value for each other. An example, market places, you have buyers and sellers. They need each other, the more opposite side the better, an increase in demand tends to lead to a growing supply and vice versa. They are highly defensible but vulnerable to multi tenanting.
• Data network effects: when a product’s value increases with more data, data is at the centre of product value. Initially, the more usage leads to a higher threshold of data collected, after a certain point the value stops growing. An example is Google Maps, users share data with Google which in turn allows Google to create new products like traffic information. However, at some point, more data won’t make the map of traffic information better.
• Tech Performance Network Effects: when the technical performance of a product improves directly as the number of users increases. A product or service becomes faster, cheaper or safer with the growing number of devices or users on a network.
• Social Network Effects: as you can imagine from the name, these are produced from the interactions between people. Individuals encourage others to join the network by influencing how they think about a product or service; they encourage using a specific product and even reinforce the connection by continues use of the product. An example of this is people referring to “googling” or “grab an Uber” these words are ‘umbrella’ terms for searching on the internet or grabbing a cab; nonetheless, they refer to specific companies Google and Uber, and when someone suggests to “grab an Uber” others will feel pressured to go for an Uber and not a traditional taxi or Lyft. People verbally using your company is a big advantage but also a challenge. The more people use a term the more valuable it becomes.

Virality ≠ Network Effect

Network effects and virality often go hand-in-hand, but not all network effect products are viral, and not all viral products have network effects. In general, marketplaces have lost virality, but having network effects is vital for scaling and sustaining a marketplace. Furthermore, viral effects, exist, and are about getting new users to use your product, but do not add more value beyond that. Viral effects helped Facebook and Buzzfeed become popular but not defensible nor valuable. Virality and viral effects are flashy and short lived.

Network effects are a complex phenomenon. This is as in-depth as you can go on a relatively short article. Do you want to know more? Or are you interested in how you can transform your company to get an advantage out of network effects? Send us an email, we’re happy to help you!

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Our next article we’ll be focusing on one of the risks of network effects that is constantly ignored, the tendency towards monopoly, because unfortunately the winner takes all.

At Protium.digital we provide end to end digital solutions that transform organisations from traditional to digital. We help our clients pinpoint emerging opportunities, find unexpected value and create new businesses by harnessing the full power of digital. Our clients are family businesses, entrepreneurial organizations, venture capitalists and private equity firms. Reach out to talk about opportunities.