Understanding the basics of Network Effects — The Power of the Platform
For platform businesses, positive network effects are the main source of value creation and competitive advantage. I tried to dig deep into this topic by referring the book, Platform Revolution by Geoffrey Parker and Sangeet Paul Choudhary.
Here’s a graphic shared in the book that reflects the virtuous cycle Uber enjoys.
Supply economies of scale Vs demand economies of scale
In the industrial era, the giant monopolies were created by supply economies of scale. These were driven by production efficiencies, which reduce the unit cost of creating the product or service as the quantities produced increase. These supply economies of scale can gave the largest company in an industrial economy a cost advantage that was extremely difficult for competitors to overcome.
Today, in the Internet era, comparable monopolies are being created by demand economies of scale. By contrast with supply economies of scale, demand economies of scale take advantage of technological improvements on the demand side. Demand economies of scale are driven by efficiencies in social networks, demand aggregation, app development, and other phenomena that make bigger networks more valuable to their users. They can give the largest company in a platform market a network effect advantage that is extremely difficult for competitors to overcome. Demand economies of scale are the fundamental source of positive network effects, and thus the chief drivers of economic value in today’s world. This is not to say that supply economies of scale no longer matter; of course they do. But demand economies of scale, in the form of network effects, have become the most important differentiating factor.
Robert Metcalfe, co-inventor of Ethernet and founder of 3Com, pointed out that the value of a telephone network grows nonlinearly as the number of subscribers to the network increases, making more connections among subscribers possible. It was called the Metcalfe’s Law. It is precisely the characteristic growth pattern seen in companies like Microsoft, Apple, Facebook, and Uber.
Major economic consequences follow from this pattern. Growth via network effects leads to market expansion. New buyers enter the market, attracted by the growing number of friends who are part of the network. If prices also fall — as they often do when technology matures and production quantities increase — then network effects work together with more attractive pricing to drive massive market adoption.
Two-sided Network Effects
In Metcalfe’s telephone example, phone users attract more phone users. But in the case of Uber, two sides of the market are involved: riders attract drivers, and drivers attract riders. A similar dynamic can be seen in many other platform businesses. In the case of Google’s Android, app developers attract consumers, and consumers attract app developers. On Upwork (formerly known as Elance-oDesk), job listings attract freelancers, and freelancers attract job listings. On PayPal, sellers attract buyers, and buyers attract sellers. And on Airbnb, hosts attract guests, and guests attract hosts. All of these businesses attract two-sided network effects with positive feedback.
The importance of these effects for stimulating network growth is so great that platform businesses will often spend money to attract participants to one side of the market. They know that, if they can get one side to join the platform, the other side will follow. Two-sided network effects with positive feedback explain how Uber can afford to use millions of dollars of money from its investors to “give away free rides worth $30 each. Uber’s coupons buy market share in a way that attracts a virtuous cycle of drivers and riders who will later pay full price to participate in the network.
The book shares an example of a local bar that holds a weekly Ladies’ Night, when discounted drinks are offered to female customers. When the women show up, the men appear — and they’re happy to buy their own drinks at full price. Thus, in a two-sided market, it can sometimes make economic sense to accept financial losses — not just temporarily, but permanently! — in Market A if growing that market enables growth in a related Market B. The only proviso is that the profits to be earned in Market B must outweigh the losses incurred in Market A.
Thus, in a two-sided market, it can sometimes make economic sense to accept financial losses — not just temporarily, but permanently!
Network Effects Vs Other Growth Building Tools
There is a distinction between network effects and other familiar market-building tools, such as price effects and brand effects. During the dot-com boom, investors in startups like eToys, Webvan, and FreePC regarded market share as practically the only significant metric of business success. Captivated by slogans like “Get big fast” and “Get large or get lost,” they urged companies to spend lavishly to lure customers in hopes of achieving an insurmountable market share advantage. The companies responded: for example, via discounting and couponing, they created price effects. Attracting customers through extraordinarily low pricing — as low as zero in some cases — is a foolproof way of buying market share, at least temporarily.
The problem is that price effects are evanescent. They disappear the moment the discounts end or another firm offers a better price. Typically, only 1–2 percent of customers convert from free to paying. Thus, you need to reach millions of customers before the giveaway model becomes profitable. Freemium models also create freeloaders than can be hard to monetize (that is, to profit from).
Brand effects are stickier. They arise when people come to associate a particular brand with quality. But brand effects, like price effects, are often difficult to sustain.
Price effects and brand effects have their place in a startup’s growth strategy. But only network effects create the virtuous cycle as described above, which leads to the building of a longlasting network of users — a phenomenon called lock-in.
Network Effects vs Virality
Network effects is easy to be confused with virality. Virality is the tendency of an idea or brand to be circulated rapidly and widely from one Internet user to another. Virality can attract people to a network but network effects keep them there. Virality is about attracting people who are off the platform and enticing them to join it, while network effects are about increasing value among people on-platform.
Scaling Network Effects: Frictionless Entry and Other Scalability Tools
Network effects depend on the size of the network. So one important corollary is that effective platforms are able to expand in size quickly and easily, thereby scaling the value that derives from network effect. It’s hard to remember now, but there was a time when Yahoo was a more popular portal to the Internet than Google. The story of how Google overtook Yahoo — despite the latter’s four-year head start — vividly illustrates the importance of being able to scale both sides of a network.
Networks that permit frictionless entry are able to grow organically almost without bound. Frictionless entry is the ability of users to quickly and easily join a platform and begin participating in the value creation that the platform facilitates. Frictionless entry is a key factor in enabling a platform to grow rapidly.
In some cases, the growth of a platform can be facilitated by an effect we call side switching. This occurs when users of one side of the platform join the opposite side — for example, when those who consume goods or services begin to produce goods and services for others to consume. On some platforms, users engage in side switching easily and repeatedly.
In some cases, the growth of a platform can be facilitated by an effect we call side switching. This occurs when users of one side of the platform join the opposite side — for example, when those who consume goods or services begin to produce goods and services for others to consume. On some platforms, users engage in side switching easily and repeatedly.
Uber, for example, recruits new drivers from among its rider pool, just as Airbnb recruits new hosts from among its guest pool. A scalable business model, frictionless entry, and side switching all serve to lubricate network effects.
A scalable business model, frictionless entry, and side switching all serve to lubricate network effects.
Four Kinds of Network Effects
A two-sided network (i.e., one with both producers and consumers) has four kinds of network effects. It’s important to understand and consider all four when designing and managing a platform.
- Same-side Effects: Same-side effects are network effects created by the impact of users from one side of the market on other users from the same side of the market — the effects that consumers have on other consumers and those that producers have on other producers.
- Cross-side Effects: “network effects created by the impact of users from one side of the market on users from the other side of the market — the effects that consumers have on producers and those that producers have on consumers. Both same-side effects and cross-side effects can be positive or negative, depending on the design of the system and the rules put in place. ”
The first category, positive same-side effects, includes the positive benefits received by users when the number of users of the same kind increases — for example, the effect that arose as the number of subscribers to the Bell Telephone network grew. The more of your friends and neighbors who were accessible on “the Bell,” the greater the value you received from your Bell membership. Today, a comparable positive effect on the consumer-to-consumer side can be seen with a gaming platform like the Xbox MMOG: the more fellow gamers you encounter on the platform, the greater the fun you experience when using it.
Positive same-side effects can also be found on the producer side. For example, consider Adobe’s all-but-universal image production and sharing platform. The more people who are creating and sharing images using the PDF platform, the greater the benefit you get from using the same platform for your own image production needs.
However, not all same-side effects are positive. Sometimes there is a downside to the numbers growth on one side of a platform. This is called a negative same-side effect. For example, consider the information technology platform Covisint, which connects businesses that are interested in developing cloud-based networking tools with service providers. As the number of competing suppliers on the Covisint platform grows, customers are attracted to the platform, which makes the suppliers happy. But when the list of suppliers grows too great, it becomes more difficult for appropriate providers and customers to find one another.
Cross-side effects arise when either consumers or producers gain or lose based on the number of users on the opposite side of the platform. Positive cross-side effects occur when users benefit from an increase in the number of participants on the other side of the market. Think about a payment mechanism like Visa: when more merchants (producers) agree to accept the Visa card, the flexibility and convenience of the shopping experience increases for shoppers (consumers), creating a positive cross-side effect. The same effect works in the opposite direction, of course; more Visa cardholders lead to more potential customers for merchants. In a similar way, when the number of app developers for Windows grows, the versatility and power of the operating system increases for users; and when the number of Windows users grows, so do the potential benefits (financial and otherwise) for app developers. Positive cross-side effects produce win-win results.
Of course, cross-side effects are not necessarily symmetrical. On OkCupid, women attract men more than men attract women. On Android, a single developer’s app attracts users more than a single user attracts developer apps. On Twitter, the vast majority of people read, while a minority tweet. On question-and-answer networks like Quora, the vast majority asks questions, while a minority answers them.
Structural Change: Network effects turn firms inside out
As we’ve seen, in the industrial era, giant companies relied on supply-side economies of scale. By contrast, most Internet era giants rely on demand-side economies of scale. Firms such as Airbnb, Uber, Dropbox, Threadless, Upwork, Google, and Facebook are not valuable because of their cost structures: the capital they employ, the machinery they run, or the human resources they command. They are valuable because of the communities that participate in their platforms. The reason Instagram sold for $1 billion is not its thirteen employees; the reason WhatsApp sold for $19 billion wasn’t its fifty employees. The reasons were the same: the network effects both organizations had created.
A team of experts collaborating with the consulting and accounting firm of Deloitte published research that sorts companies into four broad categories based on their chief economic activity:
- Asset builders: Asset builders develop physical assets that they use to deliver physical goods; companies like Ford and Walmart are examples.
- Service providers: Service providers employ workers who provide services to customers; companies like UnitedHealthcare and Accenture are examples.
- Technology creators: Technology creators develop and sell forms of intellectual property, such as software and biotechnology; Microsoft and Amgen are examples.
- Network orchestrators: Network orchestrators develop networks in which people and companies create value together — in effect, platform businesses.
The research suggests that, of the four, network orchestrators are by far the most efficient value creators. On average, they enjoy a market multiplier (based on the relationship between a firm’s market valuation and its price-to-earnings ratio) of 8.2, as compared with 4.8 for technology creators, 2.6 for service providers, and 2.0 for asset builders. Quantitative difference represents the value produced by network effects.
Furthermore, where network effects are present, industries operate by different rules.On e reason is that it is far easier to scale network effects outside a firm than inside it — since there are always many more people outside a firm than inside it. Thus, where network effects are present, the focus of organizational attention must shift from inside to outside. The firm inverts; it turns inside out. The management of human resources shifts from employees to crowds. Innovation shifts from in-house R & D to open innovation.The primary venue for activities in which value is created for participants shifts from an internal production department to a collection of external producers and consumers — which means that management of externalities becomes a key leadership skill. Growth comes not from horizontal integration and vertical integration but from functional integration and network orchestration. The focus on processes such as finance and accounting shifts from cash flows and assets you can own to communities and assets you can influence. And while platform businesses themselves are often extraordinarily profitable, the chief locus of wealth creation is now outside rather than inside the organization.
Network effects are creating the giants of the twenty-first century. Google and Facebook each touch more than one-seventh of the world’s population. In the world of network effects, ecosystems of users are the new source of competitive advantage and market dominance.
