What's the Network Effect? This is our Crash Course for 2023. |
If you're offering a service that relies on gaining an unbeatable number of customers such as a ridesharing platform the service will become more valuable as more people make use of it. Why? because the greater number of people who use your service, the more you're able to lower costs, boost the availability of your service, and maintain the demand for your service.
That's the network effect. In this article, we'll introduce you to the concept of the effect. We'll explain the origins of the network effect and explain how tech firms use it to achieve billion-dollar valuations.
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The network effect in an encapsulated view
A few examples of the network effect
Direct or indirect network impact
What is a direct network effect?
What is an indirect effect of a network?
Network effects that complement it
The network effect helps tech companies soar
How the network effect helps human-centered businesses
The network effects and flywheels for community
Examples of the effect network a community flywheel business
Tips to generate the network effect
Advantages and disadvantages from the Network Effect
The effect of network at a glance
- The effect of networks occurs when the value of a platform increases when more users use it.
- Many of the biggest and most profitable companies from the last century have grown thanks to the network effect which has affected everything from telephones to trains to social media to online shopping.
- The effect of the network is what makes community business so powerful, as they see rapid member led growth to create a flywheel of community that quickly creates profitability.
What exactly is a network effect?
The term "network effect" refers to the way in which the value of a platform, product or service grows with the increase in users; according to economists Michael Katz and Carl Shapiro, it's the phenomenon where people who use popular goods are better value.
They noticed that certain products don't have value in their own right (e.g. nuts that don't have bolts); in the same way, some platforms aren't as valuable (or in any way) without the users.
For example, a social media website as a whole is nothing more than a piece of software. If nobody uses it then it's useless. It's the interaction and presence of their users that make platforms like Facebook, Instagram, LinkedIn and others. their importance. It is possible to assign a clear value on every user on the network such as, for instance the year 2021 was Facebook averaged $43.39 in revenues per user. This was in addition to $13.89 net revenue.
The effect of network can create value for a company through a number of different methods:
- User-generated and user-generated content: For example, YouTube would be worthless if people didn't show up and create videos. In many social media networks an effective network effect can only occur if the users make use of the software. Meta's recent Threads launch saw 100 million people joining for the initial month, only to have the number of active users reach 10 million one month following. This isn't yet a complete picture, but it shows that value isn't in sign-ups, it's in active users.
- by monetizing their network. Social media platforms can monetize the attention of their users (selling advertisements) as well as make use of the size and scope of their networks to charge extra for targeting specific to demographics, etc.
- Networks also generate data, which is monetizable too. The larger a set of data becomes, the more valuable it becomes for data scientists to draw data from.
Source: Katz, Michael L., and Carl Shapiro. 1994. "Systems Competitiveness and Network Effects." Journal of Economic Perspectives, 8 (2) (93-115).
A few examples of the network effect
Here are a few examples of the effect network in action in a bunch of different sectors:
- Communications: Landlines, Cable TV, email - These tools get more useful the more users they are able to serve. For example, a land line is more valuable in case you have the ability to contact anyone on it.
- Scheduling tools: Calendly, Google Calendar - Calendar tools grow quickly with the network impact, as once you've sent the person an invitation to join a group, they require an acceptance calendar.
- Social Media: Facebook, X (Twitter), LinkedIn, Instagram - Social media companies literally generate billions of dollars from the network effect, leveraging increase in user numbers into revenue from advertising (and sometimes directly selling premium services). In the case of LinkedIn, for instance, the primary reason a job seeker might pay for LinkedIn Premium is that there are many companies on LinkedIn.
- Discussion Forums: Reddit, Quora - These platforms only work because of the network impact. When people are there and participate, you can have powerful discussions.
- Video Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you've got a handful of users uploading video on YouTube and Facebook TV, you've got an interesting diverting. If you have millions, you have a service which can take the place of traditional television.
- AI Tools: ChatGPT - It's still relatively new, but ChatGPT rapidly grew to over 100 million users with word of mouth And the larger the user base it has, the faster it will be able to learn about information.
- Delivery apps: DoorDash, Uber Eats, Grubhub - It's only due to the huge number of people ordering food that drivers can make money from these apps. This is the effect of networks!
- eCommerce platform: Amazon, eBay - Amazon was able to grow as large as it did due to it had a mass of customers. Other online bookstores fizzled. Once it had millions of readers It could also expand to merchandise other than books.
- Communities for customers: Apple Community, Quickbooks Online Community, Lego Community The value of these communities is as users sign up and share their knowledge typically for enjoyment. When you're an Apple customer who has issues in using the item, it's likely to get the solution in the Apple Community. It would also be useless for people to not jump in and help for free!
- Subscription companies: Netflix, Amazon Prime Video, Disney+ - With these platforms growing, they earn more subscription revenue. These can then be reinvested into the creation of content.
What do all these aspects have in common? All of them become useful the more users they are used to, due to various motives.
- In some instances it is possible that the technology improves when there are more users (e.g. ChatGPT)
- In some cases it is possible for the platform to provide content for users to interact with, thanks to more users (e.g. Facebook, reddit)
- In some instances, the more popular audience allows a company to offer ads for sale at a price (e.g. Facebook, LinkedIn)
- In certain cases, there's a "real world" benefit to the network result (e.g. LinkedIn helps you find an employment ).
- In certain cases it is possible for the network effect to create a big enough customer community that individuals and businesses can offer a particular service (e.g. Uber). We refer to this as indirect network impact.
Example:
Airbnb: Airbnb has quickly been a top choice for owners who want to lease their property in short-term rentals to guests. It is a prime example of a network effect because the value of the site increases with the number of users join the site seeking to rent their homes, which gives property owners a consistent flow of revenue. In addition, there is value also for renters, since homeowner's properties are opened for rent it provides renters with a wider range of options to select from. The value of the network increases as renters as well as homeowners join the network.
Direct vs indirect result
All of the examples above included what economists refer to as direct and indirect network effects. The difference between the two types of network effects is crucial to understand.
It's an extremely simple way to understand the differences between direct and indirect network effect:
What is an effect of a network that is direct?
A direct network effect, sometimes referred to a "same-side" also known as a "one-sided" impact of networks is created whenever a larger number similar users join a platform. It means that the value of the network will be created as a result of a greater number of people signing up.
For example, if I want to send you an email using WhatsApp but you don't have the app, there's a simple alternative. It's possible to download WhatsApp! The app has just become more valuable because now we're both using WhatsApp!
We see the network effect in action all the time with communities on the internet. In communities, there is an immediate effect of the network as members generate content and quality, while people from the outside are eager to join in order to gain this benefit! This means communities can offer memberships, courses, premium content, and events - and these things are all based on the amount of members.
This is the reason why this network effect could create a flywheel community business, which we'll get further down.
What is an indirect network effect?
Indirect network effects, commonly known as an "two-sided" effects of network are when the expansion of one network results in benefits for another. For example, a growing number of users on Uber brings benefits to another system: drivers. As more Uber customers are there and the greater chance there are for driver. While drivers and users on Uber are two different types of users and want different things, the two platforms affect each other: the indirect network effect.
Complementary network effects
A different term might see used here: an effect that is a part of the network. The phenomenon of a complementary network occurs in the event that a similar product or service increases in value due to the growth of networks of a different network than their own. In this case, LinkedIn grows because of the influx of employers and job seekers. But these enormous networks also provide value to recruiters. LinkedIn serves them as a complementary network.
What is the effect of network helps tech companies soar
The vast majority of businesses that we communicate daily use the effect of network to their advantage. If you examine the most successful companies worldwide by market cap most of them have made use of the network effect in order to achieve huge expansion. For example:
- Amazon (plus $1 Trillion) - It's used the network effect to catapult an online bookshop to become the largest store that on the planet. And Amazon is using its network effect to establish profitable businesses, for example, AWS provides cloud computing and web services for application suppliers and for vendors to service their clients.
- Alphabet (and $1.5 Trillion) Alphabet (+ $1.5 Trillion) Alphabet includes a plethora of companies within it, however it began by creating the most powerful search engine on earth (Google) that quickly grew because of the network effect. These searchers helped make Google the company that it has become currently.
There's a reason the network effect has helped tech firms become the most profitable firms on earth. It comes down to what we call externalities.
Externalities can be described as the positive or negative outcomes of networks and they can limit the network development. In the old days, externalities were a result of network. For example, railway companies grew because of the network effect-with more riders bringing more money. BUT there were still huge expenses to keep the system operating. They had to maintain railway networks, bridges tunnels, stations, and bridges, not to mention keeping their engines stocked with coal.
Those externalities limited the expansion of the network.
Here's how the network effect helps tech companies.
Tech firms have few externalities. If Amazon is able to put the infrastructure in place, anyone around the globe can access the site and make purchases. The cost for a railway would be millions in externalities to add more customers. It would require additional engines, cars, tracks and stations. The only cost is Amazon an additional server, which can be as low as pennies.
Tech firms can expand almost unlimited networks without adding huge cost to their operations. That's why the network effect has helped push numerous tech companies up to the top of the stock exchange.
What is the effect of network can benefit human-centered companies
We've been really excited about the way that network effects work with human-centered software. are online communities that explode with growth and become successful businesses due to the effects of network. So we've seen thousands of flourishing communities, both small and large. They have become enterprises thanks to this trend.
In the field of community building, a network effect refers to the phenomenon where the value of a community increases as the number of people who join. Every new member who joins brings along the unique viewpoints knowledge, experience, and experiences that add value to you, your brand, and the members you have.
This could be of direct benefit to membership sales. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).
The network effect doesn't just talk regarding membership costs, though. The effect of the network also describes how value in these types of organisations increases due to member activity.
The members create content and also encourage others to join in, which adds even more value to the community. It creates a chain reaction where additional users create additional value, which in turn draws other members who provide an additional value.
We call this member-led growth, and once you realize it's life-changing. Members-led growth makes use of the effects of network to bring your customers, subscribers customers, towards being members. Members belong. When your business is able to benefit from member-led growth you'll see the network effect in action.
For creators as a creator, the effect of network is important because, as you build a network of connections between the members of your community, you will be able to focus on endlessly producing content. In a community that is flourishing, the valuable ideas and experience your members provide to each other can keep conversations continuing long after the release of new content for them.
Effects of networks are generally positive, and result from the potential buyer gaining higher value from your item or service due to how others they know making use of the product or service.
The network effects as well as community flywheels
The year before, McKinsey identified a type of enterprise that they predicted to dominate the next decade. They called these businesses community flywheels. The community flywheel is created when a company's brand is able to grow by forming a community through the network effect. Most often, it's a compelling branding story that brings your community. It also leads to supermembers producing content and participating in the process, which helps your community expand automatically.
THEN, McKinsey says, the brands launch hero products that fit their members, and the selling process is a breeze since supermembers are eager and ready to purchase. No funnels. Pressure is not there.
Simply amazing, organic, member-led growth thanks to the network effect.
A few examples of the effect network a community flywheel business
In the Cut: Rae Benjamin created In the Cut to be an online community focused around providing resources and connections for marginalized artists to make it into the television and film business. The community of In the Cut has quickly grown in its size since its debut in 2020 and now is home to over 1,000 people. In their Mighty Network, they offer jobs, webinars and paid webinars, a network of like-minded artists, and host virtual events.
Sktchy Art School: Jordan Melnick founded Sktchy Art School as a community for artists keen on portraiture. It allows them to develop new skills, share their artwork, and gain feedback about their work. Since its launch in 2018, the community of Melnick has expanded to include over 14,000 users. The members of the community are able to enroll in art classes, engage in group art challenges as well as join an ever-growing art community.
History of the Network Effect
Here are some of the most important ways that the network effect has worked across the years:
- Telephone Networks (19th century) as more and increasing numbers of users had access to phones as they grew in popularity, the importance of the whole network grew rapidly. It was because of this that in 1908 Theodore Vail, president of Bell Telephone, presented the concept of the network effect during the company's annual meeting.
- Radio Networks (1920s) : As more people got radios, it made broadcasting more profitable and powerful.
- Television Networks (1950s from the 1950s to) : Similar to radios, the mass uptake of TVs within households resulted in higher prices for programming and advertising.
- Fax Machines (1970s-80s): Fax machines would only expand as networks as more people were using them. There had to be an send and receive component similar to telephones. The year was 1980. Robert Metcalfe brought the theory of the network effect into general public when he noticed that the importance of a communication network (e.g. phone lines) wasn't the real price of the equipment, it was rather an exponential benefit for every added user. The ethernet card needed to reach a crucial number of users to be able to prove their value as a network.
- Personal computers (1980s-90s) In the years when more and more households got a Mac or Windows-based personal computer, the software that runs these computers became increasingly valuable. This was what helped make Microsoft and Apple the companies they are today.
- Internet and Email (1990s) in the 1990s: The two merged as digital communications increased. Between 1985 and 1995, Michael L. Katz, Carl Shapiro, Joseph Farrell and Garth Saloner carried out a lot of the foundational work for the network effect as an economic theory.
- Social Media Platforms (2000s to): Social media platforms used the network effect to generate mass amounts of users, who also created themselves content. Do you remember Myspace? It was among the first!
- Share Economy Apps (2010s) The impact of the network was that sharing apps could expand to become a major part of our lives, and as apps such as Airbnb or Uber became possible.
- Cryptocurrencies and Blockchain (2020s) (2020s): The values have risen, but the technology underlying both crypto and blockchain relies on the network effect and probably isn't going to change. Actually, the potential of Web3 will be the highest level of a network effect: the internet is not centralized.
Strategies to create the effect of network
If you're planning to create your own business which will benefit of using the effect of the network and the network effect, here are some tips:
- Make use of the power of user-generated content. The enormous growth in of social media businesses was the result of creating a platform and then turning the human imagination loose.
- Utilize platforms that allow people to join, create and share their experiences with others (ie. social platforms). Assuming ownership over platforms (getting off the path) lets natural growth.
- Create a product or service that, in its nature, stimulates growth by invite others to join (e.g. Calendly).
- Niche down. Members join and participate in networks (esp. social networks) in order to meet individuals who are interested in the same things as they do. Even though the social media giants boast huge users, they thrive on independent networks. For example, Facebook thrives on family and friends. LinkedIn has a presence in workplaces and industry. Twitter is a way to connect people who share interests (e.g. politics)
Advantages and Disadvantages in the Network Effect
Benefits
- Businesses can experience rapid growth and profits.
- Human brands could gain from having more people engaged and contributing (e.g. the online community is based by leveraging human creative ).
- The increased number of users lets the brands to design more appealing products and experiences.
Disadvantages
- The internet can create negative externalities. As an example, a large volume of users using social media websites can open opportunities for predators.
Then Read: 5 Strategies to monetize Your Customers