What's The Network Effect? This is our Crash Course for 2023. |
If you have a product which relies on the acquisition of a critical mass of users, like a rideshare platform the service will become more valuable as more people make use of it. Why? because the greater number of people who use your services means that you are able to reduce costs, improve availability, and sustain a large demand.
This is the effect of networks. In this post we'll explain the concept of the network effect. We'll share the history of the phenomenon and explain how tech companies use it to hit billion dollar valuations.
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The effect of networks at a glance
Some examples of the effect network
Direct vs indirect network effect
What exactly is the direct effect of network effects?
What is an indirect network effect?
The network effect aids tech companies to rise.
The network effect can benefit human-centered companies
The network effects and flywheels of community
Examples of the effect network the community flywheel.
The history of the Network Effect
Tips to generate the network effect
Advantages and Disadvantages from the Network Effect
The network effect at a glance
- The network effect occurs when the value of a platform increases as more people use it.
- Many of the biggest and most profitable businesses of the past century have grown due to the network effect which has affected everything from telephones to trains to social media to eCommerce.
- The network effect is what makes community business extremely effective, since they witness rapid growth driven by members into a community flywheel 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 rises as more people use it According to economists Michael Katz and Carl Shapiro this is the reason why popular products are inherently better value.
They observed that just as some products aren't valuable on their own (e.g. nuts without bolts); in similar fashion, certain platforms won't be as useful (or in any way) without users.
As an example, a social media platform in and of itself is an application. If it isn't used by anyone, it's virtually worthless. It's the interaction and presence of the users who give platforms like Facebook, Instagram, LinkedIn and others. their value. You can even put an exact value to every user on the network: for example, in 2021, Facebook had an average of $43.39 in revenue per user, and $13.89 net earnings.
The effect of network can bring value to a business in different ways:
- Through user actions and generated content by users: For instance, YouTube would be worthless if people didn't show up and upload videos. For many social media sites, a successful network effect is only possible if people actually use the program. Meta's most recent Threads release had 100 million new users join the first month, and then more than 10 million users active a month following. The release is still in its early stages, but it shows the value of a service isn't just in signing ups but in active users.
- By monetizing the network. Social media platforms are able to monetize their audience (selling ads) as well as utilize the massive scale of their network to charge higher rates for targeted advertising, demographics, and so on.
- They also produce data which can also be sold. The larger a set of data gets, the more useful it is for data scientists to take observations from.
Source: Katz, Michael L., and Carl Shapiro. 1994. "Systems competition and network effects." Journal of Economic Perspectives, 8 (2) (93-115).
Some examples of the network effect
Here are some examples of the network effect in action in a bunch of different industries:
- Communications: Landlines, Cable TV, email - These tools get more important the more customers they have. For instance, a land line can be more useful when you are able to call any person on it.
- Scheduling tools: Calendly, Google Calendar - Calendar tools grow quickly with the network effect. This is because, once you've sent someone an invite, they need a calendar to accept.
- Social Media: Facebook, X (Twitter), LinkedIn, Instagram - Social media companies literally make billions off the effect of networks, turning the growth of users into advertising revenues (and sometimes direct sales of premium products). In the case of LinkedIn, for instance, the primary reason that a job-seeker would pay for LinkedIn Premium is due to the fact that the number of employers using LinkedIn.
- Discussion Forums like Reddit and Quora, Reddit - These forums function because of the network impact. If people show up and are engaged, you will get lively conversations.
- Video Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you have a few people uploading videos to YouTube, you have an interesting diverting. If you have millions, you have a service that can replace traditional TV.
- AI Tools: ChatGPT is still in its early days, however ChatGPT rapidly grew to over 100 million people through word of mouth The larger the user base, the more it will be able to learn about information.
- Delivery applications: DoorDash, Uber Eats, Grubhub - It's only due to the huge number of customers ordering food that the drivers make money from these applications. That's the network effect!
- eCommerce platform: Amazon, eBay - Amazon only grew as big as it did because it was awash with customers. Other online bookstores fizzled. Once it had millions of readers, it could expand into different products besides books.
- Community of customers: Apple Community, Quickbooks Online Community, Lego Community Communities like these are valuable because customers log on to share their experiences generally for the sake of having fun. When you're an Apple user who is having issues using a particular product, you'll usually locate the answer within Apple Community. Apple Community. It would also be useless for people to not jump in and help for free!
- Subscription companies: Netflix, Amazon Prime Video, Disney+ - The more these platforms expand, they earn greater subscription revenue. These can then be reinvested to create content.
What do these things all have that they share? They're all more useful the more users they have, for various motives.
- In certain cases it is possible that the technology improves with increasing numbers of users (e.g. ChatGPT)
- In certain cases there is content on the platform that users can interact with due to more users (e.g. Facebook, reddit)
- In some instances, the more popular number of users allows the business to advertise at a higher price (e.g. Facebook, LinkedIn)
- In certain cases, there's a "real world" benefits to the networking result (e.g. LinkedIn assists you in finding jobs that ).
- In certain cases the effect of network creates an adequate customer base for businesses and individuals to offer a particular service (e.g. Uber). This is referred to as an indirect network result.
Example:
Airbnb: Airbnb has quickly become the go-to platform for owners who want to rent their properties in short-term rentals to guests. They are an instance of a network effect, as the benefit of the site increases with the number of users join Airbnb seeking to rent their homes, which provides property owners with a steady flow of income. In addition, there is value for renters too, as the more homeowners offer their homes for rental, it gives renters with more choices to select from. The benefit of the network grows as more renters and more homeowners join the platform.
Direct or indirect network impact
All of the examples above combined what economists call both indirect and direct network effects. The difference between the two things is important to know.
It's an extremely simple method to comprehend the distinctions between direct and indirect network effect:
What is a direct network effect?
An immediate network effect often referred to as a "same-side" or "one-sided" network effect happens in the event that more of the same type of users join a platform. This means that network value can be generated as a direct consequence of the increased number of users joining.
If, for instance, I want to send you an email using WhatsApp but you don't have the app There's an easy solution. It's possible to download WhatsApp! And the app just became better because now we're both on it!
The network effect is seen in action all the time when we look at online communities. Communities have an immediate effect of the network as members generate content and worth, and those on the outside want to join for that worth! The result is that communities are able to offer memberships, courses, exclusive content, as well as occasions - and are all based on the amount of members.
This is how the network effect can also lead to a community flywheel company, which we'll come down below.
What is an indirect network effect?
Indirect network effects are also known as the "two-sided" effects of network are when the expansion of one network results in benefits for other networks. As an example, the growing network of customers using Uber creates benefits for another driver's network, which is Uber's drivers. The greater the number of customers and the greater chance there exists for the drivers. Even though drivers and customers on Uber have different kinds of people and are looking for different aspects, these two network affect one another through an indirect network effect.
Network effects that complement it
Another term that you might see used here called a complementary network effect. The phenomenon of a complementary network occurs in the event that a similar product or service increases in value as a result of the expansion in a network that's not theirs. As an example, LinkedIn grows because of hiring and job seekers joining. But these enormous networks also hold value for recruiters; LinkedIn serves them as an alternative network.
How the network effect helps tech companies soar
Many digital businesses we engage with every day make use of the effect of network to benefit themselves. In fact, if you look at the top corporations in the world according to market value, many of them have used the network effect in order to experience huge increase in revenue. For example:
- Amazon (plus $1 Trillion) The company has used the effect of networks to propel an online bookstore to the single biggest store on the planet. Additionally, Amazon is using the network effect to launch thriving businesses alongside; for instance, AWS provides cloud computing and web-based services to application suppliers and for vendors to service their customers.
- Alphabet (plus $1.5 Trillion) - Alphabet is home to a variety of businesses within it, however it began with the creation of the most powerful search engine on earth (Google) that quickly grew due to the effect of network. These searchers helped make Google the company that it is currently.
There's a reason the network effect has helped tech businesses become some of the highest-valued companies on earth. It comes down to what we call externalities.
Externalities refer to the positive and negative outcomes of networks and they could limit the network's growth. The past was when externalities increased with the growth of the network. As an example, railroad companies prospered due to the effect of networks-with more riders bringing more money. BUT there was still massive expenses to keep the system running. They had to maintain bridges, rail lines tunnels, stations, and bridges in addition to keeping their engines stocked with coal.
Those externalities limited the network growth.
Here's how the network effect can benefit tech companies.
Tech firms have few externalities. If Amazon is able to put the infrastructure, then anyone in the world can join and browse. The cost for a railway would be millions in externalities to add more customers. They'd require more vehicles, engines, tracks as well as stations. The only cost is Amazon more server space-which could cost pennies.
Tech companies can grow nearly endless networks with no extra costs. And that's how the network effect pushed so many tech giants up to the top of the market.
How the network effect assists human-centered businesses
We've been very excited by how the network effect works by using human-centered software. Online communities expand rapidly and turn into successful businesses due to the effects of network. Thus, we've seen thousands flourishing communities, both small and large. They have become businesses thanks to this phenomenon.
In the field of community building, a network effect refers to the effect where the value of a group increases when new members join. Each person who joins brings along the unique viewpoints as well as experiences and knowledge and adds value to you, your brand, and the members you have.
It could also be of direct value of membership sales. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).
The network effect isn't just related to membership fees, however. The effect of the network also describes how value in these types of organisations increases due to membership activity.
Members create content and encourage other members to join the community, which adds even more value to the overall community. It creates a chain reaction which sees more users add value. This in turn draws other members who provide to the value.
This is what we call member-led growth and when you see it, you'll be amazed at the impact it has on your life. Member-led growth uses the network effect to move your subscribers, clients customers, towards being members. They are members. And when your business can thrive on member-led growth, you'll see the network effect in action.
Being a creator you can benefit from the network effect 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. With a vibrant community you will benefit from the ideas and knowledge that members contribute to one another can keep conversations continuing long after the release of new content for them.
The effects of network are typically positive and stem from a potential customer deriving more value from your product or service because of how many other people they see using the product or service.
The network effects and community flywheels
In the past, McKinsey identified a type of enterprise that they predicted to dominate the next decade. These businesses were referred to as community flywheels. The community flywheel is created as a brand expands into an entire community thanks to the network effect. Most often, it's a compelling brand story that ties communities together. The result is that your members are making content and becoming involved, which helps your community expand on autopilot.
THEN, McKinsey says, the brands launch hero products that fit their members, and the selling process is a breeze since supermembers are primed and excited to shop. No funnels. Pressure is not there.
Just awesome, organic growth driven by members thanks to the network effect.
An example of the effects of network with a community flywheel business
In the Cut: Rae Benjamin created In the Cut to be an online community focused around providing resources and connections to help marginalized creatives break into the film and television industry. In the Cut has quickly grown in size since it was launched in 2020 and now has over 1,000 members. In their Mighty Network, they offer paid webinars, job postings as well as a group of fellow creatives, and even host virtual events.
Sktchy Art School: Jordan Melnick founded Sktchy Art School as a community for artists who are interested in portraiture. They can learn new skills, share their artwork, and gain feedback about their work. Since launching in 2018 the community of Melnick has expanded to over 14,000 members. The members of the community are able to enroll in art classes, engage in group art challenges, and interact in an growing art community.
History of the Network Effect
Here are the most important ways that the network effect has performed all through history:
- Telephone Networks (19th C.) In the years that the number of people who had phones increased as they grew in popularity, the importance of the entire network increased exponentially. This is the reason the fact that, in 1908 Theodore Vail, president of Bell Telephone, presented the concept of the network effect in Bell Telephone's annual conference.
- Radio Networks (1920s) When more people got radios, it made broadcasting more profitable and powerful.
- Television Networks (1950s from the 1950s to) : Similar to radios, the massive use of televisions by households led to greater values for advertising and programming.
- Fax Machines (1970s-80s) The era of Fax Machines would only expand as an internet as more users got them-there needed to be both a receive and send side, almost identical to phones. The year was 1980. Robert Metcalfe brought the theory of the network effect into general public when he noticed that the value of a communications network (e.g. phone lines) was not the actual expense of the hardware but that there was an exponential value for each added user. He claimed that Ethernet cards needed to reach a crucial number of users to be able to prove their potential as networks.
- Personal Computers (1980s-90s): As more and more households got an Mac or Windows-based personal computers, the software to run these computers became increasingly valuable. This is what made both Microsoft and Apple their companies that they have become in the present.
- Internet as well as Email (1990s) Internet and Email (1990s) two merged in the 1990s as communication via digital technology grew. Between 1985 and 1995 Michael L. Katz, Carl Shapiro, Joseph Farrell and Garth Saloner carried out an extensive amount of the initial research for the effect of networks as a theory of economics.
- Social Media Platforms (2000s from the 2000s to) Platforms for social media used the network effect to generate mass amounts of users who created themselves content. Do you remember Myspace? It was one of the very first!
- Share Economy Applications (2010s) The effect of networks meant that sharing platforms could grow to dominate our lives as services such as Airbnb and Uber became possible.
- Cryptocurrencies and Blockchain (2020s) A: value of the cryptocurrency and blockchain have suffered, but the technology underlying both crypto and blockchain is based on a network effect and probably isn't going to go away. In fact, the promise of Web3 will be the highest level of an effect of network: the internet is not centralized.
Tips to generate the network effect
If you're establishing your own business which will benefit of this network effect , here are some tips:
- Utilize the power of users-generated content. The massive growth social media companies have seen came from creating platforms and then letting human creativity loose.
- Use platforms that empower people to join, create and connect with other people (ie. social platforms). The ownership of these platforms (getting out of the way) lets the platform to grow organically.
- Develop a service or product that, in its nature, stimulates growth by invigorating others (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. While these giants of social media have huge numbers of users, they thrive on independent networks. As an example, Facebook thrives on family and close friends. LinkedIn on workplaces and industries. Twitter is a way to connect people who share interests (e.g. politics)
Advantages and Drawbacks in the Network Effect
Advantages
- companies can expect fast growth and profit.
- Human brands gain from having more people engaged and creating (e.g. an online community focuses by leveraging human creative ).
- The increased number of users lets the brands to design superior offerings and experience.
Negatives
- Social media can have negative externalities. As an example, a large volume of users using social media websites can open potential for predators.
Then Read: 5 Ways to Monetize Your Customers