The Network Effect is the idea that a service or product becomes more valuable as more people use it. For example, when the internet began it only had a few types of users, and presented little value to anyone outside of those groups. Today, the internet is used by more than 2 billion people and offers exponential value — from global commerce to online education and, yes, even to that cat video you just shared with a coworker. For associations, the network effect means that your organization's value is actually exponentially greater than the number of individual members, since your members are making connections with each other. Metcalfe's Law was one of the first attempts to quantify the network effect, and proposes that the value of a network is proportional to the square of the number of users (n^2). So, if your association has 10 users, the value the network provides is: 10^2 = 100. In other words, your association can facilitate 100 distinct inter-member connections.
Much of the early work done regarding Network Effect was based on Metcalf’s Law. Metcalf’s Law states that the value of a telecommunication network is proportional to the square of the number of connected users. The modern Network Effect was developed based on the research of Joseph Farrell, Michael L, Carl Shapiro and Garth Saloner in the 1990s. The researchers coined the concept using the telephone as an example.
Optimizing for Network Effects in Platform Design
Beyond user acquisition, platforms can be designed with features that boost network effects. These five features can be broken down into five design steps called The 5 C’s of Network Effects: Connection, Communication, Collaboration, Curation, and Community.
- Step 1: Connection: Connection refers to user onboarding and their ability to find others on the platform. How easy is it for users to find the right counter parties to buy from, sell to, share and collaborate with, etc.?
- Step 2: Communication: Communication between users should be as seamless as possible, allowing for the greatest ease-of-use. Seamless mobile syncing is a must-have as well.
- Step 3: Curation: Curation maintains the usability and integrity of your platform by keeping the quality of your users and content high and easily searchable. To ensure quality, platforms must focus on two aspects of the platform: user access (who is on the platform) and content/catalog curation (what is on the platform). For example, eBay bans the sale of live animals on its platform. Secondly, from a design perspective, it should be easy for users to find any product, service, content or counterparty.
- Step 4: Collaboration: Collaboration enables users to self-organize into new networks that advance the specific agendas that are important to them individually. For example, Etsy users self-sort by interest into groups within the marketplace. Reddit’s subreddits perform the same function within the content platform.
- Step 5: Community: The final step, community, grants users a sense of ownership of the platform, such as when a user edits a fact on Wikipedia, rates an app in Google Play, or flags inappropriate content on Facebook. In a sense, it’s user-enforced curation. It not only gives users a sense of ownership over the platform’s quality, but it also provides platform managers with invaluable user feedback. For example, what type of content are users of Facebook finding objectionable, and why?
Once a platform has optimized The Five C’s, the growth generated through network effects can be a powerful force that leads to scale that’s unachievable with linear business models. Curation and Community feedback and participation provide steady guardrails for runaway growth, while Connection, Communication, and Collaboration attracts users and keep them coming to the platform over and over again.
Why Network Effects are Important
Network effects are mechanisms in a product and business where every new user makes the product/service/experience more valuable to every other user. Network effects are important because they are the best form of defensibility, and thus value creation, in the digital world (the three other major defensibilities are brand, embedding, and scale). Network effects account for the majority of value created in the technology industry in the past few decades, since many winner-take-all-companies in tech were powered by network effects.
Not all network effects are the same, however, and understanding the nuances is essential for building network effects of your own into your products. Different types of nfx are stronger or weaker than others, and they each work differently. To date we’ve identified 13 different kinds of network effects. They’re listed as follows in order of strength: Physical (e.g. landline telephones) Protocol (e.g. Ethernet) Personal Utility (e.g. iMessage, WhatsApp) Personal (e.g. Facebook) Market Network (e.g. HoneyBook, AngelList) Marketplace (e.g. eBay, Craigslist) Platform (e.g. Windows, iOS, Android) Asymptotic Marketplace (e.g. Uber, Lyft) Data (e.g. Waze, Yelp!) Tech Performance (e.g. Bittorrent,Skype) Language (e.g. Google, Xerox) Belief (currencies, religions) Bandwagon (e.g. Slack, Apple)
What the Network Effect Means to Businesses
A variety of services-for-hire apps and websites also benefit from the network effect. As more professionals list online they are available as dog walkers, tutors, or even electricians, even more customers begin to rely on such directories. E-commerce sites such as Etsy and eBay grew in popularity as more sellers joined those marketplaces and sold their products to the influx of consumers who embraced shopping online. Ridesharing services also evolved and grew through the support of more participants signing up and expanding their reach across cities and states. As more drivers became part of Uber and Lyft, those brands gained in market value with passengers seeking rides. The chief hurdle for any good or service that uses the network effect is to get enough users initially so that the network effects take hold. The amount of users required for significant network effects is often referred to as critical mass. After critical mass is attained, the good or service should be able to attract many new users because its network offers utility. If too many people use a good or service, negative network effects such as congestion can occur. In the internet example, having too many users on the same network service can hypothetically cause the speed to deteriorate, decreasing utility for users. Providers of goods and services that use a network effect must ensure that capacity can be increased sufficiently to accommodate all users.
Types of Network Effects
There are a more complex and subtle set of economics issues that may underly this simple characterization of network effects. A brief outline of some of them:
- Direct network effects: The simplest network effects are direct: increases in usage lead to direct increases in value. The original example of telephone service is a good illustration of a product that displays direct network effects. This is the kind of network effect modeled by most work in this area, including the papers by Katz and Shapiro 1985 and Farrell and Saloner 1985, which many academics consider the most influential.
- Indirect network effects: Network effects may also be indirect, where increased in usage of the product spawns the production of increasingly valuable complementary goods, and this results in an increase in the value of the original product. For instance, while there are some direct network effects associated with Windows (arising out of file compatibility), the indirect network effects that arise from the increased quality and availablity of complementary applications software are probably much more important. Economides and Salop 1992 provided one of the earliest frameworks and insight into the economics of indirect network effects; an interesting recent paper by Church, Gandal and Krause argues that indirect network effects also give rise to adoption externalities.
- Two-sided network effects: Network effects can also be two-sided: increases in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa. Both Rochet and Tirole 2001 and Armstrong 2002 provide accessible and clearly explained overviews. Hardware/software platforms, reader/writer software pairs, marketplaces and matching services display this kind of network effects. In many cases, one may think of indirect network effects as a one-directional version of two-sided network effects.
- Local network effects: The microstructure of an underlying network of connections often influences how much network effects matter. For example, a good displays local network effects when rather than being influenced by an increase in the size of a product's user base in general, each consumer is influenced directly by the decisions of only a typically small subset of other consumers, for instance those he or she is "connected" to via an underlying social or business network (instant messaging is a great example of a product that displays local network effects). The extent of clustering in the network as well as the extent of information each customer possesses may become relevant in this context.
- Compatibility and standards: In order for IT products to derive the benefits of network effects from each other, they need to be compatible. This often poses strategic trade-offs for firms, between the performance and backward-compatibility of evolving product lines, and between openness and control of core technologies. Moreover, ensuring the evolution of shared technology standards is critical in network industries, which can be difficult when competing technology firms each want their R&D to be well-represented.
Economic Consequences of Network Effect
Sales in the market are significantly affected by the increase in the value of the network, due to the addition of new users. When the value of the product obtained is higher than the price of the product, the consumer base is expected to increase. The higher consumer base happens once subscriptions reach a certain level of critical mass. New subscribers are attracted to the product because of the extra value they are getting. It is observed that inferior products dominate superior products as there is a certain level of initial lead that is necessary to attract new users. This is possible when people try a product at cheaper prices. This can also lead to dominance by a single company in the whole industry.
Due to huge dependence on prior subscriptions to critical mass level, companies need to compel the people to buy or subscribe to their product. It is possible in various ways, such as fee waiver, discounted rates, free trials, etc. A better and strong approach is to develop the product such that it doesn’t require network effect, not until the stage of critical mass at least. Once critical mass is acquired, network effect works at its best.
Benefits of Network Effect
Network effects become significant after a certain subscription percentage has been achieved, called critical mass. At the critical mass point, the value obtained from the good or service is greater than or equal to the price paid for the good or service. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the value exceeding the price.
A key business concern must then be how to attract users prior to reaching critical mass. One way is to rely on extrinsic motivation, such as a payment, a fee waiver, or a request for friends to sign up. A more natural strategy is to build a system that has enough value without network effects, at least to early adopters. Then, as the number of users increases, the system becomes even more valuable and is able to attract a wider user base.
Beyond critical mass, the increasing number of subscribers generally cannot continue indefinitely. After a certain point, most networks become either congested or saturated, stopping future uptake. Congestion occurs due to overuse. The applicable analogy is that of a telephone network. While the number of users is below the congestion point, each additional user adds additional value to every other customer. However, at some point the addition of an extra user exceeds the capacity of the existing system. After this point, each additional user decreases the value obtained by every other user. In practical terms, each additional user increases the total system load, leading to busy signals, the inability to get a dial tone, and poor customer support. Assuming the congestion point is below the potential market size, the next critical point is where the value obtained again equals the price paid. The network will cease to grow at this point if system capacity is not improved. Peer-to-peer (P2P) systems are networks designed to distribute load among their user pool. This theoretically allows P2P networks to scale indefinitely. The P2P based telephony service Skype benefits from this effect and its growth is limited primarily by market saturation.
Network effects are commonly mistaken for economies of scale, which result from business size rather than interoperability. To help clarify the distinction, people speak of demand side vs. supply side economies of scale. Classical economies of scale are on the production side, while network effects arise on the demand side. Network effects are also mistaken for economies of scope. Because of the positive feedback often associated with the network effect, system dynamics can be used as a modelling method to describe the phenomena. Word of mouth and the Bass diffusion model are also potentially applicable.
Network effect relates to the intellectual commons in a positive way. Through P2P networks users are able to share their intellectual property in a way that can benefit society as a whole.The sharing of intellectual property ultimately relates to economic growth due to the ability for creators to share information and still possibly benefit financially from it. Through P2P networks people are able to share types of education like scholarly articles, becoming a new form of public commons. Network externality like Ted.com is an example of how intellectual commons with the use of network externality benefits society as a whole. Those who present intellectual property at Ted conferences are sharing their education on a public forum that benefits whoever will listen. Therefore, the larger Ted.com network becomes positively correlates to those who benefit from its common-pool resources.
P2P networks positively affect property rights. In reference to property rights, it enables those who create the intellectual property: The right to use the good, The right to earn income from the good, The right to transfer the good to others, The right to enforcement of property rights. Through P2P networks those who provide intellectual property not only have these rights, but they also possess the right to claim their information on a public forum. Due to these rights sharing benefits the intellectual property holders and promotes P2P sharing in a positive way. Those who consume the intellectual property also benefit positively from the sharing of it because they are able to use the information freely with respect to the person who created it. An example of this system in effect is a company called Music Vault. Music Vault operates on the P2P network Facebook, enabling users who create music to openly and freely collaborate with other artists content. This is a form of remixing that benefits both parties. This is an example of how a P2P network positively affects the sharing of property rights. In Joseph E. Stiglitz essay Prizes, Not Patents, he suggests that the creation of intellectual property should be rewarded with by social gratification and rewards instead of patents preventing others from duplicating the creation and sharing it as a common-pool resource. This can be related to P2P networking because it creates a greater incentive for those who create intellectual property to share it is a common-pool resource. As a P2P sharing network becomes larger the gratification of being rewarded on a global public forum would compete with a patent. It is through large P2P networks and network externality that humans can create a reward system large enough to deter seekers of patents to be rewarded in different ways.
Network Externality positively affects the cultural commons in many ways. The reward for being part of a group, society, and even the world through a P2P network is one of the greatest benefits that a modern common-pool resource can provide.The ability to connect and create with people from different cultures, ethnicities, and beliefs is something thought to be impossible 100 years ago. Without network externality this form of communication would have been impossible. Through P2P sharing the world as a culture are able to learn and teach each other through public forums. In Sugata Mitra’s Ted talk, “The child-driven education” he placed a computer in a third world town and left it there to see what would happen. To his amazement children were able to quickly figure out how to use the computer and educate themselves on its inner workings. This example is a benefit to society for several reasons. The first is the relationship between Sugata Mitra and the P2P network which led him to place the computer in a third world town, along with the ability to present his findings on a public forum. Secondly, it is those who consumed his ted talk and benefited from the knowledge that those in third world countries just need a chance to learn and they will take it. This experiment as a whole brings the culture of the world together and connects us with those we thought impossible due to the P2P network and network externality that led individuals to the Ted talk.
Social Media Governance
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Internet of Things (IoT)
Industrial Internet of Things (IIoT)
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