Network Effect

What Is the Network Effect?

The network effect is a phenomenon in which an increase in the number of persons or participants increases the value of an item or service. Social media (Facebook, Twitter) are a few of the instances.

E-commerce sites such as Etsy and eBay rose in popularity because they access internet networks. You must comprehend your product's value and your client's willingness to pay for it. It is critical to assess whether your product or service is susceptible to network effects. 

It is defined as the extra advantages that an existing user receives when a new user joins the network. The internet is the most well-known and greatest example of this. It is a phenomenon that occurs when a community grows in value as more individuals join.  

It is positive when a potential consumer discovers many other people using the product or service.

How it works 

Placed below is the blueprint of a potential financial advisory business. It occurs when more people join your group or invest in your product or service.

As a result, social media platforms such as Facebook, YouTube, and Instagram have grown exponentially. Each new member offers unique perspectives, experiences, and expertise.

History of network effect

Network effect began with the invention of the telephone in the early twentieth century. The value of a telecommunications network is proportional to the square of the number of connected users. 

The NFX now has everyday real-world applications, such as the value of Facebook, Twitter, and LinkedIn. The theory was developed based on the research of Joseph Farrell, Michael L, Carl Shapiro, and Garth Saloner. Using the telephone as an example, these researchers coined the phrase.

Metcalfe's Law

George Gilder developed Metcalfe's Law, which Ethernet co-inventor Robert Metcalfe (1980) credited with developing. It alludes to a rise in value and connections. 

Because the internet, as we know it, did not exist when the law was written, it focused on the value of common devices. Owning only one fax machine, for example, makes no sense. 

You can communicate with the other fax machine if you have two, but that machine is worth something if you have millions. Metcalfe's law is a concept used to represent the value of networks in computer networks and telecommunications. 

According to Metcalfe's Law, a network's effect is proportional to the number of nodes in it.

If you have ten nodes in your network, their unique value is 100 (10 * 10). Metcalfe's law has been linked to the significant growth of the internet and its operation in accordance with Moore's Law over time.

Similar to the business concept of the "network effect," the value of the network provides both added value and competitive advantage. 

For example, while eBay had the best auction sites, it also had the most users. This is so difficult to duplicate that the network's power has beaten out other competitors.

Examples of network effect

All of the businesses mentioned below have one thing in common: they become more valuable to their customers as they grow in size and number of users.

• E-Commerce: eBay, Etsy, Amazon, Alibaba, Shopify
• Ticket Exchange: StubHub, Ticketmaster, SeatGeek
• Recruiting: LinkedIn, Glassdoor, ZipRecruiter, Indeed, Angelist
• Rideshare: Uber, Lyft
• Food Delivery: Grubhub, DoorDash, Uber Eats, Instacart, Postmates, Zomato, Talabat
• Social Media: Facebook/Meta, Twitter, Instagram, LinkedIn, Snapchat, Pinterest, Reddit, Tiktok
• Freelance: TaskRabbit, Upwork, Thumbtack
• Food Reservation: OpenTable, Resy
• User Reviews: Yelp, Tripadvisor

If one million sellers use Etsy or eBay instead of one hundred, the platform provides significantly more value to users. 

As more drivers join the platform, Uber and Lyft provide riders with more convenience and reliability. Regarding social media websites, users notice that as more people sign up, the channels become more interesting and diverse.

You'll need someone to communicate with on social media. You'll need someone else with a phone to make a call. It is easier to share Microsoft documents with others if it's compatible with others.

Apple Operating Systems and Apps—As more people opt for Apple iPhones, businesses will find it easier to promote their apps, increasing the appeal of the Apple iPhone. This is an NFX that works both ways.

App development will become more profitable as the Apple iPhone becomes more popular. The growth of Apple and app developers is mutually beneficial. 

Another example is Digital Money (Bitcoin), the more people who accept Bitcoin, the more appealing this digital currency becomes.

The main types of network effect

Businesses hoping to profit from these dynamics must have a thorough understanding of the various kinds of network effects.

Here, we examine the direct, indirect, bilateral, and local networks as the four main categories. Every kind has unique characteristics that influence how goods and services develop within their own ecosystems.

Let's examine these sorts in more detail to see how important they are for promoting engagement and progress in the connected world of today.

1. Direct network

This effect occurs when an increase in usage and consumers directly increase the value of a product or service for other users. Same-side effects are another name for direct network effects. The value of a service/product increases as the number of consumers increases. 

Most platforms have two types of users: producers and consumers. The more customers on the network, the more valuable it is to producers, and vice versa. 

Social media platforms generally profit from network effects since their value increases due to attracting additional users.

Apple reaps the benefits of the social network effect, where platforms contain two or more user groups exchanging value with one another rather than directly. 

The preferential handling of texts sent from an iPhone to another Apple device (through iMessage) has assisted the business in broadening its market barrier.

2. Indirect network

An indirect network occurs when the number of users of the original product increases due to the influence of a complementary product that encourages the usage of more goods. 

This effect is sometimes referred to as a cross-side effect. When a new user from a different user group joins the network, the value of the service increases for one user group. To accomplish indirect networks, you must have two or more user groups. E.g., Microsoft 365.

3. Bilateral network

A two-sided network is when both buyer and seller increase the value of a service for each other. This is because more sellers and buyers enter a market entices more sellers to join. 

When more sellers join the platform, supply increases, and prices decrease, which attracts more buyers to the marketplace. 

Platforms like Facebook need to maintain user quality to attract more valuable users and advertisers. Marketplaces like eBay are a great example of the two-sided network in action. 

Users may connect with their whole social network as well as their favorite companies, and marketers can reach out to their entire target population. To profit from this network effect, social networks must maintain their users' quality.

4. Local network

Every large social network's user base comprises several smaller, local networks. The strength of each local network determines the overall growth and engagement of the social network's user base. 

You don't value social media platforms like Instagram because they allow you to communicate with over one billion other people.

They are beneficial since all of your friends are on it, and you can easily connect with them. In addition, because your followers understand the context of your messaging, mentioning inside jokes or personalizing your postings is permissible. 

This helps you to express yourself in an environment where you feel comfortable. Local network impact happens when a network segment has a greater influence on the user.

Importance of network effect

In the highly competitive market environment of today, the significance of network effects cannot be emphasised.

These consequences frequently determine the lifespan and profitability of businesses, websites, and platforms, creating what are commonly referred to as "winner-take-all" markets. This is why it's so important to comprehend and take use of network effects:

1. Long-Term Success: The company or platform with the most market share benefits from network effects, which promote long-term success. Competitors find it difficult to dispute this supremacy since the network itself acts as an entry barrier.
2. Efficiency and Self-Replication: Network effects-driven platforms gain from technological, automated, and information-access efficiencies. These networks require less maintenance and capital once they are formed because they often self-replicate and expand naturally.
3. Strategic Imperative: Network effects must be understood in order to be incorporated into strategy and product design. Businesses may strengthen their value proposition and draw in more customers by utilising these effects, which will strengthen their position in the market.
4. Successful Real-World Examples: The effectiveness of network effects is exemplified by eBay. eBay's network effect enabled its continued success and domination in the online marketplace, even in the face of possible flaws in product quality or strategic decision-making.
5. Market Consolidation: As fewer businesses dominate a given industry due to network effects, market consolidation occurs. This consolidation may strengthen the positions of already-established rivals and erect substantial obstacles to entrance for new ones.

Network Effect vs. Network Externality

The difference between the two concepts can be seen as under:

Negative network externalities

Negative network externalities have a negative effect when contrasted to typical (positive) NFXs. 

Negative network externalities produce negative feedback and exponential decay in the same way that positive network externalities cause positive feedback and exponential growth.

Negative network externalities are natural forces that draw systems towards equilibrium, are responsible for stability, and reflect physical constraints that keep systems constrained. Furthermore, negative network externalities include more login retries, longer query times, longer download delays, and more download attempts. 

Congestion happens when the efficiency of a network declines as more people use it, reducing the value to those already using it.

Traffic congestion on the road, as well as network congestion on connections with restricted capacity, both exhibit negative network externalities. According to Braess' paradox, increasing pathways through a network might negatively impact network performance.

Network Effects And Pricing

The growth in the number of information companies may gather or buy on NFXs among customers prompts two main factors. 

The monopoly optimally gives customers price discounts in exchange for their influence and charges price premia in exchange for their susceptibility; the price risk premium and price discounts are simple functions of the network pattern. 

A portion of other customers' decisions impacts each consumer. Firms collect information on customer influence and use it to price discriminate. 

Influencer marketing results in ineffective consumer-product pairings. Investments in information by enterprises are strategic complements, resulting in a race for information acquisition that reduces welfare and corporate profits while increasing consumer surplus.

The average degree of NFXs and the dispersion of influence and susceptibility across customers are growing for both the price premium and the discount.

There are several examples of pricing discrimination based on the level of customer influence. 

By increasing your market share early, you boost your potential to raise pricing later after you've maximized NFXs and pushed as much acceptance of your service as feasible. As a result, many businesses first price their items low or give them away for free. 

Pricing choices in the face of indirect NFXs are complicated because changing the price on one side of the market impacts demand not just on that side but also on the other as each side responds to changes in participation. 

Finding the right pricing strategy is critical to a platform's success. Understanding the diverse pricing drivers is also important for policymakers seeking to evaluate the operation of a market.

Advantages of Network Effect

In today's interconnected world, network effects are crucial in determining the success and growth trajectory of many platforms and services. These effects, which are typified by a network's worth growing as more users join it, have several benefits for both individuals and enterprises.

Comprehending these benefits illuminates the revolutionary potential of network effects in propelling market supremacy and cultivating dynamic digital environments.

1. Enhanced User Experience: As a network grows, it provides a better experience for users by offering access to a wide range of services and earning opportunities.
2. Exponential Growth: Networks experience rapid and exponential growth rates without the need for extensive advertising, leading to market dominance.
3. Economic Growth: Network-based services stimulate economic activity by facilitating transactions and promoting pricing transparency, contributing to overall economic growth.
4. Targeted Marketing: Access to user data enables marketers to understand consumer behavior better and create tailored products and services, improving marketing effectiveness.
5. Innovation Incentives: The pressure to maintain and grow the network encourages businesses to innovate and develop more efficient goods and services.

Disadvantages Of Network Effect

Although network effects provide many advantages, there are certain difficulties and disadvantages that companies must deal with.

These drawbacks highlight the difficulties in maintaining and administering network-based systems, from network congestion to growth potential restrictions and susceptibility to technology changes.

By recognizing and tackling these difficulties, businesses may successfully manage risks and fully utilize network effects to create sustained development and competitive advantage in dynamic marketplaces.

1. Network Congestion: Increased usage can lead to congestion and reduced service quality, requiring technical innovation to address.
2. Limited Growth Potential: Once a network reaches saturation, further growth becomes challenging, limiting expansion opportunities.
3. Vulnerability to Change: Networks are vulnerable to technological advancements and shifts in consumer preferences, which can diminish market power.

Compatibility and Incompatibility

Product compatibility is strongly connected to network externalities in a company's competition, which refers to two systems that may function together without altering.

Compatible goods are differentiated by improved consumer matching, allowing people to benefit from the network without purchasing items from the same brand.

Incompatibility between products will aggravate market fragmentation, reduce efficiency, harm client interests, and raise competition.

Incompatibility is the opposite of compatibility and can affect prices if consumers value "mix and match" combinations of complementary network components.

Microsoft profits from indirect NFXs as a provider of Windows systems, which drives the company's market share to expand. High travel expenses strengthen the effects while emphasizing the relevance of incompatibility in ATM markets.

Optimizing for network effects in platform design

Platforms can be developed with features that enhance NFXs in addition to user acquisition. 

These five characteristics may be divided into five design processes known as The 5 C's of Network Effects: Connection, Communication, Collaboration, Curation, and Community.

Connection

User onboarding and the ability to locate people on the site are referred to as connections. How simple can users identify suitable counterparties to purchase from, sell to, share, work with, and so on?

Communication

Communication between users should be as fluid as possible, allowing maximum usability. A must-have feature is also seamless mobile synchronization.

Curation

A platform's curation ensures the quality of its users and content is high and easily searchable. From a design standpoint, consumers should be able to easily locate any product, service, information, or counterparty. 

Platforms must focus on two parts to maintain quality: user access (user access) and content/catalog curation (what is on the platform).

Collaboration

Encouraging users to work together and co-create content increases their sense of ownership and participation in the community.

Platforms ought to support cooperative projects and activities that enable users to participate, communicate, and exchange information or assets.

The network effects of the platform are strengthened, and active involvement is encouraged by placing an emphasis on collaborative features.

Community

Community gives users a sense of ownership over the platform, such as when they modify a fact on Wikipedia, rate an app on Google Play, or report problematic information on Facebook. 

In some ways, it's user-enforced curating and provides platform management with vital user input. For example, what content do Facebook users find disagreeable, and why?

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Money Illusion
• Nash Equilibrium
• Non-Farm Payroll
• Nordic Model
• Opportunity Cost