Network Effect

A phenomenon in which an increase in the number of persons or participants increases the value of an item or service.

The network effect, short for (NFX), 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 by accessing internet networks. You must comprehend your product's value and your client's willingness to pay for it. It is critical to assess if your product or service is susceptible to NFX. 

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.

M&A Modeling

Everything You Need To Master M&A Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

How it works 

Placed below is the blueprint of a potential financial advisory business.

Flow chart

 

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

It 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, but it is credited to Ethernet co-inventor Robert Metcalfe (1980). 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, the effect of a network is proportional to the number of nodes in that network.

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

  • 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

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

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 more convenience and reliability. When it comes to 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. This increases 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.

Main types

Some of the main types are:

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 NFXs. 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 there are on the network, the more valuable it is to producers and vice versa. 

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

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

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

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.

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 NFX, social networks must maintain their users' quality.

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.

Venture Capital Course

Everything You Need To Break into Venture Capital

Sign Up to The Insider's Guide by Elite Venture Capitalists with Proven Track Records.

Learn More

Importance

According to network effects, the firm, website, or platform with the largest market share will be more successful in the long term. As a result, networks play a significant role in markets and are sometimes referred to as winner-take-all markets.

Platforms are driven by technology, automation, information access, and networking. These effects are desirable since they need less upkeep. Even if they are poorly managed, once developed, they tend to self-replicate.

Understanding them is necessary to include your NFX in your products. Look no further than eBay for a real-world demonstration of this notion. The cost of network maintenance does not rise in full agreement with the network's value.

NFXs mean that there will tend to be fewer players in an industry. 

Poor product, customer service, poor strategic decision-making, and a lack of insight into what would happen. What stood out was that none of this mismanagement mattered. eBay had an NFX in place.

Network Effect vs. Network Externality

The network externality is an economic concept that outlines how the demand for a product is affected by the demand for that product from others. 

For example, if you notice many automobiles in a restaurant's parking lot, you may conclude that the establishment serves good food. 

According to the network externalities hypothesis, people prefer to buy brands that have a higher market share than those with a lower market share.

The purchases of others impact consumer purchasing habits. Positive network externalities can cause it. 

If you post great material after joining and many others appreciate the experience, it will increase engagement.

The growing returns to scale in software development result in consumer behavior that is remarkably similar to customers with preferences that display network externalities. 

There are significant variations between NFXs and network externalities. For example, if any of your friends are on Facebook, you may decide to join in the hopes of connecting with them, which is a positive externality.

Clothes constantly fall out of style due to consumer imitation purchasing and selling habits.

The growing returns to scale in software development result in consumer behavior that is remarkably similar to customers with preferences that display network externalities.

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.

Valuation Modeling Course

Everything You Need To Master Valuation Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Advantages and Disadvantages 

The critical mass is the number of users necessary for massive NFXs. When an item or service hits critical mass, it draws many new consumers because the network provides usefulness or benefits to the consumer.

Another advantage is that it pushes businesses and intellectual property producers to develop more efficient and innovative goods. The benefits are as follows:

  • Providing a better experience for a large number of individuals. As a result, they may not only access numerous services but also benefit from the platform by earning money.
  • Providing the firm with an exponential growth rate. Companies do not need to spend more money advertising their products or services.
  • Becoming a source of economic growth. eCommerce services, for example, boost the activity of purchasing and selling things. It also promotes pricing transparency by allowing us to compare the costs of similar items.
  • Introducing broader and more targeted marketing channels. Marketers may leverage user data from numerous platforms to understand customer behavior better. They can also create new products or services that are better in accordance with customer wants.

The following are the cons:

  • Bringing unfavorable network impacts and congestion to light. It occurs when an excessive number of individuals use products or services. For example, the more people use the internet, the slower network connections get. To address this, technical innovation is required.
  • If everyone on the planet has used it, there is no other way to grow it.
  • Vulnerable to technological and consumer preferences changes. This can occasionally decrease the company's 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).

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?

FAQs

Elite Modeling Package

Everything You Need To Master Financial Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Manal Fatima | LinkedIn

Edited by Colt DiGiovanni | LinkedIn

Free Resources

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