What are Network Effects?

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Network effects are important because the value of the network grows exponentially while the cost to maintain the network might increase linearly.

Network Effects

It was in 1994 that the internet became a sensation. Since then, it has provided endless opportunities for businesses and generated revenue. The internet is responsible for creating up to 70% of the value created by tech companies worldwide like PayPal, Microsoft, Uber, etc. They significantly depend on the internet for generating greater sales. This is because the internet is subjected to network effects.

As the internet experiences an increase in traffic, it offers more value, which helps form a network! It’s inarguable that once a network is created, it’s hard to break through it.

With the escalation of users, especially in pandemic-prone times, internet users are rising. The growth of internet users has led to more website engagement, and companies offering products and services online are rising. The network effects on the internet often benefit various services for hiring apps and websites. As more professionals list their services online, such as dog walkers, tutors, or electricians, more customers rely on those online directories.

Network effects are powerful, but one can reap them only when your product is valuable to its first user, i.e. when the network is necessarily small. That is why one has to make sure whether valuing products, services, or platforms is done accurately or not. One needs to understand the uniqueness of the product, whether the customers are willing to pay the price you would be quoting, and most importantly, whether the company’s profit margins will be accomplished. Another prime factor to consider is whether your product or service is subject to network effect or not, as network effect has a great impact on any ideal business.

Here, we will discuss the concepts of network effects and how it relates to business.

What are Network Effects?

To begin with, it’s a phenomenon wherein a product or a service becomes valuable only when it gains more users. According to Economics for Managers, a subjective definition of network effects states that network effect refers to any situation in which the value of any platform or product or service is based on the number of buyers, sellers, or users who leverage it. Ideally, the greater the number of buyers, sellers, or users, the greater the network effect and the greater the value created by offering.

For example, having a cell phone alone won’t make a difference until your friends own one. Once your friends join the cell phone network, the value increases for you, just like how the value of the cell phone increases for your friend. To simplify it, we could say that a phone is useful only if other people own it.

When we talk of companies and startups that have been active lately, they have been heavily influenced by network effects. A few such startups are Amazon, Uber, Alibaba, StubHub, and social media platforms like Snapchat, LinkedIn, Pinterest, and Instagram. The common attribute of these companies is that the value they provide to customers increases as they scale and acquire more users. When it comes to social media sites, users find the channel more interesting and different when they sign up for it.

Importance of Network Effects

The network effect is important because the value of the network grows exponentially while the cost might increase linearly. Network effects are mechanisms in a product or a business where every new user makes the product/services/experience more valuable to every other user.

In recent times, when everything has gone digital, the network effect has emerged to be the major defence mechanism in business. Whereas in the past, the business listed many ways to create defensibility, such as government regulations regarding taxes, money exchange, individuality, permissions, favourable locations for setting up new ventures, etc. In the digital world, these mechanisms are ineffective; that’s why network effects have become a revolutionary change in the new era of digitalisation.

In the past few decades, 70% of the value created in the technology industry has been due to network effects. When we talk about any new venture, growth is important to take it to new heights. Once a business is set up with good competitive advantages, its value increases linearly as the revenue increases. This is incredible progress but not the best. If the business moves past competitive advantages to true defensibility to protect the venture, its value will grow exponentially as its revenue increases.

Hence when we talk about the defensibilities in the digital world, we can consider 4 such defensibilities, which are:

  1. Scale
  2. Brand
  3. Embedding
  4. Network effect

Defensibility is key to success. Branding and sales are all secondary when it comes to building a company. Without a network of consumers, there would be no sales, and branding is of no use without sales. Thus network effects are needed to provide strong defensibility to businesses which is less expensive when compared to other defensibilities in the era of digitalisation. Therefore we can say that approximately 70% of the defence mechanisms of major companies rely on network effects in the new era of digitalisation. A new venture should start after you run your thought process about designing core network effects. The best way to put this is that all massive returns to investors and, of course, yourself come from businesses with long-term defensibility. Therefore even for early-stage investment, the returns lead to big hits. Hence, the best way to get true defensibility in the digital world would be using network effects.

Types of Network Effects

Categorising the types of network effects is not a walk on the road of flowers; instead, a walk on the road of thorns. So to categorise the types of network effects, we classify them in two ways:

  1. Direct Network Effects:

Direct network effects are also called the same side effects that provide direct value to the network as more users use it. The number of users increases as the value of services increases.

As mentioned above, the direct effect occurs when the value of a product or service or platform increases, causing the network to grow. For instance, the internet’s value increases only as more users join the network. This provides a direct value to all the existing users. When we talk of social media platforms, they also benefit primarily from direct network effects as the service value grows due to attracting more users.

Apple is another classic example that benefits from direct network effects. It’s known that Apple products are compatible and best run only when paired with another Apple device. Therefore the preferential treatment of messages sent from a phone to another phone through iMessages has helped the company expand its channel across the market.

  1. Indirect Network Effects:

Indirect network effects are also called cross-side effects and provide an indirect value to one user group when another user-group joins the network. As such, there needs to be a minimum of two user groups.

On the other hand, the indirect network effect depends on user groups such as users and developers or producers and consumers. As more people from one group join the platform, the other group receives great value.

This can be illustrated by e-commerce and ride-sharing examples. When Uber – a popular ride provider, launched a new feature of sharing rides with a passenger. It was beneficial as the fare split into two, and Uber would benefit by getting an additional passenger.

Network Effect and Business

According to Economics for Managers, the principles underlying network effects imply that the business, websites, or platform with the highest market share will be more successful in the long run. This means that its market share is likely to grow more substantially. For this reason, markets in which network effects play a major role are often referred to as ‘winners takes all markets’.

When the value of the product obtained is higher than the commodity’s price in the market, the sales are significantly affected by the increase in the value of the network due to the addition of new users. The consumer base happens once subscriptions reach a particular level of critical mass. The extra value attracts new subscribers to the product. The different ways through which the companies can attract new users to their network are in various ways like giving heavy discounts, giving gift vouchers, free trials, or giving free products on a purchase of a certain value.

For example, Amazon Prime gives a free 30-days before you buy Prime, or many online shopping websites offer huge discounts and giveaways to attract traffic to their website. This is nothing but the usage of network effects in the day-to-day routine. As a result, companies that can leverage or exploit network effects often experience rapid growth rates.

Network Effect and Pricing

Before pricing a product/service/platform, it’s vital to understand if the market is subjected to network effects or not. This is done because of the underlying logic that guides a typical pricing strategy in markets where network effects are the strongest.

To maximise profit, businesses typically price their products as high as possible as they consider the customer’s willingness to pay for the product. But when the market is subject to network effects, the driving concern is not much about profit. This is because future customers’ willingness to pay depends on the number of existing users.

By growing the market share early, one can increase the ability to raise prices later once you’ve taken advantage of network effects and driven the adoption of offering as much as possible. This is the main reason why corporations price their products low early on or give them off for free. It can be exemplified, for instance, the emergence of Facebook, the social media giant back in 2004, which was a free platform. The platform became popular and captured the market as it was free, replacing Myspace, its prime competitor. Facebook had no ads on its app or page until 2007. Facebook introduced ads to monetise its user interface, and it was not until 2013 its efforts were noticed.

Summing Up

By understanding the principles that drive the network effects and their impacts, one can leverage them to increase gains and sales. Once a venture has acquired a significant market share, network effects can take it there.

Existing consumers are a driving force in attracting more buyers and increasing sales. One has to work often less once the network effect has taken over the market. This is also why companies strive hard to attract more consumers by giving many discounts, vouchers, gifts, etc. They build a network to earn back all the losses incurred due to giving away by slowing rising prices once the network is established. This is also a reason why in markets with network effects, companies fiercely fight with each other to build a network that is hard to break.

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