What is The Network Effect? Our Crash Course for 2023 |
If you have a product that is dependent on getting the attention of a large number of people for example, a rideshare service and your product becomes better value as more users use it. Why? because the greater number of people who use your service means you can lower costs, boost availability, and sustain an increase in demand.
This is the effect of networks. In this post, we'll introduce you to the idea of the network effect. We'll discuss the background of the network effect and demonstrate how technology firms use it to achieve billion dollar valuations.
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In this post...
The network effect in an encapsulated view
A few examples of the network effect
Direct or indirect network result
What exactly is the direct effect of network effects?
What is an indirect network effect?
The network effect can help tech companies rise.
What is the effect of network assists human-centered businesses
The network effects as well as community flywheels
Examples of the effect network the community flywheel.
How to make the network effect
Advantages and Disadvantages in the Network Effect
The network effect in a nutshell
- The effect of network is that a platform becomes more valuable as more people use it.
- The majority of the most successful companies from the last century have grown thanks to the network effect, from phones to railways and social media, to online shopping.
- The network effect is the reason why community-based businesses are very effective. They see rapid member led growth into a community flywheel that produces rapid profits.
What exactly is a network impact?
The term "network effect" refers to how the value of a product, platform or service grows with the increase in users as per economic experts Michael Katz and Carl Shapiro It's a phenomenon that occurs when the most popular items are naturally more valuable.
The researchers found that, just like certain products don't have value by themselves (e.g. nuts that don't have bolts) In the same way, some platforms won't be as useful (or at all valuable) without users.
As an example, a social media platform as a whole is nothing more than an application. If no one uses it is useless. The presence and interaction of users that give platforms like Facebook, Instagram, LinkedIn as well as others. their value. It is possible to assign the value of each user in the network: for example, in 2021, Facebook had an average of $43.39 of revenue per user. This was in addition to $13.89 net earnings.
The effect of network can create value for a company by a variety of ways:
- User-generated and generated content by users: For instance, YouTube would be worthless in the event that people did not show up and create videos. In many social media networks an effective network effect is only possible if people actually make use of the software. Meta's recent Threads release saw 100 million new users join for the initial month, but only the number of active users reach 10 million a month after. This isn't yet a complete picture however, it's clear that value isn't in sign-ups but in active users.
- By monetizing the network. Social media platforms have the ability to earn money from the eyeballs in their network (selling ads) as well as make use of the size and scope of their networks to charge higher rates for targeted advertising, demographics, etc.
- They also produce data that can be monetized too. The more data a collection becomes, the more valuable it gets as a data scientist can take data 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 effect network
Here are a few examples of the network effect in action in a bunch of different fields:
- Communications: Land lines cable TV, land lines, email These instruments become valuable the more users they have. For instance, a landline is worth more when you are able to call any person on it.
- Calendaring tools like Calendly and Google Calendar - Calendar tools increase in popularity with the networking impact, as the moment you email people an invitation and they're required to have an acceptance calendar.
- Social Media: Facebook, X (Twitter), LinkedIn, Instagram The social media giants make billions off the effect of networks, turning user growth into ad revenues (and often direct sales of premium services). For example, the only reason a job seeker might purchase LinkedIn Premium is due to the fact that there are so many employers on LinkedIn.
- Discussion Forums: reddit, Quora, Reddit - These forums operate because of a network impact. When people are there and participate, you can have powerful discussions.
- Video Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you have a few people uploading videos to YouTube and Facebook TV, you've got an interesting diverting. If you're in the position of having millions in your account, then you've got a platform that could replace TV.
- AI Tools: ChatGPT - It's still relatively new, but ChatGPT quickly increased to reach 100 million customers through referrals The larger the user base, the more it can be taught by the machine.
- Delivery applications: DoorDash, Uber Eats, Grubhub - It's only due to the huge number of food-ordering customers that drivers can make money from these applications. This is the effect of networks!
- eCommerce platforms: Amazon, eBay - Amazon was able to grow as large as it did because it had a mass of users. Others online bookstores slowed. At one time, it had millions of customers and could grow into merchandise other than books.
- Community of customers: Apple Community, Quickbooks Online Community, Lego Community Communities like these are valuable since users log in and contribute their expertise, usually for fun. If you're an Apple customer who has issues using a particular item, it's likely to find the answer in the Apple Community. It would also be useless if people didn't jump on and do it for free!
- Subscription businesses: Netflix, Amazon Prime Video, Disney+ - The more these platforms expand, they earn higher subscription revenues. These can then be reinvested in entertainment.
What do they all have to do with each other? All of them become valuable the more users they have, for a bunch of different reasons.
- In some instances, the technology gets better when there are increasing numbers of users (e.g. ChatGPT)
- In some cases, the platform has content that users can interact with due to a larger number of users (e.g. Facebook, reddit)
- In certain situations, the greater audience allows a company to offer ads for sale at a price (e.g. Facebook, LinkedIn)
- There are instances where there is the possibility of a "real real" advantage to the network effect (e.g. LinkedIn can help you locate a job ).
- In some instances the effect of network creates an adequate number of customers for businesses and individuals to provide a specific service (e.g. Uber). This is referred to as an indirect network impact.
Example:
Airbnb: Airbnb has quickly became the preferred platform for homeowners looking to let their homes in short-term rentals to clients. Airbnb is an example of a network effect, as the benefit of the service increases when more and more people join the site who are looking to rent. This allows property owners to maintain a constant flow of revenue. In addition, there is value for renters too, as homeowner's properties are opened for rental, it gives renters with more choices to select among. The benefit of the network increases as renters as well as homeowners join the platform.
Direct vs indirect network impact
All of the examples above mixed what economists call direct and indirect network effects. The difference between the two things is important to know.
This is a very simple way to understand the differences between a direct vs indirect network impact:
What exactly is an effect of a network that is direct?
An immediate network effect also known as an "same-side" or "one-sided" effects of network happens in the event that more people of the same kind of people join an online platform. This means that network value is generated directly as a consequence of the increased number of users joining.
If, for instance, I'd like to send a message via WhatsApp but you don't possess it There's an easy answer. It's possible to try downloading WhatsApp! It's just become more valuable because now we're both on WhatsApp!
We see the network effect constantly in communities on the internet. In communities, there is an immediate effect of the network as members generate content and quality, while people from the outside would like to join in order to gain that benefit! The result is that communities are able to sell memberships, courses, exclusive content, as well as events - and these things all work because of the amount of members.
This is why the effect of networks can create a flywheel community enterprise, which we'll get down below.
What is an indirect effect of a network?
Indirect network effects, commonly known as a "two-sided" network effect happen when growth in the one network leads to benefits in other networks. As an example, the growing customer base on 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 who use Uber are two different types of users and want different items, both networks impact one another: The indirect effect of the network.
Complementary network effects
There's one more term you might see used here as the effect of a complementarity network. The phenomenon of a complementary network occurs in the event that a similar item or service is increased in value due to the growth of networks within a community that isn't their own. In this case, LinkedIn grows because of job seekers and employers joining. However, these massive networks hold value for recruiters; LinkedIn acts as a complementary network.
The network effect helps tech companies soar
The vast majority of businesses that we communicate with every day employ the effect of networks to gain advantage. In fact, if you look at the top corporations in the world according to market value, many of them have used the network effect to soar to huge increase in revenue. For example:
- Amazon (+ $1 Trillion) The company has used the effect of network to launch an online store to become the single biggest store on the planet. Additionally, Amazon has utilized the network effect to launch successful businesses along with it. For example, AWS provides cloud computing and web-based services to application providers and vendors to serve their clients.
- Alphabet (and $1.5 Trillion) - Alphabet is home to a variety of firms within it however, it was founded when they built the world's best search engine (Google) that quickly grew due to the effect of network. Those searchers made Google into the business that it is today.
There's a reason why the network effect has helped technology firms become the most profitable companies on earth. The reason is externalities.
Externalities refer to the positive and negative effects of a network and they could limit the network's growth. In the old days, externalities increased with the growth of the network. Railway companies, for instance, prospered because of the network effect-with increasing numbers of passengers bringing in more revenue. BUT there were still huge expenses to keep the system operating. It was necessary to keep up with railway networks, bridges, tunnels, and stations in addition to keeping their engines stocked with coal.
Those externalities limited the network growth.
This is how the network effect helps tech companies.
Technology companies are not awash in externalities. If Amazon has its infrastructure and technology in place, everyone anywhere in the world could join and browse. It would cost a railway millions of dollars in externalities to add more customers. It would require additional vehicles, engines, tracks and stations. The only cost is Amazon more server space-which could be as little as a penny.
Tech companies can grow nearly unlimited networks without adding huge additional costs. This is why the effect of networks has helped propel numerous tech companies to the top of the market.
How the network effect assists human-centered businesses
We've been really excited about the way that network effects work using software that is human-centered. Are online communities that expand rapidly and turn into lucrative businesses thanks to the effects of network. Thus, we've seen thousands flourishing communities, both small and large. They have become companies thanks to this phenomenon.
In the field of community building, a network effect is a phenomenon where the value of a community grows as the number of people who are a part of it. Every new member who joins the community brings the unique viewpoints knowledge, experience, and experiences and adds value to you, your business, as well as your customers.
This can be directly benefit to membership sales. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).
The effect of the network isn't only about membership fees though. It also explains how the value of organisations increases due to the activities of members.
Members create content and invite other members to join the community, which adds even more value to the group. The result is a loop which sees more users add value. This in turn attracted other users, who give to the value.
We call this member-led growth, and once you experience it, this is life-changing. The member-led growth technique uses the effects of network to bring your customers, subscribers customers, towards being members. They are members. And when your business can prosper through member-driven growth, you'll see the network effect being demonstrated.
Being a creator, the network effect is extremely beneficial because when you build a network of relationships between people in your community, you can focus less in creating content. In a community that is flourishing, the valuable ideas and expertise your members bring to each other can keep conversations running long after you have released fresh content.
Effects of networks are generally positive and derive from the potential buyer gaining more value from your product or service due to how many others are making use of it.
The effects of network 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. A community flywheel starts as a brand expands into by forming a community through the network effect. Usually, there's a powerful narrative that connects your community. The result is that your members are making content and becoming involved, which makes your community grow on autopilot.
THEN McKinsey says that these brands introduce hero products that fit their members, and the selling process is a breeze since members are energized and eager to purchase. No funnels. No pressure.
Simply amazing, organic growth that is driven by the members due to the network effect.
A few examples of the effects of network with the community flywheel.
In the Cut: Rae Benjamin In the Cut was created by Rae Benjamin In the Cut to be an online community focused around offering resources and connections for marginalized artists to break into the TV and film industry. The community of In the Cut has quickly grown in scale since its launch in the year 2000 and currently is home to over 1,000 people. In Their Mighty Network, they offer free webinars, job ads and a community of similar-minded creatives, and even host online events.
Sktchy Art School: Jordan Melnick founded Sktchy Art School as a community for artists interested in portraiture to learn new techniques, show their work, and get feedback on their art. Since the school's launch in 2018, the community of Melnick has expanded to over 14,000 members. Melnick's members can attend art classes, take part in challenges for group members as well as join an constantly growing community of artists.
History of the Network Effect
Here are the main ways in which the network effect has performed throughout history:
- Telephone networks (19th C.) In the years that more people got phones and computers, the worth of the entire network increased exponentially. Because of this, it was when in 1908 Theodore Vail, president of Bell Telephone, presented the concept of the network effect during Bell Telephone's annual conference.
- Radio Networks (1920s) : As the number of radio users increased, it made broadcasting more profitable and powerful.
- Television Networks (1950s up to) : Similar to radios, the mass uptake of TVs in households led to higher prices for programming and advertising.
- The Fax Machine (1970s-80s): Fax machines were able to grow into networks as more people got them-there needed to be an send and receive component similar to telephones. In 1980, Robert Metcalfe brought the theory of network effect to the mainstream when he recognized that the value of a communication network (e.g. telephone lines) did not come from the price of the equipment, but that there was an exponential cost for each new user. He argued that ethernet cards had to hit a critical number of users to be able to prove their value as a network.
- Personal computers (1980s-90s) In the years when more and more households got the Mac or a Windows-based computer, software that runs the computers started to become more important. This is what made both Microsoft and Apple the companies they have become in the present.
- Internet and Email (1990s): The two came hand in hand when digital communication became more prevalent. From 1985-1995, Michael L. Katz, Carl Shapiro, Joseph Farrell and Garth Saloner performed an extensive amount of the initial work for the network effect as an economic theory.
- Social Media Platforms (2000s to) The social media platforms employed the network effect to produce massive numbers of users, who also created their own content. Remember Myspace? It was one of the first!
- sharing economy Applications (2010s) The effect of networks meant that sharing platforms would grow to take over our lives, as things 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 as well as blockchain is based on a network effect and it's not going anywhere. In fact, the promise of Web3 is the ultimate in the network effect, the internet is not centralized.
Tips to generate the effect of network
If you're planning to create a business that's going to benefit from the effect of the network , here are a few tips to follow:
- Utilize the power of users-generated content. The huge growth that the social media industry has seen was the result of creating platforms and then letting human creativity loose.
- Utilize platforms that allow individuals to connect, make and connect with other people (ie. social platforms). Assuming ownership over platforms (getting out of the way) lets organic growth.
- Make a service or a product which, by nature, encourages growth while invite others to join (e.g. Calendly).
- Niche down. Members join and participate in networks (esp. social networks) which allows them to connect with people who share their interests. While these giants of social media have huge numbers of users but they thrive in independent networks. For example, Facebook thrives on family and acquaintances. LinkedIn is a great tool for industries and workplaces. Twitter connects people with shared interest (e.g. politics)
Advantages and disadvantages of the Network Effect
Benefits
- companies can expect rapid growth and profits.
- Human brands could benefit from more people engaging and creating (e.g. the online community is based by leveraging human creative ).
- The increased number of users lets the brands to design better offerings and experience.
Disadvantages
- Networks can produce negative externalities. A high volume of users using social media websites can open potential for predators.
Then Read: 5 Strategies to monetize Your Viewers