What's The Network Effect? The Crash Course we're offering for 2023 |
If your product that relies on gaining the attention of a large number of people, like a rideshare platform and your product becomes more valuable as more people use it. Why? Because the more people using your service means you can lower costs, boost accessibility, and keep a large demand.
This is the effect of networks. In this article we'll explain the concept of the effect. We'll explain the origins of the effect network and show you how tech companies use it to hit billion dollar valuations.
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The effect of networks at an encapsulated view
Examples of the effect network
Direct vs indirect network impact
What is the direct effect of network effects?
What is an indirect network effect?
How the network effect aids tech companies to rise.
How the network effect helps human-centered businesses
The network effects as well as community flywheels
An example of the network effect with an enterprise that is a community flywheel
A History of the Network Effect
Tips to generate the network effect
Advantages and disadvantages of the Network Effect
The network effect in a nutshell
- The effect of networks occurs when the value of a platform increases as more people use it.
- Many of the top-performing businesses of the past century have grown because of the effect of networks that has spanned everything from railways to phones and social media, to eCommerce.
- The network effect is what makes community businesses very effective. They witness rapid growth driven by members to create a flywheel of community that quickly creates profitability.
What is a Network effect?
The term "network effect" refers to the way in which the value of a particular product, platform or service grows when more users use it; according to economists Michael Katz and Carl Shapiro this is the reason why people who use popular goods are better value.
They noticed that certain products don't have value by themselves (e.g. nuts without bolts); in similar fashion, certain platforms aren't as valuable (or in any way) without their users.
As an example, a social media website by itself is just an application. If it isn't used by anyone is useless. It's the interaction and presence of their users that make platforms such as Facebook, Instagram, LinkedIn, etc. their value. There is even a clear value on any user who joins the platform such as, for instance that in 2021 Facebook averaged $43.39 in revenue per user. This was in addition to $13.89 net income.
The network effect can create value for a company in different ways:
- By user actions or user-generated content: For example, YouTube would be worthless If people weren't there and upload videos. In many social media networks an effective network effect can only occur if the users use the program. Meta's most recent Threads release had 100 million people joining within the first month only to have the number of active users reach 10 million one month later. It's still early days, but it shows the value of a service isn't just in signing ups and active users, but rather in the number of them.
- Through monetizing the network. Social media platforms have the ability to earn money from the eyeballs in their network (selling ads), and can utilize the massive scale of their network to charge higher rates for targeted advertising, demographics, etc.
- Networks also generate data, which can also be sold. The more data a collection gets, the more useful it gets in terms of data science researchers to take data from.
Source: Katz, Michael L., and Carl Shapiro. 1994. "Systems Competition and Network Effects." Journal of Economic Perspectives, 8 (2) 92-155.
Examples of the effect network
Here are a few examples of the effect network that are in use in a range of diverse industries:
- Communications: Land lines or Cable TV These instruments become important the more customers they are able to serve. For instance, a land line can be more useful when you are able to call any person on it.
- Tools for scheduling: Calendly, Google Calendar - Calendar tools increase in popularity with the networking impact, as the moment you email the person an invitation to join a group, they require an acceptance calendar.
- Social Media: Facebook, X (Twitter), LinkedIn, Instagram The social media giants earn billions from the effect of networks, turning the growth of users into advertising revenues (and occasionally directly selling premium services). As an example, the sole 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 - These platforms only operate because of a network effect. If people show up and engage, you have powerful discussions.
- Video Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you have a few users who upload videos on YouTube, you have the potential for a fascinating distraction. If you have millions of users, you've got a service that could replace TV.
- AI-powered tools ChatGPT The technology is new, but ChatGPT quickly grew to 100 million customers through referrals The larger the user base, the more the machine can learn information.
- Delivery apps: DoorDash, Uber Eats, Grubhub - It's only because of the large number of food-ordering customers that delivery drivers are able to earn money from these apps. This is the effect of networks!
- eCommerce platform: Amazon, eBay - Amazon was able to grow as large as it did because it has a large number of customers. Other online bookstores fizzled. At one time, it had millions of users and could grow into products other than books.
- Community of customers: Apple Community, Quickbooks Online Community, Lego Community Communities like these are valuable because customers log on and share their knowledge, usually for fun. If you're an Apple user having trouble in using the product, you'll usually locate the answer within the Apple Community. And it would be worthless in the event that people don't take advantage the bandwagon and get it done completely free!
- Subscription companies: Netflix, Amazon Prime Video, Disney+ - The more these platforms expand they generate greater subscription revenue. The money can be put back to create the creation of content.
What do these things all have to do with each other? They all become more useful the more users they are used to, due to a bunch of different reasons.
- In certain cases, the technology gets better with more users (e.g. ChatGPT)
- In certain cases it is possible for the platform to provide content to engage with thanks to more users (e.g. Facebook, reddit)
- In some situations, the greater number of users allows the business to offer ads for sale at a price (e.g. Facebook, LinkedIn)
- There are instances where there is an "real world" benefits to the networking effect (e.g. LinkedIn helps you find an employment ).
- In certain cases, the network effect creates an adequate number of customers that individuals and businesses can serve a niche (e.g. Uber). We call this an indirect network result.
Example:
Airbnb: Airbnb has quickly been a top choice for property owners looking to rent their properties for short-term stays to traveling customers. Airbnb is an illustration of the network effect because the value of the platform increases as increasing numbers of people sign up to Airbnb seeking to rent their homes, which provides property owners with a steady flow of revenue. Additionally, value is created also for renters, since more homeowners open their properties to rent, giving renters with a wider range of options to select from. The benefit of the network increases as renters as well as homeowners join the site.
Direct vs indirect effect
Each of these examples included what economists refer to as the direct and indirect effects of networks. The difference between the two effects is essential to understand.
This is a very simple method to comprehend the distinctions between a direct vs indirect network result:
What exactly is an effect of a network that is direct?
A direct network effect, also known as a "same-side" also known as a "one-sided" impact of networks occurs whenever a larger number similar people join an online platform. It means that the value of the network is generated directly as a result of a greater number of people signing up.
For example, if I want to send you a message via WhatsApp and you don't have it you can do it with a straightforward solution. It's possible to install WhatsApp! It's just become better because now we're both on it!
It is evident that the effect of networks in action all the time with online communities. With communities, there's a direct network effect as members produce content and create value and people on the outside would like to join in order to gain the worth! The result is that communities are able to sell memberships, courses premium content, and occasions - and all work because of the size of their membership.
This is the reason why this network effect could result in a community flywheel company, which we'll come down below.
What is an indirect network effect?
Indirect network effects, commonly called a "two-sided" effects of network, happen when growth in the one network leads to benefits in another. In the case of Uber, for example, an expanding customer base who use Uber creates benefits for another system: drivers. The greater the number of customers and the greater chance there is for drivers. Even though drivers and customers who use Uber have different kinds of customers and have different needs, things, the two networks impact one another: an indirect network effect.
Complementary network effects
A different term may encounter here as a complementary network effect. The term "complementary network effect" is used when a related product or service gains value because of network growth of a different network than theirs. As an example, LinkedIn grows because of the influx of employers and job seekers. But these enormous networks also hold value for recruiters; LinkedIn is an additional network.
How the network effect can help tech companies rise.
A lot of digital companies we interact with every day employ the effect of network to their advantage. Indeed, if you examine the most successful companies worldwide by market cap they have all made use of the network effect in order in order to experience massive increase in revenue. Examples:
- Amazon (+ $1 Trillion) is using the effect of network to launch an online bookstore to one of the biggest stores on the planet. And Amazon has used the network effect to launch thriving businesses alongside; for instance, AWS provides cloud computing as well as web-based services for app providers and vendors to serve their clients.
- Alphabet (and $1.5 Trillion) - Alphabet has a ton of companies within it, however it began by creating the top search engine in the world (Google) which grew rapidly thanks to the network effect. The searchers who used it made Google into the business it is now.
There's a reason why the network effect has made tech companies become the most valuable firms on earth. This is due to externalities.
Externalities refer to the positive and negative outcomes of networks and they could limit the network's expansion. The past was when externalities grew with the network. Railway companies, for instance, grew because of the network effect-with more riders bringing more money. BUT there was still massive costs to keep the network operating. It was necessary to keep up with bridges, rail lines tunnels, stations and bridges, not to mention keeping fuel for the engines up to date.
Externalities like these slowed the network growth.
Here's how the network effect can benefit tech companies.
Technology companies are not awash in externalities. If Amazon has the infrastructure, then anyone around the globe can sign on and shop. It would cost a railway millions in externalities to add more customers; they'd need more vehicles, engines, tracks as well as stations. This will cost Amazon an additional server, which can be as little as a penny.
Tech companies are able to expand nearly infinite networks, without imposing huge extra costs. And that's how the network effect pushed so many tech giants into the top spot on the market.
How the network effect assists human-centered businesses
We've been really excited about how the network effect functions with human-centered software. are online communities that expand rapidly and turn into successful businesses due to the effects of network. Thus, we've seen thousands successful communities both small and large, grow into enterprises thanks to this trend.
When it comes to community development, the network effect is a effect where the value of a community increases as more people sign up. Each new person that joins the community brings their own unique perspectives knowledge, experience, and experiences that add value to you, your business, as well as your customers.
This can be directly importance to sales of memberships. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).
The network effect isn't just related to membership fees, however. The network effect also describes the extent to which value of organisations increases due to the activities of members.
Members create content and encourage other members to join the community, that adds value to the community. This creates a cycle which sees more users add value, which in turn attracts other users who add an additional value.
We call this member-led growth and when you see it, this is life-changing. Member-led growth uses the effect of networks to shift your subscribers, clients customers toward becoming members. Members belong. And when your business can benefit from member-led growth you'll see the network effect being demonstrated.
For creators, the network effect is extremely beneficial because when you establish a network of relationships between members of your community, it is easier to concentrate on endlessly producing content. In a community that is flourishing your valuable thoughts and knowledge that members contribute to one another will keep the conversation running long after you have released new content to them.
Effects of networks are generally positive and stem from a potential customer deriving greater value from your product or service due to the many other people they see using the product or service.
The network effects and community flywheels
Last year, McKinsey identified a type of enterprise that they predicted to dominate the next decade. These businesses were referred to as community flywheels. Community flywheels are created when a company's brand is able to grow a community-thanks to the effects of networks. In most cases, there is a strong branding story that brings communities together. The result is that your members are making content and becoming involved, which makes your community grow by itself.
THEN, McKinsey says, These brands offer hero items which are suitable for their customers, and selling happens effortlessly because supermembers are primed and excited to shop. There are no funnels. No pressure.
Absolutely amazing, natural growth that is driven by the members due to the network effect.
An example of the effect network a community flywheel business
In the Cut: Rae Benjamin In the Cut was created by Rae Benjamin In the Cut to be an online community that is focused on connecting people and resources that help creatives who are marginalized make it into the TV and film business. Through the Cut has quickly grown in its size since its debut in the year 2020, and is home to over 1,000 people. Through Their Mighty Network, they offer jobs, webinars and paid webinars, a network of like-minded creatives, and even host virtual events.
Sktchy Art School: Jordan Melnick created Sktchy Art School as a community for artists keen on portraiture. It allows them to develop new techniques, showcase their artwork, and gain feedback about their work. Since launching in 2018 Melnick's group has grown to more than 14,000 people. The members of the community are able to attend art classes, take part in art competitions for groups and join in the constantly growing community of artists.
A History of the Network Effect
Here are the most important ways that the effect of network has been working throughout history:
- Telephone networks (19th C.): As increasing numbers of users had access to phones as they grew in popularity, the importance of the whole network grew rapidly. It was because of this the fact that, in 1908 Theodore Vail, president of Bell Telephone, presented the concept of the network effect in Bell Telephone's annual conference.
- Radio Networks (1920s) as more and the number of radio users increased and broadcasting became more effective and profitable.
- Television Networks (1950s up to) : Similar to radios, the mass uptake of TVs by households led to greater rates for both programming and advertisements.
- The Fax Machine (1970s-80s): Fax machines would only expand as a network as more people were using them. There had to be both a receive and send side, almost identical to phones. In 1980, Robert Metcalfe brought the theory of network effects to mainstream when he recognized that the value of a network for communications (e.g. telephone lines) did not come from the expense of the hardware however, there was an exponential value for each additional user. The ethernet card must reach a certain volume to realize their full value as a network.
- Personal Computers (1980s-90s) In the years when increasing numbers of households purchased an Mac or a Windows-based computer, the software to run the computers started to become more important. This was what helped make Microsoft and Apple the companies they are in the present.
- Internet along with Email (1990s) Internet and Email (1990s) two merged as digital communications became more prevalent. Between 1985 and 1995 Michael L. Katz, Carl Shapiro, Joseph Farrell, and Garth Saloner did much of the fundamental work for the effect of networks as an economic theory.
- Social Media Platforms (2000s on) Platforms for social media utilized the effect of networks to produce massive numbers of users creating themselves content. Are you familiar with Myspace? It was one of the very first!
- sharing economy Apps (2010s) The impact of the network was that sharing platforms could grow to dominate our lives as services like Airbnb and Uber became possible.
- Cryptocurrencies and Blockchain (2020s) (2020s): The values have risen yet the technology that underlies the cryptocurrency and blockchain is based on a network effect, and is likely to be going anywhere. In fact, the promise of Web3 is the most powerful form of an effect of network: an internet that is decentralized.
How to make the effect of networks
If you're planning to create a business that's going to benefit from using the impact of networks and the network effect, here are some suggestions:
- Harness the power of user-generated content. The huge growth that of social media businesses resulted from the creation of an online platform, and later letting humans' creativity free.
- Utilize platforms that allow users to create, join and share their experiences with others (ie. social platforms). Giving ownership of platforms (getting away from the process) lets natural growth.
- Develop a service or product that, in its nature, stimulates growth by inviting others (e.g. Calendly).
- Niche down. Individuals join and become part of networks (esp. social networks) in order to meet individuals who are interested in the same things as they do. Although social media giants have enormous numbers of users however, they are thriving on their own networks. As an example, Facebook thrives on family and acquaintances. LinkedIn is a great tool for industries and workplaces. Twitter brings together people who have similar interest (e.g. politics)
Advantages and Disadvantages of the Network Effect
Benefits
- companies can expect rapid growth and profits.
- Human brands can profit from more users engaging and creating (e.g. the online community is based by leveraging human creative ).
- The increased number of users lets brands to create more appealing offerings and experience.
Disadvantages
- Social media can have negative externalities. A high number of users on social media websites can open potential for predators.
You can now read: 5 Ways to Monetize Your Viewers