The Power of Network Effects: Why they make such Valuable Companies, and how to Harness them
By: Eric Jorgenson
Tags: Network Effect, Marketplaces, Business Strategy, Competitive Advantage, Startup

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Some of the most powerful and fastest-growing companies are based upon Network Effects. That makes this an exciting topic—to find out what’s behind Apple’s app ecosystem, Facebook’s social content, and Airbnb’s community.

Here’s what’s coming up in this Edition of Evergreen:

Distinct Types of Network Effects — yes, there are types

What Network Effects are Not — don’t get it twisted

Why Network Effects are powerful

How to Create Network Effects

What Exactly are Network Effects?

Network Effects were not really ‘a thing’ until we started to build a layer of technology for communication around our planet. It was coined in the early 1970's as academics began to study the growth of the telephone network.

Here is the best definition I could find of Network Effects:

A product displays positive network effects when more usage of the product by any user increases the product’s value for other users (and sometimes all users).

This is a more precise definition than many others floating around because of a few key concepts:

Distinguishing positive (there are negative as well, which we’ll get to)

‘Usage’ rather than ‘adding a user’ (which implies all users are identical)

Types of Network Effects

There are different ways that Network Effects can exist, and their dynamics change depending on the application. These concepts are often mistakenly conflated into ‘Network Effects’. Work to understand the differences, because they are not conceived the same way, and they don’t create the same results. This short breakdown from the Stern School of Business (NYU) defines the types of Network Effects:

Direct Network Effects:

The simplest network effects are direct: increases in usage lead to direct increases in value. The original example of telephone service is a good illustration of a product that displays direct network effects.

Indirect Network Effects:

Network effects may also be indirect, where increased in usage of the product spawns the production of increasingly valuable complementary goods, and this results in an increase in the value of the original product. For instance, while there are some direct network effects associated with Windows, the indirect network effects that arise from the increased quality and availability of complementary applications software are probably much more important.

Two-sided Network Effects:

Network effects can also be two-sided: increases in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa. In many cases, one may think of indirect network effects as a one-directional version of two-sided network effects.

This is the type of Network Effect that defines Marketplaces such as Airbnb, Uber, and Zaarly. More riders does not necessarily improve my Uber experience but it does attract more drivers, which will improve Uber for me.

[If you happen to be working on a Marketplace or interested in them, this is an important core concept to understand. Here are two more great resources on this topic, specifically: Strategies for two-sided markets, and Jean Tirole on Platform Competition. Both valuable contributions by Karthik Rajeshwaran]

Local Network Effects:

The microstructure of an underlying network of connections often influences how much network effects matter. For example, a product displays local network effects when each user is influenced directly by the decisions of only a small subset of other users — those they are “connected” to via an underlying social or business network.

Zaarly is also a good example of this: A new Homeowner who joins in Denver contributes to the Denver Network Effect, and does not influence the quality of the experience for Homeowners in Austin.

Instant messaging is another great example of a product that displays ‘local’ network effects which are social rather than geographical.

What Network Effects are Not

In addition to being conflated amongst themselves, Network Effects are also conflated with other adjacent concepts in business. To understand any concept well, it’s helpful to understand what it is Not.

Network Effects are Not Virality

A viral product is one whose rate of adoption increases with each additional user. The more people join, the faster it grows — until a certain point. They’re often confused because both Network Effects and Virality increase growth of a business and it’s value as new users join. However, they are completely independent concepts, as we see here:

There are products that exhibit virality without exhibiting network effects. A case in point being email and cross-platform communication products. A key feature here is that they are either interoperable across networks (Hotmail) or leverage an underlying network for both the viral transmission as well as delivery of the value proposition. In the case of SurveyMonkey, EventBrite etc., that underlying network may be mail, a social network or even a blog. There are others that exhibit network effects without exhibiting virality. Products with indirect network effects such as marketplaces may not grow virally. In such cases, network effects are a result of aggregation of the two sides and while each side can be brought on virally through some incentive, it’s very difficult to leverage the indirect network effect to get users on one side to come on through invitations or interactions from the other side.

Here’s a graphic that shows some examples of each of these concepts independently, as well as companies that have both:

Thanks to Karan Khandpur for suggesting the great post with these ideas!

Network Effects are Not Economies of Scale

Economies of Scale arise (and there’s a whole separate Edition to come on this) when there’s sufficient volume of production to massively reduce the costs, so the largest player can maintain the best margin of profitability.

Network Effects are distinct from Economies of scale because they produce greater value for the marginal increase in cost. As Networks grow larger, the cost increases, but the value of the product increases faster.

The fact that Apple sells a lot of iPhones does not mean that it has Network Effects, just Economies of Scale. The fact that people want to buy it so that they can use iMessage with their friends — that’s the Network Effect.

Why Network Effects are Powerful

To the fun part — how to create Network Effects, and benefit from their incredible power to extract value. Let’s start with the Endgame.

Why Networks create so much value

There is one graphic that conveys the full concept of Network Effects. It was contributed by Ray Stern, who created it when he was training employees as CMO of Intuit. Take it all in…

This visual showed me the value of Network Effects more clearly than all of the other posts and papers out there. The heart of the power of Network effects is right here: Value Increases Exponentially — Costs increase Linearly.

The cost of maintaining the network does not grow as fast as the value of the network. The value increases as the size of the network increases.

The implication is a principle that anyone operating in an industry influenced by Network Effects should understand: in the long run, there will tend to be fewer players, and they will continue to grow larger.

“You can suck at everything and still make money”

Another reason that Network Effects are so valuable is that they don’t require a ton of maintenance. Once they’re built, they tend to perpetuate themselves. Even if they’re managed completely incompetently. To paraphrase Warren Buffett: “It’s great to own a business that a monkey could run — because sooner or later, one will.”

Here’s what James Currier learned from his time working at Monster.com:

In every element of the business other than the sales team, this was a poorly run company. I don’t think they had changed the website in two years. Poor product, poor customer service, poor strategic decision making, and from what we could tell, a lack of insight into what was about to happen to them because of LinkedIn and others. What stood out was that none of this mismanagement mattered. They had a network effect in place. Like Craigslist, the only feature that mattered was that everyone was there. The buyers found efficiencies in using them and so did the sellers. Both sides of the marketplace kept coming, and Monster kept making money.

That sounds like a good business to run — lots of margin for error, which is a great asset. We should all aspire to start businesses where we can suck at everything and still make money. (Then if we don’t — it’s all upside!)

How to create Network Effects

Not all businesses can create Network Effects, and not all businesses should. There are a lot of approaches to this strategy, and it’ll look very different depending on your company and your industry.

Come for the Tool, stay for the Network

It seems like in many cases, strategic openings to create Network Effects only become available after certain levels of success with simpler products.

Chris Dixon has a very short post about this on his blog, which was suggested by Itamar Goldminz, Karan Khandpur, and David Barnes :

The idea is to initially attract users with a single-player tool and then, over time, get them to participate in a network. The tool helps get to initial critical mass. The network creates the long term value for users, and defensibility for the company.

For example:

Instagram’s initial hook was the cool photo filters. At the time some other apps like Hipstamatic had filters but you had to pay for them. Instagram also made it easy to share your photos on other networks like Facebook and Twitter. But you could also share on Instagram’s network, which of course became the preferred way to use Instagram over time.

You can’t attract your first user with a network effect (because there is no network, and therefore no value.)

Unless…

Dominating Extremely Tiny Markets

Another option is to create Network Effects in minuscule markets. We saw this as Facebook got started at Harvard. They had to start with a tight social group, like a class or group of friends — and grow quickly within a small and well-defined group, until they had a meaningful network to that demographic.

This is a concept that Sean Ellis calls “Minimum Viable Critical Mass”.

Product/Market Fit in Network Effect Products

If you’re relying on a Network Effect as your competitive advantage, it’s not as easy to test your value proposition and get early feedback from customers. Sean Ellis has some great slides about how different it is to find Product/Market Fit for a Network Effect Product:

This last slide, Priming the pump is code for ‘Fake it till you make it’. If your product relies on Network Effects — you may have to create the illusion of a network for early users. Do what it takes to test your concept and get validation and early traction.

Content Networks vs. Connection Networks

So far we’ve only talked about Networks of people. The Network Effect Playbook, by Sangeet Choudary (which was suggested by Eric Wilson and Itamar Goldminz) proposes that there are two ways to solve the problem of creating a Network — connection and content.

Traditionally, startups have solved this problem by racing to connect users with each other, essentially providing them the pipes to interact with each other. Twitter, Facebook and LinkedIn have grown big with this connection-first model. However, a new breed of networks is gaining ground with the content-first model. They provide users with tools to create a corpus of content, and then enable conversations around that content. Behance, Pinterest, Instagram, Dribble, Scoop.It have all gained traction by building a corpus of content before building a social network.

Content platforms create Network Effects not through interaction, but through hosting videos, posts, etc. This lets them reach the point where they’re providing more value to new users much more quickly than the connection model, which relies on existing users in a social circle.

The secret to creating a social product that demonstrates immediate value is to enable content before creating the network. Content created on the network is the new source of competitive advantage. The videos on YouTube, the pictures on Instagram, the answers on Quora are the primary source of value for users and the key driver of competitive advantage for these platforms.

This stored value has a long tail, and will be an asset to the platform for potentially years to come.

There are some very good thoughts in the Network Effect Playbook, and lots of inspiration for new ways to build content platforms, which could build Network Effects.