Some of the most powerful and fastest-growing companies are based upon Network Effects.
What are Network Effects?
A product displays +ve network effects when more usage of the product by any user increases the product’s value for some/all of other users.
What are its types?
[1] Direct Network Effects
Increase in usage lead to a direct increase in value.
Example:
Telephone service
[2] Indirect Network Effects
Increase 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.
Example:
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.
[3] Two-sided Network Effects
Increase in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa.
Example:
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.
[4] 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.
Example:
Zaarly - 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?
[a] 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.
Examples:
[a.1] Products that exhibit virality without exhibiting network effects:
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.
[a.2] Products 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 an image showing some examples:
[b] Network Effects are Not Economies of Scale
Economies of Scale arise 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.
Example:
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 & why do they create so much value?
[Reason 1] Above visual shows that:
Network Effects' 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.
[Reason 2] Network Effects don’t require a ton of maintenance. Once they’re built, they tend to perpetuate themselves - Even if they’re managed completely incompetently.
Example:
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.
Not all businesses can create Network Effects, and not all businesses should. But how to create Network Effects?
[a] Come for the Tool, stay for the Network
Point is: You can’t attract your first user with a network effect (because there is no network, and therefore no value.) So, in many cases, strategic openings to create Network Effects only become available after certain levels of success with simpler products. 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.
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.
[b] Dominating Minuscule (Extremely Tiny) Markets
This concept was labeled “Minimum Viable Critical Mass” by Sean Ellis. In this case, you can attract your first user with a network effect.
Example:
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.
[c] 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.
[d] Content Networks vs. Connection Networks
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. 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.
Example:
Behance, Pinterest, Instagram, Dribble, Scoop.It have all gained traction by building a corpus of content before building a social network.
What are Network Effects?
A product displays +ve network effects when more usage of the product by any user increases the product’s value for some/all of other users.
What are its types?
[1] Direct Network Effects
Increase in usage lead to a direct increase in value.
Example:
Telephone service
[2] Indirect Network Effects
Increase 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.
Example:
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.
[3] Two-sided Network Effects
Increase in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa.
Example:
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.
[4] 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.
Example:
Zaarly - 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?
[a] 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.
Examples:
[a.1] Products that exhibit virality without exhibiting network effects:
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.
[a.2] Products 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 an image showing some examples:
[b] Network Effects are Not Economies of Scale
Economies of Scale arise 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.
Example:
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 & why do they create so much value?
[Reason 1] Above visual shows that:
Network Effects' 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.
[Reason 2] Network Effects don’t require a ton of maintenance. Once they’re built, they tend to perpetuate themselves - Even if they’re managed completely incompetently.
Example:
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.
Not all businesses can create Network Effects, and not all businesses should. But how to create Network Effects?
[a] Come for the Tool, stay for the Network
Point is: You can’t attract your first user with a network effect (because there is no network, and therefore no value.) So, in many cases, strategic openings to create Network Effects only become available after certain levels of success with simpler products. 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.
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.
[b] Dominating Minuscule (Extremely Tiny) Markets
This concept was labeled “Minimum Viable Critical Mass” by Sean Ellis. In this case, you can attract your first user with a network effect.
Example:
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.
[c] 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.
[d] Content Networks vs. Connection Networks
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. 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.
Behance, Pinterest, Instagram, Dribble, Scoop.It have all gained traction by building a corpus of content before building a social network.
Shamelessly copied-&-edited from:
Medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8
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