What Is The Network Effect? Why Is It Valuable?
Why do companies like Facebook, Whatsapp, Instagram, Snapchat, etc rule their respective niches without any fear of their competitors? Or rather, why you don’t want to switch to a different platform than these?
It’s all because of a phenomenon called the Network Effect.
What Is The Network Effect?
The network effect, also known as the network externality or demand-side economies of scale, states that a good or service becomes more valuable when more people use it.
Precisely, more the usage of the product or the service, more is its value. The phenomenon might seem simple intuitively, but there’s more to it than you might think. The network effect works in a particular manner and is a powerful tool for certain growing businesses.
How Does The Network Effect work?
Network effect becomes significant after only when the service has a certain percentage of subscribers on board. This certain percentage is called the critical mass. Once this critical point has been achieved the value obtained from the good or service is greater than or equal to the price paid for the good or service. This works in a positive loop. As the value increases by the number of users of a good or service, more users would want to purchase it, and hence more users would be added to that good or service further increasing the value of it and adding even more users. It can scale very rapidly.
The key to making this system work for you is not to focus what happens after the loop has begun but before it. After the network effect starts working its magic, there’s not much needed to get more users. The challenge lies in getting users to join in before the critical mass is hit. You can rely on extrinsic motivation, like a payment, a fee waiver (like WhatsApp), or a request for friends to sign up (like Snapchat). Or you can opt for a more sustainable method wherein your product or service is valuable enough, if not for all, at least for early adopters to start using. This is more efficient and effective as the product works for itself and it provides good fruit later on in the business. Then, as the number of users increases, it will get a wider user base.
However, caution must be taken to issues like congestion or saturation. As the network effect scales, the network itself can get overloaded. This will stop the uptake. Congested is caused by overuse. Before the congestion point, every added user adds value to the network. But after the congestion point, every other user decreases the value of the network. For example, the telephone network. As the user base is below the congestion point, every user adds value to another user. But, if too many people join the system, the system can get overloaded and the network will reach saturation. Practically, this would lead to busy signals, poor customer service, etc. From here on, the positive effect of the network effect stops working and a negative one begins. The next critical point is where the value obtained again equals the price paid. The system needs to be enlarged or it will crash.
Types Of Network Effect
A network effect business model can be formed in many ways. Not all of them work the same way and they even create different results. These are the types of network effect business models that exist:
Direct Network Effect
The direct network effect is simple to understand. Increase in usage leads to a direct increase in value. The telephone network is a good example.
Indirect Network Effect
A Network Effect may also be indirect. Here, increased usage of a product leads to an increased production of complementary products which then adds value to the original product. With operating systems like windows, the increase in better applications increases the value of Windows itself.
Two-sided Network Effect
This phenomenon benefits both the main and the complementary product. When two-sided network effect hits in, an increase in usage by a set of users increases the value of a complementary product to another distinct set of users, and the other way around. Companies like Airbnb and Uber which runs a network/aggregator business model capitalize on the two-sided network effect.
Local Network Effects
A product displays local network effects when a user is influenced directly by the decisions of a small subset of other users. It is usually those that are connected via a common platform or social network.
Network Effect Case Study – Facebook
After Mark Zuckerberg started Facebook in 2004, for the first few years, his meetings would end in a one-word chant: Domination!
And that’s what the company rightfully did.
The way things are going right now, Facebook is going to dominate the internet. There are nearly a billion people on Facebook—half of which use it daily. Zuckerberg obviously had to do a lot to get Facebook to where it is today. But he understood what it takes to make a successful business, like the likes of Bill Gates and Larry Page. A successful network effect is what he needed and what he got. He said,
I think that network effects shouldn’t be underestimated with what we do as well.
The network effect that Zuckerberg capitalized on is precisely the reason why Facebook is so dominant and also why Google is also scared of it. People simply got on Facebook because others were using it and they don’t want to be left out.
WhatsApp also used the network effect to scale but its approach was a little different. It focused more on engagement than a large user base. Initially, it was highly clustered among close family and friends and WhatsApp groups. This led to people spending more time on Facebook. It used the phone book as a social graph. People invited others to WhatsApp from their contact list. This also spread in a way that as more people got on WhatsApp, normal messaging diminished, because of the features that WhatsApp provided and for the fact that people didn’t want to miss out.
The network effect is a really powerful technique for a successful business. All the great entrepreneurs that used this in their business strategies scaled to unimaginable heights. In this generation, where almost everything is dependent on technology and media, using the network effect is rather simple and genius. All you require is to have the next big idea, and with this effect in your favour, you too can become the next big success story.
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