What are Network Effects?
Network Effects refer to the incremental benefits gained from new users joining the platform, which results in the product becoming more valuable for all users.
Table of Contents
- How Do Network Effects Work
- Direct vs. Indirect Network Effects: What is the Difference?
- What are the Sources of Network Effects?
- What are Examples of Network Effects?
- How Does Metcalfe’s Law Explain Network Effects?
- How to Interpret Negative Network Effects?
- What is an Example of Platform Network Effects?
How Do Network Effects Work
Network effects describe the phenomenon in which the value of a product improves for all users as more users join a platform, even for the existing user base.
The concept of network effects is particularly important in the digital age, given continued technological disruption amid rapid globalization.
The core premise of network effects is that each new user improves the value of a product/service for both new and existing users alike.
Specifically, companies pay attention to network effects because of the possibility of establishing barriers to entry (i.e. “moats”) that can protect their long-term profit margins from competitors.
Companies with network effects observe that more product usage is beneficial for their entire user base. However, “usage” refers to customers that actively use a product or participate on the platform.
Therefore, the impact of network effects is contingent on the total number of potential buyers and sellers in the market and how much the company can leverage its user base.
- High Barriers to Entry → High Difficulty in Market Entrance (Low Competition)
- Low Barriers to Entry → Low Difficulty in Market Entrance (High Competition)
Direct vs. Indirect Network Effects: What is the Difference?
In particular, there are two different types of network effects: Direct Network Effects and Indirect Network Effects.
- Direct Network Effects → In the case of a direct network effect, or “one-sided network effect”, the value of a product or service rises in tandem as more users join the platform. The more users signed-up on and active on the platform, the more value derived by existing users. For example, a social media platform such as Twitter becomes more valuable as more users join and participate, especially “influencers” with large followings.
- Indirect Network Effects → In contrast, the value of the product or service rises for a group of users if more users join a different group that is part of the network. For instance, the customer experience for ordering from a food delivery application such as Grubhub improves with shorter wait times if there are more available delivery drivers and restaurants in the area.
To elaborate on the latter type of network effects, suppose a new customer joins Grubhub to order food delivery.
The incremental value to other users (and most drivers) is near zero in theory. Yet, drivers within the same location, i.e. one subgroup of existing or potential future drivers, could someday benefit from that user joining as they can service the new user.
Another example of indirect network effects would be upselling/cross-selling of software tools (e.g. Microsoft 365, G Suite), as the positive benefits emerge later on from a different product, after an upgrade, or from the collaboration between the tools.
Two-Sided Network Effects
Two-sided network effects occur when more product usage by one distinct group of users increases the value of a complementary offering to a different set of users (and vice versa).
What are the Sources of Network Effects?
The value creation can stem from various sources, with some causes of network effects being the following examples:
- Marketplace: Aggregating customers and suppliers into one shared marketplace to exchange goods (e.g. Amazon, Shopify).
- Data Network: Gathering more user data and insights over time can establish a competitive edge (e.g. Google Search Engine, Waze).
- Platform: User growth and high retention rates within the product ecosystem (e.g. Apple, Meta/Facebook).
- Physical: Significant initial spending needs can be a barrier to entry that creates a network (e.g. Infrastructure, Utilities, Telecommunication, Transportation).
