Network Effect
Takeaway: The network effect occurs when the value of a product or service increases as more people use it.
The network effect is a valuable intangible asset for companies because it can create a virtuous cycle where the more people use a product or service, the more valuable it becomes. This can lead to higher customer retention rates, the attraction of new customers at a much lower marketing cost and improved revenue growth.
Also, the network effect can create barriers to entry for competitors because it is challenging to replicate an organic network effect of an established product or service.
How can companies develop a network effect?
Developing a network effect is a strategic goal for many modern companies seeking to build a strong competitive advantage. Thankfully, the path to creating a workable network effect (or at least encouraging one to form) is well-trodden.
Firstly, a company needs to create a compelling value proposition that attracts users to its platform or product. This value proposition should clearly communicate the benefits and advantages people will gain by participating. The best way to attract people is to solve a problem. The more efficiently a problem can be solved, the more likely people are to share that solution with friends.
Secondly, achieving critical mass is crucial for developing a self-driving network effect. Critical mass refers to reaching a point where a network's value significantly increases with each new user. To get there, companies may need to organise targeted marketing, create partnerships with incumbents, or develop incentives to attract an early user base. Achieving critical mass is worth the effort since it lays the foundation for a network effect to take hold.
Thirdly, think about ways to maximise the value of the network by enabling connections, communication and resource-sharing between users. It should be as easy as possible for people to talk with each other no matter where they might be located on the platform or service.
Think of messaging systems, user profiles and collaborative tools. By continuously iterating on a network's features, analysing user feedback and fostering a vibrant ecosystem, companies can create sustainable value for their users.
Why is it important for companies to create a network effect?
A network effect is the secret sauce of competitive advantage in the Information Age. If a company has a strong network effect, it becomes increasingly difficult for rivals to enter the market and compete.
A me-too company or rival might have a better product, but if no one knows about it or that service doesn’t have the same level of social proof, then it simply won’t outcompete an incumbent that does. That’s the awesome power of the network effect.
On top of acting as a mosquito repellent for competitors, companies with a strong network effect can charge higher prices or monetise their user base through advertising or data analysis.
What kind of companies benefit from a network effect?
Network effects are particularly valuable for companies that operate in sectors where the cost of acquiring new customers is high. One example is social media platforms. Companies like Facebook, Twitter or Instagram thrive on network effects since the value of these platforms increases with the number of active users.
As more users join, social media becomes more attractive to others, leading to an ever-growing user base, increased engagement and more opportunities for advertisers or creators.
Another beneficiary of the network effect is online marketplaces. Companies like eBay and Airbnb are only successful if they can connect buyers with sellers or hosts with guests. As the number of participants on the platform increases, a marketplace becomes more attractive to both buyers and sellers.
A larger user base means more product variety, competitive pricing and a higher likelihood of people finding what they need. As the network effect strengthens, these marketplaces dominate their respective industries, making it challenging for new competitors to enter and catch up.
Examples of companies that have created a network effect
Facebook: Facebook is widely regarded as one of the best examples of a successful and leveraged network effect. From its early days as a social networking platform exclusively for Harvard University students, Facebook expanded rapidly to become a global phenomenon today (and change its name to “Meta” along the way).
Facebook's massive user base is a crucial aspect of its network effect. With billions of active users, Facebook has created a vast interconnected network where people can connect, communicate and share content. The more users on the platform, the more valuable it becomes for each individual user.
The website’s engagement features also play a significant role in strengthening the network effect. Features like news feeds, likes, comments and sharing facilitate connections and information flow between users. People are encouraged to spend more time on the platform, engage with content and build connections with others. As users interact with posts, their actions are visible to their network, leading to further engagement and content discovery in a positive feedback loop.
Facebook has acquired and added complementary services like Instagram, WhatsApp and Oculus to its ecosystem. These services leverage Facebook's user base, infrastructure and features offering ways for users to seamlessly connect and share across multiple services, expanding their social circles and interactions.
Uber: One of the key elements of Uber's network effect is its large and diverse user base. As more riders join the platform, the availability of drivers increases meaning people don’t need to wait as long to begin their journey. This cuts both ways. As more drivers join Uber, riders have access to a broader pool of drivers, increasing the likelihood of finding a ride quickly. This positive feedback loop attracts more users to the platform, creating a virtuous cycle of growth and enhancing the overall value of the service.
Uber's network effect is further strengthened by its global expansion. As the company enters new cities and regions, it increases its potential user base, making the service more appealing. Moreover, Uber's global presence means users can rely on the service wherever they go and drivers benefit from a larger pool of potential passengers.
Uber's reputation mechanism plays a vital role in building its network effect. Both riders and drivers rate each other after each trip, which helps improve trust and ensure a positive experience for everyone. High-rated drivers attract more riders, while high-rated riders are more likely to receive prompt and quality service. This rating system incentivises users to maintain a good reputation, creating a reliable and trustworthy network that drives user engagement and encourages more individuals to join Uber.
Airbnb: Airbnb's focus on building a strong sense of community sets it apart from other online travel platforms. Through its review system, communication tools and shared spaces, the hospitality app fosters a sense of trust and connection between hosts and guests. Positive experiences and interactions within the community encourage hosts to continue listing their properties and for guests to return to the platform if they have future bookings. The network effect is reinforced by the social aspect of Airbnb, where users benefit not only from the accommodations but also from the relationships and shared experiences they have with hosts and other guests.
Airbnb also taps into the sharing economy by allowing people to monetise their spare rooms or properties. This has empowered a new wave of entrepreneurs around the world. As more hosts join the platform, they contribute to the network's growth and diversification, making Airbnb increasingly valuable for both hosts and guests. Airbnb has already disrupted the traditional hospitality industry by adding a sense of community-driven commerce to the sector that simply didn’t exist before.
Facebook, Uber and Airbnb each demonstrate how companies can create a strong network effect by offering a product or service that is valuable to a large number of people and incentivising adoption and sharing. Each of these examples may have competitors, but those rivals cannot boast the intangible asset of the network effect in quite the same way. And that makes all the difference.