What's The Network Effect? The Crash Course we're offering for 2023 |

Sep 4, 2023

If you have a product which relies on the acquisition of an unbeatable number of customers, like a rideshare platform, then your service becomes better value as more users make use of it. Why? because the greater number of people who use your service, the more you're able to cut costs, increase the availability of your service, and maintain the demand for your service.

That's the network effect. In this blog, we'll introduce you to the concept of the network effect. We'll explain the origins of the effect network and show you how tech companies use it to hit billion-dollar valuations.

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The effect of networks at one glance

What exactly is a network effect?

A few examples of the effect network

What do all these aspects have to do with each other? They all become more valuable the more users they have, for a bunch of different motives.

Direct vs indirect network result

What exactly is an effect of a network that is direct?

What is an indirect network effect?

Network effects that complement it

How the network effect can help tech companies rise.

The network effect helps human-centered businesses

The effects of network and community flywheels

Examples of the network effect with the community flywheel.

The history of the Network Effect

Tips to generate the effect of network

Advantages and Drawbacks from the Network Effect

The effect of networks in a nutshell

The effect of networks occurs when the value of a platform increases because more and more people utilize it.
Many of the biggest and most profitable firms of the last century have grown due to the effects of network technology, from phones to railways and social media, to online shopping.
The network effect is what makes community businesses extremely effective, since they see rapid member led growth to create a flywheel of community that rapidly creates profit.

What is a Network effect?

The term "network effect" refers to how the value of a particular product, platform or service grows when more users use it as per the economists Michael Katz and Carl Shapiro this is the reason why people who use popular goods are better value.
They observed that just as some items aren't worth it on their own (e.g. nuts without bolts) In the same way, some platforms won't be as useful (or in any way) without the users.

As an example, a social media platform by itself is just a piece of software. If nobody uses it, it's virtually worthless. It's the interaction and presence of their users that make platforms like Facebook, Instagram, LinkedIn as well as others. their importance. You can even put the value of every user on the network such as, for instance the year 2021 was Facebook averaged $43.39 in revenue per user and $13.89 net earnings.

The network effect can add value to a firm by a variety of ways:

Through user actions and the creation of content by users. For instance, YouTube would be worthless in the event that people did not show up and make videos. On many social media platforms the network effect is a success but it is only possible if people actually use the program. Meta's most recent Threads launch saw 100 million new users join for the initial month, and then the number of active users reach 10 million one month after. The release is still in its early stages, but it shows the importance of sign-ups isn't only in numbers and active users, but rather in the number of them.
By monetizing the network. Social media platforms can monetize their audience (selling advertisements) They can also utilize the massive scale of their networks to demand higher rates for targeted advertising, demographics, etc.
Data generated by networks can also be monetized, which can also be sold. The larger a set of data gets, the more useful it becomes for data scientists to make observations from.

Source: Katz, Michael L., and Carl Shapiro. 1994. "Systems competition and network effects." Journal of Economic Perspectives, 8 (2) (93-115).

Some examples of the effect network

Here are a few examples of the effect network in action in a bunch of diverse sectors:

Communications: Land lines or Cable TV - These tools get more valuable the more users they are able to serve. For example, a landline is worth more in case you have the ability to contact anyone using it.
Scheduling tools: Calendly, Google Calendar - Calendar tools expand quickly due to the network effect, because when you send people an invitation, they need a calendar to accept.
Social Media: Facebook, X (Twitter), LinkedIn, Instagram - Social media companies literally generate billions of dollars from the network effect by leveraging increase in user numbers into revenue from advertising (and occasionally direct sales of premium products). For example, the only reason why a job applicant would spend money on LinkedIn Premium is that the number of employers on LinkedIn.
Discussion Forums: reddit, Quora and Reddit. These sites work because of the network effect. If you have people who show up and participate, you can have powerful discussions.
Videos Sharing: YouTube, IGTV, Facebook TV, Vimeo - If you're one of the users uploading video on YouTube, you have something to look at as a fun diverting. If you have millions, you have a service that can replace traditional TV.
AI tools: ChatGPT - It's still in its early days, however ChatGPT quickly increased to reach 100 million customers through the help of word-of-mouth, and the more users it has it has, the faster it will be able to learn about information.
Delivery applications: DoorDash, Uber Eats, Grubhub - It's only because there's a critical mass of food-ordering customers that drivers can make an income from these applications. That's the network effect!
eCommerce platforms include Amazon, eBay - Amazon was able to grow as large as it did due to it has a large number of customers. Others online bookstores slowed. Once it had millions of customers and could grow into merchandise other than books.
Customer communities: Apple Community, Quickbooks Online Community, Lego Community Communities like these are valuable because customers log on and contribute their expertise typically for enjoyment. In the event that you're an Apple user who is having issues using a particular product, you'll usually find the answer in the Apple Community. And it would be worthless if people didn't jump on the bandwagon and get it done completely free!
Subscription companies: Netflix, Amazon Prime Video, Disney+ - The more these platforms expand and expand, they will earn more subscription revenue. The money can be put back to create entertainment.

What do all these aspects have to do with each other? All of them become valuable the more users they are used to, due to a bunch of different reasons.

In some instances it is possible that the technology improves with more users (e.g. ChatGPT)
In some cases, the platform has content for users to interact with, thanks to a larger number of users (e.g. Facebook, reddit)
In certain instances, the more popular number of users allows the business to advertise at a higher price (e.g. Facebook, LinkedIn)
In some cases, there's an "real real" advantage to the network impact (e.g. LinkedIn helps you find a job ).
In some instances the effect of network creates a big enough customer community for individuals and companies to offer a particular service (e.g. Uber). This is referred to as an indirect network effect.

Example:
Airbnb: Airbnb has quickly become the go-to platform for homeowners looking to let their homes for short-term stay to clients. It is a prime instance of a network effect because the value of the service increases when more and more people join Airbnb who are looking to rent. This allows property owners to maintain a constant flow of business. In addition, there is value for renters as homeowner's properties are opened for rent it provides renters more options to choose from. The worth of the platform grows as more renters and more homeowners join the site.

Direct vs indirect result

Each of these examples included what economists refer to as both indirect and direct network effects. However, the distinction between these two things is important to comprehend.

Here's a really easy method to comprehend the distinctions between an indirect and a direct network impact:

What exactly is the direct effect of network effects?

An immediate network effect sometimes referred to an "same-side" also known as a "one-sided" network effect is created in the event that more people of the same kind of members join a particular platform. It means that the value of the network can be generated as a direct result of a greater number of people signing up.

If, for instance, I want to send you a message on WhatsApp but you don't have it There's an easy alternative. You might try downloading WhatsApp! It's just become more useful because we're both on WhatsApp!

- Graphics - Courses and live streaming - Galaxy DAO

It is evident that the effect of networks constantly when we look at online communities. With communities, there's a direct network effect as members create content and add value and people on the outside want to join to get this worth! The result is that communities are able to sell memberships, courses premium content, and events - and these things are all based on the amount of members.

This is why the network effect can also create a flywheel community enterprise, which we'll get further down.

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What is an indirect effect of a network?

Indirect network effects, commonly called an "two-sided" effects of network are when the expansion of the one network leads to benefits in another. As an example, the growing number of users using Uber generates advantages for a different driver's network, which is Uber's drivers. The more customers there are that are there, the better chance is for drivers. While drivers and users on Uber are different kinds of users and want different things, the two networks impact one another: The indirect effect of the network.

Enhancements to the network

There's one more term you might see used here as an effect that is a part of the network. A complementary network effect happens when a related item or service is increased in value as a result of the expansion within a community that isn't their own. For example, LinkedIn grows because of hiring and job seekers joining. These massive networks provide value to recruiters. LinkedIn serves them as a complementary network.

The network effect can help tech companies rise.

The vast majority of businesses that we communicate in daily interactions use the effect of networks to gain advantage. If you look at the top corporations in the world according to market value, many of them have utilized the effect of networks to achieve huge expansion. Examples:

Amazon (+ $1 Trillion) is using the network effect to catapult an online store to become the largest store that the world has ever known. In addition, Amazon has used the network effect to launch profitable businesses, for instance, AWS provides cloud computing and web services for application suppliers and for vendors to service their customers.
Alphabet (plus $1.5 Trillion) - Alphabet has a ton of companies within it, however, it was founded by creating the world's best search engine (Google) that quickly grew because of the network effect. The searchers who used it made Google into the business that it has become today.

There's a reason why the network effect has helped technology companies become the most valuable firms on earth. It comes down to what we call externalities.

Externalities can be described as the positive or negative results of a network-and they could limit the network's development. The past was when externalities increased with the growth of the network. As an example, railroad companies prospered due to the effect of networks-with increasing numbers of passengers bringing in more revenue. BUT there was still massive cost to keep the railways going. They had to maintain bridges, rail lines tunnels, stations, and bridges and keep the engines full of coal.

Externalities like these slowed the network growth.

Here's how the network effect benefits tech companies.

Technology companies are not awash in externalities. If Amazon has its infrastructure, then anyone in the world can access the site and make purchases. It would cost a railway millions in externalities to add more customers. They'd require more vehicles, engines, tracks as well as stations. The only cost is Amazon more server space-which could be as low as pennies.

Tech companies are able to expand nearly unlimited networks without adding huge additional costs. And that's how the network effect has helped push many tech giants up to the top of the exchange.

How the network effect can benefit human-centered companies

We've been very excited by the way that network effects work using software that is human-centered. Are online communities that explode with growth and become successful businesses due to the network effect. So we've seen thousands of thriving communities-large and small-become companies thanks to this phenomenon.

In community building, a network effect describes the phenomenon where the value of a group increases when the number of people who sign up. Every new member who joins the community brings their unique perspective, experiences, and expertise and adds value to you, your brand, and the members you have.

This could be of direct importance to sales of memberships. For example, most generate between $27-$33/mo in membership fees ($240-$319/year).

The network effect doesn't just talk related to membership fees, however. The effect of the network also describes how the value of organizations grows because of the activities of members.

The members create content and also inspire others to join in, that adds value to the community. It creates a chain reaction that sees additional members add value, which in turn attracted other users, who give to the value.

This is what we call member-led growth, and once you experience it, this is life-changing. Member-led growth uses the effects of network to bring your customers, subscribers or customers to become members. They are members. And when your business can thrive on member-led growth, you'll see the network effect working.

As a creator you can benefit from the network effect so valuable because as you build a network of relationships among the people who make up your community you can focus less to creating content on a constant basis. In a community that is flourishing your valuable thoughts and knowledge that members contribute to each other can keep conversations running long after you have released new content to them.

Effects of networks are generally positive and derive from the potential buyer gaining higher value from your item or service due to how many others are who are using the product or service.

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The network effects as well as community flywheels

Last year, McKinsey identified a type of business that they predicted will dominate in the years 2020. They called these businesses community flywheels. Community flywheels are created as a brand expands into a community-thanks to the effect of network. Usually, there's a powerful branding story that brings the community together. The result is that your members are creating content and getting involved-which allows your community to grow automatically.

Then, McKinsey states, the brands launch hero products that fit their members, and the selling process is a breeze since supermembers are eager and ready to purchase. No funnels. Pressure is not there.

Simply amazing, organic growth driven by members thanks to the network effect.

A few examples of the effect network a community flywheel business

In the Cut: Rae Benjamin founded In the Cut to be an online community that is focused on providing resources and connections for marginalized artists to get into the TV and film business. The community of In the Cut has quickly grown in scale since its launch in 2020 and now has over 1,000 members. In Their Mighty Network, they offer paid webinars, job postings, a network of like-minded creatives, and even host virtual occasions.

Sktchy Art School: Jordan Melnick founded Sktchy Art School as a community for artists interested in portraiture to learn new techniques, showcase their work, and get feedback on their work. Since launching in 2018 the community of Melnick has expanded to more than 14,000 people. Melnick's members can enroll in art classes, engage in challenges for group members as well as join an ever-growing art community.

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A History of the Network Effect

Here are the most important ways that the network effect has performed across the years:

Telephone networks (19th C.): As the number of people who had phones increased and computers, the worth of the network exponentially. It was because of this the fact that, in 1908 Theodore Vail, president of Bell Telephone, presented the idea of a network effect during the company's annual meeting.
Radio Networks (1920s) When more people got radios, it made broadcasting more profitable and powerful.
Television Networks (1950s on) : Much like radio, televisions' widespread use within households resulted in higher values for advertising and programming.
Fax Machines (1970s-80s) The era of Fax Machines were able to grow into networks as more people were using them. There had to be an send and receive component, almost identical to phones. In the year 1980, Robert Metcalfe brought the theory of network effects to mainstream when he recognized that the value of a network for communications (e.g. telephone lines) wasn't the real expense of the hardware but that there was an exponential cost for each added user. He claimed that Ethernet cards must reach a certain mass to achieve their true worth as networks.
Personal Computers (1980s-90s): As growing numbers of homes got a Mac or Windows-based personal computer, the software that runs them became more valuable. This is the reason that made Microsoft and Apple the companies they are in the present.
Internet and Email (1990s) in the 1990s: The two were inextricably linked in the 1990s as communication via digital technology increased. Between 1985 and 1995, Michael L. Katz, Carl Shapiro, Joseph Farrell and Garth Saloner carried out an extensive amount of the initial work for the concept of network effects as an economic theory.
Social Media Platforms (2000s to) The social media platforms utilized the effect of networks to generate mass amounts of users who created the content they wanted to create. Do you remember Myspace? It was one of the very first!
Sharing Economy Apps (2010s) : The network effect meant that sharing platforms could grow to become a major part of our lives, and as apps such as Airbnb and Uber could be made.
Cryptocurrencies as well as Blockchain (2020s): The value of the cryptocurrency and blockchain have suffered however the technology behind the cryptocurrency and blockchain is based on a network effect, and is likely to be going to go away. In fact, the promise of Web3 will be the highest level of the network effect, a decentralized internet.

How to make the effect of networks

If you're creating an enterprise that will profit of using the effect of the network Here are some tips:

Harness the power of user-generated content. The huge growth that the social media industry has seen resulted from the creation of an online platform, and later letting human creativity loose.
Use platforms that empower users to create, join and share their experiences with others (ie. community platforms). Assuming ownership over platforms (getting out of the way) will allow for organic growth.
Make a service or a product that by-its-nature compels growth and invite others to join (e.g. Calendly).
Niche down. Members join and participate in networks (esp. social networks) where they can find individuals who are interested in the same things as they do. While social media giants have enormous numbers of users however, they are thriving on their own networks. For example, Facebook thrives on family and friends. LinkedIn on workplaces and industries. Twitter brings together people who have similar interest (e.g. politics)