In the digital era, most companies have followed the idea of network effect to come to the position they are now.
Most of us are unaware of the fact that network effect plays a major role in the success and failure of marketplace platform businesses. Big conglomerates like PayPal, Microsoft, Facebook, Uber, Twitter, Salesforce, etc. are the successful children of network effect. Ultimately, the system is acting as a stepping stone for start-ups to help scale the business, increase customer base, market share and overall value position of the company’s product, and generating increased profit.
In the digital era, most successful companies have followed the idea of network effect to come to the position they are now. When companies use network effect as their marketing strategy, the network becomes more valuable to users as more people utilize it. At its core, the theory behind network effects suggests that platforms and products with network effects get better as they get bigger. Not just in value, but also in accruing more resources to improve the products, thus strengthening the working system. A three-year study by NfX suggests that network effect is responsible for around 70% of the value created by tech companies since the Internet took centre stage in 1994. Today, the functionality is shaping start-ups.
What is Network Effect?
The network effect is the phenomenon whereby increased numbers of people or participants improve the value of a product or service. Network effects exist in any place such as old-school landline phones, the internet, or other platforms. Network effects are the incremental benefit gained by an existing user for each new user that joins the network. For example, if a person has a social media account, the value for the account is zero. If everyone holds a social media account, then the interaction increases and the value also spikes.
In the early stage of network effect’s development, Metcalf’s Law was used to enhance the structure. Metcalf’s Law states that the value of a telecommunication network is proportional to the square of the number of connected users. Later in the digital days, modern Network Effect theory was developed based on the research of Joseph Farrell, Michael L, Carl Shapiro, and Garth Saloner in the 1990s.
Types of Network
Direct network effects: Direct network effects, also known as same-side effects increases the value of the product when the number of users goes up. For example, if the telephone industry is using network effect, the more people there are who have telephones, the more useful it gets.
Indirect network effect: Indirect network effect is also known as cross-side effects. With the indirect network effect, the value of the service increases for one user group when a new user of a different group joins the network. To achieve indirect network effects, the platform must have two or more user groups.
Network Effect for start-ups
Start-up’s success in the internet era largely depends on building network effects. The company grows when people have interaction on the platform or marketplace. Unlike huge companies in the industrial age, which grew as they produced more effectively, start-ups didn’t get value because of the capital they employ, the machinery they run, or the human resource they command. They are gaining value solely because of the communities they participate in.
For example, Trivago owns no hotels. Yet, the platform serves as a medium of communication between hotel owners and people who want to book a hotel room. The same goes for OLX that sells products to consumers by connecting the owners with them. When more people, both consumers and owners engage in the platform, start-up gains its importance and improves revenue.