Network Effects
A powerful mental model through which we evaluate businesses, start-ups, money, human societies, and nature.
Building connections that really matter. It’s why we exist, and why we do what we do. But how can you capitalize on the concept?
First, a little history.
Network Effects1 can be defined as the phenomenon by which each incremental user of a product or service adds value to the existing user base.
It’s a positive feedback loop.
The product or service become more valuable to the users as more people use it.
The idea of Network Effects originated with Theodore Vail, the president of AT&T (American Telephone and Telegraph) in the late 19th and early 20th century. In the company’s 1908 annual report, Vail wrote:
[The telephone’s] value depends on the connection with the other telephones—and increases with the number of connections.
While it took until the 20th century for the concept of network effects to become identified and popularized, it’s been a core feature of human society for at least a millennia.
Religion, language, and early forms of money all benefitted from network effects.
Types of Network Effects:
Direct Network Effects
Clean and simple. They exist when the increased usage of a product leads to increased value of the product to each user.
More users - more value per user.
Indirect Network Effects
More complex. In an environment with two sides,—supply side and demand side—network effects exist when new users on either side add incremental value to users on the opposite side. The Uber business model is a class example of indirect network effects:
Drivers are supply side users. Riders are demand side users.
New drivers add value to existing riders—easier access, lower waits.
New riders add value to existing drivers—more rides, less downtime.
The indirect network effects of the Uber business model created powerful growth loops. More riders led to less driver downtime, which in return encouraged new drivers to join, reducing rider wait times and encouraging new riders to join.
When network effects are embedded in a business model, the environment tends to become a winner-takes-all mentality. This often leads to a mad rush to raise and deploy capital to accelerate growth and become the market winner.
Conclusion.
The concept of Network Effects is an incredibly powerful model to understand. The most innovative companies of today and tomorrow will be grounded in the concept.
Take Clubhouse for example, the invite-only audio-chat social networking app—also known as the HOTTEST new app—that launched in 2020. New users create more value for existing users by increasing the quantity and quality of discussions on the platform. The user growth in return attracts celebrity users like Elon Musk, who in return attracts even more users!
Overall, Network Effects are a powerful tool to have in your toolkit. Those that understand it, will capitalize. Those that do not, will stagnate.
Shout-out to Dr. Kieran Arasaratnam for teaching me this concept over Clubhouse and Instagram.