Demystifying Network Effects: Understanding the Value and Growth of Online Platforms

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Jul 22, 2023

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Demystifying Network Effects: Understanding the Value and Growth of Online Platforms

Introduction

In the digital age, network effects have become a key driver of growth and value for online platforms. These effects are often misunderstood, but they play a crucial role in the success of platforms like Airbnb, OpenTable, and Apple's App Store. In this article, we will demystify network effects and explore their various aspects, including retention, monopoly, hacks, and defensibility. We will also discuss the concept of viral growth and how it differs from network effects. By understanding these concepts, we can gain insights into the factors that contribute to the value and growth of online platforms.

The Value of Network Effects

Network effects occur when the value of a product or service increases as more people use it. This increased value can be seen in various aspects, such as better engagement, user rates, and customer lifetime value. As the network/platform scales, network effects also lead to better margins due to a reduction in customer acquisition costs. This trend can even lead to zero customer acquisition costs and activate a pull effect, where users are drawn to the platform organically.

Viral Growth vs. Network Effects

While viral growth can lead to economies of scale and cost-benefits, it does not necessarily make the product or service more valuable to its users. Viral growth focuses on the speed of adoption, while network effects focus on the retention, monopoly, and defensibility of the platform. It is important to note that as a network/platform grows, network effects become more valuable, while viral growth may not correlate with increased customer lifetime value.

Factors Influencing Network Effects

Besides the key driver of network effects, other factors contribute to the growth and value of online platforms. One important factor is the depth and choice of the offering and how entities are connected within the network. The way these factors influence, contribute, and reinforce value growth with size and participation is crucial. Figure 1 illustrates the starting point of a 2-sided network effect, while figure 2 shows how the brand value proposition perception increases as a reinforcing mechanism. Figure 3 demonstrates how technology improves with increasing access to data, and figure 4 explains how existing demand allows platforms like Airbnb to introduce integrative business models, such as experience hosting.

Critical Mass and Value Perception

Critical Mass refers to the number of participants or the size of the network needed to allow the platform to generate its own growth. This is achieved when the value perception of the platform grows faster than the growth of the network itself. For example, OpenTable found that they needed about 25 restaurants in a given city to attract guests and use the booking service, while Airbnb required around 300 homes per city to achieve its quasi-magic number. This magic number indicates the level of participation needed to reach critical mass.

Commoditized or Differentiated Supply

The type of supply offered on a platform can impact its network effects. A commoditized supply often leads to an asymptotic curve in network effects, meaning that the value reaches a plateau even when more depth is added to the offering. On the other hand, a differentiated supply can continue to drive network effects and increase the value of the platform.

Symmetry or Asymmetry of Supply and Demand

Most online platforms have asymmetric weights of supply and demand. This asymmetry can offer insights into which side of the platform to attract first. For example, when Apple launched the iPhone, they self-developed key applications because there was no economic potential for mobile app development at that time. Once the user base grew substantially, they opened access to developers. By subsidizing the supply side, Apple was able to anticipate the achievement of liquidity and the plateauing of network effects. Supply-side asymmetry and high frequency on the supply side often contribute to the anticipation of liquidity.

Flexibility of Location: Locally or Globally Bound

The level of localization within a network can impact its liquidity and critical mass. A locally bounded network may find it challenging to achieve liquidity on a global scale. However, the concept of liquidity in a heavily local network can be reimagined as a sum of different liquidity/critical mass events at a local level. The spill-over of value from a local sub-network to the larger network of networks is a crucial consideration.

Single Tenancy or Multi-tenancy

The type of tenancy within a network can also affect its network effects. Commoditized offerings often result in single tenancy, where users have limited options and are less likely to experience the full benefits of network effects. Artificial constraints are sometimes put in place to prevent single tenancy, particularly in public or regulated services that are platformized by institutional players.

Transaction Frequency and Lifetime

The frequency of transactions within a network is another key property that can impact network effects. In multi-sided systems, transaction frequency may vary depending on the relationship being focused on. High frequency on the supply side can help anticipate liquidity but may also contribute to the asymptotic plateauing of perceived value.

Actionable Advice

  • 1. Understand the unique value proposition of your platform and how it contributes to network effects. Focus on creating a compelling reason for users to join and participate in the network.
  • 2. Consider the depth and choice of your offering. Differentiated supply can continue to drive network effects and increase the value of your platform, while commoditized supply may lead to a plateau in network effects.
  • 3. Anticipate the achievement of liquidity by subsidizing the side of the platform that is most important for growth. By providing single-user value that doesn't necessarily depend on network effects, you can attract and retain users, leading to the eventual growth of the entire network.

Conclusion

Network effects are a powerful driver of growth and value for online platforms. By understanding the various aspects of network effects, such as retention, monopoly, hacks, and defensibility, we can make informed decisions that contribute to the success of our platforms. Additionally, considering factors like the depth and choice of the offering, symmetry or asymmetry of supply and demand, and transaction frequency and lifetime can further enhance the growth and value of our networks. By incorporating these insights into our strategies, we can harness the full potential of network effects and create thriving online platforms.

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