Introduction

Global Internet use, the emergence of cloud computing, and the phenomenal expansion and use of smartphones have affected practically every area of our lives during the last few decades. However, the effect of these technologies is not restricted to individual customers. Several firms in the technology industry have reaped substantial benefits from the “network effect”, i.e. the phenomenon in which the value of a product or service rises exponentially as more people use it. Consider WhatsApp and Instagram as illustrations. As more users join these applications, it becomes easier to locate friends, family, and groups with whom users may share photos, videos, and engage in different activities.

This is the second article in our series on “A Brief Overview of Moats: Creating an Undeniable Advantage for Businesses.” In this article we will analyse the network effects as a source of sustained competitive advantage.

The Network Effect: Definition

A network effect moat is a phenomenon through which the value of a commodity or service increases as more people use it. Network Effect refers to the network of a company’s services or consumers. Each new user increases the value of the company’s product or service and strengthens its competitive edge. It is also essential to keep in mind that not all network effects are inherently positive and may be detrimental to the business if the quality of service declines owing to an excessive number of consumers. However, the network effect moat is quite robust and the business may sustain longer even if it has few inefficiencies. Network effects can also contribute to the existence of high entry barriers. A network’s dominant participant enjoys a virtuous cycle that pushes the weaker networks to shrink.

The phrase “critical mass” is frequently associated with the network effect. If a product’s or service’s user base reaches a critical mass, the network will likely expand on its own. Before the network effect can be identified as a source of competitive advantage, it is crucial to assess a company’s capacity to monetize a network.

The Network Effect: Examples

Many prominent businesses and startups have significantly utilised network effects in their strategy. Few of them are listed below:

• E-Commerce: eBay, Etsy, Amazon, Alibaba
• Ticket Exchange: StubHub, Ticketmaster, SeatGeek
• Rideshare: Uber, Lyft
• Delivery: Grubhub, DoorDash, Uber Eats, Instacart, Postmates
• Social Media: Facebook, Twitter, Instagram, LinkedIn, Snapchat, Pinterest

The Network Effects: Types

Not every network impact is the same. They are frequently divided into direct and indirect categories.

Direct network effects arise when the value of a product, service, or platform rises merely because the number of users grows, hence driving the network to expand. Social media platforms are predominantly influenced by direct network effects since the value of the service increases as a direct result of drawing additional users. Same-side effects are another name for direct network effects. The telephone is another example of Direct network effects; it is only functional if the people needed to contact also have telephones.

In contrast, indirect network effects arise when a platform or service is dependent on two or more user groups, such as producers and consumers, buyers and sellers, users and developers, etc. Cross-side effects are also known as indirect network effects. As more members of one group join the platform, the value received by the other group increases. Using Uber as an illustration, when more passengers (consumers) join the platform, it becomes more helpful and valuable to drivers (producers) since there are more prospects for the business.

The Network Effects: Pricing 

Before setting a price for any product, service, or platform, an organisation must determine if the market is sensitive to network effects. This will play a crucial role in taking pricing decisions.

Businesses often price their items as high as possible without surpassing customers’ willingness to pay in order to maximise profit margin. However, when a market is prone to network effects, the primary issue is market share, especially in the early stages.

This is because the willingness to pay prospective consumers is contingent on the quantity of present users. By increasing market share early on, the owner of the business boosts market potential to increase pricing at a later point, when the organisation has maximised network effects and acceptance of service. For this reason, many firms first provide their products at low prices or for free.

The Network Effects: Optimization Using “5C”

In addition to user acquisition, platforms can be developed with network effects-enhancing features. The 5 C’s of Network Effects may be broken down into these five design steps: Connection, Communication, Curation, Collaboration, and Community.

• Step 1: Connection

The term “connection” refers to the process of onboarding new users and enabling them to locate other users on the site. How simple is it for users to locate the appropriate counter parties with whom they may share and cooperate on projects, purchase and sell goods and services, etc.?

• Step 2: Communication

Communication between users should be as smooth and unobtrusive as is humanly possible to enable the greatest amount of usability. In addition to that, a seamless mobile sync is an essential feature.

• Step 3: Curation

Curation preserves the usefulness and integrity of the organisation platform by keeping the user and content quality high and searchable. To guarantee the quality, platforms must pay attention to two aspects: user access (who is on the platform) and content/catalogue curation (what is on the platform). For instance, eBay prohibits the selling of living animals. From a design standpoint, it should be simple for people to locate any product, service, information, or rival.

• Step 4: Collaboration

Collaboration enables people to self-organise into new networks that push agendas that are personally significant to them. For instance, Etsy’s members sort themselves into categories based on their interests inside the marketplace. The subreddits of Reddit serve the same purpose inside the content platform.

• Step 5: Community

The last phase, community, gives consumers a sense of ownership over the platform, such as when a user amends a Wikipedia page, scores an app in Google Play, or reports offensive information on Facebook. It is, in a way, user-driven curation. It also offers platform management with crucial user input. For instance, what kind of content do Facebook users find offensive, and why?

Once a platform has optimised The Five C’s, the growth created by network effects may be a potent force that leads to scale that is impossible to achieve with linear business models. Curation and Community engagement and feedback offer consistent guardrails against out-of-control expansion, while Connection, Communication, and Collaboration entice users and keep them returning to the platform again.

Financial returns of network effects

As a platform grows in size, its per-unit expenses reduce logarithmically. In contrast, as sales expand, linear firms are bound by a U-shaped cost-per-unit curve. For an understanding of why, consider a timber company. Initially, the firm enjoys economies of scale as its operations become more effective and it is able to process vast volumes of wood at reduced prices. To target the complete potential market, the lumber firm must invest substantial resources in growing its ability to manufacture and sell more lumber and inventory.

In contrast, a platform expands not via the purchase of additional assets, but through the acquisition of additional users, which costs lower as the existing user base increases. When Uber wants to add more vehicles to its platform, for instance, it only has to recruit more drivers to its network, not buy a fleet of automobiles. This is a significant cost advantage to the business.

Conclusion

The strongest types of competitive advantage create network effects in the business. While these moats are comprised of platforms, not all platforms are suitable for network effects-based moats. Likewise, not all networks have moats. Due to the breadth of their moats’ competitive advantages, these firms are exceptionally difficult to displace. However, such moats are relatively uncommon. In a world where every technologically driven company is lauded as a network effects firm, this article presents how a network effect can be created for a platform and how the business pricing relates with the network effects.