Network Effects - A comprehensive conceptual study of how network effects work

The network effect is a phenomenon whereby increased numbers of people or participants improve the value of a good or service. The Internet is an example of the network effect. Initially, there were few users on the Internet since it was of little value to anyone outside of the military and some research scientists.

However, as more users gained access to the Internet, they produced more content, information, and services. The development and improvement of websites attracted more users to connect and do business with each other. As the Internet experienced increases in traffic, it offered more value, leading to a network effect. Similarly, telephone services also enjoyed the same benefit.

Concept of Network Effect

The network effect can lead to a better experience for the users as and when more users participate and take an active part and the existing users can benefit from them and also encourage new users to join to obtain the benefit.

The network effect can be predominantly found in Social Media Industry. As more users join Social Media, more content is been created which makes the platform useful for the public. The network effect is what has led to the growth of Social Media giants like Facebook, Twitter, and Linkedin.

Multiple network effects have occurred from individuals joining social media platforms. As more users join and participate, companies looking to advertise their products and services rush to join these sites to capitalize on the trend. The increase in advertisers leads to more revenue for social media websites. As a result, the sites evolve and are able to offer more services to the consumer.

Network Effect vs. Network Externality

Although similar, network effects and network externalities have distinct differences. Network externality is an economics term that describes how the demand for a product is dependent on the demand of others buying that product. In other words, the buying patterns of consumers are influenced by others purchasing a product.

For example, if you see a lot of cars in a restaurant's parking lot, you might assume the restaurant has good food. As a result, you give it a try since all of those people can't be wrong. Trends in fashion also influence the buying patterns of consumers. Clothes routinely go in-and-out of style based primarily on copycat buying and selling patterns of consumers.

Positive network externalities can lead to a network effect. If a lot of your friends are on Facebook, you might join hoping to connect with them, which is a positive externality. If after you join, you post quality content, and that leads to many people enjoying the experience, it'll boost engagement–creating a network effect.

Strength of Network Effect

Less well acknowledged is the fact that the strength of network effects can vary dramatically and can shape both value creation and capture. When network effects are strong, the value provided by a platform continues to rise sharply with the number of participants. For example, as the number of users on Facebook increases, so does the amount and variety of interesting and relevant content.

It is possible for firms to design features that strengthen network effects, however. Amazon, for example, has built multiple types of effects into its business model over the years. In the beginning, Amazon’s review systems generated same-side effects: As the number of product reviews on the site increased, users became more likely to visit Amazon to read the reviews as well as write them. Later, Amazon’s marketplace, which allows third parties to sell products to Amazon users, generated cross-side network effects, in which buyers and third-party sellers attracted each other. Meanwhile, Amazon’s recommendation system, which suggests products on the basis of past purchase behavior, amplified the impact of the company’s scale by continually learning about consumers’ preferences. The more consumers used the site, the more accurate the recommendations Amazon could provide them.

“But any company that wants to leverage network effects will also face the high hurdle of attracting a sufficient amount of users to produce enough momentum for a network effect to even take place.”

This threshold is called the critical mass point, where the product’s value becomes greater than its cost, which is what ultimately attracts new users.

Before hitting the critical mass point, though, the cost of signing up for a product is greater than the value of signing up for it. To incentivize early adopters to sign up for their product, brands usually use discounts or referral benefits to lower the product’s price to the point where the value of subscribing is higher than the cost of subscribing.

Once companies can attract enough early adopters and users to surpass the critical mass point, they can start leveraging network effects. But they can’t just coast from that point on. Businesses must be able to sustain their network’s growth and to avoid congestion or saturation, they must align the growth of their staff and capacity with the growth of their user base.