Network Effects

"Over the past 26 years, Network Effects have accounted for approximately 70% of the value creation in tech" ~ nfx.com

Metcalfe's Law

Network effects occur when a product or service becomes more valuable to its users as more people use it. You have a much better chance of success if your start-up leverages Network Effects. It follows "Metcalfe's Law" which states that the utility of the network is proportional to the square of the number of users of this network $\approx n^2$. This is due to the fact that the number of unique links in the network with the number of nodes ($n$) can be mathematically expressed by the triangular number $\frac{n\cdot(n-1)}{2}$, which asymptotically approaches $\frac{n^2}{2}$.

In practice, this means that if one link in the network brings a person 1 conditional benefit unit, then for a group of 10 people this benefit is 45 conventional units, 100 people - 4,950 conventional units, and so on, - grows in quadratic dependence. The law caused a boom in the appearance of dotcoms.

Network Effects does 2 things: it creates barriers to exit for existing users, and creates barriers to entry for new companies. e.g Youtube, the more people that are on the service, the better it is for everyone else. For Airbnb, the more people hosting, the more people use the service

However, the challenge of network effects is how do you reach "critical mass". This is the typical chicken and egg problem. 4 metrics for kick starting network effects:

1. Come for the tool, stay for the network
   • Initially attract users with a single-player tool and then, over time, get them to participate in a network.
   • E.g. Instagram's tool was the innovative photo filters.
2. Grow your network with bowling pin strategy
   • Constrain your problem to a small network/niche. Dominate that network, and then move onto a new/broader network/niche. For example, Facebook focused on just universities. They then moved onto other universities.
   • Keep a few customers, keep validating your problem and learn from feedback
   • Don't try to address ALL the people/network straight away
3. Bootstrap on the back of other companies to tap into their existing network
   • e.g. the original Airbnb posts were on craigslist. This way you create a create "two-sided marketplace"
4. Subsidize one side of your network
   • This method involves making it cheap to begin with to build the network and seed the platform.
   • Provide discounts to incentivize early adopters in the hope that they tell their friends and family about the product.
   • Once they're on the platform, you can monetize later
   • Google Maps essentially works like this - the more consumers, the more traffic data, better data to improve maps. It is in Google's interest to offer it for free.

Always consider if your business venture has network effects and how you can attract a network to your business. Is this important enough strategy to focus your business on from the beginning? YES. If you can incorporate these effects, then leverage the benefits! Network effects are hard to gain and it may be difficult to reach a tipping point in which the business can grow rapidly, however once this point is reached, the scale on which the business can operate will be enormous.

Platforms

The business landscape has been profoundly transformed by the emergence of platform businesses, a phenomenon analyzed in two books: "Platform Scale" by Sangeet Paul Choudary and "The Business of Platforms" by Michael A. Cusumano. These books provide insights into the evolution, operation, and influence of platform businesses.

The Emergence and Evolution of Platform Businesses

Choudary's "Platform Scale" gets into the shift from traditional linear business models ("pipes") to platform-based models. Traditional businesses (pipes) create and push value in a linear flow, while platforms allow a multidirectional flow of value, enabling interactions among users and resources. The platform model, exemplified by Google and Uber, underscores a significant shift in how businesses are structured and how value is created.

Cusumano's "The Business of Platforms" complements this by tracing the historical development of platform strategies. The book illustrates the inception of platform thinking in the tech industry, notably through Microsoft's collaboration with IBM on MS-DOS, marking a shift from product-focused strategies to ecosystem-building.

Key Shifts in Business Models

"Platform Scale" identifies three crucial shifts:

1. From Consumers to Producers: Platforms enable users to assume roles of both producers and consumers, contrasting with the traditional one-way value flow in pipe models.
2. From Resource Ownership to Ecosystems: The value in platforms arises from orchestrating interactions within their ecosystems rather than from owning resources.
3. From Processes to Interactions: Value creation in platforms is centered around dynamic interactions between users, a departure from linear processes.

"The Business of Platforms" expands upon these ideas, categorizing digital platforms into two types: innovation platforms and transaction platforms. The difference between innovation platforms and transaction platforms lies in their primary functions and how they interact with users and businesses:

1. Innovation Platforms: These are like foundations or building blocks used to create other products or services. Think of them as a base upon which other companies or developers can build their own unique offerings. A good example is a smartphone operating system like Apple's iOS or Google's Android. These platforms provide the necessary technology and environment for developers to create and offer their apps to users. The more apps available, the more useful and attractive the platform becomes, creating a cycle where new apps attract more users, and more users attract new apps.

2. Transaction Platforms: These platforms are more like marketplaces or intermediaries that facilitate exchanges between different groups. They are mainly about connecting people so they can buy, sell, or exchange services or goods. Examples include Amazon, where buyers and sellers come together for transactions, or Uber, which connects drivers with people who need a ride. The value of these platforms increases as more users join, since this brings more choices for buyers and more potential customers for sellers.

In essence, innovation platforms are about creating and expanding an ecosystem of products or services, while transaction platforms are focused on facilitating interactions or transactions between different users.

Network Effects and Market Dynamics

Both books emphasize the significance of network effects in platform businesses. Choudary explains how platforms grow through network effects, where increased user engagement enhances the platform's value, thus attracting more users. Cusumano further elaborates on this, describing how platforms generate value by connecting multiple market actors, thus creating a multiplier effect in utility and value.

Platform Strategies and Business Models

Cusumano’s work goes into the strategic and operational differences between innovation and transaction platforms. He highlights that while both platform types follow similar steps in building their businesses, they engage different market participants, face unique monetization challenges, and oversee different types of ecosystems. For example, the unique monetization strategies for innovation platforms and transaction platforms reflect their different functionalities and user interactions:

1. Innovation Platforms:

   • Licensing Fees: Charging for the use of the platform itself, like Microsoft does for Windows.
   • Selling Hardware: Some platforms make money by selling the hardware that their platform operates on, like Apple's iPhones.
   • Revenue Share from Sales: Earning a percentage from sales made through the platform, common in app stores where the platform takes a cut from app sales or in-app purchases.
   • Subscription Models: Charging for ongoing access to the platform or premium features, as seen in cloud services like Amazon Web Services or Microsoft Azure.
   • Advertising: Displaying ads within the platform, often seen in free-to-use platforms or alongside other monetization methods.

2. Transaction Platforms:

   • Transaction Fees: Charging a fee for each transaction processed through the platform, like eBay or Airbnb, which take a percentage of each sale or booking.
   • Subscription or Listing Fees: Charging businesses or individuals for listing their products or services on the platform.
   • Freemium Models: Offering basic services for free while charging for premium features, as seen in platforms like LinkedIn.
   • Lead Generation Fees: Charging for providing leads to businesses, common in service-oriented platforms.
   • Advertising: Similar to innovation platforms, transaction platforms can also generate revenue through targeted advertising based on user data and preferences.

Each type of platform leverages its unique ecosystem and user base to create revenue streams that align with the value it provides to its users. Innovation platforms often focus on enabling and profiting from the creations of others, while transaction platforms typically monetize the connections and transactions they facilitate.

Challenges and Future Directions

Both authors address the challenges faced by platform companies. "Platform Scale" offers insights into community management, liquidity management, and the importance of data in orchestrating ecosystem interactions. "The Business of Platforms," meanwhile, discusses the dilemmas conventional companies face in adapting to digital competition and the governance challenges inherent to digital platforms.

Resources:

• The Business of Platforms, Michael A. Cusumano
• Platform Scale, Choudary, Sangeet Paul