Network Effects Definition and Strategy

Many more recent strategies and projects have at their roots the idea of ‘network effects’. At the most basic level, network effects occur when the value of a product, service, or platform increases simply because the number of users increases.

This post focuses on initial background about network effects: history of network effects, network effects definition, some examples of network effects, and ways to achieve the benefits of network effects.

History of Network Effects

networks effects definitionNetwork effects exist in any network, and while the internet and its continuing maturing have taken it to a whole new level, the effects of networks on the evolution of organizations has been around for a long time.

Going a way back, think about the pony express for delivering mail around the United States back even in the 1800’s. Using the most basic definition of network effects, I think it is fair to say that the value of the pony express service increased as the number of users increased.

Now consider old-school landline phones. Truly there was an incremental benefit gained by an existing user for each new user that joined the network.

Consider one more historical network – railroads, which are decidedly low tech. Standardization on rail gauge – the exact size and configuration of the rails that the trains ride on – provided the basis for the network effect. Once standardization was in place, the value of the rail service increased for all users with each new user that joined the network.

Similarly, the value of financial exchanges, cryptocurrencies, software, web sites, and credit cards has increased for all users with the addition of each new user.


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Network Effects Definition

Let’s examine some different approaches to defining Network Effects.

A Harvard Business School Online article What Are Network Effects? states that the term network effect refers to any situation in which the value of a product, service, or platform depends on the number of buyers, sellers, or users who leverage it. Typically, the greater the number of buyers, sellers, or users, the greater the network effect—and the greater the value created by the offering.

It further outlines two types of network effects:

  • Direct network effects – occur when the value of a product, service, or platform increases simply because the number of users increases, causing the network itself to grow.
  • Indirect network effects – occur when a platform or service depends on two or more user groups, such as producers and consumers, buyers and sellers, or users and developers.

Investopedia says that a Network Effect is a phenomenon whereby increased numbers of people or participants improve the value of a good or service, providing the internet as an example. Initially, internet users (and beneficiaries) were restricted to military and some research scientists. Increased participation led to increased benefits to users, which led to increased advertising potential and increasing commercial value.

Wikipedia says that in economics, a network effect is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products. As the demand side counterpart of economies of scale, network effects increase a customer’s willingness to pay. It is broken into two distinct effects:

  1. Total effect – an increase in the value to all other users
  2. Marginal effect – the enhancement of other non-users motivation for using the product

Finally, What are Network Effects?, by Nicholas L. Johnson, advises that by understanding network effects first, platform designers can implement higher platform growth techniques. Besides asserting that network effects are the incremental benefit gained by an existing user for each new user that joins the network, it also cites direct and indirect network effects as above.

Examples of Network Effects

The following are some examples of some areas where network effects can be important:

  • Social media – We all need other people to communicate with – more people creates more value
  • Microsoft Office – When other people have compatibility, it is easier to share documents
  • Apple operating system and Apps – The more people choose an Apple iPhone, the more attractive it is for business to promote Apps, which produces a two-way network effect as the growth in Apple iPhone makes producing Apps more profitable.
  • Bitcoin – The more people use and accept bitcoins, the more attractive this digital money becomes.
  • E-Commerce: The more people that use e-commerce, the more valuable it becomes for everyone. eBay, Etsy, Amazon, and Alibaba are among the majors that benefit, and many businesses and other organizations of all sizes have the ability to build sub-networks of increasing value.
  • Ticket Exchange: StubHub, Ticketmaster, and SeatGeek have leveraged the network effect to create large communities for purchasing and selling tickets.
  • Rideshare: Uber and Lyft has disrupted the taxi industry with a unique ‘two-sided’ network that includes drivers on the sell side and riders on the buy side.
  • Delivery: Grubhub, DoorDash, Uber Eats, Instacart, Postmates, and others include growing networks that build competitive advantage as the networks grow.
  • Social Media: Facebook, Twitter, Instagram, LinkedIn, Snapchat, Pinterest are among the most obvious examples that increase the value of the network to all as they grow.

Nuances of Network Effects

Network effects are something that builds over time.

It is critical that project managers understand what network effects are all about and what specific network effect(s) are at work on their project. This will enable them to design useful metrics.  The purpose is to monitor progress toward the ultimate goal to leverage network effects.

The following are some interesting observations and insights that have been made about network effects:

  • Markets in which network effects play a major role are often referred to as ‘winner-takes-all markets‘. Once you’re ahead, you tend to stay ahead; your demand grow even faster as you get bigger. An example is Facebook.
  • Positive network externalities – like ‘people follow the crowd‘ – can lead to a network effect. The quantity of users required for significant network effects is called the critical mass. Self-sustainment can occur if too many people use a good or service and congestion is created.
  • Markets with network effects may result in inefficient equilibrium outcomes. With simultaneous adoption, users may fail to coordinate towards a single agreed-upon product, resulting in splintering among different networks, or may coordinate to lock-in to a different product than the one that is best for them.

Conclusion and Ideas for Action

Network effects have been around in some form for a long, long time. Information technology and especially the internet have spawned an explosion of opportunities for organizations of all types to take advantage of network effects.

The key is to realize that network effects are available broadly and apply to many, if not most, situations.

Network effects are not just available to the Facebooks, Googles, and other tech giants of the world. If you can find the opportunities for employing network effects even is just a segment of your project, program, and organization, you can grow your success by a multiple of what you might otherwise achieve.


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