What is Network Effect?
When more usage (not adding number of users) of a product increases its value for other users, we can say that network effect is created.
Not all types of companies can have it and not all types of companies need it. This is just one way of growing.
For manufacturing companies, the companies whose products are displayed when a customer uses it usually have network effect. For example, when one goes to buy a phone, he/she prefers to buy a branded mobile like an Iphone. But when one goes to buy paint for your house, one doesn’t care whether it is from Asian Paints, Nerolac, or any other brand if the quality is the same.
How does it benefit your company?
Cost of maintaining network doesn’t grow as fast as the value of the network itself. But you need to be well prepared to handle high volumes before the network effect begins. If you won’t be prepared, your service or product quality will degrade or you won’t be able to meet the demand and eventually you won’t be able to take the benefit from network effect.
Types of networking effects:
Direct – increased usage directly leads to increased value. For example, Instagram, Facebook, etc.
Indirect – Increase in usage of the product spawns the production of increasingly valuable complementary goods, and this results in increase in value of original product. For example, windows (both direct and indirect), apple (app store), etc
Two-sided – Increase in usage by one set of users increase its value for the other set of users. Eg. Airbnb (more people who want to rent a house will attract more people who want to give house on rent), Uber(more drivers will attract more people who want to a cab), Ebay(more sellers will attract more buyers),etc.
Main hurdles in creation?
The major hurdle one faces in their company while creating Network Effect is that they are unable to develop a successful strategy to acquire a critical mass to start the network effect.
How is it created?
You need to attract a minimum number of people who can start the chain reaction to bring about network effect. You can’t attract critical mass with a network effect. You need to provide some additional benefit to attract customers. For example, when Instagram started, it provided free photo filters. One could also easily share pics on Facebook, Twitter and Instagram. Eventually people started sharing on Instagram.
Another way is to start with a small and niche market and try to dominate it. Once you have dominated the smaller market, try to expand slowly and steadily. Eg. Facebook started in a small market (Harvard) and then the awareness spread due to word of mouth, demand increased and then it was launched in bigger markets. Then there is a different approach known as Content network model. Here, the company provides users the tools to create content and then enable conversations around the content. For example, Twitter, Pinterest, LinkedIn, Behance, Instagram, Quora, etc grew by this method.
How can it be destroyed?
If the network effect has already started off and demand is being created and you at that point of time are not well prepared, you will lose the golden opportunity. Eg. You have an online platform and when too many people came, your speed slowed down.
Your network effect can be destroyed if a new player enters the market with better features and he/she has also started a network effect in his /her company, your market share might reduce. But here, you can easily make out what your competitor is trying to do and accordingly take effective steps to retain your customers before the result of your competitors network effect comes out.
Application in Finance:
Warren Buffer said “Its great to own a business that even a monkey could run- because sooner or later, one will.”
When looking for companies to invest money in, look for companies that have a good network effect. Here, the existing customers do the work of bringing in more customers and so management has to do considerably less wok in customer acquisition. This builds an impenetrable moat for the business!
Kashvi Gandhi 