All You Need To Know About Network Effects

Overview and Introduction

It is common to hear references to network effects as well as how marketplaces and online platforms may produce value more rapidly for various sorts of user groups as per this innovative phenomenon. At first look, the notion of network effects may seem to be complicated to understand, yet it is really rather simple. By first comprehending network effects and what they precisely are, platform strategists start incorporating platform growth methodologies into their systems and enhance their network’s fundamental working mechanics.

What are Network Effects?

The network effect is a phenomenon that occurs when a large number of individuals or players contribute to the enhancement of the price of an investment, service or resource. The internet serves as an illustration of the network effect. It took a long time for the world wide web to gain popularity since that was of limited usefulness to anybody beyond the armed services and a small number of academic researchers in its early days.

Nevertheless, as more people acquired a connection to the web, they created more material, knowledge, and applications for others to enjoy. Increased user connections and commercial transactions were made possible as a result of the creation and enhancement of websites. As the internet traffic increased, the service became more valuable, resulting in the phenomenon known as the network effect. Network effects may be seen in every network, whether it was the Pony Express, old-fashioned home phones, the world wide web, or platform-based computing systems. The additional advantage earned by an individual user with each user account that discovers and joins a connection is referred to as network effects.

For example, if you are creating an online organization, this phenomenon will manifest itself with the introduction of each new member. With each new recruit who reaches your organization, you, your business, the society, and its participants gain in value as a result of their participation. Those who have joined then urge everybody else to join, which increases the group’s overall value. This results in a feedback loop in which extra users provide greater value, which then, in turn, encourages other customers who generate much more importance, and so on. Network effects are often progressive in nature and result from a prospective client receiving incremental benefits from your goods or services as a result of the large number of other individuals who are utilizing it.

In other words, a phone is only functional if it is shared by a group of individuals (called users). In the case of a single phone, the usefulness of the telephone system is zero since they are unable to make use of the network in any way. Who would you call or text if no one else has the same gadget as you do? A second user’s telephone means that the very first person may contact the second man, and if doing so is useful to both of them, the networking has escalated in its significance this way. The telephone company is very important to all users if everyone has access to one of the mobile phones, such as your close friends, governmental organizations, telecommunications companies, and so on.

Consider the first moment the police department connected to the phone system and began providing the immediate call service 9-1-1. It was a momentous occasion. Because of their participation in the network, the new customer (police departments) added considerable importance to all other smartphone owners.

Although, the phone network is a straightforward example, it only provides for one form of network impact. Network impacts may be classified into two categories: direct network effects and indirect network effects, which we’ll study in-depth in the next paragraphs. However, it should be noted that phones get the benefits of direct network effects, while platforms reap the benefits of indirect network effects. This distinction is really critical to the explosive growth of platform business strategies that we have experienced in recent years.

How Do Network Effects Work?

Let’s talk about how the network effect operates right now. A network effect occurs when such an increasing number of individuals engage your group or make an investment in your goods or services, even at the most fundamental level. When a newcomer enters, they bring with them their individual unique views, insights, and knowledge, which adds to the overall worth of the organization, including you, your business, and your membership.

Since the network effect allows you to concentrate less on constantly creating new material, it is a huge benefit for a content provider. You may devote less time and energy to creating new material due to this phenomenon. Within a flourishing network, the important ideas and skills that your participants share with one another will maintain the debate going long when you have already released fresh material for any of them to consume and discuss. The value of your products has increased as more individuals use them, such as a transportation company. This is especially true if your product depends on obtaining a critical threshold of customers. Why? Since the greater the number of people who use your company, the greater your capacity to reduce prices, expand accessibility, and maintain a high level of demand. Oh, definitely more profit for you and your firm!

What are the Different Types of Network Effects?

The network effect occurs with each new user who joins the old network, boosting the usefulness or value for all current users. The network begins with a basic number of customers, then expands and links additional people in the chain until it reaches a certain level of connections. The pace of this network effect subsequently keeps increasing alongside co-creation, as the users naturally subscribe for the economic benefit they are receiving from the co-creation. Let’s have a look at some of the many forms of network effects:

Direct Network Effect

When users immediately profit from the introduction of new users, this is referred to as a direct network effect or a same-side network impact. A direct network impact is directly proportionate to the number of people who used the initial product. Users who already have access to the internet, for example, will gain from the increase in the number of online users. As an illustration, consider the telephone. It will be of service to you only if the individuals you want to contact are also equipped with telephones. The greater the number of individuals who have smartphones, the more beneficial it is for you to get one as well.

Indirect Network Effect

On the other extreme, the indirect network effect, also known as the cross-side networking, occurs when the number of consumers of the genuine products increases not as a result of any direct benefit but as a result of the influence of a given commodity that prompts the usage of more goods. It occurs when a network or program is reliant on two or more customer segments, such as users and programmers or producers and consumers, for its operation to be successful. As more individuals from one group join the network, the other party earns a larger sum of money in exchange for their participation. For example, current Internet users will gain from the introduction of new users that will be produced as a result of the availability of low-cost laptop computers on the market in the near future.

Bilateral and Local Network Effect

Whenever there is a growth in customers of a complementary product and consumers of that product gain; as a result, the term “bilateral network effect” is used. For example, the usage of the Internet has increased as a result of the growth in the number of smartphone owners. The complementary relationship between the two items increases the number of worldwide web users. On the other hand, local network effects are defined as situations in which a user’s benefit is influenced by a smaller handful of participants instead of the whole handful of participants. As an illustration, if a user of messaging service has acquaintances who also use the same online messaging software, he will profit from this, but he’ll never profit from such an increase in the overall number of users of messaging service.

What are some of the Present-Day Implications of Network Effects?

Though there are a number of examples of businesses that have worked around the idea of network effects, here are some of the most-known and eminent ones: 

A marginalized resource and networking group, In the Cut, was founded by Rae Benjamin in 2009 with the goal of giving tools and relationships to underprivileged artists seeking to break through into the movie, television and music industries. Since its inception in 2020, In the Cut has rapidly expanded in scope, and it presently has more than 1,000 participants. They provide paid seminars, job ads, a community of similar-minded content creators, and even conduct virtual gatherings on their efficient network base.

Airbnb has swiftly established itself as the go-to network for individuals who want to rent out their houses for short term rentals to travelling consumers. Their success is an illustration of something like a network effect since, as more individuals engage the network in search of a place to rent, the attractiveness of the marketplace improves while providing property owners with a steady stream of new business. Furthermore, renters benefit from the increase in the number of homeowners who make their houses available for rent since it gives them more alternatives to select from. The more diversity, the better it is. As more tenants and landowners sign up for the portal, the potential of the substrate network increases in valuation, which is exactly what a network effect is.

It’s no surprise that Facebook has had a profound impact on the way we generally think about social networking sites. Their platform has more than two billion active users and is a crucial illustration in every discussion about network effects that are held in the media. As more individuals embraced their platform, its worth as a social media platform rose, and they were able to outperform its competitors at the time, such as Myspace. It’s vital to emphasize that Facebook itself profits from their widespread adoption rather than the content providers who are distributing their work and building Groups on the social network.

Jordan Melnick founded Sktchy Art School as a place for passionate artisans who needed a platform to put their art pieces together, learn new techniques, share their knowledge and receive criticism on their own production. Melnick’s community has expanded to include over 14,000 individuals since its inception in 2018. Members who belong to this organization may attend art lessons, engage in group art competitions, and communicate with other members of a rapidly expanding artistic community.

What is the Connection Between Network Effects and Cryptocurrencies?

I am sure you’ve definitely come across the word “cryptocurrency” and have searched about it over google. Without a doubt, it’s one of those glooming advancements that is paving the way toward a more digital and secure financing world. Like other social media platforms, network effects are a vital aspect to consider when it pertains to cryptocurrencies and blockchain-based technological systems. Take, for example, the cryptocurrency Ethereum. Eth has a number of very desirable characteristics, a large number of investors in it, and a significant, really significant, network impact.

Miners are important for computer security, and they have a lot of cash on hand to keep their businesses running. However, suppose a new network is developed with the goal of serving a similar use application to that of Bitcoin. Miners may receive bigger payouts, but they may not have the same flexibility to liquidate their holdings as they would otherwise. They might take a chance and anticipate that liquidity will become more plentiful in the coming years. Alternatively, they might just continue processing bitcoin with a high degree of confidence that they will be stable in the market. That’s how a network effect works in real life. If the competitor was substantially better or offered more incentives, it would not always be a good idea to change. After everything is said and done, it should be noted that this is not only due to Bitcoin’s network effects. Bitcoin has essentially unique qualities that would be exceedingly difficult to recreate if it had not been launched fairly.

Network effects are an essential consideration in the Decentralized Finance (DeFi) domain, as well as other areas of computing. Characteristics owned by a company, organization, or perhaps even smart contract may be really tough to handle if any other ventures replicate it. DeFi, on the other hand, is still in its infancy. Many of us would say that no item has yet reached a network effect that allows them to be a clear and definitive champion.

What Are the Advantages and Disadvantages of Network Effects?

Like every other technology ever made, the network effect has both advantages and disadvantages, which we’ll now consider. 

The most difficult obstacle for any business or product that uses the network effect is acquiring traction or attracting sufficient customers at the outset. The network effect can take root and become widespread. The critical mass is in actuality, the percentage of participants necessary for substantial network effects to be felt by the organization. When critical mass is reached, the product or service draws a large number of additional users as a result of the network’s usefulness or advantages to the users. This is one manner in which the promise of the network effect might assist businesses in their efforts of becoming self-sustaining.

Yet another beneficial aspect of the network effect is that it motivates entrepreneurs and intellectual property producers to develop more effective and distinctive items to offer to the general market in order to increase their profitability and popularity.

Congestion, on the other hand, may arise when goods or services are used by an excessive number of individuals. When it comes to the Internet, for illustration, having a thousand of users on the very same remote system might cause the network to slow down, so reducing the value to the consumers. It is the responsibility of suppliers of products and services who benefit from the network effect to guarantee that availability can be raised adequately to satisfy all consumers. Another possible drawback of the network effect is that, after a firm has achieved and maintained critical mass, this could tend to be much less competitive and inventive, understanding that they’ve had a large and loyal customer base to draw from.

Final Thoughts

It is possible to have network effects in many different economic sectors, particularly cryptocurrency. The concept is that when new customers join the network, they contribute to its overall value. Those involved in the creation of blockchain-based systems or any other online platform might gain a great deal from understanding the processes that cause network effects.

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