The “network effect” is one of the most powerful ideas in technology and business. The idea is that the more users there are in a network, the more valuable the network becomes.
Network effects are a big deal for both businesses and investors. For companies that have critical masses of users and have established lock-in, it can mean profits that grow and grow and grow. It also means that investors may be willing to have a company they fund lose money for a while if they have a shot at becoming the number one business in a field with network effects.
We can see networks in all sorts of businesses, but especially ones based around the internet, which connects individuals to one another. There are network effects in the internet, in social networks, and in digital products like cryptocurrencies.
What Is a Network Effect?
The basic idea behind network effects comes from a relatively old form of technology: the telephone. Imagine you’re the first person with a landline telephone installed. You can pick it up and listen to a dial tone, but without anyone else with a telephone, it’s merely a sculpture plugged into your wall. If you had to pay for it, the phone is perhaps of negative value, unless you really like how it looks.
But there’s value for the second person getting a phone installed—after all, they can call you up and you can call them. As more phones get installed, the value of the phone network increases. When there are strong network effects, the value of new users rises for existing users as more and more users are added to the network.
How Does the Network Effect Work?
Network effects are crucial for basically any internet-related business, including the web itself. One of the most influential attempts to quantify network effects comes from Robert Metcalfe, the co-inventor of Ethernet. He maintained that the value of a network grew as the square of its number of users.
Following this line of thinking, the value of the network to the customers or users would grow exponentially while the cost of adding new users grows linearly. For businesses that can establish network effects, then, it may make sense to invest very very heavily in user growth, even if it means losing money in the short run.
What are Businesses with Network Effects?
There are a number of modern-day industries that benefit from network effects.
Communications Networks
Network effects apply to parts of communications infrastructure that are not exactly businesses per se. For example, the World Wide Web, which is a platform for all sorts of nonprofit and for-profit activity and is not controlled by any one company, is characterized by network effects.
Marketplaces
Online marketplace eBay is a useful look at how network effects work in marketplace businesses, where a service tries to connect buyers and sellers. One reason eBay was so successful in its early years was that it achieved “lock-in” (the point where it doesn’t make sense to go to other services) for individuals wanting to auction items online. It did this in part by making the service free for sellers in its early days, attracting new users eager to make money off their items.
Social Networks
Perhaps the most prominent example of businesses characterized by network effects are social networks. Facebook, YouTube, Twitter, and other social networks improve for users as more users, usually people they know or are interested in, use them. Once everyone you know is on a social network, it may become harder to avoid and easier to simply succumb to signing up.
Cryptocurrency
If the previous examples of network effects were internet infrastructure or internet businesses, cryptocurrency may be a combination of both. Some cryptocurrencies are incredibly valuable and have built up an ecosystem of service around them.
As more people consider Bitcoin to have value, it creates an incentive for miners to secure the network—the network effect at work. In the case of Ethereum, as more apps are deployed, each one becomes a building block. This drives increased usage, and ultimately more demand for Ethereum.
In both cases network effects are a sign that the cryptocurrency could have staying power: If it does something useful for its holders, it may do something useful for people who buy in.
Granted, many other cryptocurrencies have flamed out. One big question going forward is the extent to which crypto can be characterized as having network effects — driving greater organic usage, rather than people primarily viewing cryptocurrency as an investment.
The Takeaway
A network effect is an idea that as a product or service gets more users, it will inherently attract more users — thus creating a pattern of success. The network effect can be seen most clearly in communication technology, including digital products and services like social media. For investors, it can be smart to keep an eye on the network effect in businesses you’re invested in, or are considering.
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