Network effects and platform business models

What are network effects?

Network effects are the increase in a network’s value to its users as more users join. A telephone is useless alone and valuable when everyone you know has one. Many internet businesses are built on this idea: messaging and payment apps, online classifieds, social media and ride-sharing. Network effects also exist in older, pre-internet businesses such as telephone service, card payment systems and stock exchanges. Digital technology did not invent them; it made them cheaper and faster to build.

In all these businesses the key metric is the number of users and their growth rate. They draw on both economies of scale and scope, but they are not the same as scale. Economies of scale lower the cost of each unit produced; network effects raise the value each user gets.

Once a network reaches enough users, it becomes attractive to marginal users too, which further speeds growth. That threshold is its critical mass .

One-sided or multi-sided?

In a one-sided network only one type of user matters to the other users. Telephone services and peer-to-peer payment apps are examples: connections between users are what counts, and there is only one kind of user. Once the network is large enough, the cost of adding another user is lower than the revenue the user brings.

In a two-sided network , there are two types of user, such as buyers and sellers in an online marketplace. A multi-sided platform has two or more. Typical examples are card networks (cardholders and merchants), digital marketplaces (hosts and guests) and food delivery apps (diners, restaurants and couriers). As each group grows, it attracts the others: more diners bring more orders, which attract more restaurants and couriers, which attract more diners. These loops make multi-sided platforms capable of exponential growth.

	One-sided	Two- or multi-sided
Users	one type; all connect with each other	two or more types that need each other
Examples	a messaging app; a peer-to-peer payment app	a card network; a delivery app
Growth engine	more users, more people to reach	more buyers attract more sellers, who attract more buyers
Key metric	number and growth of users	users on each side and transactions between them

Network effectsvalue to each user rises as more users join

• One-sided network Memorize one type of user, all connect with each other
  • Telephone and messaging more people to reach
  • Peer-to-peer payments more people to pay
• Two-sided or multi-sided platform Memorize two or more user types that need each other
  • Card networks cardholders and merchants
  • Digital marketplaces hosts and guests, buyers and sellers
  • Delivery apps diners, restaurants and couriers
• Crowdsourcing Memorize often built in: users create the content or product

How fast does value grow with users?

A simple rule of thumb shows why platforms race for scale. If every pair of users in a one-sided network can connect, the number of possible connections between $n$ users is $n(n-1)/2$. Each of the $n$ users can link to $n-1$ others, and dividing by two stops each pair being counted twice. This is an illustration, not a valuation formula.

$$C = \frac{n\,(n - 1)}{2}$$

Ten users have 45 possible connections. One hundred users have 4,950. Users grew ten times, but connections grew about 110 times.

On a two-sided platform, only links between the groups count. Buyer-to-buyer links do not create value, so the count is buyers times sellers.

$$X = B \times S$$

What is crowdsourcing?

Network business models often include crowdsourcing , in which users contribute directly to the product or service. Examples include social media and short-video feeds, open-source software, wikis, and customer reviews and ratings. The company builds the service and sets rules, and the community supplies the content, with a small amount of moderation and oversight from the host. In effect, the company creates a service that users build.

Why do network effects create barriers to entry?

Network effects create strong barriers to entry and are a form of competitive advantage. A network’s value to each user rises with its size, so users gravitate toward the biggest network. A challenger must reach critical mass against a larger incumbent, and a challenger that merely matches the incumbent’s price still offers fewer people to reach. The result is that a few platforms often dominate, so industries with strong network effects tend to concentrate.

Exam tip Scale lowers the cost of each unit. Network effects raise the value to each user. Different advantage, same barrier.

Go deeper Disintermediation

Disintermediation is the displacement of an established intermediary. An online travel platform is itself a two-sided network (travelers and hotels); by automating research, price comparison and booking, it displaced many traditional travel agents and shifted the balance of power between agencies and hotels. The remaining agencies have to specialize. Hotels responded by investing in their own websites, customer data and direct booking.

Go deeper Network effects in industry analysis

When an analyst studies an industry, network effects show up as a barrier to entry and as a driver of concentration. A market where one or two platforms hold most users will show a high concentration ratio, and an entrant faces a harder path than in a market where customers can use several services at once. Ask whether users can easily use rival networks at the same time, and whether the platform charges one side and subsidizes the other.