The concept of network effects is a powerful mental model through which to evaluate businesses, startups, money, society, and nature.
But what are "network effects" and how do they work?
First, a few definitions.
A network effect is a phenomenon by which each incremental user of a product or a service adds value to the existing user base.
The product or service becomes more valuable to the users as more people use it. It's a positive feedback loop.
The idea originated with Theodore Vail, the president of AT&T. In the company's 1908 annual report, Vail wrote, "The telephone's value depends on the connections with other telephones - and increases with the number of connections."
For an existing user, this value increases with every telephone added to the network.
The concept of network effect was popularised when Metcalfe's Law entered the lexicon. It stated that a network's inherent value is effectively equal to the square of the number of users in the network. New analysis shows that the relationship between users and value is not that simple but the fundamentals still hold.
More users = more value per user.
Let's illustrate with a simple example.
Imagine a telephone network. If there are two telephones in the network, there is only one possible connection.
If you add a third telephone, there are three potential connections. If you add a fourth, there are six. And so on...
The key point here is that the fourth telephone user added more value to the network than the third telephone user.
Each incremental user adds more value to the network than the prior incremental user.
Language, religion, and early forms of money all exhibited and benefitted from network effects. There are two core types of network effects:
Direct Network Effects
Indirect Network Effects
Let's cover the basics of each type.
Direct network effects are clean and simple. They exist when the increased usage of a product leads to increased value of the product to each user.
Indirect network effects are more nuanced. In an environment with two sides: supply-side and demand-side, indirect network effects exist when new users on either side add incremental value to users on the opposite side.
For example, in the Uber business model, drivers are the supply-side and riders are the demand-side users.
New drivers add value to existing riders (access, availability, lower wait times).
New riders add value to existing drivers (more rides, less downtime).
The indirect network effects of the Uber business model created powerful growth loops. More riders led to less driver downtime, which encouraged new drivers to join, reducing rider wait times and encouraging new riders to join.
When network effects are present in a business model, the environment tends to become winner-take-all (or most), there is a high first mover advantage. This often leads to a mad rush to raise and deploy capital to accelerate user growth at the cost of turning a profit.
The concept of network effects is an extremely powerful mental model to have in your toolkit for the modern, technological age.
A few examples in present day that you could benefit from.
Bitcoin network effects
The more people and institutions turn to Bitcoin as a store of value, the greater the incentives of miners to secure the network and maintain integrity. New users benefit from the value they create via price appreciation, driving more user growth.Clubhouse network effects
The hottest new app on the block. New users create more value by increasing the quantity and quality of discussions on the platform. User growth attracts super users (like Elon Musk), whose presence attracts more users.
So here's a new tool in your toolkit - network effects as a powerful mental model to evaluate the world.