Network Effects: the Principles that Govern How Networks Emerge and Compete
June 14, 2010
Senior Managing Director, Entertainment, Media & Digital
How do many-to-many networks emerge? How do they compete? LinkedIn will IPO this year and Facebook is contemplating one. eBay is already public. And venture capital is chasing every startup that might produce the next huge collaborative network. In this article we summarize the key underlying principles that govern the emergence, growth and competition of net-work-driven businesses.
In this paper we describe the key economic rules that govern the emergence, growth and competitive behavior of many-to-many networks. These networks masquerade as social networks, exchanges, peer-to-peer sites, telephone networks, chat networks, dating sites, tweets, wikis, etc. But at the heart of them all is the key element that the network becomes more useful as more people join. Such networks at scale have extraordinary resistance to competitors because participants want the largest gathering place possible. As we write this, Facebook now has 700 million members and will probably reach a billion before the end of 2011. Today it is estimated to be worth over $100 billion dollars. Several of these networks like LinkedIn are gearing up for their IPOs. YouTube was bought by Google for $3 billion, and eBay is the largest auction site in the world. As we write this article, the VC community is scrambling to fund any startup that exhibits these “network effects”.
The companies that master these network effects are the ones most likely to prosper disproportionately in today’s internet economy.
On the internet it is easy to create these types of networks. Unlike their physical equivalent, such as a capital-intensive cell-phone network, these virtual internet networks can be set up in days. Economists have been studying the behavior of networks for quite some time in a field they call network economics. It is the study of goods and services whose usefulness is determined, in whole or in part, by the number of other consumers that use them. They say such goods and services exhibit “network effects” or network externalities. Several books such as Information Rules1 were written during the first dot.com that brought the concept of network economics into the spotlight. However, these books did not anticipate how pervasive these many-to-many networks would become. The goal of this article is to resuscitate some of these principles, bring in some of the newer thinking from economists, and describe a few principles of our own. Indeed, it is not too much to sug-gest that those companies that master these new network effects are the ones most likely to prosper dispro-portionately in today’s internet economy.