Network effects, yes, network effects!
Network effects are probably the spine of platform businesses. It is for this reason – network effects – that we talk about platforms as much. It’s not because now we have the technology and before we didn’t. The reason why we talk about platforms today is the power of network effects. So, direct network effects, let’s start with that. Direct network effects are same-side effects. They occur when the increasing number of customers or users of a product drives an increase in value or utility for that same type of user. We also refer to direct network effects as direct network externality, as used in economics, for example, or same-side network effects.
So what is a direct network effect?
Take the example of Facebook. On Facebook, we have, among others, same-side effects. We have one side that is users like you and me on Facebook. There is a direct network effect because the more users like me on Facebook are on the social networking site, the higher the probability of finding new friends or that my actual offline friends on Facebook. And this means the higher the value or the utility for me to use Facebook. The same-side effects concern one user side: I’m a user, my friends are users, and I know I can write them messages or get in touch with them or be up to date on what’s happening in their life through Facebook. So, I’m using Facebook because the more my friends on Facebook, the higher the value is. Same-side effect. Okay, I hope you get this as this is a very, very important aspect.
The telephone as an example of direct network effects
Simple example: telephone. The telephone is not a platform, okay, but to exemplify the direct network effect, let’s talk about this significant invention. The telephone is an excellent product. In the beginning, when telephones developed and if you had one telephone at home it didn’t bring you any value, right, because: if you if you’re the only one who has a telephone, you know, you’ve got no one to call and I wouldn’t know to call, nobody calls you, okay? So, the telephone is useless. It increases in value if more users have a telephone at home or I use a telephone. The telephone, thus, is a typical example of a direct network effect okay. It’s useless as if there are no other users. And it increases the more users there are. The higher the value of the platform or the telephone to you initially. However, direct network effects can also be negative. So, as an example here, we can take the case of a nightclub. If we want to avoid severe competition, men might prefer to have fewer other men be in a nightclub – and the other way around. (However, the question still is who and what’s offer and demand here, right? Don’t let me get into that here, but, of course, if there are more men or more people of the same gender, for example, it means more competition. And more competition is perhaps not good for you. So, direct network effects can be harmful as well.
What’s an indirect network effect?
Let’s get into the second example or the second type of network effect: indirect network effects. Indirect network effects are actually where the power of multi-sided platforms kicks in. An indirect network effect occurs when an increase in the number and quality of customers on one side of the platform drives increased value for customers on the other side. Okay, so, another side. We refer to this also as cross-side network effects. Compare that to the same-side network effects we discussed previously. Now, we talk about cross-side network effects. So, when we have at least two or more distinct types of customers, it is beneficial to talk about the positive indirect network effect. It means that the more there is another group or another type of customer joining the platform, the more interesting it is for me to be on the platform.
OpenTable: Indirect network effects in action
An example is OpenTable. OpenTable is a tool for restaurants and visitors at the same time to book a table. As a guest, book a table at the restaurant. Okay, how far are there indirect network effects? For you as a guest, someone looking for a restaurant for tonight – once we can again go to restaurants, right – and it is more interesting to go to OpenTable if there are many restaurants referenced. The more restaurants there are on OpenTable, the more interesting it gets for you as a guest – somebody looking for a restaurant for tonight – to go on OpenTable. On the other side, as OpenTable or as the restaurant, it is more interesting to be on OpenTable. The more customers, the more potential guests are registered on OpenTable as well. The OpenTable example is not about same-side effects. I’m not going on OpenTable because other people like me are going on OpenTable looking for a restaurant. I don’t care. It might even be harmful because then there’s more competition for perhaps limited spots at my favorite restaurant, for example. The same holds for the restaurant: if there are more of my competitors on the OpenTable, it’s not more enjoyable for me to be on OpenTable. Okay, it might be the case. So, to have no competitive disadvantage – because all the others are on OpenTable, but you are not – this might be another discussion, of course. But the power of OpenTable is cross-side network effect or cross-side effect, or indirect network effects. Okay, the more restaurants, the more customers or guests are potentially interested in registering and going on OpenTable. And the more there are potential guests on OpenTable, the more interesting it gets for restaurants actually to join OpenTable, okay? Of course, indirect network effects can also be negative.
Ad-supported media and the possibility of negative indirect network effects
An example might be ad-supported media. Indirect network effects usually run only one way. Think about YouTube. I don’t know if you have an ad blocker installed on your internet browser. When I ask my marketing students in other classes, usually basically yeah 50, 60, sometimes 75 percent of hands go up. Okay, saying that many marketing students installed an ad blocker on their internet browser and what those students explain to me is that one of their primary motivators to do so – to install an ad blocker – is to avoid ads on YouTube. Because it’s annoying that there are those interruptions or pre-roll ads, and this might be annoying. At this moment, there’s a negative indirect network effect: the more advertisers join YouTube, the less interesting it is for me as a viewer to be on YouTube because I’m so annoyed by all those interruptions of my favorite videos. Keep in mind that both network effect types can be positive and can be negative.
Network effects are the spine of platform businesses. Attracting and developing relationships with the different sides of the platform is a significant challenge for platforms. The free online crash course “Platform Business and Strategy” helps you understand platforms and network effects and find your product’s platform. Start the free online course today!