Network Effects 101

The theory of network effects, how they create value, and how it influences our lives.

In this essay, I’ll discuss the basics of network effects, how they create value, their influence on our decision-making, and how dependence can be a negative outcome.

Network effects are a key concept in understanding the value creation of network businesses, such as social networks and marketplaces. Simply put, network effects occur when the value that users derive from a product or service increases with the size of the total user base.

In other words, they are “effects” that a business’s product or service has on itself as it gets bigger.

Now, let’s dive in.

Value Creation

Network effects are the most powerful force in tech, which means that companies with network effects tend to be the most valuable too. The reason is that network effects are a virtuous cycle. When more people sign up, they create more value for existing users, which encourages more people to sign up again. This cycle is what compels exponential growth.

Think about the immense value that users get when they sign up for Facebook or Twitter — you can immediately connect with your friends and family and share information.

This is an example of a positive network effect: the more people who join Facebook or Twitter, the more valuable the platform becomes for all users. Similarly, eBay became more valuable as sellers joined (and buyers joined to buy from them), and Uber is more useful as more drivers join because users get rides faster.

For better or worse, Facebook has become a utility. It’s one of the first places people go to check the news online and keep up with friends, which means its 2 billion users are unlikely to abandon it. In fact, they’re likely to keep adding more friends, which strengthens the network effects that make Facebook so powerful in the first place. This is how a platform like Facebook can hold on to its audience even as its user base ages and younger users move onto new platforms like Snapchat or Instagram (which is also owned by Facebook).

Network effects don’t just power business strategy — they also affect our daily lives in significant ways.

Influencing Choice

From the phone we buy to the email we use, network effects both create value in business and drive our decision-making.

When you’re trying to decide which smartphone to buy, you might ask yourself, “Which one has the most apps?” or “What phone does my best friend use?” As a consumer, you have no way of knowing how many developers will build for a particular platform, but the more people who buy a specific phone, the more likely it is that others will join in. This is a network effect.

• The more friends you have on Facebook, and the more frequently you use it, the more likely it is that you’ll add more friends.
• The more people who live in your neighborhood, the more likely it is that new businesses will open nearby. The reverse is true if people move out.
• If everyone else is driving a certain type of car, or using a specific brand of mobile phone or computer, you may be more likely to do so as well.

We tend to stick with things that other people use because it’s easier to collaborate if you’re all using the same service or application than if you’re all using different ones.

Overdependence

Network effects can be positive or negative.

The negative type is known as a congestion effect, where increased usage creates congestion that significantly decreases the value. Think rush hour traffic: the more cars increase, the more congested the roads become, and therefore, the longer it takes to get to your destination.

Uber, for example, uses network effects in the form of surge pricing: The more people who use the app, and thus drive supply up, the more affordable prices become. So what happens if supply doesn’t increase? We saw that during the reopening of 2021 when Uber and Lyft couldn’t get enough drivers on their platform and caused prices to skyrocket.

Concerns over congestion are real but limited. There is a problem when our dependence grows too much and a break in the product or service causes huge disruptions. Remember when Gmail went down?

Network Effects Are All Around Us

The theory of network effects suggests that a product or service becomes more valuable to you as the number of other people using it increases.

It is a tool of value creation that has brought us some of the best products and experiences of our time. However, with the positive also comes some negative. The congestion effect and dependence it builds in consumers can monopolize whole industries until a new option is presented.

There are many more examples of network effects. NFX created The Network Effect Bible which is an amazing resource of well-researched case studies into the many ways network effects are utilized today.

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