Is Network Effects really that magical?

Network effect is powerful to businesses as there is a ‘rich-becomes-richer’ dynamic between scale and value in businesses. Bigger scale leads to greater value for users, which in turn attracts more users. Therefore, once network effects are set in, business start to boost and become highly defensible. Companies include Microsoft, Alibaba and eBay, which are over 15 years old but still dominating their sectors thanks to the network effect.

Microsoft Windows is a very typical case. As Windows own the first mover advantage, many software is developed for them, which makes more people buy Windows computer, which in turn makes more developers build apps for Windows. This virtuous circle makes Windows valuable and undefeatable.

However, some people have a different opinion and doubt the ‘magical’ power of network effect. “One way that network effects can be defeated is through what we’ll call verticalization,” said Business Insider Australia.

One example is Twitter. Twitter takes the “status update” feature on Facebook and turns it into its own service, with its own identity and use case. The other popular feature of Facebook is sharing photos, and Instagram is the one tackled the opportunity. With cameras and the Internet function in our phones, it’s possible to make an app for picture sharing that are more tailored to the majority of Facebook picture sharing use cases.

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Even Facebook itself won the battle with MySpace through the loophole of network effects: lateral competition, where the entry barriers of network effects are weak. If Facebook had focused on bands, they would have failed because MySpace had locked up with strong network effects. While Facebook targeted a population (college students) that was less into MySpace, attacking laterally and won.

What’s more, the two most famous online companies: Google and Amazon, benefit from economies of scale rather than network effects.

The more people use Google search, it gets better as it gives Google more data to refine the algorithm. Amazon’s scale allows them to get better prices from suppliers, which allows them to pass on savings to customers to make themselves bigger and better. These are not about network externalities but scale externalities.

Former Facebook president Sean Parker have said: “Companies that harness the power of networks will dominate the future of the internet.” It may be true, but it may be not.

 

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