Network Effect: 3 Advantages of Network Effects

In business, a network effect describes the enhanced experience users get from a product or service when the number of users increases. The overall user base typically benefits when a brand builds a critical mass of users or customers. Also known as network externality or demand-side economies of scale, the network effect relies on new users subscribing to the business model to elevate the experience for all, including existing users. An example of a network effect is the invention of the telephone. The value of a telephone network directly corresponds to the number of users people can contact.

There are two main types of network effects that describe how this phenomenon functions: direct and indirect network effects.

1. 1. Direct: Direct network effects arise when a user’s experience improves as more people join the service. This is different from price discounts or new features; direct network effects mean the overall service quality improves as additional users join the service.
2. 2. Indirect: Indirect network effects, or cross-side effects, happen when there are at least two interdependent groups who benefit from the other’s use of the service. For example, an advertising website benefits when there are buyers and sellers/providers, two groups that rely on one another for positive network effects.

Advantages of the network effect include the following:

1. 1. Creation of new products and services: The network effect can inspire entrepreneurs to develop unique products and services to appeal to audiences.
2. 2. FOMO: FOMO (fear of missing out) speaks to the power of network effects: As potential customers learn about the service, they may feel like they need to jump on board to join friends and peers. This can mean more revenue for the company and greater customer enjoyment.
3. 3. Word-of-mouth marketing: The network effect can lead to more substantial word-of-mouth marketing, giving a company a competitive advantage and a more significant market share. Through increased usage, the word will spread.

There are some potential downsides to the network effect. In some cases, an increase in network usage can decrease a product's or service's value. If startups see exponential growth in their service, congestion can occur. It is timely and expensive to ensure companies have the bandwidth for many people using their app or product. Similarly, companies may become less invested and customer-forward after reaching critical mass.

Typically, the value of the product or service increases with user engagement. There are many examples of network effects across different industries, including:

1. 1. Cryptocurrency: For a cryptocurrency to have value, it relies on others’ participating in and putting a value on it.
2. 2. Home rental apps: Homesharing platforms for short-term rentals benefit from more hosts. The more customers there are the more money the hosts will make, and vice versa.
3. 3. Online marketplaces: Online marketplaces that sell goods from consumers to consumers and businesses to consumers need a strong network of buyers and sellers to create a thriving online marketplace.
4. 4. Rideshare apps: Ridesharing apps are a good example of this phenomenon. To save money, users need other people to be part of rideshares. When people utilize rideshare apps, the user experience improves because it is more likely that others around them will be willing to share a ride, saving them money.
5. 5. Social media platforms: Social media platforms rely on many users to build profiles and accounts for users to engage with one another through messaging online. Such platforms have seen exponential growth, increasing the experience of using and the value of a product.

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