NETWORK EFFECTS EXPLAINED

 


When pricing products, services, or platforms, one should consider several factors to ensure you’re doing so effectively. You need to understand the unique value the business offers, your customers’ willingness to pay for that value, and the profit margins the business requires to reach its goals.

It’s also important to consider whether the product or service is subject to any network effects, which could impact your pricing strategy.

Not familiar with the concept of network effects? Below is an overview of what network effects are, how they can impact a business strategy, and how one can leverage them to increase profitability.

Network effect refers to any situation in which the value of a product, service, or platform depends on the number of buyers, sellers, or users who leverage it. Typically, the greater the number of buyers, sellers, or users, the greater the network effect—and the greater the value created by the offering.

Many of today’s most popular companies and startups are heavily influenced by network effects, such as:

  • E-Commerce: Amazon, Alibaba
  • Rideshare: Uber
  • Delivery:  Uber Eats
  • Social Media: Facebook, Twitter, Instagram, LinkedIn

DIRECT AND INDIRECT NETWORK EFFECTS

Not all network effects are the same. They’re often broken into two different types: direct and indirect.

Direct network effects occur when the value of a product, service, or platform increases simply because the number of users increases, causing the network itself to grow.

Social media platforms primarily benefit from direct network effects because the service's value grows as a direct result of attracting more users.

Indirect network effects, on the other hand, occur when a platform or service depends on two or more user groups, such as producers and consumers, buyers and sellers, or users and developers. As more people from one group join the platform, the other group receives a greater value amount. This is best illustrated by the e-commerce and ridesharing examples noted above.

WHY ARE NETWORK EFFECTS IMPORTANT TO UNDERSTAND?

The underlying principles of network effects imply that the business, website, or platform with the highest market share will be more successful in the long run. This means that its market share is likely to grow more substantially. For this reason, markets in which network effects play a major role are often referred to as winner-takes-all markets.

Businesses that can leverage or exploit network effects often experience rapid rates of growth, Not just that: Once you’re ahead, you tend to stay ahead. Your demand keeps growing even faster as you get bigger.

NETWORK EFFECTS AND PRICING

Before pricing your product, service, or platform, it’s crucial to understand whether your market is subject to network effects. Why? Because the underlying logic that guides a typical pricing strategy reverses itself in markets where network effects are felt strongest.

To maximize profit margin, businesses typically price their products as high as possible without exceeding their customers’ willingness to pay. But when a market is subject to network effects, the driving concern isn’t so much profit as it is market share—especially early on.

This is because future customers’ willingness to pay depends on the number of existing users. By growing your market share early, you increase your ability to raise prices at a later date, once you’ve taken advantage of network effects and driven adoption of your offering as much as possible. For this reason, many companies price their products low early on or give them away for free.

The emergence of Facebook as a social media giant is an excellent example of this premise in practice. When Facebook launched in 2004, it was a free social media platform. By virtue of being free, the platform became more popular, capturing greater market share and eventually displacing Myspace, its primary competitor at the time. It wasn’t until 2007 that Facebook introduced ads in an effort to monetize its user base, and it was until 2014 that the company became profitable.

USING NETWORK EFFECTS TO YOUR ADVANTAGE

By understanding the principles that drive network effects and the impact they can have, you can leverage them to increase profitability and grow a business.

Once you’ve gained significant market share, you can often sit back and let the network effect take over, Your existing buyers and sellers are, in effect, your sales force in attracting more buyers. You often have to do very little. This is also why, in markets with network effects, you see businesses competing fiercely early on to get customers—even giving away the product for free—but then raising prices afterward once they have network leadership.

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