Built-In Network Effects
Scaling Strategy by The Family
By Nicolas Colin (Co-Founder & Director) | The Family
This story is part of a The Family series exploring business strategy in the 21st century. Sign up for my weekly newsletter to make sure you’re up-to-date on how businesses thrive in the digital age.
There are many reasons why increasing returns are now trumping traditional supply-side economies of scale in the realm of corporate strategy. The most important is that the digital economy creates the possibility of conquering a powerful kind of competitive advantage under the form of network effects.
Amazon is a case in point: like any traditional retailer, it could have kept on competing on price; but because technology enabled it to generate network effects (with features such as user reviews, wish lists or the recommendation engine), it has been able to build a sustainable competitive advantage into its product in the form of an exceptional customer experience. Like I wrote in an in-depth discussion about Amazon,
[on Amazon’s market], the only way to retain customers without bringing down the prices [is] to provide an exceptional experience. [Amazon] has accordingly set a new standard… The more you rely on [it] for your day-to-day life, the more difficult it becomes to even consider offers by its competitors. Of course, you can compare prices whenever you have something to buy. But saving a few cents here and there may not be enough to compensate for the effort that it takes to go browse prices all over the Internet… Amazon proves that you can design an experience that invites customers to simply trust the company over the long term instead of constantly evaluating the competition.
The rise of built-in network effects as a competitive advantage has two major consequences.
First, unlike those developed by companies in postal services, railroads or telecommunications, digital-driven network effects are mostly generated by the demand-side: they depend on customers, not on a tangible infrastructure. Hence to sustain these kinds of network effects, tech companies have to retain their customers with an exceptional experience, an experience that network effects contribute to creating as they increase the value of the product — an idea embedded in Chris Dixon’s formula “Come for the tool, stay for the network”. In the presence of network effects on the demand side, acquisition costs are not so much about spending as they are about investing in an improved customer experience. This, after all, is the very definition of a network effect: the more users the product has, the more value it delivers.
Second, as already mentioned, network effects contribute to generating increasing returns. They don’t only offset the diminishing returns that result from implementing tangible activities, they also help sustain economies of scale in ways that were impossible to reach without them. For a tech company, when traditional supply-side economies of scale run out of steam, network effects are there to sustain further scaling up to a size at which the company is able to again generate economies of scale. (This doesn’t mean that network effects are not subject to exhaustion past a certain size: they are, and the phenomenon is known as “reverse network effects”.)
In other words, the positive feedback loop initiated by network effects doesn’t replace supply-side economies of scale and traditional strategic positioning. Instead, it amplifies them, combining the effects of three different positive feedback loops. To mention Amazon again, the network effects generated thanks to its “architecture of participation” enable it to subsidize more expensive warehouses closer to its customers (competitive advantage) so as to support an even larger scale of operations and bigger purchasing volume (economies of scale).
This can been described as the balance between the Northern Side (tangible) and the Southern Side (intangible). As more and more companies choose to compete in both worlds, we can now discern how traditional, brick-and-mortar activities fit together with a new breed of digital activities to sustain network-driven competitive advantages.
In this regard, a while ago, Spark Capital’s Jeremy G. Philips wrote that “Netflix has scale advantages and strong customer captivity, but zero network effects; it does not become more entertaining with more subscribers.” I disagree: while being predominantly fueled by supply-side economies of scale and the competitive advantage derived from its original series, Netflix also generates network effects thanks to its recommendation engine while also exploiting network effects elsewhere on the Web through the communities of passionate fans that grow around its original content. You can’t do that with every consumer segment and every product, but Netflix has the luxury of piggybacking on other platforms to build powerful network effects that sustain its growth.
Here’s a series of questions for you executives:
- Do you need to reinforce your positioning? If yes, you should probably seek to build network effects.
- Are there already such network effects built in your product? If yes, are they supply-side network effects (linked to an asset you own) or demand-side network effects (driven by interactions, direct or indirect, between your users)?
- If no, what kind of features could you add to your product to start generating network effects? Could you piggyback on network effects generated by others?
