Network Effects

Network Effects (Metcalfe’s Law)

Network effects explain the success of most digital businesses around today. These include notable companies such as Facebook, Google, and Apple. While this concept might seem new, it is an idea that you are very much familiar with: the value of a product or business increases as its number of users increase. This principle is tied to Metcalfe’s law, which explains how network value grows exponentially.

What is Metcalfe’s Law?

Credited to Robert Metcalfe, this law asserts that the value of a network is proportional to the square of the number of its nodes. In simpler terms, a network’s value increases as more nodes or users are added. This value doesn’t increase linearly but rather exponentially with the addition of more nodes.

The history of this theory is traced back to the Ethernet ports, which Metcalfe helped to invent. The electrical engineer also co-founded 3Com, a company that produced networking cards that helped computers connect to the Ethernet.

Metcalfe explained that the cost of a network was directly proportional to the number of networking cards installed but the network’s value was proportional to the square of the number of users. In promoting the product, he claimed customers needed to increase Ethernet cards to a specific critical mass to get the benefits.

Network Value Simplified

Metcalfe’s Law represents the first attempt at quantifying the network effect. It suggests that a network’s value is proportional to the square of the number of connected users (n2). This means you can think of n as standing for users.

The above expression then shows that the value of a network increases exponentially. When you add a new user, value increases by more than just that single user. Let’s assume a digital business has 8 users. Its network value would be 82, which is 64. Adding another user will increase the total value or connections to 81.

Network Effects and Digital Companies

Metcalfe’s Law helps you to understand how some popular tech companies achieve success. It explains how digital businesses can gain a competitive edge by building network effects, interactions, and relationships.

The number of users a network-based business has will be, perhaps, the principal determinant of its growth. As this increases, so will value grow exponentially as more connections will be created.

Social networks arguably best typify the importance of the network effect. Let’s suppose you have just created an app that connects people, such as Facebook or LinkedIn. You are not going to get very far if you have only a handful of users. However, as more users join the network, more connections are created and its value burgeons.

Unlike in the case of linear businesses, the assets of a network-based business are its network effects and relationships as well as the data generated.

Network effects are critical to digital businesses in their drive to succeed. They make scalability easier and give a competitive edge by helping to gain greater control of a market.

Types of Network Effects

Network effect comes in two major types:

  • Direct network effect – Also called symmetric network effect, this arises when the addition of a new user increases connections, utility, or value for all users in the system. An example would be when a user signs up for Facebook or Instagram. The more the number of users, the better for everyone.
  • Indirect effect – This is what happens when an increase in the number of a group of users increases the utility created for another group of users. Airbnb and Uber are two good examples of this kind of network effect. More hosts and drivers create more indirect utility for guests and passengers respectively.

The type of network effect that a business will have is a factor of its business model. Therefore, many forms are possible and these come under either direct or indirect network effects.

Other Measures of Network Value

Metcalfe’s Law represents the first attempt to calculate the network effect. It is, however, not the only one that can be used for this purpose.

A more recent theory is Reed’s Law, which suggests that group-forming ability helps to promote more rapid growth. According to it, the value of a network is a factor of how many group connections are created among members. The number of subgroups is what actually drives value based on this viewpoint. This law expresses value as two raised to the power of n (2n).

Another assertion on network value is Zipf’s law. It relates frequencies of events or occurrences to their rank order. In other words, value is based on where new additions rank as well as on their frequency. The best approach to use for measuring the value of your network will depend on your growth strategy. However, Metcalfe’s Law is arguably the most popular and consistent. Both Reed’s Law and Zipf’s Law are a bit more extreme in how they perceive increases in value.

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