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77Principle · Group 9

Network Effects

Network effects in business

“An offering that becomes more valuable with every user attracts more users, and the more it costs to switch, the more firmly they stay; but the same force can also empty a network in the opposite direction.”

Some offerings become more useful the more people use them. A single telephone is worthless; millions of telephones form a network.

Group 9: Markets and OrganizationsT6 Business Strategy
Go to the in-depth section ↓
A single dot, then a second, connected by a line; with every new dot many lines are added, a gold arc rises more and more steeply, and a smaller mist-blue network empties toward the large one. A frame of teal lines encloses the large network, then a gap opens in it, and groups of connected dots move into a new network.
In short

An offering that becomes more valuable with every user attracts more users, and the more it costs to switch, the more firmly they stay; but the same force can also empty a network in the opposite direction.

What it’s about: Some offerings become more useful the more people use them. A single telephone is worthless; millions of telephones form a network. More users attract more users, often through complementary groups as well: more users of an operating system draw more developers, and more programs draw more users. Whoever is ahead grows stronger faster, and a market can tip until one provider has almost everything. In churches, a community often grows through friendships and families: if you already know someone, it is easier to join.

In depth

The principle in detail

Three steps through the principle: grasp it, place it, put it to work. Open each topic on its own.

The core messageCore statement and 3 clarifications
In essence

An offering that becomes more valuable with every user wins more users on its own, and switching costs hold them in place.

It does not say
That size reliably protects you. If users can switch easily or use several services side by side, a market does not tip, or it tips back, as with MySpace and Facebook.
It does not say
That the value of a network grows exactly with the square of its users. Robert Metcalfe’s rule of thumb was never precisely proven.
It also says
Density counts for more than sheer size. A few real relationships bind more strongly than many loose contacts.
The explanationOnce your own friends are somewhere else, a network empties quickly.

Then there are switching costs: stored data, learned routines, contracts, relationships. The higher they are, the less it matters whether something better exists elsewhere.

The same force also works in reverse. Once your own friends are somewhere else, a network empties quickly.

The question

Do people stay with you because of what you offer them, or only because switching would be a hassle?

The signs3 signs when you heed it · 3 when you overlook it
When you heed it
  • You know through which relationships new people come to you, and you nurture them.
  • You ask why people stay, and you separate real value from the hassle of switching.
  • When individual groups start to drift away, you take it seriously early on.
When you overlook it
  • You treat your size as protection and handle users carelessly.
  • You count heads instead of relationships.
  • You rely on hurdles and contracts to keep people rather than on value.
The backgroundTradition T6 Business Strategy
  1. 1908
    Theodore Vail

    President of AT&T

  2. 1985
    Michael L. Katz and Carl Shapiro

    Network Externalities, Competition, and Compatibility

  3. 1989
    W. Brian Arthur

    Competing Technologies, Increasing Returns, and Lock-In by Historical Events

  4. 1999
    OriginCarl Shapiro and Hal R. Varian

    Information Rules

  5. Tradition T6
    TraditionBusiness Strategy

    Michael E. Porter, Richard P. Rumelt, Henry Mintzberg, Clayton M. Christensen, W. Chan Kim and Renée Mauborgne

    See the tradition on the Origin page
Read more: the full background

From Carl Shapiro and Hal R. Varian’s work “Information Rules” (1999), building on Michael L. Katz and Carl Shapiro (1985) and W. Brian Arthur (1989). The idea itself was set out by Theodore Vail, president of AT&T, as early as 1908 for the telephone network.

The research3 sources: 2 theories, 1 review · 1985–1999 · with limitations of the research
3 sources1985–1999 period2 theories1 review
Strength of evidence
  1. weak
  2. moderate
  3. strong

The economic theory is well developed; it does not follow that networks provide lasting protection, and the reversal has been shown only through individual cases.

  1. 1985
    Theory
    Michael L. Katz and Carl Shapiro

    “Network Externalities, Competition, and Compatibility”: the value of a good rises with the number of its users; in the model, one provider can dominate the market, and providers with a large network avoid compatibility.

  2. 1989
    Theory
    W. Brian Arthur

    “Competing Technologies, Increasing Returns, and Lock-In by Historical Events”: under increasing returns, early chance events lock a market into one technology, even an inferior one.

  3. 1999
    Review
    Carl Shapiro and Hal R. Varian

    “Information Rules”: positive feedback, standards wars, switching costs and lock-in as the basic rules of the network economy.

Where the research reaches its limits
  • Network effects do not reliably protect.
  • Where users switch easily or use several services side by side, a market stays open.
  • Network effects are often confused with economies of scale in production.
  • Lock-in can entrench inferior solutions and then draws the attention of antitrust authorities.
  • The sources cited support the last part of the core statement, the emptying of a network, only indirectly.
Read more: what research shows

In 1985, Michael L. Katz and Carl Shapiro described goods whose value to each individual rises with the number of other users in the same network, such as telephones or computers with compatible software. In their model, economies of scale arise on the demand side. Several equilibria are possible, including one in which a single provider dominates the market. Providers with a large network often have little interest in compatibility. In 1989, W. Brian Arthur showed that under increasing returns, early, chance events can lock a market into one technology, even an inferior one. In 1999, Carl Shapiro and Hal R. Varian summarized positive feedback, switching costs and lock-in for practitioners. This page supports the idea that the same force can empty a network with the case of MySpace, not with a study of its own.

The related principles65 Focal Points · 76 Disruption · 78 First Movers and Followers · 81 Path Dependence
Path DependenceFocal Points

To go deeper, see 81 Path Dependence (lock-in permanently entrenches an early, often accidental choice) and 65 Focal Points (a standard becomes the point everyone aligns with)

First Movers and Followers

78 First Movers and Followers shows when early size tips the balance in network markets

Disruption

76 Disruption stands in tension with it: a new network can empty an old one from below

Read more: the full text

To go deeper, see 81 Path Dependence (lock-in permanently entrenches an early, often accidental choice) and 65 Focal Points (a standard becomes the point everyone aligns with); 78 First Movers and Followers shows when early size tips the balance in network markets. 76 Disruption stands in tension with it: a new network can empty an old one from below.

The action steps5 things you can actually do

  1. Write down which offerings, tools or groups in your organization are worth more the more people take part.

  2. Find out through whom new members or customers arrive, and deliberately strengthen those relationships.

  3. Among those who stay, distinguish between value and switching costs. Ask instead of assuming.
  4. Watch for places where people are already using another offering in parallel or where whole circles of friends are leaving. That is where a mass departure begins.

  5. Build loyalty through value rather than hurdles, and check honestly whom you keep only through switching costs.

The reflection questions3 questions: What do your people use mainly because everyone else uses it too?
  1. What do your people use mainly because everyone else uses it too?
  2. Through which relationships do new people come to you, and who looks after those relationships?
  3. How would you notice that a network you are relying on is beginning to empty?

Take your time with one question. Write down your answer – or talk it over with someone you trust.

To finish
The picture to rememberThe animation once more, with an explanation
  1. A single dot, then a second, connected by a line
  2. With every new dot many lines are added, a gold arc rises more and more steeply, and a smaller mist-blue network empties toward the large one
  3. A frame of teal lines encloses the large network, then a gap opens in it, and groups of connected dots move into a new network
Strategy Check

Why do they stay with you?

Get your profile across all 12 groups in about 10 to 15 minutes.

Start the Strategy Check
In context

Group 9: Markets and Organizations

Guiding question: How does an organization win in the long run?

Stage 3 of 5: Choose the path

Where the 92 principles come from: eight traditions of strategy, from classical war theory to dealing with uncertainty.

More about the origin

Background: WEGVISOR’s own selection from the strategy literature · More about the origin

Examples

The principle in practice

From the different spheres of society.

Media

Facebook, MySpace and Network Effects

In 2005, MySpace is the largest social network in the world and is sold for $580 million. In 2008, Facebook overtakes it worldwide, and in 2011, MySpace changes hands for about $35 million. The story shows that network effects bring strength but do not guarantee protection.

Network Effects
GovernmentBusiness

The Microsoft Antitrust Case and Network Effects

In 1998, the U.S. government sues Microsoft. The court finds that Windows is protected by a wall of tens of thousands of programs. Users stay because the programs exist, and developers write programs because the users exist.

Network Effects
Education

The Bologna Declaration and Network Effects

In 1999, 29 European countries commit to comparable university degrees and a common credit system. With every additional country, a degree becomes more valuable in all the others, and once a country has made the switch, there is hardly any way back. Today, 49 countries take part.

Network Effects
BusinessMedia

Movie: The Circle

A young woman starts out in customer service at a powerful technology company and becomes the face of its platform. The film shows how a network grows more powerful with every user until there is no place left outside it.

Network Effects
FAQ

Questions about Network Effects

What do network effects and lock-in mean?

An offering becomes more valuable for each user the more others use it, and so it attracts more and more users. Switching costs such as data, programs and habits then hold users in place, even when alternatives exist.

Where does the principle come from?

The idea goes back to the telephone network; Theodore Vail described it in 1908. Michael L. Katz and Carl Shapiro developed it scientifically starting in 1985, and in 1999 Carl Shapiro and Hal R. Varian summarized it for strategists in “Information Rules.”

What examples are there?

Windows with its wall of applications, Facebook versus MySpace and the European Bologna Process illustrate the principle.

How well is Network Effects supported by research?

Evidence: moderate – the economic theory is well developed; it does not follow that networks provide lasting protection, and the reversal has been shown only through individual cases.

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