The internet has greatly facilitated the speed at which ideas and culture can spread. Companies that are well versed in network effects are more likely to gain a competitive advantage, consolidate their competitive position in the market, and emerge as industry leaders.
Network effects are also an essential element for Internet entrepreneurs to succeed. Network effects in the software industry are ubiquitous, covering various products and services such as operating systems, search engines, social networks, instant messaging systems, online trading platforms, and taxi-hailing software. Beyond software technology, the spread of religion, culture, and language can also be attributed in part to network effects.
The network effect affects the competitive landscape of the Web3 industry to a large extent. It can build a moat for projects that enter the market earlier and resist attacks from new entrants with more advanced technologies.
This article defines the concept of network effects, discusses some classic cases of network effects, and explains how network effects will help Web3 projects build a strong economic moat.
What are network effects?
Network effects refer to the increase in the number of participants in a system that increases the value and utilization of the underlying network and its services. As more people join the network, users will gain greater value from the service, forming a virtuous circle that will further promote service demand. In short, network effects can attract more people to join the network, thus increasing the value of the product.
The popularity of landlines is a typical network effect: a landline is worthless, but every time a new landline is added to the network, the utilization rate of the entire network will also increase. A landline is equivalent to a node. As the connectivity of nodes continues to improve, the utilization rate of the network will also increase. Likewise, the greater the number of users in a social network, the higher the service value it provides to users. Another example of a network effect is a payment platform like VISA or a ride-hailing platform like Uber. The higher the number of users, the higher the value of the network.
Direct, indirect and negative network effects
Network effects can be divided into direct and indirect categories. The direct network effect means that the increase in the number of users directly promotes the utilization rate of the network, such as the landline example mentioned above. In addition, network effects can also have indirect effects. For example, if a new cryptocurrency wants to directly compete with Bitcoin, it not only needs to surpass Bitcoin in terms of underlying community belief and security, but also needs to build a stronger ecology. Bitcoin has already done very well in these dimensions, and its network effect can continuously attract more developers, tools, advocates and users.
Indirect network effects usually occur between two different groups of participants, and the network effects created by one group of participants tend to affect the other group of participants. For example, third-party game developers develop high-quality games for game consoles, which can increase the value of the game console itself.
Negative network effects mean that new users only extract value from the network rather than contribute value to the network. For example, most modern cities suffer from traffic congestion. Some cities use cars as the center of urban planning, so people basically have to choose to drive when traveling. As more and more people travel by car, the throughput of the highway will decrease, which will reduce the utilization rate of the highway. Often, the solution is to build more highways, which is what city planners tend to do. However, doing so would lead to more cars on the road, thus further exacerbating road traffic problems and ultimately creating even more negative network effects.
What phenomena look like network effects but are not?
Network effects should not be equated with "network externalities". A network externality is when a user's demand for a product depends on other buyers' demand for the same product. For example, a restaurant with a long line at the door is likely to attract more customers than an empty restaurant. Because customers are willing to sacrifice some time for a better dining experience, and their decision is influenced by other customers in line.
Also, many people confuse network effects with “economies of scale”. Economies of scale refer to the reduction in the cost of producing a commodity as the total output increases. In industries such as manufacturing, economies of scale really equate to network effects. But in fact, the network effect only involves the demand side in economies of scale, that is: the network effect can increase the willingness of users to participate, but it does not necessarily increase the productivity of the supply side (or the underlying network).
How to build network effects?
To build a network effect, a breaking point must be reached. Every time a new participant is added to the network, its value also increases. As a result, users who have already joined the network actively seek out new participants and drive network growth. Many times, no one can figure out how the network effect is generated, but once generated, it is not easy to disappear. However, as the network continues to expand, the growth rate will gradually slow down.
Open and neutral networks are more likely to build long-lasting network effects. If the underlying architecture is not neutral, network effects will be difficult to achieve. The Internet is built on open standards and treats all users equally. We can imagine that in another parallel world, the Internet is only open to some people. In this world, it may be difficult for the Internet to have such a subversive impact on society. Still, many large corporations want to create a permissioned internet where they can control the information on the network. And this makes the decentralized Web3 particularly important, because it can continue to maintain the open spirit of the Internet.
Network effects also affect economic diversity, especially for software and communication technologies. Although the scale of the World Wide Web continues to expand and new products and services are constantly being developed, the number of users on the Internet's major platforms seems to be shrinking. These large platforms have established a strong network effect and increased the switching cost of users, which means that Web2 is gradually moving towards a dead end of monopoly.
It is also possible that network effects will fade. There are many reasons, such as close to 100% penetration in the target market; inability to adapt to environmental changes; and unsustainable economic model, etc.
The Classic Case of Network Effects
Facebook vs MySpace
Facebook, whether consciously or not, has a very effective way to build its initial network effect. Facebook began as a real-name social networking platform for college students. In the early days of the Internet, such social platforms were uncommon. Facebook has set up two layers of mechanisms to build long-lasting network effects for itself.
First, when users first join the platform, they can directly connect with other users. Building connections between users helps increase service utilization, so Facebook can build a social graph faster than other anonymous social platforms. If new users can’t find someone to connect with, they may not log on to the platform again, and the platform never reaches its breaking point. In addition, users are more likely to connect through mutual acquaintances.
Another advantage of Facebook's business model is that it creates a psychological effect similar to FOMO (Note: FOMO is an acronym for fear of missing out, which refers to the psychology of people's fear of missing out). If a student's circle of friends is using Facebook, he may worry that he will miss some important social activities, and it will be more difficult to maintain relationships with friends, so he will also want to join Facebook. Facebook built a social network based on the real world, which was able to achieve a strong network effect and expand from the initial college student group to any community.
At that time, MySpace, the mainstream social network, was unable to keep up with the rapid growth of Facebook for various reasons, and eventually lost. The main reason is that Facebook has built a strong network effect and is focused on achieving user growth. This caused MySpace to lose ground in the competition, and Facebook eventually became one of the most disruptive platforms in the social networking field.
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Microsoft Encyclopedia vs Wikipedia
The case of Microsoft Encarta also fully illustrates the importance of network effects. Encarta is a digital multimedia encyclopedia released by Microsoft between 1993 and 2009. In 1993, creating an encyclopedia that could be continuously updated was a very innovative concept. However, Encarta ultimately lost out to an open platform released almost a decade later.
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Wikipedia was only launched in 2001. It is a free encyclopedia, written and maintained by community volunteers in an open and collaborative manner. Although Wikipedia's editing system also has some problems, it has still become one of the most visited websites on the Internet, ranking in the top ten in the world for a long time.
In theory, Microsoft Encyclopedia's paid subscription service could provide the same functionality. However, Wikipedia's focus on community building and maintaining an open and free "knowledge network" has attracted many like-minded contributors. These people also believe that knowledge should be free and therefore volunteer their time to contribute to the platform. The larger this knowledge network, the more readers it will attract, and the more valuable content those readers will contribute, which will in turn attract more readers to become content contributors, and the cycle continues.
The Microsoft Encyclopedia uses a paid subscription model and is maintained by company employees. By contrast, Wikipedia's network effects give it a huge competitive advantage. Microsoft may go bankrupt or remove its products (Note: Microsoft did remove the encyclopedia in the end), but the content and core values on the Wikipedia platform are likely to remain forever. A profitable product may be of higher quality, fuller features or better user experience, but it also has weaker network effects. Once a platform like Wikipedia reaches a certain scale, no one company has enough resources to compete with it.
Currency Network Effects
Currency is a "collective consensus", and network effects drive this consensus to spread in society. A fax machine is worthless unless other people use it. Likewise, currency only has value if the recipient agrees.
Broadly speaking, currencies go through the following stages of development:
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Commodity money: Commodity money has intrinsic value, and this intrinsic value is different from its value as money. Common commodity currencies include gold coins, silver coins, silk, salt, or instant noodles in modern prisons.
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Alternative currencies: Alternative currencies are currencies that are pegged to the value of the underlying commodity (mostly gold or silver).
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Fiat currency: Fiat currency has no intrinsic value and can be exchanged for valuable commodities. The value of fiat currency is backed by the government that issued the currency.
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Cryptocurrency: Cryptocurrency is the newest type of money that uses mathematics and physics to provide security and value.
For a new currency to compete with its predecessors, it must overcome its established network effects, which often takes a long time. New types of currencies can even take advantage of existing network effects. For example, alternative currencies use the network effects of commodity currencies to provide additional social consensus for the underlying commodity and present it in another way (paper currency). Another example is the euro. The euro replaces many monetary systems while also taking advantage of the cumulative network effects of these monetary systems.
We can say that a commodity currency does not need to build network effects because its properties as a commodity already give it value. But commodity value is not equal to monetary value. If a commodity is also used as a currency, then the underlying consensus and network effects must be established. For example, instant noodles are a currency in prison. Instant noodles are divisible, homogeneous, easy to store and non-perishable commodities. Even so, the network effect of instant noodles as currency does not extend to the tax system, but is limited to the special environment of prisons.
How Web3 Enterprises Use Network Effects to Build Moats
The blockchain token is the underlying mechanism of the Web3 ecology, which can coordinate the incentive mechanisms of different participants and organize communities through economic and game mechanisms. Instead of doing traditional products or services, many Web3 projects want to build a network that organizes users, distributes value, or processes data in an economically sustainable way, without any centralized entity to ensure operation.
The fundamental belief in the Web3 ecosystem is decentralization and trust minimization, so network effects play a decisive role in the success or failure of many Web3 projects, such as DeFi protocols, blockchain games, decentralized organizations, NFT projects, and metaverses. In short, the more users a crypto network can attract, the more services the network can provide to users. Also, since most Web3 projects are open source, projects need to be resistant to imitation by competitors. The code of successful projects is often copied by competitors, but the project's network effects (such as community) cannot be replicated.
The Web3 ecosystem has just started, so it is difficult to judge whether the current network effect of Web3 will continue in the next few decades. However, there are key points that Web3 projects should consider if they want to build network effects:
Community
"Community-centric" is the core marketing strategy of many modern businesses. However, for Web3 companies, being community-centric is not only about convincing as many people as possible to buy your product, many Web3 projects are even completely operated by the community. Building, growing, and managing a community takes a lot of effort, but doing so can be effective in attracting more developers, users, advocates, and enthusiasts. New players can leverage their expertise to further drive network and community growth and create a virtuous cycle that ultimately increases user demand in the network. The Web3 community includes not only users, but also contributors, which can establish a powerful flywheel effect and greatly promote user growth.
economic model
To establish a communication and value system in Web3, it is necessary to skillfully balance various incentive mechanisms and coordinate the interests of different participants. Since there is no centralized decision-making entity, the underlying economic model needs to have a sustainable framework to promote a standardized decision-making process, enhance the encryption economic security of the network, and better motivate the continuous operation of the network. A sustainable economic model can lay a strong foundation for the long-term development of the network.
fluidity
Blockchain tokens are the foundation of the Web3 economy, helping each participant to interact through deterministic code logic. Improving interaction efficiency is a key element to ensure the level of decentralization.
first mover advantage
It takes a long time to build network effects, so some projects will try to launch early to accumulate network effects. This is especially evident in some emerging verticals. With network effects, even if latecomers have better technologies or services, the competitive advantages and economic benefits of the first movers will not be shaken. But then again, if you want to build a value network, you must focus on security. Theft of user funds as a result of rushing to market can instantly shatter trust in a product and may never be rebuilt.
Composability
It is worth noting that since Web3 can achieve permission-free composability, the network effect of the entire Web3 ecosystem will far exceed that of other industries. Different decentralized applications can be flexibly combined, which will give birth to subversive products and drive innovation in unprecedented ways, which cannot be achieved by centralized business models.
For example, in the Web2 world, users must create separate accounts for each social platform, and there is no interoperability between different platforms. Web3's communication and social network protocols allow users to use the same social graph across platforms, which can transfer competition to the application layer, ensure the decentralization and neutrality of the underlying protocols, and provide a settlement layer for interactions on the platform.
Summarize
Whether it is social media, currency, or P2E games, network effects play a vital role in the dissemination of information and the application of new technologies, and largely determine the success or failure of communication and value networks in Web3.
Although it is still impossible to judge which technologies and application protocols in the blockchain industry can establish long-term sustainable network effects, projects that successfully establish network effects will be more likely to create economic moats.