After studying this section you should be able to do the following:
- Identify the three primary sources of value for network effects.
- Recognize factors that contribute to the staying power and complementary benefits of a product or service subject to network effects.
- Understand how firms like Microsoft and Apple each benefit from strong network effects.
The value derived from network effects comes from three sources: exchange, staying power, and complementary benefits.
Facebook for one person isn’t much fun, and the first guy in the world with a fax machine didn’t have much more than a paperweight. But as each new Facebook friend or fax user comes online, a network becomes more valuable because its users can potentially communicate with more people. These examples show the importance of exchange in creating value. Every product or service subject to network effects fosters some kind of exchange. For firms leveraging technology, this might include anything you can represent in the ones and zeros of digital storage, such as movies, music, money, video games, and computer programs. And just about any standard that allows things to plug into one another, interconnect, or otherwise communicate will live or die based on its ability to snare network effects.
Exercise: Graph It
Some people refer to network effects by the name Metcalfe’s Law. It got this name when, toward the start of the dot-com boom, Bob Metcalfe (the inventor of the Ethernet networking standard) wrote a column in InfoWorld magazine stating that the value of a network equals its number of users squared. What do you think of this formula? Graph the law with the vertical axis labeled “value” and the horizontal axis labeled “users.” Do you think the graph is an accurate representation of what’s happening in network effects? If so, why? If not, what do you think the graph really looks like?
Users don’t want to buy a product or sign up for a service that’s likely to go away, and a number of factors can halt the availability of an effort: a firm could bankrupt or fail to attract a critical mass of user support, or a rival may successfully invade its market and draw away current customers. Networks with greater numbers of users suggest a stronger staying power. The staying power, or long-term viability, of a product or service is particularly important for consumers of technology products. Consider that when someone buys a personal computer and makes a choice of Windows, Mac OS, or Linux, their investment over time usually greatly exceeds the initial price paid for the operating system. One invests in learning how to use a system, buying and installing software, entering preferences or other data, creating files—all of which mean that if a product isn’t supported anymore, much of this investment is lost.
The concept of staying power (and the fear of being stranded in an unsupported product or service) is directly related to switching costs (the cost a consumer incurs when moving from one product to another) and switching costs can strengthen the value of network effects as a strategic asset. The higher the value of the user’s overall investment, the more they’re likely to consider the staying power of any offering before choosing to adopt it. Similarly, the more a user has invested in a product, the less likely he or she is to leave.
Switching costs also go by other names. You might hear the business press refer to products (particularly Web sites) as being “sticky” or creating “friction.” Others may refer to the concept of “lock-in.” And the elite Boston Consulting Group is really talking about a firm’s switching costs when it refers to how well a company can create customers who are “barnacles” (that are tightly anchored to the firm) and not “butterflies” (that flutter away to rivals). The more friction available to prevent users from migrating to a rival, the greater the switching costs. And in a competitive market where rivals with new innovations show up all the time, that can be a very good thing!
How Important Are Switching Costs to Microsoft?
“It is this switching cost that has given our customers the patience to stick with Windows through all our mistakes, our buggy drivers, our high TCO [total cost of ownership], our lack of a sexy vision at times, and many other difficulties […] Customers constantly evaluate other desktop platforms, [but] it would be so much work to move over that they hope we just improve Windows rather than force them to move. […] In short, without this exclusive franchise [meaning Windows] we would have been dead a long time ago.”
Comments from a Microsoft General Manager in a memo to Bill Gates (Parsons, 2004).
Complementary benefits are those products or services that add additional value to the network. These products might include “how-to” books, software add-ons, even labor. You’ll find more books on auctioning over eBay, more virtual storefronts in Second Life, and more accountants that know Excel, than on any of their rivals. Why? Book authors, Second Life partners, and accountants invest their time where they’re likely to reach the biggest market and get the greatest benefit. In auctions, virtual worlds, and spreadsheet software, eBay, Second Life, and Excel each dwarf their respective competition.
Products and services that encourage others to offer complementary goods are sometimes called platforms. Allowing other firms to contribute to your platform can be a brilliant strategy, because those firms will spend their time and money to enhance your offerings. Consider the billion-dollar hardware ecosystem that Apple has cultivated around the iPod. There are over ninety brands selling some 280 models of iPod speaker systems (Hansell, 2008). Thirty-four auto manufacturers now trumpet their cars as being iPod-ready, many with in-car docking stations and steering wheel iPod navigation systems. Each add-on enhances the value of choosing an iPod over a rival like the Microsoft Zune. And now with the App Store for the iPhone, iPod touch, and iPad, Apple is doing the same thing with software add-ons. Software-based ecosystems can grow very quickly. In less than a year after its introduction, the iTunes App Store boasted over fifty thousand applications, collectively downloaded over one billion times.
The iPod Economy
Products built to work with the iPod range from automobiles to the iCarta toilet paper holder.
Apple offers certification programs, where developers of accessories for the iPod and iPhone that meet certain guidelines can use the depicted logo. Each of these third-party products potentially enhances the value of owning an Apple product, while each logo serves as an additional advertisement for Apple. Apple even receives a royalty from firms that use the “Made for iPod” logo in advertisements and on product packaging.
These three value-adding sources—exchange, staying power, and complementary benefits—often work together to reinforce one another in a way that makes the network effect even stronger. When users exchanging information attract more users, they can also attract firms offering complementary products. When developers of complementary products invest time writing software—and users install, learn, and customize these products—switching costs are created that enhance the staying power of a given network. From a strategist’s perspective this can be great news for dominant firms in markets where network effects exist. The larger your network, the more difficult it becomes for rivals to challenge your leadership position.
- Products and services subject to network effects get their value from exchange, perceived staying power, and complementary products and services. Tech firms and services that gain the lead in these categories often dominate all rivals.
- Many firms attempt to enhance their network effects by creating a platform for the development of third-party products and services that enhance the primary offering.
Questions and Exercises
- What are the factors that contribute to the value created by network effects?
- Why is staying power particularly important to many technology products and services?
- Think about the kinds of technology products that you own that are subject to network effects. What sorts of exchange do these products leverage (e.g., information, money, software, or other media)?
- Think about the kinds of technology projects you own. What sorts of switching costs are inherent in each of these? Are these strong switching costs or weak switching costs? What would it take for you to leave one of these services and use a rival? How might a competitor try to lessen these switching costs to persuade you to adopt their product?
- Which other terms are sometimes used to describe the phenomenon of switching costs?
- Think about the kinds of technology products that you own that are subject to network effects. What sorts of complementary benefits are available for these products? Are complementary benefits strong or weak (meaning, do people choose the product primarily based on these benefits, or for some other reason)?
- Identify firms that you believe have built a strong platform. Can you think of firms that have tried to develop a platform, but have been less successful? Why do you suppose they have struggled?
Eisenmann, T., G. Parker, and M. Van Alstyne, “Strategies for Two-Sided Markets,” Harvard Business Review, October 2006.
Hansell, S., “The iPod Economy and C.E.S.,” New York Times, January 7, 2008.
Parsons, M., “Microsoft: ‘We’d Have Been Dead a Long Time Ago without Windows APIs,” ZDNet UK, April 22, 2004, http://news.zdnet.co.uk/software/0,1000000121 ,39152686,00.htm.
This is a derivative of Information Systems: A Manager's Guide to Harnessing Technology by a publisher who has requested that they and the original author not receive attribution, originally released and is used under CC BY-NC-SA. This work, unless otherwise expressly stated, is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.