Network Effect: What It Is, Working, Advantages, And Disadvantages

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Network Effect What It Is, Working, Advantages, And Disadvantages

The Network Effect is a situation where the addition of a new user in the business helps in making the product or service and the experiences better for the already existing users. With a higher growth and higher density of the network, the value of the business and its products to the user increases exponentially. The network effect is mostly seen in tech companies, eCommerce, and social media platforms.

In this article, you will learn what the network effect is and how it works for businesses to help make better experiences for users. Apart from that, you will also learn about the types of network effects possible in business. Finally, we will discuss some of the major advantages and disadvantages of network effects. Hence, to learn more about this phenomenon, read on through to the end of the article.

Contents

What Is The Network Effect?

According to Investopedia,

The network effect is a phenomenon whereby increased numbers of people or participants improve the value of a good or service. The internet is an example of the network effect. Initially, there were few users on the internet since it was of little value to anyone outside of the military and some research scientists.

However, with the rise of the Internet, more and more people got access. This way, they produced more information, content, and services on the Internet. Websites improved and developed, and hence attracted more users to connect to each other. This allowed businesses to grow on the Internet. With the increase in traffic, the Internet offered more value to all, which is a pure example of a network effect.

Let’s take an example of a business running through memberships. Suppose the business has only one member. The value of the single membership is positively improved when more users become members of the platform. As the value increases, the factor encourages more users to join the platform, which further increases the value of the latter.

When it comes to platform businesses, their main source of value creation and competitive advantage in the market is through positive network effects. You can see this constantly happening with social media platforms, eCommerce websites, and other internet platforms as well.

How Does The Network Effect Work?

According to the Wall Street Mojo,

The effect occurs because of the impact the event creates. When additional members join, they bring extra value with them to the brand, community, and its members. As a result, popularity, trust, and value keep increasing. This, in turn, attracts members further, resulting in an avalanche effect.

In most cases, the network effect leads to an improved experience for the end consumer as more consumer starts to become part of the business. Apart from that, it also encourages new participants in the business to benefit more from the network as the network increases its options.

As already explained, you can see the network effect working best for social media platforms. For example, consider the social media platform named Facebook. The more its users post content, such as media and links to the platform, the more useful the platform becomes to the users. Hence, platforms like X (formerly Twitter), Threads, Instagram, and YouTube achieved exponential growth.

With every new individual joining a social media platform, there can be multiple network effects to be seen. As more users join and participate in the platform, other companies present in the platform start advertising their products and services while capitalizing on trends. As advertisers in the platform increase, it also helps in generating more revenue for the social media platform.

This way, the platform website evolves with time and is able to provide more usage options to its users.

What Are The Types Of Network Effects?

The following are the major types of network effects that you will come across:

  1. Direct: The increase in users makes the offerings more valuable.
  2. Indirect: The value of the offerings increases with the expansion of the network.
  3. Two-sided: The value of offerings that increase with the expansion of the network further increases the value of original offerings.

What Are The Advantages And Disadvantages Of The Network Effect?

What Are The Advantages And Disadvantages Of The Network Effect

According to Forbes.com, “Once you see the underlying math, it’s clear that network effects are the one business defensibility that stands the test of time, cultural change, and technological progress. Defensibilities are critical because they help you maintain your competitive advantage in the face of changing technology, culture, and markets.”

The following are some of the major advantages and disadvantages of the network effect:

Advantages Of The Network Effect

Here are the major advantages of the network effect from which businesses benefit:

  1. Once a business achieves critical mass, the goods and services attract new and additional users due to their benefits and utilities.
  2. With time, the companies start becoming self-sustaining.
  3. It creates avenues for new entrepreneurs and creators to pursue unique and efficient products for the public.
  4. It is easier to increase the capacity of the business with the rise in the number of users.

Disadvantages Of The Network Effect

Here are a few disadvantages of the network effect which you must be aware of:

  1. It is hard to gain traction at the initial stage (hard to achieve the critical mass status).
  2. Once the platform achieves critical mass, it might lose its efficiency and innovative character.
  3. In some cases, there can be situations of congestion if too many people use a product or a service. (Example: Having too many users on the same network at the same time slows down the network.)

Final Thoughts

The network effect is a situation in business wherein as the number of users/ consumers in the business increases, the business is able to improve the value of its goods and services. Some of the major examples of network effects are the growth of eCommerce sites, social media platforms, and various other Internet-based platforms.

The network effect helps in various ways. With the rise in the popularity of the business, the users in the business effectively act as salesmen while they spread the word of the business by themselves to a greater audience. How do you think the network effect helps a new business to grow? Share your opinions in the comments section below.

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