The Right Hand Side of The Network Effect

We all know about network effects. We understand them intuitively.

In economics and business, a network effect (also called network externality) is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service increases as more people use it.

The classic example is the telephone. The more people own telephones, the more valuable the telephone is to each owner. This creates a positive externality because a user may purchase their phone without intending to create value for other users, but does so in any case.

Network Effect, Wikipedia

The Four Stages of Product Adoption

I bet most of you know this image. Dividing customers into early adopters, majority and laggards is Business of Software 101. What we usually don’t discuss is the effect of the accumulated graph, which is the level of technology saturation.

The stages of a product need to fit not only the type of people in the segment, but also the level of market share and saturation in the population. Getting a repeat customer is very different than selling for the first time. Expectations are different and so the product must be different.

Network effects are paramount to the adoption of new technologies, and not only because early adopters talk about them and evangelize them. Network effects have everything to do with usability, and this is something you need to understand when you think about strategy.

1. The Runway (The Chicken and Egg Problem)

Let’s take HDTV, as an example. We don’t usually think of TV as a business with network effects, but in fact it has very strong network effects. The more people buy TVs that support HD, the more incentive there is for media producers to provide HD content. It also goes backwards. The more HD content is out there, the more people will buy HD television sets. Basic rule of network effects applies: value is proportionate to adoption rates.

Early adopters eat eggs for breakfast, if you show them a chicken. The rest, not so much. The runway can be very long. Fax machines took almost twenty years to catch up. Color TV took ten years, etc.

2. The Hockey Stick (Ramping Up)

Network effects are getting stronger. Value of adoption is rising as the product gets more popular. This is what every investor is looking for.

The Hockey Stick growth phase is a wild ride. You hang on for dear life, as you turn (faster and faster) into the next big thing. You will see very steep growth in revenue. You are happy, your investors are happy, your users are happy. This is when DVD becomes available at every Blockbuster, the USB port is suddenly available on every computer or the internet makes newspapers look arcane.

The image below displays adoption rates of some of the most popular technologies of the past century. The X axis is time and the Y axis is percent of penetration. You can see the hockey stick on most product. Then, there are those who seem to rise slower, like cable TV. That also has to do with network effects (or lack thereof). Click on it to see a larger version.

3. Saturation (Super Size Me)

Everyone has a TV, a DVD player, a cellphone. Revenue streams steadies, as there are no more new customers buying the product. Stockholders are anxious. They expect the company’s revenue to continue to grow. Strategy changes drastically.

There are no more new customers. Now you need old customers to replace the product they already have. I replace my cellphone every two years, my DVD player breaks every six months, the TV goes out every five. How do they manage to get me to spend, spend, spend? There are several strategies:

  • Sell more to each customer. A household of six should have four TVs, six cellphones and three cars. Wait. What? When I was your age, we only had the one horse!
  • Sell better features, minor changes within the same technology. This is the age of bigger TVs, super sized McDonald’s meals, smaller cellphones, shiny cars.
  • Sell services and not products. Flickr for your pictures, YouTube for your videos, Facebook for your friends, and very little ownership.
  • Make it to break. Price goes down, and so does quality.
  • Make minor changes to the technology. Faster networks (and the always-connected-bandwidth-guzzling iPhone charged by the kilobit).

4. Decline (So 90’s)

Ye Olde GramophoneVHS was replace by the DVD. Newspapers are replaced by news websites. Books will be replaced by e-readers. Each of these newer technologies had or will have a long runway, but change is inevitable. The old product declines inversely to the hockey stick growth of its replacement.

Some companies predict the change, and move from one technology to the next. Others die. It’s the circle of life.

Technical Addendum

Bass Diffusion Model helps you calculate the adoption rates of your technology:

So if at given point in time t, N(t) consumers have adopted the new technology, and a total of x(t) consumers have adopted it so far, 0<p<1 is the internal influence  and 0<q<1 is the external influence (the network effect) then dx/dt is the rate of adoption of the technology by the market.

For more on this, you can read the materials from a course I’ve taken about diffusion of new technologies, available here.

So can you now predict the growth of your product?