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?

Democratizing Taxes

There’s an old proverb:

Nothing in this world is certain except for death and taxes, but scientists are still trying to prevent death.

Government and taxes

Governments are a way for people to provide certain basic needs at scale. Most commonly, the services best provided by the government are those of natural monopoly: control over natural resources, electricity and water supply, roads and railroads, safety (police and army), health and education. Things that have economy of scale, where competition is ill advised, and privatization will not benefit the people.

Let’s analyze the army, as an example: the army provides security. It prevents threats to the people of this country by the people of other countries. Let’s say, for the sake of example, that the army is privatized. My neighbors pay for protection and I don’t. Can the army protect their country without protecting mine? No. Therefore, I’m incentivized not to pay, not to conscript. I leach on others. Governments are built to prevent such behavior, and it is done by taxes.

A tax is a way of collecting money from the people, for the benefit of the people through these

natural monopolies. And in order to make things easier, all tax money is pooled into one big pool, and then spread back to the different services. Through the centuries of slow information and transaction flow, this provided a certain fairness. Collecting taxes was complicated, spreading the money was complicated. Asking people what they want was complicated – even in relatively modern democracies.

Over the years, technology and changes in moral stands may change what is considered as public service and what is considered for private service, as the example of the privatized firefighters becoming popular again in the US – they will save your life, but will only save your property if you pay extra. However, the amount of control you had about how your tax money was spend was extremely limited.

Charity and taxes

There seems to be a charity boom over the past few years. I think there are two reasons for this:

  1. Increase in available income: there has been a tremendous improvement in the average quality of life over the past hundred years. Over the last decade, a lot of technologies have reached a level of maturity that we get so much bang for the buck, that there are we have spare bucks in the bank. Computers are dirt cheap, cars are smaller and cheaper, overall health is better, etc. This leaves more income for charity – because giving makes us feel good about ourselves.
  2. Internet makes charity direct: take Kiva, for example. Kiva provides you with an interface to control exactly what happens with every dollar you donate. You know who gets it, and what they plan to do with it. This is not an organization governed by a group of old people in suits. This is you helping one other person.

I think that for these two reasons, we will see more and more charity in the coming years.

There are claims that charity is the sign of bad policy. That is, if governments did a better job, we wouldn’t need charity. I think it’s the other way around. Governments were the only way we could manage the basic services in the old days. There just wasn’t any other way. Taxes are built to fit the old days.

Charity is people voting with their money on what services are important and what aren’t. What they believe should be the basic rights of every human being and what isn’t. I believe that we will see more charity-like models enter governments over the next fifty years, as democracy becomes more direct and more open than ever before.

Charitable Taxation

Don’t get me wrong – I think taxes are extremely important. It is crucial that we force everyone to partake in the payment for the public services we consume. What I suggest is a concept of Charitable Taxation, under which you will get a choice of spending some of your income tax directly to charity or government service of your choice. For example, I think most of my income tax should go to health and education services. Other may think the police is more important.

Services that are underfunded will have to change. They will be forced to become private – as it seems that nobody feels they are necessary as government services. Others will bloom, as the people feel they are more important. And what services are provided by the governme

nt will be in constant change, always adapting to the time.

There is a lot of details that need to be brushed out, obviously. I’m not completely certain that this mechanism is, in fact, stable. However, I think that we are best provided when we are more involved in how our governments act. After all, they are the government of the people, by the people and for the people.

Teaching Your Customers

The way of the world is to throw coincidences at us. Random events happen all the time (how many new couples have met at airports because of the recent volcano eruption?). It takes a conscious mind to make a connection between these unrelated events.

My previous post discussed learning. Right after publishing it, I encountered a this talk about teaching your customers, which described the same steps I have, only better. This is the sort of coincidences I love so much. They make me feel as if the world is trying to help me.

That’s not true, though. Things just happen. Most of the time, we don’t notice. When we’re busy thinking about something, though, are brains get attuned to it. We start noticing it more often. We see more details. We start living in high-definition.

Proof By Example

What's in this photo? A smartphone? An iPhone? Can you tell which version of the iPhone this is?

What's in this photo? A bird? A swallow? Do you know the airspeed velocity of an unladen swallow?

The more you are interested by a subject, the finer the details you notice. If you knew this is the iPhone 3GS, you may be  a gadget freak. If you knew this is an European Swallow, you are probably a bird-watcher. If you saw a phone or a bird, you are not. Standard definition sucks.

Living In HD

You should help your customers live in HD in regard to what you do. They will reward you by being passionate about you and your brand. They will tell their friends. They will buy more. They will upgrade to the more expensive model. How do you take a non-customer and turn them into a fanatic? You teach them how to become better. If they will feel empowered and awesome, they will be motivated to stay with you.

  1. The Suck Zone – Your user feels he is over his head. He is afraid to try, unmotivated to use the product. Last post I’ve talked about cooking and coding. These are great examples. If you haven’t cooked anything before, you will not feel empowered by a new frying pan. You will feel that you suck.
  2. Easy Breezy – If your user tries your product and starts using it regularly, he moves here. This is what I feel regarding my digital camera. It has twenty bazillion options, but I mostly use it as a point and click camera (which I love). I’m not that into photography.
  3. La Passion - The user is passionate about what your product enables them to do. They want to learn more. They will try to find ways to get better. Being there for them is a great opportunity to create brand loyalty, to sell them extra products, to help them become even better. Seth Godin talks a lot about the passion and building a tribe. You should be here.
  4. The Stuck Zone - Like in many marriages, left alone the passion fades. Be careful. Something else will fill the void. Once the user is lost, they will hardly ever come back.

Make Me Awesome

Let me go back to the example of photography.

Flickr is such a great site, because it is full of opportunities to learn more techniques about photography. You start with the free account, but once you start seeing great photos and try to create some yourself, soon you need the pro account.

Canon creates great cameras that professional photographers are passionate about. What about me? When should I manually control the shutter speed? Their documentation is boring and frightening.  It’s a missed opportunity. They could have explained what effect shutter speed has on the quality of the image. They could have turned me into an amateur photographer. Next thing you know, I’d be buying a new camera with replaceable lenses.

In short:

Send me this:

Not this:

The Scalable Workplace

Imagine the following scenarios:

  • Michael is a lawyer. He’s married with a boy and a girl at home. Michael spends most of his day at the office, working hard. He gets paid for his effort, as his paycheck is highly correlated to the amount of billable hours he can put on his clients. In fact, no hours – no pay.
  • Lucy works at a large creative office in NY city. She manages a team of graphic designers who design billboard ads. Work starts at nine and ends at five, when she leaves for home. Most evenings she stays at home with her boyfriend. Sometimes they go out for a beer. When they do, she always points at the ads she was responsible for. She takes pride in doing a good job. Her monthly salary is enough to live the comfortable life she learned to love.

Now, imagine the following scenarios, and find the difference:

  • Ragga was a software developer at Microsoft. Last year he got an iPhone and it changed his life. He promptly quit his job and started developing applications for the iPhone. Slowly, his revenue started rising. Soon enough he was raking a whopping $1000 a day, as one of his applications, an ad-supported dating service, was awarded favorite by a popular magazine. Today he is working for two hours a day, and the profits just keep growing.
  • David sits in front of a computer. Numbers in green and red fill the screen. He sweats in the Miami heat, and moves uncomfortably in his chair. That morning he accidentally bought a large amount of call options for a stock of a large pharmaceutical conglomerate. If he can’t undo what he has done, he will lose his pension. He hopes he can sell them before his wife notices what he’s done. Luckily, by the end of trading hours the price of the options has risen, and he is able to sell them for a hefty profit. That evening, the happy couple opens a bottle of champagne to celebrate their good fortune.

The Secret Of Scalability

I define scalable and non-scalable workplaces as follows:

Non-Scalable Workplaces are workplaces where reward is correlated with work/effort.

In Scalable Workplaces, no such correlation exists.

Non Scalable Safety

If Lucy performs exceptionally well, she gets promoted. If she’ll stop working, she will be fired. Michael gets paid by the hour. There is a limit on the amount of hours he can work in a month, and there’s also a limit on the amount he can charge for an hour’s work (even if it is a high limit). Both these cases roughly translate to:

Pay = Work x Time

This equation brings us to the conclusion that although you can be wealthy, if your hourly rate is good, these jobs will not make you filthy rich. To become filthy rich, like Bill Gates, Warren Buffett and Carlos Slim Helú, you must play the scalable game.

The Scalable Game

Ragga and David represent the scalable game. Ragga put a lot of effort into his iPhone application, but the amount of his success is not directly correlated to amount of effort he has put. In fact, an external effect was the biggest driver of his success. The dating application became so wide-spread, that he could work less and still make more. It was just as likely that he would not make even enough to cover the rent on his apartment. David made a large sum of money in one day. In that day he could have lost his entire savings, or gain an untold fortune.

In the scalable game, the profit equation is roughly:

Profit = Risk x Reward

where risk is always random, and sometimes the reward is, too. And neither is limited by the bell curve.

Mediocristan and Extremistan

There are two countries we are dealing with: Mediocristan and Extremistan.

Mediocristan is where most of us live. It is ruled by the bell curve. Most people’s heights and weights fall within a boundary. So do the salaries of the same profession. It is just as rare to find a taxi driver making $5000 an hour as it is to find a 10ft tall man. Pay is a function of work and time, both limited resources.

Extremistan is the land of information. Information is not bound to the rules of matter. It multiplies almost without effort. In fact, the less effort it takes to multiply information, the more extreme Exteremistan becomes. When software has direct access to the stock market, fluctuations in get amplified. When a book becomes a bestseller, it sells tenfold more than the second book on the list.

Living in Extremistan is a gamble, a winner-take-all game. If you control information that turns out to be valuable, like the copyrights to a popular video clip, you can make a big profit. If your information turns out to be worthless, you get nothing.

Entrepreneurs live in  Extremistan

Will work for milk & cookiesStartup founders live in Extremistan. By starting our own technology company, we accept the risk of losing everything for the small chance at fame and fortune. We do it for various reasons, which may have nothing to do with neither fame nor fortune, but we take the risk nonetheless.

It is important to understand that in Extremistan, there is a great deal of randomness and unpredictability. The market is complex and changes all the time, and the rewards are often spread unevenly. Chances are you will not become a billionaire. Chances are you will not be followed by a million users on Twitter. Chances are you will not succeed. But you might, if you are lucky.

In fact, Extremistan it is such an arbitrary place, that I’d suggest not living there. Our brains are not fit for such a place. Live in Mediocristan. It is safer there. And when you do, choose a profession with good return on your time. Be a lawyer or a doctor. If nothing else, it’ll make you mother proud.

For King And Country

The last couple of days I’ve indulged myself with a course on the philosophy of morality. This is an online Harvard course dubbed Justice: What’s The Right Thing To Do, brilliantly delivered by Michael Sandel.

Just to get the obvious out of the way – I have never imagined such an engaged class room. Most of the professors in the universities I studied at described teaching as a necessary evil. In our schools teachers tend to dictate the materials and leave no room for discussion (to the extent that I’ve heard of a teacher being fired for trying to engage the students). This course is based honest debate in class. It’s a shame I’ve never experienced such vigorous learning methods in my day (ha! I was lucky. It got worse after I left, or so I hear).

In one of the sessions arose the question of army service. Let me present you with the question raised in class:

The army has discovered it is not able to fill its ranks, and they are falling behind on their recruiting targets. Which of the following methods do you consider more morally just or fair?

  1. Increase pay and benefits – by offering better work conditions to soldiers, retention will go up.
  2. Conscription – a draft, selecting out of the able men and women and forcing them to enlist.
  3. Outsource – hire mercenaries who are willing to work for the existing wages.

Most people voted for Option #1. Did you? Let’s discuss this option a bit further.

The Civil War Method

During the Civil War, the Union used a hybrid system. It was based on conscription, however, if you were selected to enlist and could afford it, you were allowed to hire a substitute to go to war in your stead. What do you think about this system? In modern society, it seems unjust. It dictates, too clearly, that the poor will enlist to protect the rich. Those who have not will risk their lives to protect those who have.

The All Volunteer system, as suggested in option #1, allows anyone who wishes to join the army the option to do so. An All Volunteer army raises an image of patriotism before our eyes and the scent of virtue in our noses. If you look at the statistics, you’ll notice that those who join the army come mostly from specific social-economic backgrounds (and not from the top). For example, now that recession is in place, retention is close to an all time high. Job security becomes number one driver for enlistment.

In fact, if you follow this logic through, the All Volunteer system seems not so different from the mercenary system. People hired by means of money, regardless of their sense of obligation to the country they partake in.

The Israeli Method

Any system has its inefficiencies. In Israel, we have a conscription system where ideally every able man and women would serve two to three years of compulsory service for the country. This system is long in debate, as wars become less frequent and less threatening to the survival of this fairly young country.

First, there’s the economic toll on society. In theory, most of the able minds and bodies in the country donate two to three years to the country. And when I say “donate”, I mean it in the most literal sense. There is almost no pay. There are hardly any benefits. Most do not learn any profession they can use afterwords. And there are more soldiers than there are jobs, so there are grave inefficiencies for the economy as a whole. For many of the youth, these are wasted years, where the alternative would have been in a productive workforce in the market.

Second, nearly half of today’s youth do not serve in the army. For various reasons they are considered unfit. Forcing them to enlist would grossly outweigh the benefits of enlisting them.

These reasons (and some other) convince people that it may be better to move from conscription to the All Volunteer army.

Motivational System

The situation is slightly different if you decide to stay for longer than the compulsory three years. I’ve served in the army for nine years, six of them as an officer. During this time I was surrounded by people who were highly motivated and capable. We believed what we did had direct effects on the safety of the Israeli citizens. This is the one major benefit of the volunteer army. If you chose to be here, you will try harder.

Money is a bad driver of  motivation. Most of us were paid 30% under market value, yet many people felt that the job they are doing is both more interesting and more important than the financial rewards of working nine-to-five at any other workplace.

This is why we need to be careful with monetary compensation. It creates a divide between the interests of the employer and the interests of the employee. It pushes people away from creativity and risk taking and into the realm of mediocrity. I’ll talk about this point some other time. In the mean time, you can read this.

Some Partial Conclusion

Returning to the world of business, I want you to consider the methods of motivation and fairness where you work. Joel has mentioned before that he’s against monetary rewards. When you start doing something you love for money, you stop loving it. If you code for money, the project becomes less important than the money. It’s sad, but it’s true. And it is worse where performance is directly linked to pay.

You need people in your company to feel as if they are creating tremendous value. Know they are correcting a wrong. Want to fix the world. You want patriots in your company, not employees.

May this be a Happy, Moral and Advantageous year to us all.

Watch it!

Here’s a link to the first lecture. Also, I’ve embedded here the lecture discussing army conscription.