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Network effects and the performance of social media companies


Over the past year, the stock price for many social media companies did not fare well in the market. Companies like Zynga and Groupon saw their stock prices decrease over 70%, and even the best performing social media sites like Yelp and LinkedIn saw a decline in stock prices recently. This is no different for the largest social media company, Facebook, as its stock price drop almost 50% since its IPO in May ($19.21 as of 11/09/12). The optimisms on these companies’ growth potentials quickly faded away as earning reports indicated signs of slow growth one after another. Multiple factors contributed to these slow growths, and to understand them, we should first look at what drives growth.

For social media companies, revenue growth is directly correlated with the user’s growth. This is because more users translate to more opportunities to sell, which in turn will attract more advertisers. Social media companies are unique in that the network effects heavily impacts the growth. As we learned in class, network effects mean that the more people using a particular product (the social media websites in this case), the higher the demand is for that product (until the stable equilibrium is reached). There are usually three equilibriums: a stable one at 0% usage, an unstable one at a low percentage usage, and another stable one at higher percentage usage. In the case of a social media site, once the usage percentage is above the unstable equilibrium (the tipping point), everyone will want to use the social media site, which drives fast growth. However, the reverse can happen just as fast: if the usage percentage is below the tipping point, then the site will be no longer valuable to people, which drives a steep decline in usage rate. A prime example of this is Myspace, where the once most visited social media site no longer attracts users.

Most of the public social media websites are well known. Every one of those sites has already acquired a large user base, and it might be hard for them to drive rapid growth, especially if they are already near the second stable equilibrium. If this is the case, then usage rate will fluctuate, but will always come back down to the equilibrium, preventing growth. The growth prospects of these companies are further damaged by newly emerged competitors. For example, LinkedIn’s emergence decreased the chance of Facebook dominating in the professional networking market. The application of the network effect theory will help to explain why competition lowers user growth. Let us consider the price of using social media sites as time and energy consumption. If a competitor is offering better service or product, the price of the first site will increase, relatively speaking. This will decrease the second stable equilibrium for the first site, driving down user base size. Therefore, the increase in competition in the social media space is costing these public social media companies’ growth potentials.

The future of the social media industry is still very uncertain, as companies have shifted their focus to the mobile space. As time passes, perhaps one of these sites will become the next Myspace, while a new company will rise into dominance with a superior product.

– Cascade


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