Network Effects in the Tech Industry
Technology giants are hitting all-time high valuations. With today’s ever-changing environment, success in the tech industry has been increasingly driven by network effects. According to a study, over the past 23 years, network effects have accounted for approximately 70% of the value creation in tech. As stated in the article, companies that leverage network effects have asymmetric upside yet less than 20% of startups have network effects as an element of their business plans. Applying network effects to companies creates defensibility, which is the key to a sustainable competitive advantage.
In class, we talked about the small-world phenomenon — the idea that the world looks small when you think of how short a path of friends it takes to get from you to almost anyone else. This phenomenon suggests that not only do you have paths of friends connecting you to a large fraction of the world’s population, but these paths are surprisingly short. With that said, if one individual starts using a new application, the likelihood of someone on the other side of the world knowing about this new application through this path/connection to this one individual is higher than we think. The world is more connected than we think it is and information as well as knowledge about new ideas can be spread very quickly. Given this small-world phenomenon, it is very possible to find a user base of a platform grow exponentially. This wide reach contributes to the network effect — when an additional user makes the service more valuable for every other user. There are several types of network effects in technology: direct (e.g. Facebook), two-sided (e.g. eBay), data (e.g. Waze), tech performance (Skype), and interpersonal (Slack). All of these successful technology companies sustain their competitive advantage using the network effect, making it defensible.