Network effect and the New Sharing Economy
The article discusses the role of network effects on market power in sharing economies. This business model, based around peer to peer market interactions, has given rise to a host of fast-growing, powerful start-ups. “Unicorns are startup companies that have not generated a single cent in revenue but are able to marshal multimillion-dollar amounts of capital from investors and cross the one-billion-dollar threshold in market value.” Rather, these companies are valued on the basis of the number of customers they attract and the amount of traffic that goes through their ecosystem every day, which in turn translates to market power in their respective markets. This shows how in this market, network effect that a product produces in of itself is worth billions of dollars.
For a company to generate a large number of customers in the beginning (the “initial adopters” of the product), it must keep its prices low. In other words, the reservation price of the product must be low enough that consumers would be willing to modify their consuming habits. Historically, this business strategy seems ineffective. Yet this changed with the rise of the Internet, telecommunications, air travel, shipping, and the spread of global phenomenon such as globalization. Suddenly, economic markets are much larger networks than they were before. While if fifty years ago a market for a restaurant represents primarily the people who live nearby, meaning that no matter how good a restaurant is, its growth will always be limited to the number of nodes within its network (hence the network effect it produces has a limit), nowadays a business can expand transnationally and dominate over global rather than local markets.
Hence, a new economic model that trades revenue for consumer acquisition. Sharing economies happen to be particularly effective at this strategy as their peer-based interaction model essentially “links” its customers together as nodes, allowing for rapid creation and expansions of networks. As more and more sharing economies seek to dominate their respective markets, we see phenomena that appears to be common within the modern global economy today: 1) companies has incredible amounts of revenue yet takes a long time to turn profits and barely does so when they do 2) monopolies are much more prevalent and difficult to displace than they were ever in the past. Uber, Airbnb, and Amazon are all examples of companies that contribute to these phenomena. “In some markets, sharing economy platforms like Uber and Airbnb have grown so much that they are attracting lawsuits of abuse of dominance.” Keep in mind that Uber and Airbnb were all founded less than 10 years ago and are already looking like unbeatable monopolies. Alongside this, companies like Amazon regularly acquires, or outcompetes, smaller competitions. Yet despite their tremendous size and power, Uber is still turning billions of dollars in losses, and even a much larger, more established company like Amazon still operates on very small margins. All of this make sense if we once again use network effect principles to explain them. To attract and maintain a large network, companies must ensure that reservation prices for consumers are low, hence the tight profit margins. A successful sharing economy represents massive and highly interconnected cluster, with high cluster density and large number of outlets (nodes) to influence nearby networks (and the internet just serves to expedite any cascading effects), hence the fast-rising, seemingly unbeatable monopolies.
All of these effects combined can be both hugely beneficial and problematic at the same time. As one might see when comparing between current and past business models (think Uber vs. taxis), mass markets are able to provide consumers with much better price and convenience. A few decades ago, providing free 2-day shipping would seem like an impossible money-loser for a retailer, but it is only possible now thanks to the size of Amazon (it lost $7B last year on shipping, but who cares when you’re worth $1 trillion and that’s the whole reason your customer chooses you anyways). Monopolies, on the other hand, might hurt competition and prevent innovative ideas. Either way, whether we like it or not, it seems as though this network-based business model is the way of the future.