Nir Eyal and Sangeet Paul Choudary have written an absolutely terrific column for TechCrunch about network effects. The essay is titled, "The Network Effect Isn't Good Enough." Network effects, of course, exist when the value per user rises as the number of users of a particular good or service rises. When network effects are strong, one firm can become the standard in a market - think eBay in auctions, for instance. In these situations, firms tend to try to "get big fast" so as to move up the curve and achieve a high value per user. Then they hope that switching costs will lock users into their good or service. Eyal and Choudary point out that many startups in Silicon Valley bank heavily on the notion of network effects. They willingly run up huge losses in the early years, hoping to cover those losses with venture money. Then they hope to reap the rewards when they have become the dominant player in their particular market.
The authors point out, however, that network effects may not be the elixir that many startups believe they will be. Why? The authors make several key points. Here is an excerpt from their argument:
For one, in the old days, consumers paid to access the network through their upfront investment in hardware. These upfront costs locked users into the network and once they were in, they were in for good, thus erecting barriers to entry for would-be competitors. However, the cost of providing access to the network has fallen precipitously. The days of customers buying expensive hardware to use a network are gone as is the correlating lock-in effect. In addition to access costs falling to zero, another key component of what once kept users locked into a network has vanished. Once, porting contacts onto a new network, like switching instant messaging services from Yahoo! to AIM, was a non-trivial task. Today however, customers use their Facebook, Twitter or Google profiles to join a new service in seconds. A burgeoning network, take Instagram or Pinterest, can leverage the single sign-on enabled by the social graph to reach critical mass faster than ever before.
In other words, switching costs may not be nearly as high as many startups believe them to be. Thus, the lock-in effect doesn't materialize as hoped. Consumers flock to a platform, but then they may just as quickly move on to a different product or service. Think MySpace relative to Facebook. This limitation on switching costs may explain why many startups have a hard time "monetizing" their eyeballs. If they try to extract more value from their consumer, they face the startling possibility that people will simply switch to another product or service.