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One of the key characteristics of a platform business is the network effect.
In the area of platform business, I’ll define the network effect as the business value depends highly on the number of users, buyers, and sellers interacting on the platform.
In short, the more users we have on a platform, the higher the network effect and the higher the business value.
How would the network effect bring a higher business value?
The Network Effect and the Business Value
Let’s take a look at this diagram:
In a platform business, if we have providers and users on the same platform and transactions take place. The platform takes a small cut of the transaction to enable to deal. The small amount will not be enough to cover the business if there are, say, a few hundred providers and users.
However, if the platform has over 10,000 providers and users, each making a transaction, that is a lot of money to the platform business.
Simple maths as an illustration. If we have 2 platform businesses: Platform A and Platform B. Assuming that the transaction amount is $100, and the platform business earns only $1 per transaction.
Platform A
Platform A has 500 users, each making one transaction:
Total transition made: 500 transactions
Total transacted amount: $50,000
Platform business earns: $500
Platform B
Platform B has 10,000 users, each making one transaction:
Total transition made: 10,000 transactions
Total transacted amount: $1,000,000
Platform business earns: $10,000
From the above example, we can see that Platform B benefitted from a larger network effect.
Assuming that we define business value as pure revenue earned, we can also see that the business value of Platform A is $50,000 while the business value of Platform B is $1,000,000
This is why a high network effect will bring a higher value to a business.
Network Effects and Network Externalities
We may have read the interchangeable terms “network effect” and “network externalities.” Are they the same?
On the surface, it’s very much used interchangeably with a slight difference in the scope.
For the purpose of this article, we will define them differently.
In “Network Effect,” the growth of the platform business is based directly on the growth of the network.
In “Network Externalities,” the growth of the platform business is impacted by independent events. i.e., the business didn’t pay for such events.
For example, a new factory in a residential area decreases Airbnb rental prices, creating a negative externality. A new shopping mall in a residential area increases Airbnb rental prices, creating a positive externality.
Positive Externalities and Negative Externalities
As you can see, positive externalities are very important for businesses. A positive externality promotes growth and, in turn, grows the value of the business and adds more value to the user community on the platform.
If the platform has some resulting negative externalities, the business should not ignore such externalities but address or internalize the externalities so that they will not impact the growth of the platform.
For example, the growth of Grab and Uber in Indonesia has caused unrest among taxi drivers. It is so serious that there are stories of conflicts between taxi drivers and Grab/ Uber platform drivers, specifically on Bali island.
The growth of Grab (since Uber has sold the Southeast Asia business to Grab) in Indonesia has been hampered by the resistance of the local taxi drivers.
Today, Grab is still working with the government and sent appeals to the local taxi drivers to work together.
Economies of Scale in Network Effects
The economy of scale in platform business has also taken a change.
We know that in the economy of scale for traditional businesses, the cost of goods produced will usually go down over a period of time due to efficiency and experience in the operations.
This is also commonly referred to as supply-side economies of scale: A business will earn more when the cost of goods goes down.
For the platform business, it is demand-side economies of scale. A business will earn more when there are more users on its platform.
Two-Sided Network Effects
Most network effects are two-sided: The supplier and the user. And we can see this in many businesses:
- Grab: Drivers and riders
- PayPal: Sellers and buyers
- Airbnb: Hosts and guests
- Google Ads: Advertisers and searchers
Two-sided network effects are an easier implementation than multi-side network effects. A new platform business that is two-sided can easily focus on bringing suppliers. When the supplier reaches a critical mass, there will be natural growth in the user base.
We can see this happening in some businesses:
- Grab hires Grab drivers by giving sign-up incentives to new drivers
- Airbnb offers no fees for new hosts
- Google offers $75 credits for new advertisers
It is important to note that when a platform business wants to grow the network, they have to ensure that entry to the platform is easy. We commonly call it “Frictionless Entry.”
Frictionless Entry
In the frictionless entry, platform businesses should ensure that the registration process is as easy as possible.
For example, Fiverr registration is as easy as entering an email. Once the new user is registered, they join the marketplace almost instantly. When they need to hire a supplier, they will have to add the details of their profile.
Many platform businesses have also made frictionless entry easier with single sign-on (SSO) using their Google, Facebook, or Apple account.
Using SSO is one of the good ways to ensure frictionless entry to a platform, ensuring rapid network effect growth.
Side Switching
In two-sided network effects, you can also scale the network by switching sides: i.e., Sellers can become buyers, and buyers can become sellers.
Side switching is useful when the network becomes lopsided. Platform businesses can offer coupons or discounts to switch some users to go over to another side.
This is commonly seen in businesses like Grab (incentivize riders to be drivers) and Lalamove (incentivize senders to be drivers).
Frictionless entry and side switching are important tools to help grow network effects.
4 Kinds of Network Effects
We have seen network effects in terms of positive and negative. We have also explored the two-sided effects. Now let’s go internally to explore 4 kinds of network effects.
As a platform business operator, you will need to know the 4 kinds of network effects:
- Positive Same-side Effects
- Negative Same-side Effects
- Positive Cross-side Effects
- Negative Cross-side Effects
Same-side effect means that the growth of the network affects only the respective sides of the platform. i.e., Sellers affecting sellers, buyers affecting buyers.
Cross-side effect means the growth of the network affects the other side of the platform. i.e., Sellers affecting buyers, buyers affecting sellers.
We can see the relations between the sides against the positive/negative effects in this chart:
Understanding the models will enable a platform business to react quickly to any changes in the network effects. If it’s a positive effect, the business can reinforce to scale more. If it’s a negative effect, the business should take measures to mitigate the negative downturn.
