Chapter 2. Networks Multiply Effects

Chapter 2. Networks Multiply Effects

FOR MOST OF US IN THE REAL (OFFLINE) WORLD, TRAFFIC IS A BAD THING. More cars on the highway at rush hour create negative network effects. Each driver reduces the quality of the experience by congesting and overloading the highway network past its limit. But in the online world, traffic is a powerfully good thing.

Positive network effects created the Web 2.0 network platforms and contributed to the online hypergrowth of networks such as Google, Yahoo!, eBay, Skype, Wikipedia, Craigslist, Flickr, and others. These enterprises have strategically combined different kinds of network effects—including direct, indirect, cross-network, and demand-side—to multiply the overall positive impact of network value creation. Positive network effects explain, for example, why it could make brilliant but counterintuitive economic sense for GoTo—an early search engine innovator—to pay 5 cents to acquire a new search user just to get advertisers to pay 1 cent or more for that search user's pay-per-click keyword advertising.

Latecomer Google demonstrated a complete set of two-sided network effect multipliers that enabled it to be the first to reach critical mass and sustainable profitability in the paid keyword search race, even before first-movers GoTo and Excite. Ad-revenue-based online competitors, like Google, are disrupting the rules of the game for their offline rivals in the technology and media industries by providing free services to search engine users (the consumer-focused side of the Google platform), subsidized by advertisers (the second side or group linked to the Google platform by the AdWords self-service advertising network).

U.S. advertising expenditures were about $100 billion in 2007, nearly half of the global total. Just for comparison, U.S. venture capital investment in all stages (from early to late) during the first quarter of 2007 was a relatively modest $7 billion and was probably less than $30 billion for the year. U.S. marketers will continue to shift their spending into online advertising for a projected total of $19.5 billion in 2008, with $8.3 billion being spent on paid search ads, which are typically PPC, cost-per-action (CPA), and online sponsorships. Growth is coming from "new money": 44% of the companies in search advertising started in the past two years and are buying more keywords, leading to higher prices and overall increases in budgets and spending.

Google is the big winner in online advertising, dominating in the U.S. and internationally. It not only generated the most global online revenue in 2006, but it also grew at nearly two times the rate of its peers. Despite competition from other U.S. online advertising networks—such as Yahoo!, Marchex, AOL, Monster, Gannett, the New York Times online, and Knight-Ridder—Google grew its net advertising revenue by 63% year to year.

Google's amazing success makes it easy to forget that it faced at least two critical make-or-break junctures in its race to dominate the "winner-takes-most" paid search marketplace. Two natural experiments in Google's past were especially critical:

• Despite being a latecomer, Google used a powerful combination of network effects strategies to defeat its strongest competitors.

• AOL helped tip the paid search market to make Google's average U.S. search revenue per query more than triple that of its competitors. Positive network effects explain why the value of AOL's 7–9% market share points were worth as much as $4 billion to Google, although analysts argued at the time that $1 billion was too much to protect Google's traffic from falling into Microsoft's hands.

2.1. Web-Enabled Online Network Effects

Positive network effects increase the value of a good or service as more people use or adopt it. The simplest network effects are direct: increases in usage lead to direct increases in the value of the system. Telephone service is a great example of this. The more people available to call, the more valuable the system becomes.

Web-enabled online networks have generated several new types of positive network effects. They combine the powerful economic characteristics of digital economics—high upfront costs but negligible incremental costs—with the opportunities of exponential network growth in users and usage, as well as willingness to pay. When increases in usage create more value across all users, a rise in returns is generated that alters the nature of the competition substantially. Achieving critical mass offers the potential for exponential growth, as we saw with Flickr in the previous chapter.

In Web 2.0, managing combinations of online network effects is key to competitive success for the following reasons:

• Upfront capital costs have dropped so that there are lower barriers to entry and frictionless scalability in online networks compared with physical networks. As a result, customer acquisition costs are reduced, and free basic services (rather than only promotional or trial usage) are relatively low-cost and sustainable in the long term.

• Online networks have strong demand-side scale economies where users bring other users. Social and/or late users can increase the overall global value of the network for all members and create a bandwagon or "tippy" effect, whereby the market tips in favor of one company or another. This is rarely seen in physical networks—which tend to be dominated by economies of scale in production—where higher volume leads to lower unit costs and commoditization, rather than higher or premium prices and increased market attractiveness.

• Online networks form faster, more frequently, and more interactively than before. Active one-percenters and uploaders can rapidly trigger a critical mass of online adoption and formation of communities. Many-to-many network effects become more commonplace.

• Online networks and services can expand rapidly and often virally across borders, geographies, market segments, media types, and channels.

• Barriers to entry are low, but barriers to success are high because of timing sensitivity and customer volatility, as expressed in winner-take-most competitive races, tippy markets, path dependency, standards, and compatibility battles.

There are different kinds of network effects:

Direct network effects

The value of a good or service increases as more people use it. Each new customer boosts the value of the network and often increases the willingness of all participants to pay for network services. The fax machine is a classic example of direct network effects because the first buyer of a fax machine finds it useless with no one to fax, but as his network of users expands, so does the value of having a machine.

Indirect network effects

More usage of the product spawns the production of increasingly valuable complementary goods, resulting in added value to the original product or service. For example, although some direct network effects are associated with Windows and file compatibility, the indirect network effects that arise from the increased quality and availability of complementary applications software are more significant.

Cross-network effects (sometimes referred to as two-sided network effects)

A rise in usage by one group of users can increase the value of a complementary product or service to another distinct group of users. Hardware and software platforms, reader/writer software pairs, marketplaces, and matching services display this kind of network effect.

Social network effects (sometimes referred to as local network effects)

Instant messaging shows local network effects. A user is influenced directly by the decisions of a typically small subset of other consumers; for instance, those she is connected to via an underlying social or business network. The extent and density of clustering in the network, as well as information access, becomes strategic in technology adoption and pricing choices.