What is the Network Effect?

If you buy a calculator, its value to you is static. It does math. It does not matter if you are the only person on earth with that calculator or if a billion people have it. The utility is fixed.

Now, consider a telephone. If you are the only person with a telephone, it is a useless brick. If two people have one, it has some value. If everyone has one, it becomes indispensable. This is the Network Effect.

The Network Effect is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products. It is the holy grail of startup business models because it creates a winner-take-all dynamic.

For a founder, a network effect is the ultimate defensive moat. As you grow, your product naturally becomes better. This makes it incredibly hard for a competitor to attack you.

Imagine trying to compete with Facebook. You can build a website that looks better. You can write cleaner code. You can have no ads. But if all of a user’s friends are on Facebook, your superior features do not matter. The value is not in the software; the value is in the connection to other people.

This is why network effect businesses like Uber, Airbnb, and LinkedIn tend to become monopolies or duopolies. The big get bigger, and the small get crushed.

Not all network effects work the same way. It is important to distinguish between the two main types.

Direct Network Effects: This is the telephone example. More users equals more value directly. Social networks and messaging apps live here.

Indirect (Two-Sided) Network Effects: This is a marketplace. More drivers on Uber creates more value for riders (lower wait times). More riders creates more value for drivers (less idle time). The two distinct groups feed each other.

Understanding which type you are building is critical for your Go-to-Market strategy. If you are building a marketplace, you have to balance supply and demand perfectly. If you have too many drivers and no riders, the drivers quit. If you have too many riders and no drivers, the riders quit.

The biggest challenge with network effects is getting started. This is often called the “Chicken and Egg” problem. The network is worthless until people are there, but people won’t come until it has worth.

To solve this, founders often have to “do things that don’t scale.”

• Fake the Supply: Reddit founders posted fake links from fake accounts to make the site look busy.
• Subsidize the Network: Uber paid drivers to sit online even when there were no rides just to ensure availability.
• Start Small: Facebook launched only at Harvard. By restricting the network to a tiny geographical node, they created density quickly. A network of 500 students is valuable. A network of 500 people spread across the globe is useless.

A common mistake is confusing “virality” with “network effects.” They are different.

Virality is about acquisition. It means users invite other users. You grow fast.

Network Effect is about retention and defensibility. It means users stay because the value increases.

You can have a viral product with no network effect (like a funny cat video site). It grows fast and dies fast. You want both. You want users to invite friends (viral) and you want them to stay because their friends are there (network).