Unleashing Competitive Advantage through Network Effects : HR Vista

NALIN SHARMA, IOCL

sharmanalin@indianoil.in

Graduated in Civil Engineering from IIT Roorkee and completed an MBA from IIM Lucknow, the author has worked extensively in the field of downstream Oil & Gas construction projects and is currently associated with IndianOil’s business expansions in Africa and MENA regions. The author is an avid traveller and has completed multiple National Himalayan treks.

Abstract:
In the current business world, the barriers to entry are diminishing, the differentiations in products are converging, the products are getting reverse-engineered, and the businesses are becoming easily replaceable.

In the age of quantum computing and Generative AI, there are only a few defences left to protect the competitive advantage of the business. The Network effect is one such strong defensibility which has the potential to provide a protected environment for a business to flourish and maintain its competitive advantage.

The concept of network and network effects is hard-wired in our DNA by natural selection. First studied by Sarnoff in the early 1900s, the concept of Network Effect has evolved from being used in telecommunications to marketing, and now creating a shield of defence for our business.

Main Content:

1. Introduction
The Dean of Valuation, Prof. Aswath Damodaran, mentions in his initial lectures of the Valuation course the power of network effects. He emphasises the power that the networking giant – Meta harnesses through its social networking platforms – Facebook, Instagram and WhatsApp. Imagine a phenomenon, which is so potent and ubiquitous that it propels companies to the Fortune rankings! Such is the power and importance of network effects that have become a fundamental topic in structured and unstructured teachings.

70% of the value created by technology companies since 1994 is attributed to network effects. One of the first mentions of the network effects was associated with telecommunications during the early 20th century. David Sarnoff, who founded the National Broadcasting Company, proposed that ‘the value of a network increases in direct proportion to the number of users/participants on that network’.

But how is telecommunication linked to marketing?
The foundation principles of marketing, such as Porter’s 5 Forces [created in 1979] have transformed marketing. These principles are so powerful that even after 45 years, they are still regarded and practised as the bible of Marketing.

However, these foundational models often overlook the strategic defensibilities necessary to sustain a business built with great effort and dedication. That’s where the Network Effects come into play.

Network effects are, in fact, among the most powerful defensibilities in today’s digital world. They create a self-reinforcing loop where the value of a product or service increases as more people use it, making it indispensable. Let’s explore the core defensibilities that businesses can leverage to secure a competitive edge and ensure long-term sustainability.

2. Core Defensibilities of Business:
In the rapidly evolving digital landscape, businesses can leverage four core defensibilities to secure a competitive edge and ensure long-term sustainability:

Scale: Expanding the scale of your business both organically and inorganically helps to solidify your market dominance. Scaling up involves increasing your operational capacity, broadening your market presence, and potentially integrating vertically or horizontally to control more of the supply chain and customer journey.
Brand: Developing a strong brand image is crucial. A robust brand resonates with consumers, creating a lasting impression that makes your products or services highly sought after. This involves not only consistent and appealing branding efforts but also delivering quality and value that meet or exceed customer expectations.
Embedding: Embed your products or services deeply within the customer’s value chain or daily routines. This makes your offering indispensable, as customers come to rely on your solutions for their operational success or personal convenience, thereby creating high switching costs.
Network Effects: Harness the power of network effects where the value of your product or service increases as more people use it. This is particularly powerful in platforms or services that connect users, as each additional user adds value to every other participant in the network.

These defensibilities, when strategically implemented, can shield the business from competitive threats and foster sustainable growth in the digital economy.

3. Fundamentals:
Before diving deep into the realms of network effects and how we can leverage them to create competitive advantage, let us first understand some of the core concepts:

Network: In the context of technology and business, a network refers to a group or system of interconnected entities or nodes that interact with each other. These entities can be various components, such as computers, devices, people, or organizations. Networks facilitate communication, data exchange, collaboration, and resource sharing among the connected entities.
Network Effects: There are a lot of definitions and explanations that exist about network effects. However, one of the simplest explanations goes like this:
The network effect is a phenomenon by whose virtue, the addition of any user adds to the value of a product/service for every existing as well as prospective user.

There are 16 different types of network effects, which we will glance at in the next section.

Competitive Advantage: There are a lot of definitions available for competitive advantage, however, my strategy professor gave one of the simplest and most powerful definitions of competitive advantage:

The ability to create additional value

Additional value is nothing but the scarcity value, which translates to how much more the perceived value of your product/service in the minds of the consumers is compared to its opportunity cost.

There are three types of competitive advantages – Differentiation, Cost Leadership and Dual advantage [which is very rare and results in the creation of a valuable product at a lower cost]

4. Types of Network Effects
As we understand, the network effects are core to the digital environment. If you think about it, every digital company or for that matter, every business is trying to leverage the network effects to create a defensive barrier as well as expand the business at the same time. The bigger the user base, the stronger the value chain and the more intense the network effect.

Out of the 4 defensibilities discussed earlier, the others asymptote at some point; i.e., the returns for every additional investment in that particular defensibility, flatten out. However, investments in network effects provide incremental returns.

Broadly, there are 16 network effects identified. Each of these network effects has its distinctive features and is grouped into five broad categories:

Direct Network Effects: – Highly Effective Network Effects:

Physical– Physical network effects are tied to physical nodes and usually have physical links. For example, telecommunication companies like Jio and Airtel have physical nodes in place as part of their network.
Protocol– Protocol network effects arise when there are common communication standards or guidelines on which users can plug in and utilize the strengths of the networks as in the case of HTTP/ FAX/ Blockchain.
Personal Utility – Personal utility networks have two key features – the network would have the personal identities of the users tied to it, and they form an essential part of the user’s lives, like Facebook Messenger, WhatsApp, etc.
Personal– Personal network effects occur when a person’s identity or reputation is tied to a product. Personal network effects arise from the interpersonal, tribal impulse to build connections with others e.g., Facebook, LinkedIn, etc.
Market Networks: A Market Network combines the identity and communication aspects of a personal network with the transaction focus and purpose that typify a marketplace, e.g. IvyMark Headnote, etc.
Hub-and-scope– A Hub-and-Spoke network effect occurs when equal nodes submit content or goods to a central Hub. Then the Hub “pushes” a chosen few pieces out to all – or nearly all – of the nodes.

2-sided Network Effects – Moderately Effective Network Effects

Marketplace (2-sided) The two sides of a marketplace are buyers and sellers. Successful 2-sided Marketplaces like Craigslist are very difficult to disrupt. To break them apart you must have a better value proposition for both parties simultaneously, or else nobody moves. Customers are there for the vendors, and vendors are there for the customers. One won’t leave without the other, e.g. eBay, or Alibaba.
Platform (2-sided): 2-sided platforms have supply-side nodes (developers) and demand-side nodes (users), which create value for each other through the intermediary of the platform itself (central node). The platform itself also provides significant value for both sides, e.g. iOS, Nintendo, etc.
Asymptotic Marketplace (2-sided): These types of marketplace networks have an asymptotic relationship with the increment in the nodes of the network.e., the incremental returns as value starts to decrease with the increasing number of nodes. The returns saturate such as in the case of mobility aggregators Uber and Ola.
Expertise: Products that can develop “expertise” network effects are typically tools used by professionals to do their job — the instruments with which they ply their craft, e.g. Accounting software, CMS Platforms, etc.

Data-Driven Network Effects – 3rdCategory: When a product’s value increases with more data, and when additional usage of that product yields data, then you have a Data Network Effect. In a data network, each node (user) feeds useful data to the central database. As the aggregated data accretes, the value of the data for each user also grows, e.g. Google, IMDB, etc.

Tech Performance Network Effects: It is the 4th broad category of network effects. ‍‍In networks with tech performance, the network effects become better (faster, cheaper, or easier to use) the bigger they get. As more nodes (devices) join the network, the performance of the whole improves e.g. BitTorrent, global VPN, etc. Such as in the case of BitTorrent, the larger the number of people who use it, the greater the availability of the data and the better the network performance.

“Social” Network Effects: This is the 5th category of Network Effects and works on the psychology and interactions between people. The network effects under this category are interlinked with one another, and together, they form a very powerful tool. As is with any psychological tool, ‘social’ network effects are the hardest to deploy, however, they provide a significant competitive advantage.

Language: The language network effect refers to the increasing value of a language as more people use it, enhancing communication, information exchange, and collaboration. This effect is evident in global contexts like business, technology, and social media. English, for example, benefits from a strong language network effect, driving international communication and economic opportunities. As more people adopt a language, its utility and influence grow, creating a self-reinforcing cycle.

Bandwagon: The term Bandwagon figures in Marketing as much as it figures in sociology. The phenomenon is observed when societal pressure causes people to join a network so that they are not left alone. Apple, LinkedIn, Facebook – all these marketing geniuses thrived on the fundamentals of bandwagon effect and resulted in the birth of the most abused word – FOMO.

Belief: Belief is a powerful phenomenon and can create a significant network effect. It derives its prowess from the basic nature of humans being pack animals. The inherent nature of humans is to be part of the ‘pack’ and to stick to this pack and believe in the pack and its beliefs. Consider the disruptive digital currency – Bitcoin as an example, the more people believe in its utility, the higher its valuation.

Tribal: The tribal network effect is one of the earliest network effects of the Homo sapiens. As soon as our ancestors were created, they had two choices – fight/flight. Those who fought were, well, had their life span shortened, and those who flew were stuck together as a tribe, and as they procreated, this sense of being in a tribe was ingrained in our DNA.

5. Evolution of Network Effects:
The power of network effects has generated a certain degree of curiosity in the minds of researchers. Across the entire 20th century, there have been key guiding principles aimed at deciphering the actual prowess of this puzzling phenomenon. However, the study is still evolving.

Sarnoff’s Law – David Sarnoff, a titan of the radio and broadcast era was the first one to comment on the value of networks. He tried to decipher the power and value of the broadcasting network and concluded that the power of the broadcasting network is directly proportional to the number of users. This analogy came to be known as Sarnoff’s Law. However, this analogy was limited to the broadcasting network [one-many].
Metcalfe’s Law –Robert Metcalfe, who was one of the inventors of the Ethernet protocol, proposed Metcalfe’s Law in the 1980s. According to him, the value of communications networks grows in proportion to the number of possible links among pairs of users, i.e. to the square of the number of users on the network.
Reed’s Law – With the advent of instant messaging, researchers began analysing the concept of “group-forming networks” – this allows for the formation of clusters at a scale which is much faster than other networks. Reed’s Law, published by David P. Reed of MIT in 1999, states that the value of communications in a network grows at the rate of 2^n, where n is the number of nodes in the network.

A visual comparison of these laws is depicted herewith:

Source: The Network “Laws” – https://guides.co/g/the-network-effects-bible/121725

6. Value Creation While Utilizing Network Effects
We have seen that Network effects play a pivotal role in value creation within digital and traditional business landscapes by exponentially enhancing the utility of a product or service as more users join the network. This phenomenon is especially potent in platforms that facilitate user interaction and data exchange, such as social media sites, online marketplaces, and communication services.

As the user base grows, each additional participant adds value not only for themselves but for all existing members. This results in an exponential growth of the value for the entire network.

For instance, a larger network can improve matching in a marketplace, increase the relevance of shared content, and enhance the overall user experience, leading to greater customer loyalty and higher revenue potential. Businesses that successfully harness network effects can establish substantial barriers to entry, secure a dominant market position, and achieve long-term competitive advantages, ultimately transforming the scale and scope of their operations.

Key aspects and advantages of Network Effects:

The network effects are very powerful because of the simple Maths behind them.
Network effects are native to the digital environment.
The bigger the user base, the stronger the value chain and the greater the network effect.
Other defensibilities are asymptote at some point, while network effects give incremental returns.
The fastest way to grow a company is to design network effects rather than investing money in scale/ etc.
Part of the business evolution journey is to find what network effect to add next in our defensibility.

7. Challenges with Network Effects:
Achieving Critical Mass: One of the biggest challenges with network effects is the need to achieve a critical mass of users for the effect to kick in. Until the network reaches a certain size, it may not deliver much value to its users, making it difficult to attract and retain them.

Quality Control: As networks grow, maintaining the quality of the product or service can become challenging. For platforms that rely on user-generated content or interactions, such as social media or marketplaces, ensuring consistent quality and relevance becomes more complex with more users.

Management of Network Congestion: In some networks, particularly those involving physical goods or services, growth can lead to congestion that degrades the user experience. For example, a ride-sharing service might experience longer wait times or higher prices in times of high demand, which can diminish the perceived value of the network.

Dependence on Network Health: Businesses that rely heavily on network effects can become vulnerable if the network begins to shrink or if user engagement declines. The same positive feedback loop that can lead to explosive growth can also work in reverse, leading to a rapid decline.

Market Saturation: In some cases, networks can face challenges from market saturation. Once a network has captured a large portion of the available market, further growth can become difficult, which may slow the momentum of the business.

Conclusion:
In conclusion, network effects represent a pivotal force in shaping the competitive landscapes of digital markets. As businesses increasingly rely on the interconnectivity of users to drive growth and innovation, understanding and leveraging network effects can be the key to unlocking unprecedented value.

Though the points of concern can be acknowledged as dedication towards a comprehensible common purpose and efficient and effective management of the network to avoid confusion and misinformation, yet it has more advantages than perils. The interactive group can participate in a motivated fashion, improve the competitive edge, leverage the value of the operations, enhance the form style of the vital functions, inspire inputs and contribute to factors like the feeling of being trusted peers.

Furthermore, organisations should harness the benefits of network effects to triumph in different aspects of business and trade. To revolutionize economic development, digital marketing is an extremely crucial process. It demonstrates its criticality in industries like Social Media, Content Creation, Data Management and Telecommunications. It is the practice of the future that will incorporate the vision of the organisation in the long run.

Bibliography

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Currier, J. (2020, April). Whiteboard Breakdown: What are Network Effects? Retrieved from NfX: https://www.nfx.com/post/whiteboard-what-are-network-effects

Delmastro, A. S. (2023). The explosive value of the networks. Scientific Reports.

Guides Publishing. (n.d.). The Network “Laws”. Retrieved from Guides Publishing: https://guides.co/g/the-network-effects-bible/121725

Nfx. (2018). The 13 Types of Network Effects. Retrieved from Youtube: https://www.youtube.com/watch?v=oB_NM_kL6rM&t

Ohashi, H. (2003). The Role of Network Effects in the US VCR Market – 1978-1986. Journal of Economics & Management Strategy, 447-494.

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