Question

Is indirect network effects or direct network effects more of a defining feature of two-sided markets? Explain

Answer 1

When talking about platform businesses, the conversation often includes a reference to network effects and how platforms can more quickly create value for different types of user groups. The concept of network effects can seem difficult to grasp at a glance but is really quite simple. By understanding network effects first, platform designers can begin to implement platform growth techniques that capitalize on their understanding of network effects.

etwork effects exist in any network, whether it’s the pony express, old-school landline phones, the internet, or platforms. Network effects are the incremental benefit gained by an existing user for each new user that joins the network.

Put differently, the phone is only useful if other people (users) also own a phone. If only one person owns a phone, the value of the phone network is zero, because they cannot do anything with the network. If a second person owns a phone, then the first person can call the second person, and if that’s beneficial to them both, then the network has some value. If everyone owns a phone (e.g. personal friends, government institutions, service providers, and so on), then the phone network is very valuable to all users. Imagine the first time the police department joined the phone network and provided the emergency call service 9-1-1. That new user (police departments) provided a huge value to all other phone users simply by joining the network.

Two Types of Network Effects: Direct vs. Indirect

Direct network effects are also known as same-side effects. The value of a service simply goes up as the number of users goes up. Returning to the example of the telephone, it is only useful if the people that you need to reach also have telephones. The more people there are who have phones, the more useful it is to have one yourself.

Direct network effects aren’t as applicable to platform businesses because platforms have two or more user groups exchanging value with one another. In most platforms, there are two users groups: producers and consumers. The more consumers on the network, the more valuable that network is to producers, and vice versa.

This type of network effect is called an indirect network effect, also known as cross-side effects. With indirect network effects, the value of the service increases for one user group when a new user of a different user group joins the network. You must have two or more user groups to achieve indirect network effects.

Taking Uber as an example, as more riders (i.e. consumers) join the platform, the more useful and valuable it is to drivers (i.e. producers), because they have more business opportunities. The reverse is also true. As more drivers join the network, riders have shorter wait times and more locations available for their rides, thus the network is more valuable.

In most productive work, there is a tradeoff between quantity and quality. That’s not necessarily true for platforms. In fact, if all else holds equal, an uptick in platform membership can lead to higher quality services or products transacted on the platform.

For example, if there are many developers producing great apps on a given platform – say Apple’s iOS – more consumers will be drawn to that platform and will go out and buy iPhones. As the number of iPhone users grows, more and more people will learn how to develop apps on iOS because the market is growing, thereby opening the doors to a wider array of higher quality apps. Expert software developers who existed before Apple iOS will also see the growing platform as an opportunity too big to ignore.

When talking about network effects, the discourse implicitly refers to network effects as having a global benefit wherein each new user benefits the entire network (global here refers to the entire network, not geography). However, in practice, network effects are local and clustered into subset or micro-networks within the larger network. Local network effects can be just as, if not more, powerful and make a platform more attractive to a subset of users.

For example, YouTube has many local networks on its platforms from makeup enthusiasts to video game streamers to book reviewers. When a new video game streamer joins YouTube they benefit users who are interested in video game streams. When a new makeup guru launches a channel, their channel doesn’t add value for the gamers, but it does add value for the makeup audience. This strengthens Youtube’s resilience to competition. While Youtube still has a strong gaming culture, many gamers have moved on to game-streaming platform Twitch. Despite Twitch’s growing popularity, YouTube continues to grow overall because its other micro-networks are robust and growing. If Youtube were dependent on gamers, then Twitch’s growth would be existential.

On the flipside, in terms of distribution, the cost of serving one additional customer is also next to nothing. Returning to the example of Uber, all Uber needs to do to distribute ride-sharing services to riders is provide each user with a copy of the app.

The word ‘copy’ is key to understanding a platform’s near-zero marginal cost of distribution. An app might cost $500,000 to develop. However, every copy of that app thereafter costs next to nothing to produce and distribute. Uber made some investment in developing Uber, and today continues to improve the app through developers to enhance user experience, but development costs do not have a one-to-one relationship with each new user acquired. Thanks to the Internet and sharing technology, information goods today have a near-zero marginal cost of distribution.