The more a digital platform attracts users, the more its value potentially grows. This is the so-called network effect. Then there are infrastructures or multi-sided platforms that attract two or more different, but interdependent, user groups and connect them to each other. In this case, the value of the platform to one customer group increases as the number of customers in the other group increases, and vice versa. But how do you start to create one? And which customer segment should be attracted first? Read on to find out why multi-sided platforms cannot exist without the network effect.
What is the network effect?
Let us first shed light on the concept of the network effect. It is also called demand-side economies of scale and occurs when the value of a given product or service grows as the number of users increases. A typical example is the telephone: imagine that there are only two devices in the whole world, how many interactions would be possible? Only one! Instead, the spread of devices leads to an increase in potential calls for each, and in this way the telephone gains value.
The success of digital platforms, which have become increasingly popular with the advent of Information Technology, is also based on this same principle. Most platforms are multi-sided, meaning that they allow two (or more) different but interdependent user groups to meet. The platform becomes an intermediary whose main service is to connect and facilitate interactions between supply and demand. As a result, the network effect generated is called indirect: an increase in users from group A increases the value of the platform perceived by group B and vice versa.
In the absence of one of the groups supporting it, the infrastructure would not be able to function. Think, for example, of Airbnb populated only by homeowners, with no tourists looking for vacation accommodation. How would it work?
The point of Critical Mass for multi-sided platforms
Multi-sided platforms are all the more effective when they are able to connect audience segments that normally would not come into contact with each other. We have said that the success of these business models is based on the network effect, because the value perceived by one group of users depends on the number of people who belong to the other group, and vice versa. Therefore, it is clear that in order to make the platform work, we need to identify interdependent audience segments and find a way to attract them.
The goal is to define and reach the so-called critical mass point, which is the equilibrium point at which the value generated by the platform equals or exceeds the costs incurred. Once this threshold is crossed, it is likely that more users will sign up for the platform as they will perceive a high value given the high number of users. Of course, the service offered must be the right one and of quality! If this happens, the cost of acquiring each new customer should decrease and transactions increase. From this point on, you can see a real boom, in which new users attract other users and so on.
But how can you start to make critical mass? And which customers should be attracted first?
How to generate a positive network effect
The question that comes up is “how do I attract the first users to my platform? And which group is best to start with?” Not surprisingly, when discussing multi-sided platforms, the chicken and egg paradox is often cited!
Some platforms decide to rely on a model that initially generates value even without a network effect and over time increases the number and type of users. Therefore, in the early days you focus on one group only by creating a service or product that generates value for that audience. Then you change the business model and open up to different audiences. It’s as if Airbnb initially targeted only homeowners, for example, offering services to organise homes for guests. After gaining critical mass, it decided to open up to the tourist segment as well.
Another way is to leverage price by asking which of the user groups is most responsive to this factor. After identifying the group, we can attract it by subsidising it, such as with a free proposal or by drawing the group in with a nominal price. When the value of the platform is increased because it has reached the point of critical mass, we can decide to raise prices. An example is the video game console that subsidises players to sell a large number of units. The revenue comes from game producers, who pay royalties to make content for that console (and thus subsidise the platform).
Attracting customers is not enough, however; you also need to retain their trust and offer them a compelling reason to stay. For this, the network needs to be constantly nurtured and it is necessary to focus on its authority and reliability, as well as to provide additional services from time to time to expand the main offering.
Facebook and Airbnb
Facebook connects three types of user: content creators, those who see the content and the advertisers, and those who pay for publicity on the platform. Facebook’s business model only works if all three groups are present and only when the number of users is high.
If Facebook was full of content that none saw, the platform would not survive as it would not attract the advertisers who subsidise its activities. Facebook attracts users by giving them a free social media platform, the more people that it can reach, the greater the number of adverts that can be shown to them. The result? Greater value is created for the advertisers.
We also see the case of Airbnb, a platform that connects those in need of a vacation home with those who have a home to rent. How does the network effect come into play in this case? If there are few homes, there will be few tourists attracted. If the number of interested tourists is limited, those who have a house to rent will look elsewhere for an alternative. Therefore, the value of the platform depends on the growth of both groups.
Airbnb’s breakthrough came with the addition of insurance for damage caused to homes by guests booking through the platform. It was the first among its competitors to provide an extra degree of security to the supply side, and so it achieved a boom in sign-ups from homeowners. As a result, this wide choice attracted a large number of tourists seeking accommodation.
There would be many other examples to mention, such as Google, Uber, Nintendo, other video game systems, the list goes on.
Can it grow indefinitely?
The beauty of digital platforms is that they can potentially connect an infinite number of users from all over the world. However, they can hardly grow indefinitely and, indeed, it may happen that they reach a saturation point. At that point each new user will no longer bring added value to other users, but will diminish it, causing a negative network effect. There may be difficulties such as an overburdened system, increased page loading times, slow customer support, etc. Returning to the telephone example, think of clogged lines during special events, such as New Year’s Eve.
Remember, however, that digital platforms also allow you to collect a great deal of useful data that you can use to better profile your customers. In this way it is possible to identify and attract those groups of people most aligned with the service offered.
To summarise, in setting up the business model, it is necessary to keep in mind that the platform will be more attractive the more we identify the right service, the audience groups to cross, and find ways to increase traffic. Here is the network effect: the greater the number of users attracted to each segment, the higher the value of the platform.
For more on how to create a sound digital strategy for your business, take a look at the courses offered by Flowerista here or find the next Business’n’Play session near you!