About a year ago, I had the pleasure of attending a speech by Scott Cook, the founder of Intuit and one of the best business minds in Silicon Valley. During his speech, Scott discussed what he called "the best barrier-to-entry" that any company can have - something that results in the most powerful competitive advantage. Can you guess what it is?

eBay Has It. But Not Google!
It is something eBay has but Google doesn't - any guesses yet?!

Scott was talking about "Network Effect". This is a term that was grossly misused by many dotcoms during the boom days of late nineties. What exactly is "Network Effect" then?

Network Effect is the phenomenon whereby a product or service becomes more valuable as more people use it, thus encouraging ever-increasing numbers of users.

According to Metcalfe's law, the total value of a product/service that possesses a network effect is roughly proportional to the square of the number of customers already using that product/service.

How eBay Benefits From Network Effect
eBay's online auction marketplace is a great example of a service that benefits from network effect.

• As more and more buyers use eBay's auction marketplace, the value of the marketplace increases for sellers...
• causing more sellers to join which in turn increases its value for buyers...
• causing even more buyers to join...
• and so on...

When a competitor starts a new online auction marketplace, it is very hard to break the dominance of the incumbent. Reason: In the beginning, there are few buyers in the new marketplace - as a result of which few sellers join which in turn discourages even more buyers.

A proof of this plays out in almost every mature internet market today. Whether it is the US, Japan or Germany - one company has the dominant share of the online auctions marketplace, while all others lag far behind.

In the U.S., even when competitors like Yahoo make their auctions free - they still cannot make much of a dent in eBay's dominance despite the fact that eBay itself is raising prices! Network effect can be that powerful.

How Common Is Network Effect?
Although many of the now defunct dotcoms claimed to create network effects, network effect is not very common. Some products/services naturally lend themselves to network effects, while most do not.

The products/services that have inherent network effects usually fall into one of these categories:

• Marketplaces & Trading Exchanges:
• Physical/virtual gathering places and exchanges that enable buyers and sellers to come together and engage in trade
• Examples: eBay, Paypal, New York Stock Exchange, NASDAQ
• Platforms & Standards:
  • Frameworks upon which multiple vendors in a marketplace create products to ensure compatibility and interoperability
  • Examples: Microsoft Windows, CDMA, DVD
• Communication Tools:
• Tools that enable one person to communicate with another person who has the same tool
• Examples: AOL Instant Messenger, Skype, Microsoft Word, Adobe PDF
• Social Networking (Community) Applications:
• Tools that enable friends, business partners, or other individuals to connect and/or share information over the Internet
• Examples: LinkedIn, Friendster, Flickr, Del.icio.us

Most of the other products/services do not have network effects. An online portal doesn't create "Network Effect" by acquiring eyeballs - this was one of the popular (and incorrect) claims by dotcoms. I don't gain more value from Yahoo.com just because more and more people use it.

A search engine doesn't have network effect either - again I don't get any more value from using Yahoo Search just because many others also use it. I believe this is one of the major reasons Google was able to so easily take away Yahoo's leadership in online search.

Likewise, I don't believe Google Search itself possesses any network effect today. If a new entrant provides a significantly better search experience than Google - I believe that they can, over time, take the market leadership away from Google.

Can You Build Network Effect For Your Products?
In his interview with HBS in 2001, Scott Cook says:

I also think that a fundamental understanding of network effects is very important. ... Network effects are a fundamental characteristic of certain technology businesses. When network effects are possible, it is the most important thing in the world to follow, to understand, and to make happen. (emphasis added)

While not all products/services lend themselves to network effects, analyze your products and services thoroughly and often to see whether you can build features that result in network effects similar to the products/services in the examples above.

If you're able identify any such possibilities, make it the the most important thing in the world for your Product Management and Product Marketing teams "to follow, to understand and to make happen". You will be glad you did.

When you hit it big by doing this, don't thank me - just send money! :)

Until next time...

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