Feb 28, 2024

What are network effects?

The definition of network effects – and how marketplaces use network effects to boost their growth.

Definition of network effects

Network effects are a phenomenon where a product becomes more valuable as the number of its users increases.

Common examples of network effects are the telephone and the Internet. Both became more valuable as more and more people adopted the new technologies.

Network effects are particularly relevant for online marketplaces. Marketplaces connect supply with demand, so increasing one side adds value to the other.

More sellers mean more selection (and possibly reduced price levels due to competition), which attracts more customers. More customers means more business opportunities for new sellers.

The two-sided nature of marketplaces means their network effects are different, and more complex, than those seen on social media platforms. Early-stage founders are faced with the chicken and egg problem and need to work towards liquidity before they can benefit from network effects.

Examples of network effects

Many of today's most successful businesses benefit from the network effect.

Social media platforms are textbook examples of network effects. Their value is in user-generated content. First, there are few users to produce content, and thus little value is provided.

As user numbers increase, more and more content is added, and the value of the platform increases. The added value attracts more new users. That's why it's so difficult to compete with the established social media giants. Network effects are a core component of their defensibility.

The most common examples on the list of network effect unicorns are online marketplaces:

  • Online e-commerce marketplaces: Alibaba, Amazon, Ebay

  • Vacation rental marketplaces: Airbnb, Vacasa

  • Transportation marketplaces: Turo, Getaround

  • On-demand service marketplaces: Uber, Lyft, Doordash, Instacart

  • Events & ticketing marketplaces: Eventbrite, SeatGeek, StubHub

  • Job and freelance marketplaces: Upwork, Fiverr, Toptal

  • Fashion marketplaces: Poshmark, Vinted, Depop

  • Service marketplaces: Thumbtack, Fiverr, UrbanSitter

  • Education marketplaces: Udemy, Coursera

As the list testifies, network effects are a core component of the marketplace model.

That's why in the rest of this article, I focus exclusively on what network effects mean for online marketplaces.

What network effects mean for marketplace founders

A marketplace's value is in its users. The customers are there for the sellers. The sellers are there for the customers.

The value of a marketplace is in this network of users -- not the tech.

That's why understanding and building this network should be the primary focus of a marketplace founder.

This is where many early-stage founders make a critical mistake. They benchmark websites like Airbnb, Etsy, or Uber and think they need to build a similarly sophisticated website from the start. (A six-figure effort if done from complete scratch.)

This isn't true. Instead, a founder should build and launch the first version of their website very quickly and affordably, and double down on building early network effects. (Sharetribe's no-code marketplace builder is developed for this exact purpose.)

In fact, many unicorns are quite well-known for their technologically humble beginnings, and some, like Craigslist, still make a killing on strikingly crude tech.

So, understanding network effects is critical for an early-stage marketplace founder. Let's next look more closely at two different types of network effects that power marketplaces: two-sided and cross-side network effects,

Cross-side network effects demand liquidity

A social media platform can grow by simply (relatively speaking) adding users. An increase in users directly increases the value of the platform. A user is a user. This is called one-sided network effects (or direct network effects).

Marketplaces have two-sided network effects (or indirect network effects), and they're also typically cross-side network effects.

A marketplace has users on two sides: the sellers and the buyers. Cross-side network effects mean that an increase in the number of one side adds value to the other side.

For example, the value I get from Airbnb as a customer is finding accommodation that meets my criteria in terms of location, availability, price, and quality.

With few hosts in my desired location, I probably need to compromise on these criteria. Each added host makes it more likely that I find something that suits me, at a competitive price. An increase in hosts adds to my experienced value of Airbnb.

On the other side, a host wants to fill in as much of their availability as possible. With only a handful of customers, this is unlikely. An increase in customers means increased income.

These cross-side network effects demand marketplace founders to focus on reaching liquidity. Essentially, this means balancing the number of sellers and customers so that an average user is likely to have their needs met on the marketplace.

(That is: they're likely to find something to buy if they're a customer, or likely make a sale if they're a seller.)

Growing only one side of the marketplace disrupts liquidity and ends up making the platform less valuable. Marketplaces need to constantly manage the balance of supply and demand.

Interestingly, on marketplaces with strong two-sided network effects, the same-side network effects are usually negative. For an Airbnb guest, more demand means less availability and higher prices. For hosts, added supply brings competition and pressure to lower prices.
However, the benefits of cross-side network effects usually far outweigh the negative one-side network effects.

Winner-takes-all markets?\

The general wisdom of network effects is that the biggest player wins.

A business with the biggest market share has the most users, therefor it offers the most value, which makes it even more attractive to users.

That's why established players like Amazon, Airbnb, or Upwork are so difficult to disrupt, even by competitors with huge, VC-backed budgets.

For this reason, markets where network effects are crucial have often been called winner-takes-all markets. When a company wins, it wins big -- and keeps on winning.

This theory still seems to hold when it comes to platforms that focus on communication or interaction. On social media platforms, for example, the largest networks offer the biggest value.

For marketplaces, however, winner-takes-all isn't the whole truth.

As the marketplace model has continued to spread across markets, it's become clear that the total size of the network is only one component of competitive advantage.

Subtle differences in how network effects unfold and boost businesses have begun to emerge. Building a successful marketplace is, it turns out, much more nuanced than building the biggest network of users.

For many users, in fact, the entire size of the network matters very little. What they care about most is the size of the local network.

Local network effects benefit early-stage marketplaces

For some marketplaces, the size of the network is the entire world. The value of Airbnb is that there's one available wherever I want to travel.

On many other marketplaces, users care less about the total size of the network. What matters to them is that a few key participants in their area are there.

For example, the network that's relevant for food delivery is the few blocks within which I can get my meal delivered warm. What matters to me is not that there are millions of users in thousands of locations, but that my favorite local restaurants are there.

Local network effects don't have to be tied to geography. Any social subset of users also creates local network effects.

For example, for many social platforms, I mostly care that the people I'm already connected to use them. Social groups are also formed within subcultures and niches, professional or industry-specific networks, communities, or cultural and linguistic groups.
The common thread is that the total size of the network is irrelevant, and instead wide-spread usage within a specific group offers a lot of value.
What is more, these networks may be smaller, but they could also be stronger.

For by far the most successful marketplaces, the key to success hasn't been to build a global user base from the get-go. Instead, they've focused heavily on (first) establishing strong local network effects.

How to benefit from network effects on an early-stage marketplace -----------------------------------------------------------------
Network effects are powerful. They increase value and build defensibility beyond any other business mechanism.
Network effects can also have an aspect of virality: when the value of a platform increases with every user, users can also become active salespeople for your marketplace. Many marketplaces benefit from cross-side demonstration virality, where sellers actively promote their offering (and thus the marketplace) to buyers.

Establishing network effects, however, takes time.

While marketplace businesses are famously scalable, they're also notoriously slow to grow. In fact, growing too fast can harm a marketplace because it makes reaching liquidity harder.

Without liquidity, network effects won't unfold.

Understanding network effects and building them patiently can be the biggest competitive advantage for a marketplace -- even against big, established players.

How to build network effects

How do marketplaces start building network effects? In a nutshell, the model most successful marketplaces have followed is some variation of the following:

  1. Start in a really, really small niche.

  2. Bring in the supply side first by offering them additional value beyond customers  ("single-player mode") or by showcasing buyer potential.

  3. Bring in just enough customers to match with the first small group of sellers.

  4. Do everything you can to have these two early user groups to transact.
    The first step is the most important. The key, at first, isn't to grow the user base. The key is to jump-start network effects with a small group of very engaged, active users.

Two-sided network effects are harder to establish than one-sided network effects. An early-stage marketplace founder faces what's often called the chicken and egg problem. If sellers are there for the buyers, and buyers are there for the sellers, how do you bring in the first users?

Starting small helps with solving the chicken-and-egg problem and reaching liquidity -- two necessary prerequisites for network effects to unfold.

It might sound paradoxical, but starting small can also hold the answer to how you can compete with big established players that have gained the early advantage on network effects.  

How to compete with incumbents who have network effects

Marketplace giants that have gained a monopoly over network effects in one niche are difficult to disrupt.

Because of cross-side network effects, a competitor needs to offer something better for both the sellers and the buyers (and something worth the cost of switching to a new platform).

However, to take on an incumbent, it's not necessary (much less feasible) to go after its entire market share.

Instead, founders can identify what other network value besides the total network size they can offer. Here are ways to go about that.

Focus and build local network effects

It would be extremely difficult to compete with Craigslist as a huge, horizontal marketplace for everything.

However, Craigslist is facing increasing competition from vertical marketplaces that focus on a single category.

Verticalization gives new entrants plenty of room to offer an improved value proposition. For example, Wheelprice decided to build a platform for automotive enthusiasts exactly because of their poor experiences on Craiglist and Facebook Marketplace.

Wheelprice doesn't come close to Craigslist in crude volume. But it doesn't need to.

Instead, it benefits from the strong local network effects that come from reaching high usage within its specific audience of car hobbyists.

Offer quality and trust

Airbnb rode the verticalization trend to win over Craigslist in local accommodation, but it had another key benefit as well.

Users experienced Airbnb as more reliable, and the listings of higher quality.

Manual trust-building mechanisms like increased user verification and vetting can differentiate smaller players from big platform giants. For example, job and freelance marketplaces like Toptal, FreeUp, and Hired all communicate their exclusivity as a differentiating factor from sites like Upwork.

Build a community

Connection is another form of network value that isn't connected to the total network size.

The benefits of big but impersonal marketplaces may be outweighed by the sense of community and connection smaller platforms can offer.

This doesn't mean the community can't scale. For example, for the RV rental marketplace PaulCamper, active community-building was a key growth strategy from the early days up until being acquired for over $30M in 2022.
Leaning into a community is a great way to solve the initial chicken and egg problem and can be a core component in building an emotional connection that is a core component of marketplace defensibility.

Key takeaways

Network effects are a phenomenon where a product becomes more valuable as the number of its users increases.

In one-sided (or direct) network effects, an increase in users directly increases the value of the platform.

In cross-side network effects (or two-sided or indirect network effects), the increase in users on one side increases the value of the platform for the other side. (And in fact often brings a small decrease in value for the same side.)

Network effects are an essential building block for a marketplace. The value of a marketplace is in its network, not the website.

Key lessons an early-stage marketplace founder should take from this are:

  1. In the beginning, it's much more important to build network effects than to develop an extremely advanced platform.

  2. For building network effects, solving the chicken or egg problem and reaching liquidity are prerequisites.

  3. Network effects boost big players, but the reality is more nuanced than winner-takes-all. Local network effects, quality, trust, and community are all ways to provide network value that doesn't require having the biggest total user network.

Network effects take time to establish. Rushing marketplace growth risk making liquidity more difficult to reach, and therefore network effects can't take hold.

When you understand how network effects play out in your market and build them patiently, you establish a strong foundation for building a competitive, defensible marketplace.

Different type of network effects

Network effects in online platforms can be broadly categorized into several types, each playing a crucial role in the platform's growth and sustainability. The most common types are:

  1. Direct Network Effects: This occurs when the value of a service increases for each user as more users join the platform. Social media networks like Facebook and Twitter are classic examples, where the primary value is in the number of other users one can connect with or share content.

  2. Indirect Network Effects: These happen when the value of a service increases due to the growth of a complementary product or service. A typical example is the relationship between software applications and an operating system. The more applications available for an operating system (like Windows or iOS), the more valuable the operating system becomes to its users, which in turn drives demand for more applications.

  3. Two-Sided Network Effects: Common in marketplaces like eBay or Amazon, where there are two distinct user groups - buyers and sellers. The platform becomes more valuable to sellers as more buyers use it, and vice versa. The growth of one side of the market enhances the value for the other side.

  4. Local Network Effects: This effect is observed when the value of a service depends on the adoption within a smaller subset of the network, like a particular geographic area or a group of friends. Ride-sharing services like Uber demonstrate local network effects, where the value is higher in areas with more drivers and riders.

  5. Cross-Side Network Effects: These are a form of indirect network effects where an increase in the number of users on one side of the platform (like more viewers on a video streaming platform) creates a rise in the value for the other side (content creators or advertisers).

  6. Data Network Effects: This is increasingly significant in the age of AI and big data. Platforms like Google and Netflix become more valuable as they collect more data because this data can be used to improve the service (like better search results or personalized recommendations).

Understanding these network effects is crucial for online platforms, as they often form the basis of competitive advantage and can guide strategies for growth and user engagement.

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