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Ins and outs of network effects: how does it work and how can it be organized

Ins and outs of network effects

Thanks to Social, Mobile, Analytics and the Cloud the costs of creating a network is nearly nothing, so in every industry sector you see more and more platform businesses popping up. A key element in platforms is network effect. Sounds so simple, but what is it, how does it work and how can it be organized.


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Network effects

In the 70s of the last century the famous socialist and economist Mark Granovetter wrote in his article ‘strength of weak ties’ the power of connecting individuals, to connect with people that do not know each other in order to gain valuable information and overcome threats. Exactly this concept lies on the basis of building successful networks; people are able to access information, experts, products or services that are otherwise unavailable. To explain the success of network, the inventor of the ethernet (Robert Metcalfe), came up with the concept of network effects known as MetCalfe’s law, that state that when more users use a product or service it becomes more valuable to the people that are using it.

Network effects: deep dive

To understand network effects, we need to take a look at how platforms grow organically (unpaid). Basically there are 2 ways how a platform can grow: virality and network effects. Virality are forms where the product itself is not responsible for the growth (word-of-mouth, referrals). Network effects, on the other hand, are very much a result of the product itself and they are gained by the value offering that the product has. In essence, the product spreads as it is used. We focus in this blog on network effects.

Important to note is that there is not one network effect at play in a platform, but there might be four origins of network effects. Platforms can have same-side and cross-side network effect, and platforms can be multi-sided (one for the demand and one for the supply side). The best example of same-side network effects is online gaming, where the more gamers that are using the same game, the more value you see as a gamer to the game. For cross-side network effects, the rise of consumers will also attracts producers to the platform. Great examples are users of Android or Apple products, this will give rise to more developers (producers) that want to benefit that platform.

Bear in mind that network effects can also be negative, having less people that are using a product or service will decrease the value of it as well. Negative network effects can come from quality of connections, content or access to power users . Some example from recent history are most visible from social media platforms like Friendster, MySpace or Google Buzz.

Integrated Platform

Figure: example of network effect for an integrated mobility platform like SnappCar or BlaBlaCar

Are all the network effects the same?

Since platforms can be focused on B2B or B2C, can be multi-sided of single sided, where a demand user can switch his role to become a supplier, there is not one type of network effect in place. Network effects need to be analyzed per platform to manage these effects properly. On a high-level, there can be a difference in effect that play a role, based on the type of platform. To a large extent, there are two types of platform; Innovation and Matchmaker platforms.

Innovation platforms , are focused on co-creation between demand and supply that unifies multiple parties to jointly produce a mutually valued outcome (like app developers). In the search for the wisdom-of-the-crowd, these are products, services, and interactions are co-created or built based on shared value. Matchmaking platforms are more experiencing effects on the exchange of value (like Airbnb). By reducing transaction costs between demand and supply parties interactions can be enhanced with connection technology. Most economic and social platforms fall into the category of matchmaking platforms.

How to manage network effects?

Since network effects are integrated in the platform itself, the question remains how to organize or manage it. For successful use of network effects there are basically three elements that should be addressed;

  1. Value proposition; while economies of scale will realize competitive advantage in costs, network effects are a result of a good value proposition. A good value proposition will explain how being a member of the platform will solve problems or improves a certain situation. The question to ask is: What (intangible) value does the platform bring and/or why does the platform exist?
  2. Appropriate level of curation; the level of curation will determine if potential users will become new active users. In the beginning, the platform will be eager to open the gates for all users, but as the platform evolves the level of curation should be monitored and adapted accordingly. Depending on the purpose of the platform and type of users on the platform adequate curation can raise the level of quality users. That will attract quality users as well. Best example is AirBnB that curates all users on multiple measures (user reviews, profile, photo’s) and based on this result adjust the matching result per user.
  3. Realize stored value ; keeping users on the platform by an investment that comes in small repeatable actions, will increase the importance of the platform. Examples of such an investment are creative content (Instagram), reputation (AirBnB), usage data (Dropbox), influence (Youtube).

Auteur van deze blog is Laurens van der Kroon.

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