Network Effect

A telephone is useless if only one person owns it, but it becomes more valuable as more people have one. The same principle applies to social networks, messaging apps, payment systems and online marketplaces.

There are two main kinds. Direct network effects occur when users benefit directly from more users of the same kind, as with messaging apps: the more of your friends who use it, the more useful it is. Indirect network effects occur when growth on one side benefits another side, as with marketplaces, where more buyers attract more sellers and vice versa.

For example, a ride-hailing app with many drivers offers shorter waiting times, which attracts more riders. More riders make driving for the app more profitable, which attracts more drivers.

Network effects can create powerful competitive advantages, because a new competitor would need to attract a large number of users at once to offer similar value. They can lead to winner-takes-most markets. However, network effects can also work in reverse: if users start leaving, the product becomes less valuable for those who remain, which can accelerate decline.