Many of the large companies that dominate world markets owe their strength and continuing growth to their underlying structure: a formidable network. Such networks have special economic characteristics which provide competitive advantage.
“ The “network effect.” is created when the addition of one element to the network improves the utility of all the network participants”
Networks derive their strength from an interesting economic phenomenon known as the “network effect.” This is created when the addition of one element to the network (say a node or a member) improves the utility of all the network participants (nodes/members).
In other words, any new element joining the community benefits the connectivity of the network as well as its member organizations.
Examples of the multiplier effect
Consider a telephone. By itself it has more value as a door stopper than a communications device; there is not much else you can do with it. However, if your significant other has a telephone and you are connected, both parties benefit from this two-way communication channel.
The utility of the telephone comes from the fact that if it is ubiquitous, every person in the network can talk to each other (and teenagers do). In other words, every additional telephone connected to the network increases the ability of people to communicate.
Social networks are an obvious example of this effect. The first users of Facebook could possibly get some benefit from recording what they did that morning. But the real benefits come from the (still unexplained) deeply-rooted desire to inform others about mundane comings and goings, as more and more people join the network.
“Networks create a competitive advantage and a barrier to entry. ”
Furthermore, networks create a competitive advantage and a barrier to entry. A competitor has to have a lot of money and time to build one. And the entity offers little value to users during its nascent development stage because the number of members is relatively low.
Other examples of networks include exchanges such as Match.com. In this case, as more men join the network more women become members, which attracts more men, etc. A growing population of sellers on eBay pulls in more buyers, which attracts more sellers, etc.
Large networks grow because they are large. This basic network law even applies to college football. Despite its prowess, the University of Michigan football team would not attract a large following if there were no other teams to play against.
Finally, airlines provide an example of network economics. Not only do airlines try to serve multiple destinations thereby boosting the number of cities they cover, they also enter into mergers with other carriers to enlarge their networks and capture the benefits of scale and scope. Airlines also create alliances to extend their geographic reach.
The hub strategy
While the benefits of adding nodes (e.g. a city served by an airline, a person joining Facebook , an extra person with a telephone) strengthen a network, it is expensive to connect each node directly to all other nodes.
“ For a million telephones, the number of connections will have to be some trillion lines. ”
This is clearly not practical for the billions of phones in the world. Instead, the telephone system uses central exchanges to foster consolidation. Instead of ½∙N∙(N-1) connections between N phones, the central exchange needs to connect only to N nodes and thus the number of connections is only N+1.
Airlines use similar logistic in their hub-and-spoke systems. Instead of connecting every one of their origins with every destination via a non-stop flight, they use hubs.
Airline travelers are painfully aware of this technique. The outcome is summed up in the well known saying about the world’s busiest airport: “When I die, I don’t know if I’ll go to heaven or hell, but for sure I’ll be changing planes in Atlanta.”
The more a network depends on physical connections the more it will use hubs to connect all the nodes in the network. For airlines, the result is higher utilization (higher load factors), better service as flight frequency increases, and the ability to serve small communities that cannot support point-to-point services.
Once the network is in place, it can be exploited and monetized. Facebook created a revenue stream when it began accepting adverts, and LinkedIn followed a similar course when it introduced charges for job searches.
Airlines charge for everything they possibly can, and, in particular, charge high fares for flights in and out of their hubs (where the frequency is high and the competition non-existent).
Microsoft Windows is an example of the direct network effects as well as the potential for additional services or indirect network effects. Once the organization became a standard across the corporate world, applications such as spreadsheets (Excel), word processing (Word), and presentation software (Power Point) became standard features with their own network effects “riding” on Windows.
“ After building its worldwide network for over 100 years, UPS is offering logistics and supply chain management services on the back of its creation. ”
As mentioned, it is very difficult to compete with an established network by creating an alternative service. The Android operating system was successful only because Google distributed it for free to phone makers. Yet even Google with all its financial resources could not dethrone Facebook with the Google+ social network.
Physical networks exhibit the same degree of competitive strength. Take, for example, the UPS network. After building its worldwide network for over 100 years, UPS is offering logistics and supply chain management services on the back of its creation.
The difficulty of competing with an existing network was clearly demonstrated when DHL entered the US domestic market in 2003 in an attempt to compete with the UPS (and FedEx) networks, only to exit in 2008 after suffering heavy losses.
This article first appeared on December 2, 2014 on LinkedIn.