Ep. 3 - Mapping Out the 16 Network Effects (NFX Masterclass)

SPEAKER_1 (0:00)

You're listening to Episode 3, Mapping Out the 16 Network Effects from the Network Effects Masterclass, here on the NFX Podcast. To watch the course, visit nfx.com/masterclass.

James Currier (0:13)

So when people first encounter network effects, they think there's a network effect or there's not a network effect. That's like saying there's life and there's not life. There's actually different types of life, and there's different types of network effects, okay? Not all network effects are created equal.

And we started studying and noticing these things back in the 2000s. By the time we got to about 13 network effects, what we realized was we needed a map. And so we've come up with a map to help us visualize the different network effects and where they all fit in in terms of how strong they are, what types they are, and then delineating how they're different from each other. And that was a few years back. Now we're up to 16 network effects. We're going to walk through all of them with you right now.

SPEAKER_1 (0:53)

Go to nfx.com/masterclass to watch this course with a full video experience. Alongside transcripts, show notes, and additional reading. The NFX Masterclass tracks your progress and allows you to move at your own pace through the material. We will also be adding new seasons to the streaming platform, so be sure to register so you can gain early access to new material from NFX. And now, back to the episode.

James Currier (1:17)

Okay, so the first time we saw a commercial application of Network Effects was way back, 1907 The chairman of the board of AT&T was deploying physical phones and copper wires to connect them all together so they could talk to each other. He said in his report, his annual report, you know, you might want to buy our stock because what we've noticed is that when we go into a town and we get a few nodes and a few of these copper wire links, nobody can compete with us. And we end up taking all the business in the town. So in every town we get into, we own everything. We're probably going to have a pretty good business here. He noticed it, he explained it, and he gave business reasons why it was important. And boy, was he right. Now this physical direct network effect, the physical being the copper wires, the physical being these telephones, these heavy black telephones that would sit in people's homes. This was the first commercial network effect discovered and it turns out to be the strongest network that we know of. Okay, now there's a whole type in the center of the network effects map, these blue network effects. And these are known as the direct network effects, because every node can touch every other node in the network and wants to. The physical is the most powerful, because once you've actually embedded atoms in the ground, like if you're Comcast and you're putting cables to people's homes or your AT&T, once you have these physical things in the ground, it's very hard to rip them out. Okay, so I think Comcast has the worst NPS score of any major corporation in America, and they can afford to do that, because we can't replace them, because they have this incredible direct physical network effect. And so that's at the core of our network effects map, physical direct network effect. The second direct network effect we call protocol, and you can see this with faxes or with Ethernet or with Bitcoin, where you develop a protocol, you publish it widely, everyone can now attach to this protocol, and the more people use that protocol, the more benefit everyone gets from that protocol. So even crappy protocols like fax are still surviving in the 2020s, even though they were invented in the 70s, because so many people are using that protocol network effect. So the third most powerful network effect we've seen is the direct personal utility network effect, okay, where you have your identity, like WhatsApp or like Facebook Messenger or WeChat, where it's personal to you. It's direct because I can connect with anyone on WhatsApp, I can connect with anyone on Facebook Messenger on WeChat. And it's utility, meaning I get some utility out of it, like making a payment or picking the kids up from school. I'll tell you, if my wife hits me on WhatsApp and says, you need to pick the kids up from school and I don't, I'm in deep doo-doo. So I need to be on that network. I cannot leave that network. That is a good defensibility. That is a good retention of me. And that's what Network Effects are there to do. The fourth one is what we call the personal direct network effect, which is what Facebook has, which is it's my person, it's my name, it's my picture. And I've got all my friends. It's a direct network effect. I can see them all. They can see me. I can friend somebody, I can unfriend somebody. Every lot works, but it's not as powerful as the one with utility. I could stop using Facebook next week, not a big problem, but if I stop using WhatsApp, big problem, I didn't pick up the kids. I'm indeed doodoo. But on the other hand, it's a very powerful network effect, this Facebook network effect, this personal direct one, because am I gonna spend a ton of time building a new friend group if I've already immersed myself in that friend group? I'm really not. I might stop using Facebook for various reasons, but I'm probably not gonna spend a huge amount of time building a new friend group. When I get sick of being away from Facebook, I'll probably just go back to it. We see people do this all the time. They quit Facebook, and then nine months later, they say, I'm back. Why? Because you have this retention, this defensibility, this network effect that adds value to every node on the network, and no one wants to leave it. The fifth network effect is the market network. This is also known as an end-sided marketplace, but it's still a direct network effect. And basically, how it works is if you have a wedding, let's say, you're gonna need a florist, you're gonna need a venue, you're gonna need a wedding planner, you need a caterer. These are all nodes on a network collaborating on a project, and in the real world, they know each other. They connect with each other, but we haven't seen it put in digital format yet. So a market network puts it in digital. Now they can see each other, they can transact with each other, they can plan on their calendar. There's typically a workflow software which allows them to coordinate in this end-sided marketplace, okay? And once you're on there, once you've got your name and your reputation, your transaction history there, you're not going to want to leave because it's your source of income, just like a marketplace would be. But in this case, it's end-sided. Everybody in 360 degrees can transact with each other. Okay, so the six network effect is a two-sided marketplace network effect, very common, whether it's Craigslist or monster.com or Uber. You've got a supply side and a demand side. The more supply you have, the more value the demand gets and vice versa. It's called indirect network effects or cross-side network effects. And the marketplaces one is now in red because it's got a very different shape, because supply-demand, it's not an end-sided type of situation like a direct network effect. That's why we changed the color and made them red. These are very durable, as you know, because so many of the marketplaces online are still around years later. Now, they can be attacked. I mean, eBay has been attacked by Amazon Marketplace very successfully by building pro-seller tools that were basically better than what eBay had. So people multi-tenanted and moved off. But still, these are very durable network effects. eBay is still with us. So is Amazon Marketplace.