What do Facebook, Uber, & Airbnb have in common?
A single property is the primary cause of massive growth in these companies.
7 social media websites went after Facebook. All of them failed.
Sidecar entered the ride-sharing space before Uber, but it never became a household name.
Over 15 competitors cropped up in the lodging industry, and none of them could dethrone Airbnb.
Facebook, Uber, and Airbnb are very different companies.
But there's one property that defines them all. This property has enabled them to fight off competition and grow profits.
That property is network effects.
Network effects are mechanisms in a product where every new user makes the product more valuable to every other user.
Simply put, more users = more value.
Network Effects in Facebook
“I think that network effects should not be underestimated with what we do” - Mark Zuckerberg
Would Facebook be of any value to you if you were the only one using it?
Obviously, no. Had you been the only person on Facebook with whom would you share those memes and vacation photos?
Therefore, the value that you, and everybody else, derive from Facebook depends on the number of people using Facebook. And that value increases as the number of users using Facebook goes up.
This "value" has three sources (the 3 C's) -
Connections - as more users join Facebook, the number of prospective connections for a particular user increases
Content - as more users join Facebook, the total corpus of content scales, thus increasing the amount of potentially relevant content for a particular user
Clout - as more users join Facebook, power users (influencers/celebrities) have access to a more extensive base of potential followers
As more and more users join, the value that each user derives from the three sources increases. This leads to FOMO for the non-users - without Facebook, it would be hard to know what your friends, neighbors, co-workers, and long-lost classmates are up to. This causes the non-users to join, thus triggering a positive feedback loop.
Network effects of this type are called direct network effects - there is a change in value for users on the same side with the addition of users on that side.
Contrast this with indirect network effects - there is a change in value for users on one side when there is an addition of users on the other side.
In Facebook's context, the relationship between the users and advertisers is dictated by indirect network effects.
A rising number of users is an attractive proposition for advertisers (positive indirect network effect), and as the number of advertisers increases, the value for users decreases (negative indirect network effect).
The following diagram summarizes Facebook's network effects -
Network Effects in Uber
Uber recognizes the central role network effects play in their growth and included the following diagram in their S-11:
With this diagram, Uber aims to break down exactly how their indirect network effects (Uber calls these “liquidity network effects”) trigger a positive feedback loop.
An increase in the number of drivers leads to lower wait times and fares for riders. This attracts more riders to Uber, thus increasing earning potential for drivers, which in turn attracts more drivers.
Uber (like Facebook) has direct network effects too. As the number of riders increases, the price or wait time per ride increases, producing a negative direct effect on the demand side. Similarly, negative direct effects are produced on the supply side too - more drivers means increased competition for other drivers.
The following diagram summarizes Uber's network effects -
It is worth noting that Uber's network effects are regional, i.e., increasing supply (drivers) makes the product more valuable for the demand side (riders) within a small geographic area.
The benefits of increasing supply are realized only in that part of the city, and riders outside that area aren't delivered any incremental value.
Therefore, Uber can't establish an escalating supply-side advantage with their network effect, and their core business is vulnerable to new entrants.
This explains why Uber lost in markets where it did not have the first-mover advantage (think Didi in China, Careem in the Middle East, and Grab in South East Asia). These local competitors had established regional network effects, making it unviable for Uber to enter and operate in those markets. As a result, Uber was forced to enter into exit deals with those companies2.
Network Effects in Airbnb
The following diagram summarizes Airbnb's network effects:
Airbnb demonstrates cross-border network effects, i.e., increasing supply (hosts) makes the product more valuable for the demand side (guests) across geographic boundaries.
Unlike Uber, the benefits of increasing supply are realized across the network, and the resultant incremental value is delivered to all guests.
Therefore, Airbnb established escalating supply-side advantages with their network effect, thus creating defensibility for their business. This makes it easy for Airbnb to expand to other markets - the untapped demand from existing guests makes it easy and cost-effective to attract hosts in new markets - and ward off local competition due to scaled supply and demand.
The winner takes it all
The following graph by Raymond Stern3 describes the power of network effects:
The message is as follows: Value increases exponentially while cost rises linearly.
The above property makes network effects one of the deepest moats out there.
A competing firm would need to replicate the network before users see more value in the new network and switch away from the existing one.4
For this reason, network-effect-based businesses tend to create natural monopolies and oligopolies - the P&L of a challenge will be too ugly, so other firms just back off.
The implication for network effect-based industries is as follows: at the end of it all just a few networks will remain, and they will continue to grow larger.
https://www.sec.gov/Archives/edgar/data/1543151/000119312519103850/d647752ds1.htm
https://techcrunch.com/2019/04/11/uber-global-exits-billions/
https://www.linkedin.com/in/raymondstern/
The Little Book That Builds Wealth: The Knockout Formula .... https://www.goodreads.com/book/show/2389174.The_Little_Book_That_Builds_Wealth