Prof. Joost Rietveld is a renowned academic focusing on platform competition and strategy. He is the author of numerous papers as well as a well-known curator of insightful platform research. As ‘Academic in residence’ at Launchworks & Co, Joost provides a crucial link between academia and our research-based strategy consulting.
Today, Joost Rietveld helps us decipher some aspects of academic research relevant to platform practitioners… and this first discussion with Benoit Reillier focuses on the network effects at the heart of many platform businesses and ecosystems.
What are network effects and why do they matter?
Network effects are a type of economic feedback loop that occurs when the value of a product or service increases as more people use it. This is because the more people who use a product or service, the more valuable it becomes to each individual user.
Expanding this thinking further, Joost says it is essential to understand the difference between direct and indirect network effects:
“When more of the same type of users join the product, then the value to all users increases. And these positive externalities lead to direct network effects. Indirect network effects occur when one side of the platform benefits from the users on the other side of the platform.”
Network effects can act as a powerful differentiator for platforms, serving as a competitive advantage once the platform has gained some traction. However, as Joost points out, the idea of network effects as the ultimate early mover advantage is a pervasive myth: the reality of leveraging network effects is much more complex.
“Not all network effects are created equal. Not all network effects are sustainable over time,” he says.
Rather, network effects are expressed differently at every stage in a platform or product’s lifecycle.
Drawing on his research into video game platforms, Joost also highlights the possibilities of nested network effects when platforms may give you access to other platforms. For example you’ll find network effects at the app store level but also within the apps themselves (games like Fortnight or a social network like facebook have strong network effects). These nested network effects can cause a platform’s market position to become increasingly sticky and make it more difficult for their competitors to replicate the ecosystem’s value.
To harness network effects successfully, however, it is crucial to tweak the value proposition on both sides of the platform to gain initial traction and develop liquidity. If the platform’s value proposition has a network component, Joost says, there are different types of subsidisation to consider. Platforms often have the flexibility to subsidise one side while monetising the other, allowing for unique pricing strategies. Another type of subsidisation relates to charging different prices at different points in time. Users are likely willing to pay more for a product or platform when it has a larger network.
Overall, understanding network effects is about understanding how you grow the pie for all ecosystem participants. The underlying business strategies for network effects are uniquely focussed on how users derive value from the product or platform.
“The extent to which you want to rely on the network effects’ value component of your product is a very crucial strategic position. It can get you towards market dominance if you’re successful. But […] if the network value doesn’t materialise, you’re nowhere,” says Joost.
Research on network effects is rapidly expanding, and academically, we’re still learning about the circumstances and parameters that lead to the development and even the unravelling of both positive and negative network effects. What is clear is that this area is not only ripe for further investigation, but also a vital part of a business’ platform strategy. Joost has seen as much in his research:
“Network effects are real and have very strong implications for pricing, strategy and governance more broadly.”
The full conversation between Joost and Benoit on network effects explores these topics and many more. Read on for the complete in-depth interview. Then, check out their follow-up discussion on how to harness the power of network effects in your platform business.
What are network effects — in-depth interview
Hi Joost, great to have you with us for this first conversation. Academics and practitioners are increasingly talking about network effects… so let’s start with the beginning: what are network effects for you and why are they important?
Network effects mean that the value that a user derives from a product increases when there are more users of the same product. So, the most basic example would be the telephone… In the absence of someone else to call, the telephone has zero value. But when more people adopt the telephone, the more valuable it becomes, even though the product itself has not changed. So, the value created is a direct result of the size of the network.
We often hear academics talk about externalities… a concept that is closely related since it’s about users of a product benefiting from other users (positive externalities) or being negatively impacted (negative externalities). In the case of the telephone network, everybody benefits from everybody else being connected… In some contexts, users have a negative impact on others, for example if they pollute a river that is being used by others in which case this is a negative externality… a kind of ‘negative network effect’.
Yes, absolutely. Positive externalities are driving network effects. In the case of negative externalities, we don’t seem to refer to them as network effects per se, but I think you’re right, it’s the same logic. And it’s important to talk about the difference between direct and indirect network effects. Direct network effects is what we just talked about with the example of the telephone. When more of the same type of users join the product, then the value to all users increases. And these positive externalities lead to direct network effects. Indirect network effects occur when one side of the platform benefits from the users on the other side of the platform. That’s why they’re also called cross-side network effects. In gaming for example, users of a specific platform, like Microsoft Xbox or Sony PlayStation, benefit from the games that are developed on the other side of the platform. Likewise, game developers benefit from a large installed base of users on the platform. Here’s another straightforward example: a newspaper publisher essentially sells its services to readers who want to consume news, and to advertisers who want to expose themselves to those readers with their advertisements. The newspaper becomes more valuable to advertisers when there are more readers reading it. But arguably, the same newspaper becomes less valuable to advertisers when there are more advertisers advertising. And so, you can have both positive and negative network effects to balance one another…
In platform businesses, too much advertising often degrades the experience for users… so, it’s a negative cross side externality!
Yes. This one is quite clear, but we can also think about app stores where app developers want to be on the platform with the most consumers. This can attract many app developers and then those app developers engage in competition with each other. It’s very difficult to quantify the net effect of those two forces. More app developers means more competition, but more app developers also attracts more end users, which creates a larger addressable market for those app developers. So, you have these two countervailing forces at play of the indirect network effect that is positive and the direct network effect is potentially negative. And it’s not always clear, and I think it’s highly context specific, which one of the two is stronger.
That’s why we see that the sweet spots are often found through trial and error as opposed to an optimal design ex-ante. It’s interesting because you can be differentiated based on the type of network effects you are going after or developing, compared to a competitor. The other thing that I found interesting in your example with newspapers—which has parallels with social networks—is that this example shows that there is a cursor. You can, depending on how much ads you allow onto your platform, decide the extent to which the service is subsidised—100% in the case of Facebook. Or, you can try to find a sweet spot where you get some contribution from members and some advertising—like the balance Elon Musk is trying to strike with Twitter!
Yes, you’re right. And if you look at the market for newspapers, there are newspapers that are entirely free and there are ones that you pay for as a consumer. This is clearly a consideration on the part of the publisher. We can give away our newspaper, at the underground or train station. And it will significantly increase readership. But the flip side is that pretty much two thirds of the space on the page is devoted to advertisers because all of the money has to come from advertisers. As a result, readers of those free newspapers might not be as engaged or as loyal to the product as those who pay for newspapers such as the Financial Times or The Guardian.
So, there are choices to be made in terms of where the money is coming from, who then is part of the network and how they might behave in the network. And going one step further, we typically see that publishers deploy a range of these options. Looking at newspapers like The Guardian or The New York Times or even magazines like the Harvard Business Review, they typically have an online option that is free for users and that might be a little bit heavier on the advertising side. And then, they have a print option that you have to pay for and it might be a bit more devoid of advertisements. This can be useful to sort your users by their willingness to pay. And as an advertiser, you can choose the levels of advertising in the print edition versus the online edition based on the type of users you can expose yourself to.
This makes a lot of sense. Everybody now is talking about network effects and yet, you have lots of misconceptions or myths around them. One such myth is that once you’ve got network effects going, then that’s it! You become a monopoly. You are unassailable. Nobody can compete with you. And while in some specific contexts, network effects can give you a strong market position, experience suggests that things tend to be a bit more complicated…
Yes, and going back to maybe the late nineties, early two thousands, I think that we, as academics, and then as an extension, perhaps managers that would take the classes and read the papers of those academics, would tend to think about network effects as the ultimate early mover advantage. There aren’t many situations that lead to a true sustainable competitive advantage. But we can distinguish between isolating mechanisms and early mover advantages, and network effects are always mentioned as a kind of canonical example of an early mover advantage.
If we are first to market, we manage to attract a little bit of a user base and the product has network effects. Then, that user base will almost automatically expand and grow. It makes it virtually impossible for new entrants to get a foothold in the market because they might compete on the basis of a similar or even a better product, but they don’t have that network. And as long as the network differential is there, the incumbent can keep growing and maintaining its dominance. It’s our ground zero thinking on network effects. Over time, we started to acknowledge that things are a bit more complicated and that not all network effects are created equal. Not all network effects are sustainable over time for example. And within many markets, there are differences between the types of network effects or the extent that products rely on them for their value proposition.
That’s super interesting because when we work with clients and we start to manipulate these network effects and harness their power, we see different stages. Often you start with very little network effects because you don’t have liquidity. You don’t have enough platform participants, you haven’t found platform-market fit as we call it (the platform version of product market fit). But suddenly, after having tweaked the value proposition on both sides of the platform, you start seeing some traction often with quite significant network effects. That’s when you start to see liquidity. On a marketplace for example, every new merchant adds valuable inventory, which attracts buyers on the other side, which attracts merchants… which kickstarts this exciting flywheel dynamic. But then, after a little while these network effects start to weaken, every new merchant is not really creating this enthusiasm on the other side anymore. And every thousand additional users of the platform are no longer creating as large an incentive to join the platform as a merchant. So, these network effects don’t express themselves in the same way depending on where you are in your life stage as a platform.
Yes absolutely, and there’s so many things that we could potentially discuss here that might be driving these things. I’ve done a lot of work on the video game industry and we see exactly the same thing. Every video game console has a lifecycle of five to seven years and then their install base virtually gets reset and they start anew when a next generation gaming console is launched onto the market. While during my PhD, I made a striking observation in my data. When these platforms get a little bit older, we start to see game developers becoming overly enthusiastic and releasing new games at a much faster pace than there are new consumers coming onto the platform. Clearly there’s a bit of a mismatch there. In addition, on the developer side, because technology gets cheaper, it therefore becomes cheaper to develop new games, and we see that the quality of games going down.
The new games aren’t adding as much value as some of the earlier games. On the other side, people who buy video game consoles later have a much lower willingness to pay for content than those that join earlier. They might only buy one or a couple of games, as opposed to many more for early adopters. So there’s differences in consumers’ willingness to pay depending on the time people join the platform, kind of early versus late adopters.
And I think some users also just become saturated at some point. They have this wealth of content from sellers to fall back on. The platform becomes better in their sorting mechanisms and their algorithms improve. And the matchmaking improves and we start to see that some games or products on the platform become really successful, whereas others are kind of left in the long tail. So, there’s a lot of things that might be driving those effects. Just taking a step back, there also are diminishing marginal returns, right? At some point, the difference between the 10th and the 100th product or merchant on a platform is much bigger than the difference between the 1000th and the 10,000th.
We’re talking about network effects on a platform but of course, you’ve also got these nested network effects within platforms. If a gaming platform itself has got network effects, you can also find games within the platform that have network effects built into them… for example, if you can play against—or with—some other participants. God knows that the promise of the metaverse, a concept still emerging at the moment, is to create these digital environments where people add and contribute to the environment itself. If everybody else can benefit in some ways, these digital worlds will benefit from network effects. Although how that works in practice is yet to be determined… Network effects will likely occur in various places, and combine, even within the console ecosystem itself.
You’re touching on a very important point as I think we’re increasingly seeing platforms embedded in platforms. The platform might be a video game console or a PC game distribution platform, but some games have very strong lock-in effects and they benefit from network effects themselves. If you are playing Fortnite, there are very strong incentives to play with and against your friends and you also make purchases to dress up your avatar or give them peripherals etc. People become increasingly embedded in these products on the platform itself, which makes it a lot harder for any new entrant to effectively compete. Because again, you’re up against not only a really good game that has had the opportunity to improve itself and capture an audience, but also their network of captive gamers and players.
People really have to make a very strong conscious position to say, okay, I’m going to stop spending time and money on this particular game where all my friends are and where my avatar is fully dressed up and kitted out to try this new thing. Those positions become increasingly sticky and therefore it becomes increasingly hard for any new entrant to successfully compete on a platform where the product itself also might have network effects.
Exactly. And I guess in some cases, all your friends are on the platform. You invested so much time and resources. You went through the learning curve in terms of understanding the mechanics. You’re sort of committed and yet there are points where network effects may work in reverse. And if your best friends start leaving because there is some superior value proposition somewhere else, suddenly network effects can very quickly work in the other direction, you can’t find anybody to help you in your game or fight against various things and suddenly you migrate to a new platform. So I’m sure you see these effects as well.
Yes. And that’s very interesting because as an academic community, we don’t know much yet about the circumstances and parameters that lead to network effects unravelling. We know it’s incredibly difficult to dethrone a dominant platform. We are starting to observe that when new entrants are successful in doing that, the dominant platform can very quickly implode. But we don’t quite know yet what the driving mechanisms are, and under what conditions we’re more likely to see this than not. It’s a very timely topic, and one that we don’t know much about yet academically.
Another thing I’ve noticed is that often when we talk about network effects, we realise that there’s a confusion between network effects and viral effects. As you mentioned, network effects benefit everybody. Viral effects benefit the people selling the product but not the people buying it, right? For example a good book like Harry Potter may become viral and sell lots of copies through word of mouth. But people who read the book don’t really benefit from other people reading the book. In that sense, books are not like phones, you don’t benefit from other people having the same book as you. That’s the crucial difference, right?
Absolutely. We can distinguish between the water cooler effect where you just want to be part of the conversation and a network effect where more people consuming the product actually makes the product better. I think in both cases, users derive some value from both of them, but I think the underlying business strategies are very different. Whereas it’s really difficult to engineer for social contagion, you can try to rely more or less on network effects for your product. So, the way I like to think about products is if we think about a value proposition as a value bar that products might have, some products are just vertically differentiated, so some value bars might be higher than others, but in the context of network effects, we can break that value bar up into standalone value and network value.
So kind of two sub-components. A telephone has virtually zero standalone value because it’s all network value. Whereas a movie you watch that might have social contagion is all standalone value. You consume the movie and no matter how many people consume the movie, your viewing experience is the same. So, the extent to which you want to rely on that network effects value component of your product I think is a very crucial strategic position. It can get you towards market dominance if you’re successful. But if you’re making the telephone and no one’s really interested in it, then your product can completely fizzle out because all of your value bar is in a network value and if the network value doesn’t materialise, you’re nowhere.
And that’s probably one of the reasons why we see people effectively subsidise entry when they want network effects to kick in because they know that people are not going to buy the product itself just for the product. It’s all about the network. And when you start, it can be intimidating… You may have heard this story about the salesman trying to sell the first fax machine and finding it incredibly difficult… You have this “cold start” problem—on both sides of the platform—where you need to attract people to the platform. So, you often price very low or offer products for free in order to kick start your network. When you sell books, it’s a different logic. You want to recover the value of the product on the per unit basis very quickly.
Yes, absolutely. If it’s all standalone value plus social contagion, you need to make a profit margin. If there is a network component in your value proposition, then you need to think about two types of subsidisation. One is over time and the other is across user sides. If you’re building a platform, there is very often what is called a money side and a subsidy side. You’re going to over-monetise one side of the market—advertisers when you’re publishing newspapers. And you’re going to subsidise the other side of the market—readers —because an advertiser is more sensitive to variation on the reader side than a reader is sensitive to variation on the advertiser side.
So that’s why you want to subsidise the readers and monetise the advertisers. So that’s across sides. And then, across time periods where when you’re just starting out, you need a critical mass early on. Otherwise those network effects cannot manifest and your value bar just remains flat. Initially you may want to give some of your product away. If it’s a product that has only direct network effects, then you may want to consider making a freemium version or a free trial version.
If the product has both direct and indirect network effects, you could consider seeding the platform yourself. If you launch an app store for example, you may make some apps yourself and hopefully that will attract consumers and then that will attract outside app developers. Or maybe if I know you’re a really good app developer, I give you some money and you make apps for me to help me attract users. And you want to have greater intensity of doing these kinds of things early on in the platform lifecycle. The distinction between value creation and capture shifts over time for many platforms. Once a platform becomes dominant, it typically shifts towards more of a value capturing stance than early on in its lifecycle.
And it makes a lot of sense because the platform itself is worth more because it has a critical mass of users. It has created these network effects that benefit all participants, so it can now charge for the benefit of joining. We often use the analogy of a dating platform. If you’re the only person on the dating platform, it’s not a very exciting dating platform and the platform may not be able to charge much for it…
Unless you’re really into yourself. 😉
Actually there may well be a segment of one somewhere!
On a more serious note, this ability to subsidise one side gives quite a unique pricing flexibility to platforms. In our work, we see that many traditional firms that operate value chains have developed linear pricing models—and mental models—often on a cost-plus basis. If you’re a traditional retailer, you buy a product, you sell it and you need to make a margin. And with the small exception of maybe promotions or loss leaders, many firms apply a mark-up to their costs.
So we see traditional firms thinking like that. But when they develop a platform business, often complementary to their existing operations, so much pricing choice can be confusing. These new pricing strategies can change over time, and sides of the platform! The same debates have been happening in the academic world. Lots of people have been thinking about supply and demand in the formation of prices, and what would be predatory, etc. Suddenly, you put network effects in the equation and traditional economic theory doesn’t apply anymore.
Yes, absolutely. And I think that’s why it has spurned such a lively community of people studying these topics. Right now, I think we all understand that network effects are real and that it has very strong implications for pricing and strategy and governance more broadly. And I think we’re just trying to figure out what those implications are when they apply, and when they don’t apply. It’s currently a very fertile area for research. As you know, I curate a website of academic papers, platformpapers.com, where I keep track of academic research published on platforms. Looking at the year 2022, I added exactly 100 papers to the database. It’s the highest number of papers I’ve added in a year. Even though we’ve been thinking about network effects since the late 1980s, the research is growing exponentially. That’s because there’s just so much to learn and so much that we still don’t know.
The fact that network effects papers are growing exponentially, is a sign! 😉
I haven’t quite figured out what the network effect is for research on network effects, but I’m sure there is one!
The conversation between Joost Rietveld and Benoit Reillier continues in the follow-up article. Benoit and Joost review the impact of Generative AI on network effects and discuss how to harness their power in your platform business.
For those who like to go deeper on the topic of network effects, here are relevant research papers:
Rietveld, J., & Eggers, J. P. (2018). Demand heterogeneity in platform markets: Implications for complementors. Organization Science, 29(2), 304-322.
Rietveld, J., Ploog, J. N., & Nieborg, D. B. (2020). Coevolution of platform dominance and governance strategies: Effects on complementor performance outcomes. Academy of Management Discoveries, 6(3), 488-513.
Rietveld, J., & Ploog, J. N. (2022). On top of the game? The double‐edged sword of incorporating social features into freemium products. Strategic Management Journal, 43(6), 1182-1207.