Network Economies exist when the value realized by a customer increases as the installed base increases. Logically, Network Economies can’t exist in the infancy of a company but the prospect of them certainly can. The tenth user of Facebook or LinkedIn wasn’t finding a ton of value (yet) but one could certainly see tremendous value once millions of users joined.

Benefits of Network Economies

Of course, this is benefits from other users - a company with powerful Network Economies will be able to charge far more than its competition given the size of its user base and value it provides. Facebook (2.9 billion monthly active users) can charge advertisers (its customers) far more than MySpace (7 million monthly active users). 

Barriers of Network Economies to challengers

The cost of gaining share and challenging the Power holder is so high, competitors will be unwilling to make that investment. Moreover, even if a company had the resources to challenge, the prospect of winning or even coming close is so low that they won’t try. 

Google had a massive war chest to invest in Google+, which they did for a while, to no avail - Facebook was simply too far ahead. Google would have been better off investing that money elsewhere, most competitors recognize this upfront and don’t bother trying - a very powerful moat for a company with strong Network Economies.

Key Attributes for industries exhibiting Network Economies

• Winner take all: Once a single company achieves a certain scale, then other firms just throw in the towel. If winner take all doesn’t exist, then differential returns and compelling margins will be arbitraged away. Lyft in the US and others around the world were able to successfully challenge Uber, particularly because it was so easy for both riders and drivers to multi-tenant, ie. use multiple apps. In the end, the margins for Uber, its competition, and the drivers all got squeezed.

• Boundedness: Businesses with Network Economies are typically bound by the character of that network, LinkedIn is a professional network and Facebook is a social network, neither would be particularly successful in entering each other’s space.

• Decisive early product: When there are multiple upstart competitors battling it out for supremacy in a network economies industry, who scales the fastest is often determined by who gets the product most right early on. Enter Facebook vs. MySpace, again.

While early stage companies will never have Network Economies at the outset, I always look for the prospect of Network Economies when investing. PeerSpace is a great example - they’ve built a B2B marketplace for booking space for events, meetings and productions. Similar to AirBnb, every space that is added (supply) or potential user added (demand) adds value to both sides AND suppliers can and do become buyers and vice versa.

Up next, Scale Economies…