The Business of Creating Value through Network Effects

Digital platforms are creating colossal value as they empower new interactions resulting in massive positive network effects. The role of platforms as value creators has to be understood and honored.

Positive network effects create value. Everyone understands that network effects in traditional network industries create value. The shared use of a common infrastructure creates value for all the users. A universal telephone network creates a lot of value. A dense transport network creates value. The electricity grids have created a lot of value. The network effects created by infrastructure networks a century ago were so powerful that the whole production system was transformed, countries developed both economically and socially.

The value created by digital platforms might not be as obvious, but it is as real as the value created by the traditional network industries. As digital links connect more and more users, the value of these virtual networks increases for all the users. Communications are cheaper and more effective thanks to communications platforms, door to door transport is made possible at a lower cost thanks to transport platforms, greener electricity can be locally produced exchanged thanks to energy platforms, and so on. “Network effects are not simply abstractions.”3

A concrete example of the value created by platforms can be described for ride-hailing platforms such as Uber, Lyft, and Didi. Platforms make isolated cars work as a network. They identify the location of drivers and riders and they efficiently match drivers and riders, reducing empty runs. The higher the number of drivers and riders, the shorter the drive to pick up the rider, so the shorter the waiting time for the rider, but also costs are reduced for the driver. Cost reductions have been aggressively passed to riders. Lower prices generate new demand, igniting a virtuous cycle. This is not related to license costs, labor conditions, or regulated tariffs. Network effects are even more relevant if riders are ready to share a vehicle for all or part of a ride. The platform identifies the complementarities in demand and coordinates different requests for transport in the same area or direction. Large pools of riders make it possible to match different travel requests to be served by a single driver. Rides take a little longer, but the cost reduction is evident, as the cost is distributed among more than one rider. In terms of prices for the rider, it can add a further reduction of up to 50 percent, and again, lower prices generate new demand. A further twist was introduced in late 2017, when Uber launched Express POOL. If the rider is ready to compromise with the pick-up and drop-off points, by walking to more efficient locations in order to streamline routes, the price can be 75 percent lower than the regular Uber service. This is the power of network effects.

In other words, efficiency is generated by the better coordination of previously fragmented and isolated assets. Thanks to platforms, new complementarities are identified and a more efficient coordination is possible, which creates value. As the value generated by network effects is related to the volume of users, the massive scale of the platforms is creating colossal value. As potentially all humanity, all organizations, and all devices and things can be interconnected, it is easy to underestimate the value that can be created by platforms. Substantial research has focused on the calculation of the value derived from network effects. In Silicon Valley, venture capital has fully understood the value of these network effects.

It is important to understand that building network effects around a platform is a business in itself, a business that requires a good idea, large investment, and the best execution. Network effects do not appear magically; they are the result of the entrepreneurial adventure, which entails a lot of risk.

Firstly, a good idea is necessary. It is necessary to identify an opportunity to create value by establishing a multi-sided market that will benefit from new complementarities. It is necessary to identify an opportunity to introduce efficiency in the provision of goods and services.

Secondly, capital is necessary to build the multi-sided market. It is not always understood how much investment is required to create network effects. A mere idea will not attract users to the platform. As network effects require a minimum volume of users; this is the “chicken-and-egg” challenge for all new platforms. As the most obvious multi-sided markets have already been created, the new ones pose even lager challenges. Investment is necessary to attract users. Investment is necessary to advertise the platform, to pay for the creation of content, and to take the cost of discounts and subsidized services to attract users.

It is obvious that building an infrastructure network requires the mobilization of large amounts of capital. To recall, capital markets (banks, stock exchanges, corporations, etc.) were created to aggregate capital to invest in a network industry: railroads. Platforms might not require investments as large as traditional infrastructure networks, and they certainly do not need to stretch the reach of the current capital markets. Nevertheless, a large investment is necessary to build a multi-sided market of global reach. The main challenge is not the availability of capital, but the availability of capital smart enough to understand the business model and the profit opportunities derived from investment in the creation of something as intangible, as virtual, maybe as volatile, as network effects.

Thirdly, having the right idea and capital does not guarantee success. Execution is just as important. The construction of multi-sided markets requires a constant attention to small details, to take into consideration the needs and demands of the different sides of the market, in order to keep a balance between the different interests. The challenge is not only to create value, but to identify the right distribution of such value across the ecosystem, to ensure the right incentives for all the participants to join and to remain in the platform. Furthermore, such interests evolve over time, in such a way that the balance in the distribution of value across the market is a dynamic balance that requires permanent adjustment by the platform.

The creation of network effects by platforms in multi-sided markets is a business in itself, a complicated and risky business that has the potential to create, but also to destroy colossal value. Public authorities need to understand this new business model and understand that the creation of network effects is a business that requires heavy investment and entails significant risk. Public authorities must understand the enormous value that can be created by platforms. Society at large will benefit from the efficiency these platforms create.

Network effects lead to concentration in the market. As scale is necessary to build any kind of network effect, concentration is the unavoidable consequence in network industries. The number of competitors will always be low. Markets in platforms, just like those in infrastructures, will always be imperfect.

After an initial period of competition among literally thousands of competitors in telecommunications and electricity (hundreds in railways) in the US, as market players identified the relevance of scale and network effects, consolidation took place and the number of competitors was severely reduced. At a later stage, a further round of consolidation led to monopolies in many network industries, either private in the US or state-owned in Europe and the rest of the world.

However, deregulation has shown that monopolies are not the unavoidable consequence of the existence of network effects. Deregulation has challenged the assumption that all infrastructures are natural monopolies and will have to remain so. Some infrastructures seem to be natural monopolies, as network effects do not get exhausted and an extra user always reduces the average cost of the use of the network. This seems to be the case with railway infrastructures and electricity transmission grids, but the experience in telecommunications shows that infrastructures that have traditionally been considered natural monopolies might not be such. Network effects are always relevant, and scale is necessary to ensure the efficiencies derived from them, but once a certain threshold is reached, the efficiencies derived from network effects get exhausted. There is no substantial cost reduction in adding new customers. More than one company can deploy parallel infrastructures and compete in equal terms. These markets will certainly always present a reduced number of players, forming an oligopoly, maybe even a tight oligopoly, but not necessarily a natural monopoly.

Digital platforms present such relevant network effects that they deserve to be included in the category of network industries. Therefore, it is reasonable to question whether such network effects lead to market concentration and even to natural monopolies. Automatisms in answering these question should be avoided. Just as the answer is not the same for all traditional network industries, it seems that not all platforms will lead to the same market structure. The specificities of each market have to be considered. A factual analysis of each market is necessary, taking into consideration that these are highly dynamic markets and, in many cases, are in their infancy. Therefore, it might be too early to determine whether they are natural monopolies or not.

It seems clear that concentration is common in all digital platform markets. The number of relevant players is always small. This is the case of social networks, dating webs, communications platforms, food delivery apps, ride-hailing apps, etc. Network effects require scale and only a few players can reach the necessary scale in each market. Mobile telephony is the perfect illustration: only a small number of players ensures that all the players generate sufficient direct network effects. The number of start-ups might be large at the initial phase of a new market, as a lot of companies try to grow larger and build the network effects. Aggressive competition during this early period helps the market to mature and a few successful players, usually early movers with deep pockets, emerge as the market matures. Oligopoly seems to be the most common market structure in the new network industries.

In some markets, a single platform builds a leadership position. It might not become the only player, but a significant difference in market share and market power is created from the rest of competitors. This has been the case, in particular, with the leading non-transactional platforms: Google and Facebook. In most countries, Google has a market share above 90 percent in the online search market. The multiplatform strategy followed by Google has granted it strong positions with YouTube, Gmail, Google Maps, etc. Facebook also enjoys a strong position in the social networks market, reinforced by acquisitions such as Instagram and WhatsApp.

The market power of the most mature platforms, those that were created more than 15 years ago in the pure content industries, has raised valid questions about the winner-takes-all nature of the platform economy. The example of these gigantic companies has pushed founders and investors to adopt aggressive strategies to grow as quickly as possible, certainly faster than the competitors, growing the largest network effects, and thus conquering an unrivaled position. The winner-takes-all. This is not a new strategy. AT&T’s Theodore Vail had already identified the importance of outgrowing competitors in the network industries more than a hundred years ago. Maersk had done the same in the maritime industry, as had J. P. Morgan in the railway and electricity industries.

However, just as in the traditional network industries, a monopoly might not always be the unavoidable market structure in the new network industries. Network effects might be exhausted at a threshold that allows replication by more than one player in each market. This might be the case with ride-hailing platforms. The case of San Francisco, where both Uber and Lyft were born, might be of interest. After ten years of fierce competition, no monopoly has emerged in the provision of ride-hailing services in San Francisco. Uber is the market leader, but Lyft claims that its share of the ride-sharing market grew to 39 percent in 2018, up from 22 percent in 2016.4

It is not easy to identify whether an aggressive investment strategy to grow scale and network effects is the way to reach a solid monopolistic position, or simply a foolish way to burn capital. Investors might just be subsidizing services in a never-ending effort to outgrow competition, as smaller competitors might have the ability to benefit from the same network effects at a lower cost. San Francisco became a bargain hunter’s paradise during the past decade, benefiting from the possibility to get goods and services below cost, and even for free, thanks to the generosity of venture capitalists. Who needs to buy for instance a mattress or even pay to have it moved to a new home when an aggressive app delivers a new one to you for free as it is building scale and network effects?5

 
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