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A genealogy of network
effects
Absolutely not MECE.
Mutually
Exclusive
Comprehensively
Exhaustive
“In network theory, the value of a system
grows at approximately the square of the
number of users of the system..”
- Robert Metcalfe
Why are network effects important
at all?
A company is worth the present
value of its future cash flows.
What determines future cash flows?
There are no “economic profits” in a
perfectly competitive market.
“Economic profits” are profits
greater than a company’s risk-
adjusted returns on capital.
“Economic profits” are greater the
greater a company’s moats.
Let’s talk about moats
"So we think in terms of that moat and the ability to keep its width and its
impossibility of being crossed as the primary criterion of a great business.
And we tell our managers we want the moat widened every year.
That doesn't necessarily mean the profit will be more this year than it was
last year because it won't be sometimes.
However, if the moat is widened every year, the business will do very well.“
- Warren Buffet
Moat = defense against competition
Competition for profits
Five forces compete for y(our) profits
Profits
Existing
competitors
New
competitors
(entrants)
SuppliersCustomers
Substitutes
New entrants may enter your market
if there are little barriers to entry
Current competitors may battle with
more fierceness for a market’s profit
Internal market competition may be
tougher if assets are highly specific;
if there’s a “winner takes all”
dynamic; if marginal costs are very
little
Customers or suppliers may take
your profits away the more
bargaining power they have against
you…
Moat = defense against competition
Different types of moats.
Types of moats (Pat Dorsey):
-Economies of scale
-Intangibles (brand, tech, regulation)
-Switching costs
-Network effects
Types of moats (Hal Varian):
-Lock-in (switching costs)
-Positive feedback
-Demand-side economies of scale
-Supply-side economies of scale
Economies of scale: the more you
produce, the cheaper your costs of
production
1 sticker => R$ 10
1,000 stickers => R$ 0.2 /each
Switching costs prevent customers
from – switching – to competitors or
substitutes
How easy would be for us to leave
Heroku?
An app is deeply integrated in
Heroku. It makes us think 1,000x
before switching. Therefore they
have bargaining power with us.
Switching costs affect suppliers’
bargaining power.
Positive feedback.
According to Hal Varian, positive
feedbacks come in two forms:
supply-side or demand-side
economies of scale.
Supply-side economies of scale: cost
advantages attributable to scale.
Demand-side economies of scale are
generally called “network effects”.
Network effects make a product
worth more to each user the more
users it has.
“Whether real or virtual, networks have a fundamental economic
characteristic: the value of connecting to a network depends on the
number of other people already connected to it. This fundamental
value proposition goes under many names: network effects, network
externalities, and demand-side economies of scale”
- Hal Varian, Information Rules
How valuable would a new
Instagram be if none of your friends
were there?
Our tentative
taxonomy of
positive feedback.
Positive feedback
•Supply-side Economies of scale
• Lower unit costs attributable to scale
•Demand-side Economies of scale
• User-as-primary-driver
• Intra-side
• Cross-side
• User-as-secondary-driver
• Content
• Data/insights
Types (?) of network effects.
User
User
User
User
User
User
User
User
User
Whatsapp
Advertiser
User
User
User
User
User
User
User
User
User
Advertiser
Advertiser
Advertiser
Facebook
Advertiser
User
User
User
User
User
User
User
User
Advertiser
Advertiser
Advertiser
Google
Advertiser
User
User
User
User
Advertiser
Advertiser
Advertiser
Ebay
User
User
User
User
User
User
User
User
Quora (or Google without advertisers)
Are flywheels another type of demand-
side economies of scale?
Regorge calls these “macro growth
loops”
‘A flywheel is “a company” with positive
feedback’
-Jim Collins
Amazon’s flywheel:
More customers > Lower prices > More
customers > Lower prices
Possible because e-retail is a business
with huge economies of scale.
Weak
leader => +money => +investing power
Strong: winner takes all
leader => stronger platform
(Windows)
Back to moats.
Moats
•Regulation
•Brand?
•Positive feedback
• Supply-side Economies of scale
• Lower unit costs attributable to scale
• Demand-side Economies of scale
• User-as-primary-driver
• Intra-side
• Cross-side
• User-as-secondary-driver
• Content
• Data/insights
Thanx!!!

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A genealogy of network effects