The network effect is a phenomenon whereby a good or service becomes more valuable when more people use it. For example, how social media platforms are more useful when your own social circles are using them. Most companies aim to leverage the network effect to generate a critical mass before they can monetize their business model. However, this is often risky because there are instances where the network effect can be more of a liability than a boon.
Marketplace businesses are multi-sided platforms, where they exist to connect two or more parties. They tend to grow quickly and spawn winner-takes-it-all competencies, thereby being a gem in most investors’ eyes. Examples of these companies are industry titans like eBay, LinkedIn and also some of Sweden’s web darlings Blocket and Spotify.
The loophole in such a business model is that most companies expect the users or customers to pay for the value created in the platform when they are becoming the market leader. However, the attempt to get paid most often fell flat, because the companies themselves are unable to capture very much of the value that they provide. This is because users are not willing to pay for the service provided.
Like how the old maxim goes, ‘Why buy the cow when you can get the milk for free?’
When using the platform, users have an expectation of completeness. Let’s take Spotify for example. Spotify is a multi-sided platform that has to cater to consumers (users like you and me) and suppliers (recording labels). Users come to Spotify and expect to find the songs that they want to hear. If they don’t find the songs that they want, they will change to an alternative platform such as Apple Music.
Similarly, if Spotify only shows songs that are sponsored, users will also switch to other competitors. Therefore, it is difficult to charge users or recording artists for the services Spotify has to scramble to build. While this service creates value for all, it is not easy to capture and monetize all the value created.
How can we improve this?
The expectation of completeness of the service provided by consumers, and the resulting inability to monetize this business model, may aid in the understanding of challenges faced by companies like job-listing sites.
One way of mitigating the impact of completeness is to enroll yourself in the transaction. When you are in the middle of the money-handling, it’s easier to justify taking a cut, especially when it adds convenience and security to the payments. Another way is to cater to a really large market, just like what our favourite search engine, Google, is doing. The best way is, of course, to capture more of the value the company is providing, but this is also the most difficult.
In A Nutshell
Network effects may prove successful from a growth and engagement perspective, but certain marketplaces can be rather difficult to monetize. On platforms where the buyer or seller is expecting to choose from a comprehensive listing, these businesses typically give out more value than they are able to capture. Therefore, it is prudent to also have alternative ways to monetize the value created and not fall into the illusion of what the critical mass can generate.