One of the fundamental investment mental models in silicon valley and for evaluating startup investments is network effects.
What is network effects ?
“When the value of a product to one user depends on how many other users there are, economists say that this product exhibits network externalities, or network effects.” Carl Shapiro and Hal Varian
Examples of network effects :
1. Two sided marketplaces like eBay, Amazon, Uber
2. Social networks like Facebook
How does network effects work for companies like Uber ?
In order to build two sided marketplaces like eBay and Uber, there has to be supply side liquidity and demand side needs. Supply side liquidity means more drivers on the platform. More drivers will attract riders (demand side needs) due to lower pickup times. As more riders come on the platform, driver earning potential will increase. Driver utilization rates per hour will increase. The driver will get more rides during every hour they spend on the network which will reduce idle times and lead to better network utilization. This will drop prices, attracting more demand and more riders. This ends up becoming a positive cycle that reinforces itself and the marketplace grows.
Creating two sided network effects is hard because of the creation of both the supply side and demand side dynamic. Hence, Uber had to spend some money on fixing the cold start problem. At the same time, it is equally hard to kill two sided marketplaces because of the same reasons. For the driver, it pays off to be in this network compared to other networks because of better utilization rates. Also it pays for the driver to be in the bigger network because the bigger network is available in less densely populated areas. Most of the competitors of Uber are present in high density areas as they are local challengers and dont have the network strength to challenge in the outskirts. For the rider, it pays of to use the Uber network due to cheaper prices, lower wait times and better utilization rates in both dense and not so dense areas.
In the future articles, I will
References
1. All about network effects
2. How to measure network effects
What is network effects ?
“When the value of a product to one user depends on how many other users there are, economists say that this product exhibits network externalities, or network effects.” Carl Shapiro and Hal Varian
Examples of network effects :
1. Two sided marketplaces like eBay, Amazon, Uber
2. Social networks like Facebook
How does network effects work for companies like Uber ?
In order to build two sided marketplaces like eBay and Uber, there has to be supply side liquidity and demand side needs. Supply side liquidity means more drivers on the platform. More drivers will attract riders (demand side needs) due to lower pickup times. As more riders come on the platform, driver earning potential will increase. Driver utilization rates per hour will increase. The driver will get more rides during every hour they spend on the network which will reduce idle times and lead to better network utilization. This will drop prices, attracting more demand and more riders. This ends up becoming a positive cycle that reinforces itself and the marketplace grows.
Creating two sided network effects is hard because of the creation of both the supply side and demand side dynamic. Hence, Uber had to spend some money on fixing the cold start problem. At the same time, it is equally hard to kill two sided marketplaces because of the same reasons. For the driver, it pays off to be in this network compared to other networks because of better utilization rates. Also it pays for the driver to be in the bigger network because the bigger network is available in less densely populated areas. Most of the competitors of Uber are present in high density areas as they are local challengers and dont have the network strength to challenge in the outskirts. For the rider, it pays of to use the Uber network due to cheaper prices, lower wait times and better utilization rates in both dense and not so dense areas.
In the future articles, I will
- compare this with network effects in other companies like FB, Amazon
- how uber is strengthening the supply side and building a defensible moat over it
References
1. All about network effects
2. How to measure network effects
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