How to Rate Network Effects in Social Media

Part of the excitement driving LinkedIn’s IPO last week comes from investors associating social media with network effects. You know, the principle that the value of a network increases dramatically with the number of its participants. That’s the engine that drove Windows and eBay, not to mention the public telephone network. Markets with network effects tend to have explosive growth and can end up with winner-take-all market share.

But not all effects are equal, and assessing the valuations and competitive positions of social media companies depends on knowing which network effects are actually at work and how those could play out.

Types of Network Effects in Social Media

Pascal-Emmanuel Gobry wrote a thoughtful piece on network effects last week for Business Insider; it includes some analysis on how companies focused on market niches eat away at generalists who benefit from network effects. And as Matthew Ingram notes, network effects can work go ways: For example, Facebook supplanted MySpace, which supplanted Friendster.

Looking closer, there are several different types of network effects that work in social media:

  • Core network effect utility: There’s a difference between economies of scale and the magic of adding connections to a network. Groupon is building a user base, a sales force and relationships with thousands of merchants, but until it uses its sales data to offer personalization, targeting and other marketing programs to merchants, it won’t achieve much beyond scale. Even then, once critical mass is achieved, additional connections don’t add as much.
  • Viral growth: LinkedIn and Facebook initially grew their networks the old-fashioned way: Users invited other users to join. Viral pass-along is a key growth driver for social commerce and games, but now services and apps can hitch a ride on existing social networks, leveling what was once a steep playing field.
  • Business model that reinforces the effects: Gobry’s wrong about Google. While there are minimal network effects for its search users, there are huge ones for its advertising network. Google’s $25 billion in extremely profitable search advertising depends on attracting advertisers to its dominant search audience and insuring a liquid marketplace via bidding and enforced relevance to create an unbeatable paid search business. Plus Google lets developers using its services and APIs tap into that revenue stream with minimal effort.
  • Participant lock-in: Technology platforms create positive business opportunities for developers. But they can also achieve customer lock-in for their originator by making those same developers dependent on APIs. End users can be locked in, too, via familiarity (e.g., the QWERTY keyboard) and data storage (e.g., contact info, photos, message repositories) that raise switching costs for members.

network_effects

Source: GigaOM Pro

As illustrated in the table above, here’s how network effects are shaping competition in selected social media markets:

  • Social graph: Though there are network effects aplenty, consumers tend to belong to multiple networks (Facebook, Twitter, Foursquare), meaning would-be data miners must target multiple data sources. And the industry is only just beginning to harness that collection of big data into reliable revenue streams.
  • Likes and log-in networks: Facebook was smart to hang Likes and Sign-ins off its Connect network, as each feature complements the others and assists in distribution; now LinkedIn and Google are trying to do the same. Bolting an ad network on top of those networks could provide missing revenue reinforcement.
  • Social commerce: As noted, most social commerce is more scalar than social. Without the additional services for consumers and merchants previously mentioned, single-market entry barriers and switching costs will remain low.
  • Unified communications: A cross-channel communications hub would sponsor habitual consumer usage. But so far, interoperability requirements have restrained the potential to lock in customers.
  • Social games: Many social games don’t depend on competition between users to be fun. Facebook’s distribution channel and cross-vendor virtual currency enforce interoperability — that’s good for growth but bad for Zynga’s or Playdom’s user lock-in.

Based on that framework, Facebook is well-positioned to build on its influence and add revenue streams. Its platform is a legitimate beneficiary of network effects, even in the face of competition from tech worthies (Google) and startups. LinkedIn has a solid business, but its platform aspirations remain just that: aspirations. Besides viral growth and some network utility, it’s not clear that other social networks (Twitter, Foursquare, Instagram) have network effects behind them.

Question of the week

Where are the real network effects in social media?
Relevant Analyst
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David Card

VP Research Gigaom Research

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