Guest Post: The Rise of Networks as Market Goliaths
Many of the large companies that dominate world markets owe their strength and continuing growth to their underlying structure: a formidable network. Such networks have special economic characteristics that provide competitive advantages.
We are surrounded by networks: social networks, airline networks, highway networks, wireless networks, and numerous others. These entities contain points (“nodes”) connected by “links” or “edges.”
Networks derive their strength from an interesting economic phenomenon known as the “network effect.” This is created when the addition of one element to the network (say a node or a member) improves the utility of all the network participants (nodes/members). In other words, any new element joining the community benefits the connectivity of the network as well as its member organizations.
Examples of the multiplier effect
Consider a telephone. The utility of the telephone comes from the fact that if it is ubiquitous, every person in the network can talk to each other (and teenagers do). In other words, every additional telephone connected to the network increases the ability of people to communicate.
Social networks are an obvious example of this effect. The first users of Facebook could possibly get some benefit from recording what they did that morning. But the real benefits come from the (still unexplained) deeply-rooted desire to inform others about mundane comings and goings, as more and more people join the network. As the community evolves, the next phase involves the creation of a political movement based on Facebook communications. Twitter and LinkedIn show similar growth trajectories; their value grows as the number of members increases.
Furthermore, networks create a competitive advantage and a barrier to entry. A competitor has to have a lot of money and time to build one. And the entity offers little value to users during its nascent development stage because the number of members is relatively low.
Airlines provide an example of network economics. Not only do airlines try to serve multiple destinations, thereby boosting the number of cities they cover, they also enter into mergers with other carriers to enlarge their networks and capture the benefits of scale and scope. Carriers also create alliances to extend their geographic reach.
The hub strategy
While the benefits of adding nodes (e.g. a city served by an airline or an extra person with a telephone) strengthen a network, it is expensive to connect each node directly to all other nodes. To connect N telephones to each other directly, one would need ½∙N∙(N-1) connections. For, say, a million telephones, the number of connections will have to be some trillion lines. This is clearly not practical for the billions of phones in the world. Instead, the telephone system uses central exchanges to foster consolidation. Instead of ½∙N∙(N-1) connections between N phones, the central exchange needs to connect only to N nodes and, thus, the number of connections is only N+1.
Airlines use similar logistic in their hub-and-spoke systems. Instead of connecting every one of their origins with every destination via a non-stop flight, they use hubs.
The more a network depends on physical connections, the more it will use hubs to connect all the nodes in the network. For airlines, the result is higher utilization (higher load factors), better service as flight frequency increases, and the ability to serve small communities that cannot support point-to-point services.
Once the network is in place, it can be exploited and monetized. Facebook created a revenue stream when it began accepting adverts, and LinkedIn followed a similar course when it introduced charges for job searches. Airlines charge for everything they possibly can, and, in particular, charge high fares for flights in and out of their hubs—where the frequency is high and the competition non-existent.
Microsoft Windows is an example of the direct network effects as well as the potential for additional services or indirect network effects. Once the organization became a standard across the corporate world, applications such as spreadsheets (Excel), word processing (Word), and presentation software (PowerPoint) became standard features with their own network effects “riding” on Windows. Similarly, once a smartphone operating system—be it iOS or Android—achieves a high enough number of users, developers write apps, making the system more useful and persuading more people to use the system.
Globe-spanning networks are here to stay. Having reshaped the markets in which they operate, these entities will surely continue to redefine the rules of competition.