Metcalfe’s Law … the most powerful opportunity to improve your business … to unlock the exponential value of your business and market networks

April 22, 2023

In 2022, the Crocs Classic Clog was the best-selling item of clothing on Amazon, the brand was one of the fastest growing brands in the USA, and global net revenues had grown to $3.6 billion. Crocs were spotted on high-fashion runways, collaborating with luxury brands like Balenciaga, and on the feet of celebrities such as Justin Bieber. GenZ, in particular, loved Crocs.

Compare that to the brand just 10 years earlier. Crocs shoes were endlessly mocked for their ugly appearance, and the company was on the brink of bankruptcy.

So how did Crocs revitalise itself? Through the power of community. Tapping into what made it distinctive, in some ways its ugliness, using the power of social platforms to become the brand of choice for many different tribes – whether you’re on the beach, or loving sports, working in hospitals, or gone fishing. Being relevant, and being “one of a kind“.

Networks Effects:

From brand communities to retail franchises and business ecosystems

“Network effects” typically account for 70% of the value of digitally-related companies. And for the speed of their growth.

But they are not just about technology, digital platforms and social media. The value of networks is not in how many store you have, or partners you have, or customers you have. But in how well you connect them.

Building and unlocking the value of these connections is the real secret.

Network effects were popularised by Robert Metcalfe, the co-founder of 3Com which created networking cards that plugged into a computer giving it access to the Ethernet, a local network of shared resources like printers, storage and the Internet.

Metcalfe explained that whilst the cost of the network was directly proportional to the number of cards, the value of the network was proportional to the square of the number of users. Or in other words, the value was due to the connectivity between users, enabling them to work together and achieve more than they could alone.

“Metcalfe’s Law” says that a network’s value is proportional to the square of the number of nodes in the network. The end nodes can be computers, servers and simply users. For example, if a network has 10 nodes, its inherent value is 100 (10×10=100). Add one more node, and the value is 121. Add another and the value jumps to 144. Non-linear, exponential, growth.

Network effects have become an essential component of a successful digital businesses. First, the Internet itself has become a facilitator for network effects. As it becomes less and less expensive to connect users on platforms, those able to attract them in mass become extremely valuable over time. Also, network effects facilitate scale. As digital businesses and platforms scale, they gain a competitive advantage, as they control more of a market. Third, network effects create a competitive advantage.

This is not about the technology itself, it is about how the technology enables networks to work – how they enable people to connect with each other, to collaborate and influence, to build mutual affinity and trust. Communities emerge and where the power of peer to peer influence is the primary source of trust, recommendation and sales.

Movements are a step even further in making networks work, giving them purpose, values and momentum. This might sound obvious. But think how many retailers do nothing to connect their consumers, particularly those with similar interests. Even telecom brands, with billions of users, do almost nothing to add value beyond the basic connections it provides.

In 2015, three Chinese academics – Zhang, Liu and Xu – tested Metcalfe’s Law based on data from Tencent and Facebook. Their work showed that Metcalfe’s law held for both, despite the difference in audiences and services. They also look at every $1 billion “unicorn” business that has grown over the last 25 years. They estimated that 35% of the companies had network effects at their core, however these network effects typically added up to 68% of the total value.

Linear business vs. network business

Linear businesses traditionally gained a competitive advantage by buying assets, controlling supply chains, and driving transactions.

Network business gain competitive advantages through the multiplying effect of the networks, and crucially what happens within its connections, relationships and interactions. Network-based business typically work much more collaboratively with customers and business partners, evolving into ecosystems that reach across traditional sector boundaries and can do much more.

As the network grows, its value multiplies. Think of a dating app. Initially a few users is very limiting, but as soon as the network grows, the opportunities to find a suitable match grow much faster. The value of the network to the user is in the number of connections possible, and for the business, the commercial value becomes the data that is generated through user to user interactions. This data can be captured and analysed, to drive more interactions between people, and becomes the real advantage. Jim Collins famously termed this the “flywheel effect”, for example, where more customers creates a better experience, whose reviews attract more customers, who reduce costs or increase advertising incomes, which enables lowers costs which attracts more customers.

Network effects, relationships and data, become the assets of a network-based business. They are “light” assets, typically in the form of intellectual property (compared to primarily heavy assets of linear companies), and drive “intangible” value financially.

There is a downside to network effects, in that exponentially growing networks become harder to control, coordinate or curate. The rise of unsolicited emails, fraudsters and fake news is one obvious consequence. And whilst Facebook and other networks employ huge armies of people to try to eliminate such factors, this is probably an old way of thinking. In reality it needs to leverage network-based solutions, such as peer to peer accreditation, as in the trust profiles which users give each other on platforms such as Airbnb, eBay and Uber.

15 types of network effects

As a starting point, network effects can be direct or indirect.

Direct (same-side, or symmetric) network effects happen when an increase in users directly creates more utility for all of the users, that is, a better product or service. Consider, for example Facebook or Tinder.
Indirect (cross-side, or asymmetric) network effects happen when an increase in users indirectly create more utility for other types of users. Airbnb and Uber, where more hosts and drivers creates more utility for guests and passengers.

Different business models encourage different network effects. Dynamic pricing, for example, is used by Uber to encourage more drivers to join the network when demand is high, or more passengers when demand is low.

Many varieties of network effects emerge, depending on the types of business, each with strengths and weaknesses. Here is are 15 types, where the first 5 of direct effects, the others indirect:

Physical – infrastructure, typically utilities (eg roads, landlines, electricity)
Protocol – a common standard for operating (eg Ethernet, Bitcoin, VHS)
Personal Utility – built on personal identities (eg WhatsApp, Slack, WeChat)
Personal – built on personal reputation (eg Facebook, Instagram, Twitter)
Market Network – adds purpose and transactions (eg Houzz, AngelList)
Marketplace – enables exchanges between buyers and sellers (eg eBay, Visa, Etsy)
Platform – adds value to the exchange of a marketplace (eg iOS, Nintendo, Twitch)
Asymptotic Marketplace – effect depends on scale (eg Uber, OpenTable)
Data – data generated through use enhances utility (eg Google, Waze, IMDB)
Tech Performance … service gets better with more users (eg BitTorrent, Skype)
Language … a brand name defines a market or activity (eg Google, Uber, Xerox)
Belief … network grows based on a shared belief (eg stock market, religions)
Bandwagon … driven by social pressure of fear of missing out (eg Apple, Slack)
Community … driven by shared passion and activity (eg ParkRun, Harley Owners)
Movement … driven by shared purpose or protest (eg Occupy, Black Lives Matter)

Most iPhone apps rely heavily on the existence of strong network effects. This enables the software to grow in popularity very quickly and spread to a large userbase with very limited marketing. The “freemium” business model has evolved to take advantage of these network effects by releasing a free version that affects many users and then charges for “premium” features as the primary source of revenue.

eBay would not be a particularly useful site if auctions were not competitive. As the number of users grows on eBay, auctions grow more competitive, pushing up the prices of bids on items. This makes it more worthwhile to sell on eBay and brings more sellers onto eBay, which drives prices down again as this increases supply, while bringing more people onto eBay because there are more things being sold that people want. Essentially, as the number of users of eBay grows, prices fall and supply increases, and more and more people find the site to be useful.

Stock exchanges feature a network effect. Market liquidity is a major determinant of transaction cost in the sale or purchase of a stock, as a bid–ask spread exists between the price at which a purchase can be done versus the price at which the sale of the same security can be done. As the number of buyers and sellers on an exchange increases, liquidity increases, and transaction costs decrease. This then attracts a larger number of buyers and sellers to the exchange.

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