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APIs are Killing the Network Effect

A Harvard Business Review article titled Why Network Effects Matter Less Than They Used To asserts that network effects ain't what they used to be. According to the article:

"Economists use 'network effects' to describe contexts where a good or service offers increasing benefits the more users it has. We have long taught that network effects can provide market power and sustained or even self-reinforcing competitive advantage (the best kind). The more users you got, the larger your user base was, and the more compelling your proposition became for attracting new users."

Why don’t network effects work as they used to? The author argues that:

"For one thing, today network effects are not tied to a particular piece of hardware, like a desktop computer. Since 2000 and the desktop era, we have seen the evolution of multiple different devices, such as smartphones, tablets, and digital assistants such as Alexa. This means that network effects are no longer intertwined with a particular piece of hardware, as was the case with the desktop computer in the 1990s. Instead, any notions of scale for technology companies depend on user profiles that can be ported to multiple different hardware platforms."

As a case in point, the author points to Microsoft:

"In 2000, people thought [Microsoft] had unassailable network effects. Who would ever desert the Microsoft ecosystem and not use Word and Excel? This expectation that consumers were welded to the Windows operating system meant that developers and computer manufacturers all felt they had incentives to focus on contributing to the Microsoft ecosystem. However in 2018, Microsoft is struggling to retain customers within its ecosystem, and developers are offering many products that don’t rely on Windows."

  The conclusion (that network effects matter less) is spot-on--the rationale for why is off-base, however.

The HBR article author says "network effects are no longer intertwined with a particular piece of hardware, as was the case with the desktop computer in the 1990s....any notions of scale for technology companies depend on user profiles that can be ported to multiple different hardware platforms." This isn't correct.

Microsoft's achievement of network effects in the 1980s and 1990s stemmed from software standards adoption. Because more and more people adopted MS-DOS (and then Windows), it made little economic sense for businesses to use other operating systems (I can't even remember what they were). Building upon its dominance in operating system adoption, Microsoft went up the stack to dominate in business applications (Word, Excel, etc.) developed on top of that operating system.

Why did Microsoft lose its dominance (and hence, see a diminished network effect)? Because of the loss of dominance of the desktop and laptop computers--which didn't rely on the Windows operating system.

Google also benefited from a network effect in the 1990s and first decade of this century. As more and more people used Google's search engine, it became more valuable to the people who used it, as well as the companies advertising on it. Buh-bye Yahoo.

Why was Google able to protect its network effect in the face of declining desktop/laptop use? Because it developed a mobile device operating system that garnered a significant level of adoption.

It's all about the software--not the hardware.

Uber and Lyft Have Nothing to Do With Network Effects

The HBR author writes:

"We have long taught that network effects can provide market power and sustained or even self-reinforcing competitive advantage (the best kind). The more users you got, the larger your user base was, and the more compelling your proposition became for attracting new users."

She's partially right. The network effect works not just when more and more people use a particular product, but when there are disincentives to using another option.

This is why the HBR article's discussion of Uber and Lyft is irrelevant. Uber knows that users can easily use Lyft, and knows that many of its drivers drive for Lyft. There are no disincentives for the providers of Uber's supply and demand (drivers and riders) to use competitors.

Uber's strategic advantage doesn't come from network effects--it comes from a combination of industry defragmentation, unique sourcing of supply (i.e., drivers and cars), and user experience.

Why is the Network Effect Declining?

Despite the faulty rationale and examples, the HBR author is correct that network effects matter less today than they did 20 or 30 years ago.

The reason is APIs.

As I said, the key to the success of a "network effects" strategy isn't just amassing a large number of users--it's creating disincentives to using alternatives. Application programming interfaces effectively counter the disincentives that network effect-wannabes could create.

The Network Effect Isn't Dead, Though

Network effects are dependent upon the dominant business or technology paradigm.

Prior to the PC revolution, the dominant business paradigm was physical location. The more presence you had, in the right locations, the more dominant you could be.

Large retailers created network effects under this paradigm by having many locations which attracted many consumers--which in turn attracted many suppliers, creating a network effect. The "network effect" was not something created by Microsoft.

When technology replaced physical location as the dominant business paradigm, it opened the door to players like Microsoft to create new network effects. And with the advent of mobile as the dominant paradigm, new network effects were enabled.

What this all means is that the network effect isn't dead--but that we won't see it be a significant strategic force until a new dominant business paradigm comes along. 

And if you know what paradigm will be, please tell be now.

Ron Shevlin
Director of Research
Cornerstone Advisors

 

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