“Network effects”, a potent business strategy

KARACHI: A classic example of network effects is that of telephone networks where each time a new person joins the network, existing customers have one extra person they can reach, while any person without a telephone is “locked out” of the network of friends. The same can also be observed with Facebook where each new person joining makes the network more useful to existing members as well as future potential ones.

Mobile telecoms usually provide cheaper “on-network” calls in order to leverage network-effects. If 8 out of 10 friends have a 0321 prefix, a new subscriber will usually opt for the same since on-network calls are cheaper. This results in locking out the competition and may eventually result in monopolies since market leaders can go to extremes by providing free on-network calls, essentially making it impossible for new companies to enter the market. At least until forced to start charging again or the competition is eliminated.

As a result, “number-portability” has been introduced in most countries including Pakistan to prevent just such monopolisation. The resulting effect is that a 0321 mobile prefix can belong to any network and subscribers cannot identify which one. This shifts the focus away choosing a network based on friends and instead encourages companies to compete on other grounds.

A classic example where network-effects have a very strong hold is that of Microsoft Office. In order to read proprietary Microsoft (MS) Word documents, it is necessary to buy the software from Microsoft. Since a large majority of new and old documents are in MS Word format, it becomes necessary to purchase MS Word or be locked out from reading the document altogether--called a complete lock-out. This has resulted in tremendous growth not only for Microsoft but others as well. Adobe takes a more consumer-friendly approach by providing the PDF reader for free but charging for the PDF editor required to prepare the documents. Apple prevents the transfer of songs to any other music player and it is still tricky transferring contacts and pictures from a Nokia phone to a Motorola one without losing anything. Free alternatives have emerged for MS Word and Adobe PDF but they are not as comprehensive and don’t do much to disrupt the network-effects.

Anytime the growth of the network itself results in more value to the existing members, network-effects can be realised. eBay, Skype, PayPal and Facebook all benefit from network effects and have secured a dominant position.

Published in The Express Tribune, July 12^th, 2010.