Network effects are to entrepreneurs what compounding effects are to investors: a key to getting rich.

Sometimes a product becomes more valuable simply as more people use it. This means the product has a “network effect”.

You’re probably familiar with two famous examples of network effects:

  • Windows. People started using Microsoft Windows. Therefore, developers started building more software for Windows. This made Windows more valuable, and more people started to use it.
  • Facebook. People joined Facebook and invited their friends. Their friends joined which made the site more valuable to everyone. People invited more friends.

All businesses have network effects to some degree. Every time you buy a slice of pizza, you are giving that business some feedback and some revenue which they can use to improve their business.

Giant businesses took advantage of giant network effects. When you bought that pizza, you caused a very tiny network effect. But when you joined Facebook, you immediately made it a more valuable product for many other users(who could now share info with you), and you may even have invited a dozen more users. When a developer joins Facebook, they might make an application that improves the service for thousands or even millions of users, and brings in a similar number of new users.

The biggest businesses enabled user-to-user network effects. Only the pizza store can improve its own offering. But Facebook, Craiglist, Twitter, and Windows have enabled their customers and developers to all improve the product with extremely little involvement from the company.

Notes

  1. This is probably easier said than done.