Strategies in network-based industries

Part I. Demand effects

Andrea Bonaccorsi
Business and Project Management
 Introduction

Network industries include a large variety of industries, such as

- IT (hardware and software)
- Telecommunications
- Social media
- Platforms
- Web services
- Entertainment

From a long term perspective network industries have been generated by the interplay between two
trajectories described by strong regularities («law»)
- Moore’s Law
- Metcalfe’s Law

Due to these long term trajectories, in these industries we see phenomena that are fundamentally
different from those found in traditional industries. These phenomena take place at
- demand side (behavior of customers)
- supply side (structure of costs)
Original
formulation of
Moore’s Law
Fonte: Fuller S.H., Minett L.I. (eds) (2012) The future of
computing performance: Game over or next level? Washington,
National Research Council
https://www.theregister.co.uk/2012/05/09/wd_disk_tech_views/
Extensions of Moore’s law
Metcalfe’s Law

The systemic value of compatibly communicating devices grows as a square of

their number.

Largely used theory to justify the valuation of dot.com startup companies before
the collapse of Wall Street in 2002.
Applied this why the theory implied that investors should buy as early as
possible any startup working on Internet, because the valuation would grow
exponentially with the gradual construction of the network.
Network effect

The value of a good (product or service) does not depend only on its intrinsic features, but also on
the number of adopters.
The more people buy and use the good, the more it becomes valuable for subsequent users.

This means that the network-based good has two dimensions

- the physical good (product or service)
- the network of physical connections and of connected people using the good.

It was firstly identified by the President of AT&T back in 1900:

«A telephone without a connection at the other end of the line is not even a toy or a scientific
instrument. It is one of the most useless things in the world. Its value depends on the connection
with the other telephone and increase with the number of connections.» (Theodore Vail)

Remark
Network effects do NOT depend on imitation behavior.
They depend on the increase in value generated by the network of people using the good.
1. Becoming
2. Cognifying
3. Flowing
4. Screening
5. Accessing
6. Sharing
7. Filtering
8. Remixing
9. Interacting
10. Tracking
11. Questioning
12. Beginning

Kevin Kelly (2016). The inevitable. Understanding the 12 technological forces

that will shape our future. New York, Viking
Source: Uber Inc., Form S-1 filed 11.4.2019, SEC
When people form networks of
connections, a fundamental implication
is that they behave on the basis of the
behavior of others.

This is due to two different reasons:

(i) people believe the behavior of
others has information value
(imitation effect)
(ii) there is a direct benefit from joining
a network (network effect).

These effects change dramatically the

functioning of markets. Consequently, it
changes the way companies define their
strategy.

The dynamics generated by these

phenomena is the object of a formal
(mathematical) analysis based on graph
theory.
 Price
Part 1. Demand effects
r(0)
In conventional markets, consumers will buy a
product if its value is equal to the price.
We define this attitude willingness to pay.
Reservation
By reservation price we denote the maximum price= r(x)
amount she is willing to pay for one unit of
the product. Price

Note that the willingness to pay, hence the

reservation price, is independent on what
other people do (e.g. you buy the bread
depending on its price, you don’t care about r(1)
how many other people are buying bread).

Under these conditions the reservation price

is negatively inclined (function r(x)). 0 x
1
There will always be a price at which a given
proportion x of consumers will buy the Consumers
product. Then r(x*) = p*
 Price
Market equilibrium
r(0)
Under these conditions there will be usually
be at least one company willing to supply the
quantity x* at the price p*.
This is the market equilibrium at which all
production is sold and all demand is satisfied.

Remark. Price p*
If no company is able to produce at a price
below r(0) it means that the market does not
materialize. We see a market failure.

If more companies are willing to supply at a r(1)

price below r(0), the market will be formed by
n companies in competition.
In perfect competition all companies will
supply at the price-taking level p*. 0 x*
1
Consumers
 Price
Demand with network effects

In network industries customers will buy a

product depending on

(i) the value of the product (reservation

price)
(ii) the number of other customers buying
the product

The latter is called network effect.

Under these conditions the demand is given p*
by the same reservation function r(x) but also
by a network function f(z).
The reservation price is therefore a function
of the quantity of products (negatively
inclined), but also by the number of other
buyers (positively inclined). 0 z’ x z’’
1
The function have a multiplicative form Consumers
r(x) f(z)
Demand with network effects/2 Price

The function have a multiplicative form

r(x) f(z).
A concrete example
r(x) = 1-z
f(z) = z

Hence r(x) f(z) = z (1-z)

Parabolic shape. There is not a unique equilibrium
but multiple equilibria.

For z=0, the function is 0. p*

For z= 1, the function is 0.
There is a maximum at z=1/2. In this point the
function has value ¼.
For p> ¼ there is no solution to the equation p*=
r(z) f(z) = z(1-z). The only solution is z=0.
For p< ¼ there are two solutions defined by the 0 z’ x z’’
1
quantities z’ and z’’.
Consumers
In sum we have three equilibria, i.e. 0, z’ and z’’.
Stability of the equilibria Price

Let us study the stability of equilibria.

If z is between 0 and z’ we have «downward

pressure»: the last customer that has purchased
the good considers that the value r(z) f(z) is lower
than the price. This customer prefers she would
have avoided the purchase.

If z is between z’ and z’’ there are customers that

have not purchased the good (those in the
interval). For these the value of the good is lower p*
than the price, so they prefer they would have
purchased the good. This pushes the consumption
towards z’’ («upward pressure»).

If z exceeds z’’ there is downward pressure.

0 z’ x z’’
1
As a result
- the equilibrium z’ is not stable Consumers
- the equilibrium z’’ is stable
Strategic implications
Price
1) The point z’ is a tipping point.
It separates two regions of the market
- below this level of market adoption the market
collapses to zero
- beyond this level there is a strong pressure towards
increasing the adoption and converging to the z’’ Tipping point
equilibrium
Companies must understand where is z’ located. It
depends on the confidence of customers about the
product and its adoption

2) If customers are able to form clear expectations about p*

the adoption, the z’’ equilibrium will be a self-fulfilling
expectation equilibrium.
The expectations of customers can be influenced by the
strategy of the firm.

3) If the price is reduced companies achieve two results 0 z’ x z’’

1
- the tipping point moves to the left (= it is easier to
achieve this level of adoption) Consumers
- the stable equilibrium moves to the right (= a larger
proportion of customers is achieved).
Strategic implications

At a general level the strategic imperative for companies in network industries is to reach the tipping point as
early as possible.
Growing slowly is a recipe for failure.
Having a good product is not enough if this does not influence the expectations of customers with respect to its
adoption.

This can be done in a variety of ways:

a) Entering with a low price

• Penetration price
• Free product offering
• Freemium business model
b) Creating network effects with complementors
c) Exploiting network properties
• Reach the tipping point for a subset of customers (e.g. market niche), dominate the sub-market
and then expand into other sub-markets
• Identify fashion leaders or markt influences that may attract other customers.

If two companies compete with network-related products the winner will not be the one with the best product,
but the one who has influenced better the expectations of customers.
 Competing on price

https://res.cloudinary.com/dzawgnnlr/image/upload/q_auto/f_auto/w_auto/dropbox_s_curve.png
Competing on complementors In this celebrated case study, we examine the
competition between two producers of
videocassette recorders.
Betamax was supported by Sony and was
technically superior.
VHS was introduced by a group of lower-rank
producers.

Contrary to the expectations, the winner was VHS,

who eventually came to dominate the market.

VHS
- established a number of commercial
agreements with movie and entertainment
producers (complementors)
- had longer cassettes, so that customers could
record long programmes (e.g. sport)
- pushed hard to persuade customers since the
beginning that they would be the winner of the
competition.
Properties of networks. Power law distribution

Networks do not follow the Central Limit Theorem (i.e. if we take any sequence of small independent
quantitiees, in the limit their sum or average will be normally distributed).
For example, in the Internet, the fraction of Web pages that have k in-links is approximately proportional to
1/k2 (with the exponent slightly larger than 2). 1/k2 decreases much more slowly as k increases.
https://icon.colorado.edu/#!/

Source: L. Barabasi,
Linked. The new
science of
networks
Power law distribution. Given f(k)= a/k c
we obtain a linear log trasformation
log f(k)= log a – c log k.
Log-log plot with c= slope, log a intercept.
Properties of networks.
The long tail

Traditional entertainment markets are

constrained by physical space
(= shelf space).
This leads to concentrate the sales on
blockbusters, given the limited attention
of customers.

With the digital technology we saw a dramatic

decrease in
- costs of production
- costs of distribution

Hyperion (2006)
The long tail

New entrants are small, previously marginalized producers of content (e.g. music,
cinema, books), whi may have access to a large market of customers.

This means that small entrants might benefit from a long tail of customers, each with a
small size, that reach the offering of content on the web.

The sum of niches at the long tail might be larger than the sales of blockbusters.
Properties of networks
Rich-gets-richer, or winner takes all

Given the existence of tipping point and the stability of the

equilibrium with a large share z of customers, it is likely that
only one player wins, taking the largest market share and
pushing competitors out of the market.

This is defined «winner-takes-all» equilibrium.

A mechanism leading to this equilibrium is called

preferential attachment: for example the probability to link a
web page is not random but is proportional to the popularity
of the page.

In this case the equilibrium in the network will be of one

winner, while competitors are eliminated because the
network effect works negatively for them.
Community structure

Member of networks meet each

other (assortative mating) and
create clusters (communities) in a
predictable fashion.

Many real world networks exhibit

propertes of «degree
assortativity»
Properties of networks. Active vs passive users

https://overstated.net/2009/03/09/maintained-relati
onships-on-facebook
 Strategies in network-based industries

Reaching the tipping point and dominating the market

require a new type of strategic behavior.

Metcalfe’s Law does not guarantee the creation of

network externalities.
It is still possible that the tipping point is never
reached.

Main limitations:
- Non consideration for the initial period- very often the
network effect is not created just because initial
customers do not materialize
- It only considers the number of users, ignoring the
quality of user engagement
- It ignores the multi-sidedness of many networks
- Does not see the distinction between active users and
passive users
- Does not examine the over-crowding effect
 4
3

5
2

1
The Billion users club

Marketplace Content creation

- eBay - Instagram
- Amazon - Facebook
- OpenTable - Reddit
- Uber - TikTok
- Airbnb - Youtube
- Alibaba - Twitter
- We Chat

Collaboration tools Software development

- Dropbox - Android
- Slack - iOS
- Google
- Suite
- Zoom
 The Allee threshold in mathematical biology
Meerkats live in groups. They are able to alert the
groups about the attack of terrestrial or aerial
predators.
The effectiveness of alert, however, depend on the
size of the group.

Below a given threshold the population dynamics is

reverted: few meerkats survive to predators, the
alert is less and less effective, the population
declines.
Allee effects driven by predation DOI:10.1007/s10144-009-0152-6
JOANNA C. GASCOIGNE,ROMUALD N. LIPCIUS The evidence for Allee effects
Journal of Applied Ecology, 30 September, 2004. A. Kramer, B. Dennis, J. Drake
https://doi.org/10.1111/j.0021-8901.2004.00944.x Population Ecology, 18 April 2009
Fall of the Berlin Wall
1989
A simplified Allee threshold
model for network effects
in Internet-related markets.

Below the threshold there

is no sufficient density of
users to generate the
positive network effects.

This is called «the cold start

problem».

If the population of users

does not reach the
threshold, the dynamics is
reverted: customer
abandon the company and
sales collapse.
Cold start problem
Mini case studies
Slack

Slack has been introduced by a

previosuly unsuccessful company
called Tiny Speck, producing a
multiplayer game (Glitch).
The game was a complete
commercial failure.

After four years from the startup,

Tiny Speck launched a new product.

With the company name of Slack

Technologies Inc. it was sold for $26
billion to Salesforce.

https://www.feedbackloop.eu/2020/02/01/slack-startup-tale/
When developing the multiplayer game, engineers invented a tool to chat internally from various locations in
California and Canada. The tool used Internet Relay Chat (IRC), an old university-based technology. It was used to
store old messages and photos and to make conversations easily searchable.

After the collapse of Glitch, the cofounders turned to the internal tool and tried to re-engineer it for the market.
It was labelled Slack, or «Searchable Log of All Conversations and Knowledge».

The beta testing was done with friends of the company, or startups in the San Francisco area «many with fewer
than 10 people». The cofounders personally managed the social media and customer support activities.

Each of the beta customers formed an atomic network- or a self-sustaining groups of useres who can drive the
network effect. The minimum number of people is three. They created an invite-only launch.
The size of customers progressively increased and the product was improved.

When launched in August 2013, Slack had 8,000 companies

in list. They became 15,000 two weeks later. In 2014 they
had 135,000 paying subscribers and 10,000 new users per
day.
It has now more than 600,000 organizations, with 1 bn
messages sent each week.
 Creating the atomic network

Short term boots («growth hacks») aimed at creating the self-sustainable initial network

Slack
- early adopter startups
- Invite-only lunch

PayPal
- $5 referral fee

Dropbox
- Demo video on Hacker News

Uber
- 7x7 square miles of the city
- Uber Ice Cream promotion

Start with a hypothesis on the initial atomic network.

Credit card

The credit card was invented in 1958 by Bank of

America.

Consumers had no credit available outside traditional

bank loans, or exclusive arrangements with large retail
chains (e.g. Sears).

Credit cards enjoy extremely powerful network

effects:
- The larger the number of merchants accepting
credit cards the higher the value for consumers,
who may use it instead of cash
- The larger the number of consumers using credit
cards, the higher the value for merchants

It is an example of multi-sided network effect.

Massive test
- 60,000 residents in Fresno
received a Bank Americard
- No application process
- Instant credit $300-500 to all
consumers
- Merchant fee 6%

Results
- More than 300 Fresno
merchants signed up
immediately
- In three months the customer
base was extended to other
small cities and within a year
in large metropolitan areas
- One year after the test Bank
of America had issued 2
million cards and onboareded
200,000 merchants.
 Managing the hard side

The 1-10-100 rule

- 100% of the population benefits from the activities of other groups
- 10% of the user population might participate actively producing content
- only 1% might start a groups or a thread within a group

Tik Tok
Talent
People learning a new dance or creatively tell a story.
Entertain people

Other social media

Status
Doing something cool. Once a week or once a month.

Snapchat
Self-expression and communication
Talking to your friends. Express how you feel. Every day.
From Evan Spiegel, cofounder of Snapchat
Mini case study
Wikipedia

Extremely asymmetric distribution of contributors. Appr. 100,000 active contributors per month, about
4,000 people make >100 edits per month.
A mere 0.02% of highly motivated users generate the content for the rest of the network.

This is called the «hard side» of the

network.
People on the hard side expect status
benefits and sometimes also financial
outcomes. Given high expectations they
are difficult to engage and retain.

The easy side is formed by people that

do not contribute.
 Killer product

Mini case study

Zoom

When it was created in 2011, the market did not understand its potential.
Other solutions for conferencing were more sophisticated
- WebEx
- Skype
- GoToMeeting

The main idea of Eric Yuan, CEO of Zoom, was to offer «frictionless meetings», or meetings opened with a
single click of a link.
No meeting codes.
No dialing numbers.
Free product for the first 40 minutes. Freemium business model crucial for scalability.

This means emphasizing more the power of the network of people than the features of the software
solution. Exceedingly simple value proposition- but endless potential for network growth.
Copy and paste the Zoom link- just like memes.
The threshold identifies a
tipping point

This notion has been

repeatedly used after a
popular science book by
Malcolm Galdwell.
 Tipping point
Mini case study
Tinder

Dating apps
- need high density in a small geographic area
- high churn rate: when people pair off, they may leave the platform
- need to attract simultaneousl multiple segments of users, in the right proportions, at the same time

Tinder had a swiping feature (= ability to chat)

Launch at the University of Southern California annual party

- over 19,000 undergraduate students
- students should download the app to get in
- memorable party
- students started to chat the day after using the swiping feature
- 95% of this coohort started to use the app every day for 3 hours a day

Rapid and repeateble growth

- other cities and countries
- Valentine’s Tinder parties, sorority Tinder parties, cocktail Tinder parties etc.
Mini case study
Linkedin

Clear definition of the target

- middle layer in the professional hierarchy (not at the top- overcrowded social network)
- not job-search only but professional networking service

Invite-only
- invite mechanics as a copy-and-past feature
- start with a curated network and give people invites
- the network will copy itself automatically
- good «welcome experience»

Linkedin started from the address books of the founding team, appr. 2,000 people, not more.
The addressees were given the possibility to invite other people. During the first week the number of people
to be invited was limitless. By the second week users could sign up without an invite.
Initial invitees, as well as those who were invited first, had large contact lists.

Tipping point.
Explosive growth. >700 million registered users, sold to Microsoft for $26 billion.
Mini case study
Gmail

Invite-only
- Invite a thousand outsiders
- Offer a gigabyte of storage (against megabytes of competitors)
- Early users could grab the username they wanted

The initial technology infrastructure was designed to serve few customers and to grow slowly.
Soon after the launch in 2004 it became clear that the growth was much faster.

People started to sell and buy the invitation to join!

Mini case study
Instagram

Early app on the Apple Store- Hypstamatic

- take any foto and apply hip
- apply photo filters
App of the year 2010 Hypstamatic selected by Apple among the top four apps.
Limitations of Hypstamatic
- frictions in use
- interaction with a virtual camera
- waiting time between photos
- not able to post directly on social networks

Instagram- completely redesigned

- user profile and feed
- friend request
- invitations
- shared photo includes a link that pointed back to Instagram (=open the app to a home screen feed
of photos from other users)

82% of photos do not have any filter- the network value has become more important than the tool.
«Come for the tool, stay for the network»
Mini case study
Microsoft

Startup building tools for the BASIC programming language.

Decision to develop an operating system (DOS, Disk Operating System)

Turning point: deal with IBM after its entry in the PC industry
- all IBM PCs were equipped with Microsoft DOS
- but Microsoft retained the right to license MS-DOS to non-IBM manufacturers
- when competitors reverse engineered the IBM-PC and started the production of clones, they all
adopted DOS as operating system

Network effects
- most applications
- best tools
- established distribution
Competing operating systems displaced (Amiga, OS/2, Macintosh).
Windows confirmed the dominance of MS-DOS.

Microsoft came to dominate all segments previously opened by Lotus, Word Perfect, Ashton-Tate,
Novell, Stac, Netscape, AOL, Sun.
Mini case study
Reddit

In 2005 simple home page with a list of links each day, submitted (manually) by its users.
Currently > 100,000 active subreddit communities, millions of links.

No one wants to live in a ghost town. No one wants to join an empty community. In the early days, it was
our job each day to make sure there was good content on the front page. We’d post it ourselves, using
dozens of dummy accounts. Otherwise the community might dry up.
(Steve Huffman, cofounder of Reddit)

Spectrum of content creation

- Fully manual, human-powered
- Hybrid
- Automated, algorithms-powered

Yelp, Quora, Uber Freight- human lead.

TikTok, PayPal- powered by algorithms.
 Escape velocity

The Esape Velocity stage is all about

«working furiously to strenghten network
effects and to sustain growth»
Main strategies to achieve Escape Velocity

1. Acquisition effect
Systematic effort to achieve viral growth
Ability for users in the product network to tell others in their own personal
networks

2. Engagement effect
Denser networks create new usage from its users (e.g. Twitter after the entry in
the network of celebrities, politicians, influencers etc.)

3. Economic effect
Ability to accelerate the monetization, or to reduce costs (e.g. Linkedin for HR
professional services, or e-commerce platforms)
Acquisition effect

Mini case study

PayPal

Original product Field Link

- let people send and receive money on Palm Pilots and other
PDAs (Personal Digital Assistant)
- no Internet connection
- no network effects!

Evolution of the idea

- No handheld device needed
- «let’s people send money across the Internet».

Serious strategic issues (1999- on)

- vague value proposition
- need to teach people how to use Internet for payments
- very slow initial adoption
Case study
Paypal

One of the users (Power Sellers) of e-Bay asked to use

a feature called «We accept PayPal».
He asked permission from PayPal to use the logo on its
auction listings.
PayPal replied immediately and positively.

This initiated a viral process

- eBay users were a large and loyal community
- to reduce the friction, PayPal allowed e-Bay users
to enter their credentials and to see automatically
the «We accept PayPal» button into all their
auctions
- «productization» of the idea
- use of participants of a network to acquire new
users

The acquisition effect was magnified by the $10 Initial product 10,000 users. Few months later,
initiative: $10 to all PayPal users that invited a friend + 100,000, then 1 million. End of year 5 million users.
gift $10 for any new account.
Acquisition effect
Tool-to-network strategy

A large class of products centered on content creation, organization and reference can be developed
with a tool-to-network strategy.

Tool Network Example

Create Share with others Instagram
Youtube
G Suite
Linkedin

Organize Collaborate with others Pinterest

Asana
Trello
Dropbox

System of record Keep up to date with others OpenTable

GitHub
Look up Contribute with others Zillow
Glassdoor
Yelp
Engagement effect

«Nearly 1 in 4 people abandon mobile apps after only one use» (TechCrunch).
«Losing 80% of mobile users is normal» (data from Google)
«People spend 80 percent with just three apps» (comScore)

Of the users who install an app, 70% of them aren’t active the next day, and by the first three months,
96 percent of users are no longer active.

Benchmark for funding a startup (Andreessen Horowitz, one of the largest Venture capital fund in high
tech). Minimum baseline of retention
- 60% after day 1
- 30% after dai 7
- 15% after day 30
Very large retention rates, rarely achieved by non-networked products.

Strategy=
generate new use cases as the network develops.
Mini case study
Dropbox

Founded at MIT
After five years the Cold start problem was solved.
«Come for the tool strategy»
- synchronization of files
- network of shared folders (folder sharing) + invitation mechanism

2012 >100 million users

2018 IPO

After the initial growth Dropbox started to segment the population of users into two groups
- High-Value Actives (HVAs)
- Low-Value Actives (LVAs)

Files which people in a network tend to share, edit, interact with: Documents, Spreadsheets,
Presentations
Mini case study
Linkedin

Segmentation of users
- Active the last 7 days out of the last week
- Active the last 6 days
- Active the last 5 days
- Etc.

Continuous generation of new services and new use cases.

Approach to new use cases:

- Experimentation platform
- A/B testing
- Randomized Control Trials (RCT)
Economic effect

Larger networks have much higher efficiency than small ones.

Exploitation of underutilized assets
- real estate (Airbnb)
- car (Uber)
- time (marketplaces
By the principle of reserves we get that the underutilization rate decreases with the size of the capacity
(here, size of the network)

Uber
- subsidization of drivers in order to launch the network in the initial period and to cover the sluggish
seasons (e.g. January) = $25/hour guarantee
- in a small network drivers make less trips (= less income) = higher subsidy from Uber (e.g. $15 per
trip) («burn per trip»)
- in a larger network drivers make more trips (=more income)= much lower subsidy (e.g. $2.50 per trip)
 4
3

5
2

1
Ceiling effects

- market saturation
- churn from early users
- bad behavior from trolls, spammers and fraudsters
- lower quality engagement from new users
- regulatory action
- degraded product experience

Counterbalance the ceiling effect

- achieving the valuation of a billion dollars («unicorn»)
- work backward
- Rocketship Growth Rate= more than double each year
- average increase in size= 2.4times each year for 7-10 years
- starting position $ 2 million year 3, triple to 6mn, triple to 18mn, then double three times (36, 72
and 144 mn$)
https://slicesofbluesky.com/great-california-sardine-boom-and-bus/