What Are Network Effects and Increasing Returns? (Part 1)

This article (Part 1) aims to explain how Samaipata understands increasing returns and network effects. Part 2 will be a deep dive on how to create network effects, how to measure them and what the future holds. 

At Samaipata, why do we focus on network effects and the power of increasing returns?  

In 1996, the famed economist, W. Brian Arthur proclaimed that we lived in a world of ‘diminishing returns.’ In an economy constrained by fixed inputs of capital and labour, he said that businesses who built a dominant position into the marketplace eventually ran into limitations. As the equilibrium of prices and market shares were quickly reached, this world displayed signs of highly predictable behaviour. 

However, with the rise of intangible and non-rival assets and a shift from a resource -based economy to a knowledge-based economy became apparent, it was possible to experience ‘increasing returns to scale’. This concept refers to the idea that output proportionally increases more than input as positive feedback mechanisms are triggered. As the player ahead moves further, the player that is behind, in turn, loses further advantages. Therefore, it becomes possible to build defensibility in a sustainable fashion, where businesses can protect long-term profits in a competitive environment as increasing returns power the winner-takes-all market.

There are different ways to generate increasing returns:

Economies of scale – increased input leads to a non-linear decline in unit costs

Customer ‘groove-in’ – investment in product usage and/or brand equity leads to switching costs

Network effects (Nfx)

Generally great companies reinforce network effects by other sources of defensibilities. Doordash is a good example of this “reinforcement effect”, which powering a strong growth “flywheel” (See below an extract from their S1). That being said, at Samaipata, we are passionate about network effects because we believe they are one of the most powerful drivers of defensibility. They are responsible for c. 70% of value creation since the advent of the internet back in 1994 according to US fund Nfx.

As a pan-European venture capital fund with a significant interest in innovation and disruption, we are continuously questioned on the next trend to sweep the startup world or how to attract success in business. However, there is one repeated query that we often receive; are there any successful companies that are not displaying network effects (Nfx)? Would founders’ chances of getting seed funding be affected if their company didn’t display them either?

It could be possible to dig moats in non-networked products as some businesses’ value propositions are not directly tied to the number of people using the product (e.g. in Biotech). Although these businesses do not typically fit our investment criteria, we would need to see huge scale, strong brand equity, or switching costs to consider them for funding. 

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Definitions & considerations about Network effects

In 1908, the term ‘network effects’ was coined by AT&T in their Annual Accounts. 

They set out that “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 increases with the number of connections.” 

We see network effects occurring when i) a company’s product or service becomes more valuable as more users join the network and/or ii) engagement between users in the network increases. Typically enabled by many-to-many connections, these network effects lie at the core of our investment thesis. 

Once ‘critical mass’ has been reached, these network effects typically take effect. However, before this point, the product remains vulnerable and may not have much value to users. Conversely, from this point onwards, the value produced by the network exceeds the value of the product itself and of competing products. Although the ‘chicken or the egg’ problem’ applies to a multitude of situations, it also refers to the challenge of getting to this Minimum Viable Critical Mass (as coined by Sean Ellis) to trigger a positive feedback loop.

Yet not all Nfx are created equal: Nfx are very complex and different in nature. And companies can display different types of Nfx at the same time. Our General Partner, José, has written an entire article on Nfx classification where he comes back to the difference between:

• Positive linear vs. asymptotic vs. negative Nfx
• Direct vs. indirect Nfx
• One-sided vs. multi-sided Nfx
• Local vs. global Nfx

Ideally positive, non-asymptotic, multi-sided & global Nfx are the most powerful type of Nfx we’ve seen in the past. Yet we are also super interested in data Nfx, that occur when the product & services’ value increases with more data. That being said, we’re conscious that data Nfx tend to be weaker than many people often want to believe and might take time to materialise. We will publish more about this in the coming weeks.

One of the most obvious and well-known types of network effects are the marketplace network effects. In this transaction, there are two or more sides involved with several varied interests that directly benefit each other i.e., supply and demand on Craigslist. We are also strong believers in ‘platform network effects’ – the products and services created and sold which are part of the platform, not independent of it (e.g. iOS developers vs iPhone users)

How are Network effects different from viral effects and scale effects?

Nfx vs. Viral effects

Simply put, viral effects are about the growth of new users. They occur when existing customers lead to the increase of new customers, ideally for free. Conversely, network effects are about the defensibility of your model. When your product adds incremental value to other users, it becomes difficult to discover any alternative product that gives them as much value.  

Although rare, it is possible to have one without the other. One such example is the Sequoia-backed Quizup. Although Quiz-up raised $27M and had high virality, it had no network effects and quickly ceased operations. Alternatively, there are some B2B marketplaces that have strong network effects but are not growing virally.  

Nevertheless, both viral effects and network effects are generally seen as complementary as virality helps you achieve network effects by growing the network quicker.

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Nfx vs. Scale effects

Economies of scale occur when there is a reduction in marginal costs due to an increase in production (e.g. Apple amortising Capex on an increased number of sold iPhones). 

On the other hand, network effects (also known as ‘demand side’ economics of scale) happen when production has a greater value for the same marginal cost of production. Remember, it’s about value which should increase exponentially as costs decrease linearly.

Although they are both ways to generate increasing returns, network effects typically magnify a company’s scale advantage and vice versa.

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In Part 2, we’re addressing how to create network effects, how to measure them and what the future holds for them.

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