Growing with network effects

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AT&T (then known as American Telephone and Telegraph) first described the idea of a network effect a century ago. They noted in a report that the more people who were on their network, the more valuable it became. Today network effects are central to growing many Internet companies. (They don’t affect, of course, companies with products and services that are valuable by themselves such as cars, food, clothes, health care, and so on.)

According to Metcalfe’s Law, the value of a network is proportional to the square of the number of connected users.
network effects - Metcalfe's law

Creating a large network, though, presents a chicken/egg problem: there’s no point in being the first person on a network. How do you get people to join when the network is small?

Mark Zuckerberg famously scraped the pages of the Harvard online house face books and used the data to pre-populate Facebook so when students logged in all they had to do was claim their page.

For OpenTable, it was much harder. They had to get restaurants and diners to both sign up. To make it worthwhile to the restaurants they created software that was useful to them even with traditional phone reservations. As they say on their blog, “Long before most diners had discovered OpenTable.com, restaurants purchased our Electronic Reservation Book to help them manage reservations, assign tables, recognize repeat diners, and remember your preferences.” Restaurants paid $199 a month to improve their reservation process and provide a superior customer experience, and OpenTable was slowly building its network of restaurants that would be valuable to diners. But it took sales people a lot of time and it had to be done in city after city. Open Table wasn’t profitable for years.

Each company has to find its own way to build its network. Once you create a large network it can create a significant barrier to entry to competitors. (Or not – Myspace was once much larger than Facebook.) But it also presents a unique marketing challenge that many companies have stumbled over.