Research by Michael Schrage from MIT’s Initiative on the Digital Economy offers new insights into platform markets and network effects.
Customers, customer-centric marketers declare, are king. Businesses consequently ignore customer behaviors at their own risk. But the power and potential of network effects suggests that seeing customers as royalty may prove a poor idea and an even worse investment.
Successful platform companies and competitors see their customers and clients as assets worthy of innovative investment. Yes, treat customers very, very well, but invest smartly to make them even better. In Uber’s business model, for example, smart apps make both the company’s customers and drivers more valuable to both Uber and each other. In fact, the ability to creatively invest in one’s customers as a result of digital networks is central to our new research, Rethinking Networks: Exploring Strategies for Making Users More Valuable.
As platform companies like Google, Apple, Facebook, Uber, Amazon, Airbnb, and LinkedIn relentlessly disrupt — and redefine — mainstream industries, we see network effects as their “secret sauce” for success. Network effects increasingly determine innovation opportunity, value creation, and growth in digital markets. This holds true for Netflix, Twitter, Github and Alibaba — as well as the so-called Internet of Things — that all rely heavily upon network effects as a competitive edge and innovation resource.
Technically, economists say network effects — known also as network externalities — exist when the value of a product or service to users increases as the number of users grows. But this traditional definition is woefully incomplete. Quality of use — and users — matters as much or more to value creation as quantity. In other words, how networks are used is as important as how much they are used.
Amazon, for example, may have hundreds of millions of customers shopping for goods, but the fact that tens of millions of those customers actively browse through recommendation engine suggestions and customer reviews, sample book and video content, and write comments and reviews themselves, contributes enormously to the company’s value. Amazon’s network facilitates the creation and capture of data proffering insights into customers and products alike. These qualitative insights have quantitative impact for both Amazon and its customers.
Tapping into Network Effects
The crucial economic and business insight should be obvious: Network effects turn users into assets. Enabling network effects empowers users/customers to both directly and indirectly create new value. Network effects don’t merely create more value for more users, they make users more valuable to both the enterprise and to each other. Network effects, therefore, are special economic phenomena because they make their contributors more valuable to everyone in and on the network.
Indeed, as media infopreneur Tim O’Reilly, who coined the term Web 2.0, incisively observed: “A true Web 2.0 application is one that gets better the more people use it. [For example] Google gets smarter every time someone makes a link on the web. Google gets smarter every time someone makes a search. It gets smarter every time someone clicks on an ad. And it immediately acts on that information to improve the experience for everyone else.”
This same design sensibility holds true for browsing Amazon and Netflix recommendations; hailing — or driving — an Uber; seeking — or offering — Airbnb accommodation; and utilizing smartphone apps to get something done. The more users participate, and the more innovatively they engage, the more value — and valuable data and experiences — can quickly be generated. In turn, the more value created, the more users — and innovative uses — materialize. As my MIT Initiative on the Digital Economy (IDE) colleagues Erik Brynjolfsson and Andrew McAfee have observed, this constitutes the raw materials for combinatorial innovation.
Another way to say this is making users better makes better users. That investment philosophy helps define the tools, techniques, and technologies that improve usability and participation. For instance: How might data-driven advice or an innovative app make network participation more productive? Additionally, our research considers how platform businesses can use digital technology and social media to make customers more valued to the business and more valuable in customer’s own eyes, as well. When developing platforms, how can — and should — businesses segment users and facilitate how they share information and insights with each other?
A Framework for Value Creation
We also look at how businesses can give users new capabilities and skills that collectively create virtuous cycles of value creation. What we call the Triple-S framework– Segment, Socialize, and Skill-ify –has had enormous impact in helping traditional marketing and innovation people create and capture the benefits of network effects.
The ‘Triple-S’ research framework asks executives to deconstruct network effects into three interrelated components: Segmentation, socialization, and skill-ification, as follows.
- Segmentation.Organizations identify specific user segments — such as customers, channels, developers or suppliers — they deem particularly important or valuable. For example, they could choose to segment customers who make the most referrals; the suppliers who propose the most innovations; or the channels that enjoy the most loyalty. The 80/20 Pareto Principle is a popular discriminator; for instance, which 20% of customers are the most profitable. In short, which users do the organization want to target, invest in, and create network effects around?
- Socialization. Different social media platforms likely facilitate different kinds of network effects at every business — choosing Facebook over Pinterest or LinkedIn over Yammer. Organizations not only need to define how they want users — and user communities — to share, they must decide how they want to measure their Return on Network Effects (RONE).
- Skill-ification is about creating new capabilities in users and user communities. Sharing and editing imagery, for example, represents a capability that goes beyond sharing and editing text. Skill-ification means enhancing human capital.
The deliberate interdependencies among these three themes is central to the framework’s effectiveness. Explicitly linking Skill-ification to Socialization to Segmentation provides a potent method for examining network effects. Managing them each independently or functionally is a recipe for failure.
In two-sided markets, such as Apple’s App Store, Uber, and Airbnb, the framework is as important for the developer/supplier side as for customers and clients. Uber drivers and iPhone app developers benefit as much as Google searchers and LinkedIn job hunters from investments that improve their skills and capabilities. The digital access, algorithms, and analytics that measurably enhance individual performance on a network simultaneously facilitate and accelerate network effects. Taken together, these represent a new genre of productivity.
Understanding the impact of network effects should fundamentally shift strategic investment perspectives toward investing in one’s users. As noted, in digital economies, sustainable success comes not just from improving products, services, and user experiences, but from improving customers, clients, channels, and suppliers, as well. Networks make that possible and affordable. The next step is for marketing and innovation executives to explicitly address key questions about assessing returns on their network-effects investments and making it easier for users to participate and create connections.
The clear top-management concern must be how boards of directors and executive committees effectively oversee network effects as an organizing principle and an asset for the digital enterprise. Network-effects management is as important as risk or R&D management for platform companies. Our research also suggests that network effects, arguably, may be the most cost-effective way to facilitate value creation. As my MIT IDE research colleague and collaborator Marshall van Alstyne has observed, network effects are about “customers creating value for other customers.”
If customers are viewed as king in today’s platform markets, it’s only because the kingdoms they rule are now larger and more valuable thanks to their networked nature.
The full research brief can be viewed here.