Network Effects 101

The concept of network effects is a powerful mental model through which to evaluate businesses, startups, money, human societies, and nature.

But what are “network effects” and how do they work?

Here's Network Effects 101!
First, a few definitions.

A network effect is a phenomenon by which each incremental user of a product or service adds value to the existing user base.

The product or service becomes more valuable to the users as more people use it.

It is a positive feedback loop.
The idea originated with Theodore Vail, the president of American Telephone and Telegraph (AT&T).

In the company's 1908 annual report, Vail wrote, "[The telephone's] value depends on the connection with the other telephones — and increases with the number of connections."
While the term "network effects" had not been created, it was clearly at the heart of Vail's comment.

The value of a telephone relies on its connection with other telephones in the network.

For an existing user, this value increases with every telephone added to the network.
The concept of network effects wasn't popularized in its current form until the late 1900s, when Metcalfe's Law entered the lexicon.

Robert Metcalfe was the inventor of the Ethernet, though it was technologist George Gilder who coined the term Metcalfe's Law in 1993.
Metcalfe's Law stated that a network's inherent value is effectively equal to the square of the number of users in the network.

New analysis has suggested the relationship between users and network value is not this simple, but the basics hold.

More users = more value per user.
Let's illustrate with a simple example.

Imagine a telephone network.

If there are two telephones in the network, there is only one potential connection.

If you add a third telephone, there are three potential connections.

If you add a fourth, there are six.

And so on...
The key point here is that the 4th telephone user added more value to the network (via 3 new potential connections) than the 3rd telephone user (via 2 new potential connections).

Each incremental user adds more value to the network than the prior incremental user!
While it took until the 20th century to have the concept of network effects be formally identified and named, it is a basic feature of human society and has existed for millennia.

Language, religion, and early forms of money all exhibited (and benefitted from) network effects.
There are two core types of network effects:

(1) Direct Network Effects
(2) Indirect (or 2-Sided) Network Effects

Let's cover the basics of each type...
Direct network effects are clean and simple.

They exist when the increased usage of a product leads to increased value of the product to each user.

To reiterate: more users = more value per user.

The telephone example from above is a clear example of a direct network effect.
Indirect (or 2-sided) network effects are more nuanced.

In an environment with two sides - supply-side and demand-side - indirect (or 2-sided) network effects exist when new users on either side add incremental value to users on the opposite side.

An example...
The @Uber business model is a classic example of indirect network effects.

Drivers are supply-side users. Riders are demand side-users.

New drivers add value to existing riders (easier access, lower waits).

New riders add value to existing drivers (more rides, less downtime).
The indirect network effects of the @Uber business model created powerful growth loops.

More riders led to less driver downtime, which encouraged new drivers to join, reducing rider wait times and encouraging new riders to join.

@DavidSacks highlighted the loop with this chart.
When network effects are present (or embedded) in a business model or industry structure, the environment tends to become winner-take-all (or winner-take-most).

This often leads to a mad rush to raise and deploy capital to accelerate user growth and become the market "winner."
The concept of network effects is an extremely powerful mental model to have in your toolkit for the modern, technological age.

The most impactful emerging technologies of the coming century will be grounded in network effects.

Let's look at a few potential examples...
Bitcoin Network Effects

The more people and institutions turn to Bitcoin as a store of value, the greater the incentives of miners to secure the network and maintain its integrity.

New users benefit from the value they create via price appreciation, driving more user growth.
There have been interesting thought pieces on the network effects of Bitcoin and other cryptocurrencies.

For more, check out the following resources:

Article by @jessewldn:….

Thread by @RaoulGMI:
The @joinClubhouse App Network Effects

The hottest new app on the block.

New users create more value for existing users by increasing the quantity and quality of discussions on the platform.

User growth attracts super users (like @ElonMusk), whose presence attracts more users.
Network effects are a powerful mental model through which to evaluate the world - a new tool in your toolkit.

For more learning:

Article by @ljin18 & @DCoolican:…

Article by @trengriffin:…

Article by @NFX:…
Special thank you to @jackbutcher @visualizevalue for the incredible GIF visual!

If you enjoyed this follow me for more educational threads on business, money, finance, and economics. You can find all of my threads in the meta-thread below.
And if you are less Twitter inclined, sign up for my newsletter here, where you can find all of my old threads and receive all of my new threads directly to your inbox.

• • •

Missing some Tweet in this thread? You can try to force a refresh

Keep Current with Sahil Bloom

Sahil Bloom Profile picture

Stay in touch and get notified when new unrolls are available from this author!

Read all threads

This Thread may be Removed Anytime!


Twitter may remove this content at anytime! Save it as PDF for later use!

Try unrolling a thread yourself!

how to unroll video
  1. Follow @ThreadReaderApp to mention us!

  2. From a Twitter thread mention us with a keyword "unroll"
@threadreaderapp unroll

Practice here first or read more on our help page!

More from @SahilBloom

6 Feb
The Feynman Technique is a foundational mental model for unlocking growth in your career, startup, business, or writing.

A thread on how it works and how it can change your life...
Richard Feynman was an American theoretical physicist.

He won the Nobel Prize in Physics in 1965 for his groundbreaking work in quantum electrodynamics.

Feynman's true genius, however, was in his ability to convey extremely complex ideas in simple, digestible ways.
Richard Feynman observed that complexity and jargon are often used to mask a lack of deep understanding.

The Feynman Technique is a learning framework that forces you to strip away needless complexity and develop a deep, elegant understanding of a given topic.
Read 15 tweets
3 Feb
THREAD: Robinhood and other brokerages came under fire last week for restricting trading in certain securities, including $GME and $AMC.

A thread simplifying the underlying mechanics of this drama and explaining why our archaic T+2 settlement system is to blame...
1/ First, if you're unfamiliar with the backdrop to this story, here are the basics.

GameStop (and other "meme stocks") saw a massive price spike last week.

There were fundamental and technical reasons for the rise.

My thread below is a helpful primer.
2/ On Thursday, several brokerages, including the popular @RobinhoodApp, halted or restricted trading in many of these stocks.

The public outcry was immediate (and very loud).

Amazingly, it even had @AOC and @TedCruz agreeing on something.
Read 22 tweets
1 Feb
THREAD: With #silversqueeze trending on Twitter, it appears that this week's market spectacle may well be in the silver market.

A perfect moment for a thread on the Hunt Brothers and their alleged attempt to corner the silver market...
1/ First, let's set the stage.

The Hunt Brothers - Nelson Bunker Hunt, William Herbert Hunt, and Lamar Hunt - were the sons of Texas tycoon H.L. Hunt.

H.L. Hunt had amassed a billion-dollar fortune in the oil industry.

He died in 1974 and left that fortune to his family.
2/ After H.L.'s passing, the Hunt Brothers had taken over the family holdings and successfully managed to expand the Hunt empire.

By the late 1970s, the family's fortune was estimated to be ~$5 billion.

In the financial world, the Hunt name was as good as gold (or silver!).
Read 24 tweets
27 Jan
THREAD: The story of the week in finance is how a group of retail traders at @wallstreetbets, with assists from @ElonMusk and @Chamath, took down the establishment short sellers at GameStop.

A thread on the underlying mechanics of the $GME saga...
1/ First, for those unfamiliar with the business, GameStop is a videogame and merchandise retailer.

It has >5,000 stores, primarily in malls, across North America, Europe, and Australia.

The business has struggled to modernize, hurting its financial and stock performance.
2/ For a variety of business reasons, a bull (i.e. optimistic) case regarding its future performance has formed.

It really came to the forefront after RC Ventures, an entity managed by Chewy founder @ryancohen, disclosed a large position and assumed three board seats.
Read 23 tweets
24 Jan
In 1983, a 52-year-old senior executive at Texas Instruments was passed over for the company's top job.

He would go on to found and build the most strategically important company in the world.

Who's up for a story?

1/ Morris Chang was born into a middle-class family on July 10, 1931 in Ningbo, Chekiang, China.

The early years of his life were set against a backdrop of hardship.

Wars and widespread poverty had overwhelmed the country, exposing him to this suffering at a young age.
2/ His father - an official in the local government - encouraged Morris to focus on school.

Fleeing the violence of the ongoing wars, Morris and his mother moved frequently.

His studies became his respite.

In 1948, at the height of the Civil War, they moved to Hong Kong.
Read 22 tweets
18 Jan
THREAD: 5 powerful mental models to help you win in a competitive world.

In investing, business, startups, writing, or life...
First Principles Thinking

“The first basis from which a thing is known.”

Establish foundational truths. Build from there.

In a world of unimaginative, copycat solutions, leveraging first principles thinking is key to achieving non-linear outcomes.
Second-Order Thinking

“And then what?”

Look past the first-order effects of a decision. Deeply examine the second, third, and N-th order effects.

It will lead to asymmetric opportunities and non-linear outcomes.
Read 7 tweets

Did Thread Reader help you today?

Support us! We are indie developers!

This site is made by just two indie developers on a laptop doing marketing, support and development! Read more about the story.

Become a Premium Member ($3/month or $30/year) and get exclusive features!

Become Premium

Too expensive? Make a small donation by buying us coffee ($5) or help with server cost ($10)

Donate via Paypal Become our Patreon

Thank you for your support!

Follow Us on Twitter!