In Podcast 41, I talked about 3 ways network effects suck. They do have some major problems. And these are not discussed as much as their benefits. This will also tee up my third talk on Ant Financial, a company that is mostly about platforms and network effects.
First a little theory.
This is About Cycles and Feedback Loops
Howard Marks, founder of Oaktree Capital, has been talking forever about how all business runs on cycles. Things move one direction (credit increases, consumer confidence, etc.) and then a countervailing forces grows and eventually pushes it back the other way. So you can see cycles in the economy, in industries, in credit cycles, in investment cycles and so on.
In medicine, this same idea is talked about in terms of feedback loops and dynamic equilibrium. Your body temperature does not just sit at 98.6 degrees. It is not a static, stable equilibrium. It is a dynamic equilibrium based on feedback loops. As your temperature goes up a bit, a negative feedback loop begins (blood vessels dilate, etc.) and the temperature comes back down. As it goes down below 98.6, another feedback loop kicks in. And your temperature sits dynamically balanced between positive and negative feedback loops at 98.6. And we see such dynamic equilibrium based on feedback loops throughout the human body. At the cellular level, at the organ level and at the body level.
I view business in a similar fashion. As cycles that are created by positive and negative feedback loops. And that sometimes create dynamic equilibria that appear stable. So supply and demand curves do not automatically create a set pricing and quantity situation. It is constantly moving. And sometimes it can reach a stable equilibrium. But it doesn’t have to. Some cycles and feedback loops happen at the company level, some at the industry level and some at the macro level.
Some examples from the investment world:
- Warren Buffett has made a fortune betting on market prices oscillating around a company’s economic value. He waits until the market is overly pessimistic and underpricing a company. He buys and then just waits for the price to come back to economic value. When asked why the price comes back up, he basically said he doesn’t know. But it does.
- George Soros made his fortune of his theory of reflexivity, which was basically about feedback loops. He argued that credit and government can cause positive and negative feedback loops between market price and a company’s economic value. If credit gets plentiful, real estate prices go up. Which makes more credit available. And so on. Feedback loops lead to boom and bust cycles. Which he predicts and invests against.
Anyways, network effects act like feedback loops, usually in limited situations. As more restaurants accept American Express cards, it becomes more valuable to the consumers carrying them. And as more consumers carry the cards, they become more valuable to restaurants. We get a positive feedback loop.
And while most network effects only go on during a growth phase and then become asymptotic or an S-curve, they do tend to go up linearly and globally for credit cards. You really do want your credit card to be useful everywhere. But all network effects fade beyond a certain point. Nobody needs millions of friends. Nobody needs 100,000 cars choices to get a ride to work. The value of each additional car or friend is less and less.
This actually gets pretty complicated. You need to think about how the perceived and real value increases to each user on the platform with more activity. And it can change with user number. Or activity. Or cumulative activity. Or money spent. And it can change over time. And it can be different for each user group. And for each cohort within each user group. It’s complicated.
There are other benefits to network effects, but the two that most people talk about are:
- The positive feedback loop, especially in the growth phase.
- A collapse to a winner-take-most market and a barrier to entry against new entrants. Incumbents with scale and network effects have a better service by definition. This is also called demand-side economies of scale. It makes it difficult for a smaller player to survive. And almost impossible for a new entrant.
Nobody Talks About Negative Feedback Loops and the Network Effects Trap
I’ve mentioned many times that network effects can work in reverse just as fast. If merchants stop taking American Express cards, they are less valuable to consumers. If fewer consumers then carry them, they are less valuable to merchants. And so on. We can get a negative feedback loop.
And what do you do if you are American Express? What would you do if you are a platform based on network effects and you are seeing fewer consumers using your app each month? Or if the cost of attracting them is increasing? Or if they are spending or posting less when they do arrive? Or if your retention is falling?
This is the network effects trap that nobody talks about. Network effects make you highly dependent on keeping activity on your site.
Think about traditional competitive advantages (like economies of scale) like having a car instead of a bicycle. With these advantages, you can go faster than your competitors. It is a structural advantage. Well, having network effects (which is also a competitive advantage) is like having an airplane. You can go much, much faster. But once in the air, you also realize there is no way to land. You have to keep your network effect going. A car losing speed is not horrible (i.e., fading economies of scale). But a plane losing altitude is catastrophic.
You can see lots of network effect-based businesses getting frantic as they lose activity (and altitude).
- Ctrip and Expedia are increasingly worried about their low frequency of usage and search engines and meta search sites cutting them off from their consumers.
- Entertainment platforms like TikTok are worried they are a fad and that viewers will switch to a new popular media type, like live streaming.
- And most all online platforms have some degree of user churn. They are a leaky bucket where you constantly have to be adding new users. But for most, this is getting harder and more expensive in an age of abundance with endless choices but limited attention.
Ant Financial and their Sustained Innovation Imperative
If you read the Ant Group IPO filing, the phrase “sustained innovation” appears over and over. It is even in the Risk Section as something the company needs to achieve. And if you read carefully, you will see that they are talking about sustained innovation as their solution to the network effects trap.
In my post Ant Financial Is 3 Platform Business Models Combined, I argued that each Ant platform business model has a different function.
- A payment platform that Ant describes as “infrastructure”. Payment is what creates the digital network and gets users connected. These users are the nodes of the digital network. Payment interactions also create some revenue.
- A marketplace platform for doing simple, high frequency services. That gets engagement and behavioral data. They describe this as daily life services.
- A marketplace platform for financial services – mostly insurance, credit, and investments. They describe this as a portal for digital finance products and services. These are rarely used and much more complicated transactions but they are also the really big money.
And I showed you my standard blue diamond charts.
And each of these platforms has a network effect.
One reason network effects are called “demand economies of scale” is because they are an advantage based on a scale differential. This is similar to “supply side economies of scale” (i.e., scale advantages on the cost side). As I have discussed many times, economies of scale on the cost side only work when you are larger than your competitor. For example, your factory produces 3x as many widgets as your competitor so your unit costs are lower. Economies of scale on the cost side usually require:
- Superior scale in a cost that is mostly fixed (often in production, logistics, R&D).
- Larger market share in circumscribed market. You need to be bigger in a market with no room for another player to get to your scale. So it has to be circumscribed. And slow growth helps.
- Smart management that defends. If a competitor starts decreasing your size advantage, you need to stop them. Coca Cola famously ignored smaller Pepsi for decades as it slowly grew. When they finally did try to use their scale advantage to stop them (outspent them on marketing, price cuts, etc.), Pepsi was already large enough to match these moves. A scale advantage only exists as long as you have a scale differential with your competitors. You need to defend it actively
It is the same for demand side economies of sale (i.e., network effects).
Not only do you need to keep your activity going to avoid a negative feedback loop. You also have to maintain superior activity and market share ON BOTH SIDES OF THE PLATFORM. You advantage requires a scale differential with your competitors for all user groups and their activity. Having more merchants offering on Taobao means it is more valuable for consumers. But if another marketplace gets the same merchant market share and activity, their offering is then as good to consumers. You have to have superior scale and you have to defend this on both sides of the platform.
Ant Financial’s strategy for this is “sustained innovation’.
In their filing, they argue that they must continually increase the value they provide to the users of their platform (consumers, merchants, creditors, asset managers) with sustained innovation. They must continually offer them new products and services – and improve the existing ones. Only by sustained innovation can they continually increase their value to users – and therefore continue to have superior market share, scale and activity. Sustained innovation is how they plan to maintain their demand-side economies of scale.
And that is a good strategy for a platform in a rapidly growing market. Their services for payment, daily life services and digital finance are all expected to be big growth opportunities. That’s great. But it also means they lack a circumscribed market where there will be little room for anyone to match their scale advantage. So they are going to grow as fast as they can and keep increasing their value to users to maintain market share. That’s some solid strategy thinking. They are really good at platform strategy.
Ok. That’s enough theory for today. I hope that is helpful.
Photo by Alibaba Media Resources
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