Metcalfe's Law Why do big networks give birth to star companies?

One phone in the city is useless. Even several hundred devices scattered across millions of residents also do not create much of an effect. But once you have friends and family members with phones, and restaurants, movie theaters and stores also have telephone service, owning a phone becomes an essential necessity.

When Metcalfe came up with the idea, he was working at 3Com, the computer networking company he co-founded. At the time, he was trying to understand why his company's local area network (LAN) starter kits, which allowed 3 PC users to share a printer and hard drive, were not selling.

He concluded that the cost of the kit was not an issue, but that 3 people did not constitute a large enough network to justify the purchase.

As with early telephone installations, the cost of connecting to the network initially outweighed the resulting utility, and a point of critical mass had to be found at which the benefits of connecting to the network would outweigh the initial investment.

In this case we are talking about business models based on network effects. Network effects are the phenomenon whereby increasing the number of users on a network or system increases its value to each individual user. In the context of startups, network effects play an important role as they can drive the growth and expansion of a business or, conversely, cause its failure.

Network effects in the development of startups can manifest themselves as follows:

Viral growth: The more users join a network or platform, the more new users it attracts, creating exponential growth.

Increasing the value of a product or service: When there are a large number of users, the product or service becomes more valuable, which attracts even more users.

Economies of scale: As the number of users increases, a startup can reduce the cost of its products or services due to economies of scale. It may also lead to lower prices, making products or services more affordable for consumers.

Brand strengthening: With a growing number of users, a startup can strengthen its brand and recognition in the market, which in turn increases the likelihood of attracting new users.

Product Improvement: A large number of users provides the startup with more data and feedback, allowing it to find and fix problems faster and improve the product based on user needs and preferences.

Network effect-based entrepreneurship.

Metcalfe's Law has led to the creation of new forms of entrepreneurship based on network effects and ecosystems. In fact, the business models and success of many famous companies in recent decades are based on Metcalfe's Law. The same can be said about the rapid expansion of venture capital. It was the ability of companies to significantly increase their turnover that attracted a large amount of venture capital to this area, which ensured the scaling of the business. Look at how the most famous unicorns grew up.

When Facebook first launched at Harvard University in 2004, it was like a single phone: rather useless. But it didn't last that long. Within a month, 50% students were already on Facebook. In part, it was a case of pent-up demand: Every year, Harvard released a physical “personal book” that included every student and faculty on campus, designed to help everyone at the school get to know each other more quickly. “TheFacebook,” as the social network was then called, was an attempt to digitize this already existing physical object.

With each new Harvard student who joined the platform, its value to other students increased. Each new student received more opportunities to meet new people and exchange information with them.

As Facebook has grown, the company has added features that were designed to better exploit the mechanics of Metcalfe's Law, "bigger is better."

Photos, groups, likes, comments - they all used this concept to bring users back to Facebook again and again. And the more people were on Facebook, the more photos were posted and viewed, the more groups were created, and so on.

The nonlinear effects of Metcalfe's Law also contribute to the long-term viability and success of Facebook's advertising business. The more people on the platform, the more data and connections, the more opportunities to generate income from targeted advertising.

Metcalfe himself acknowledged the impact of his law on Facebook's growth, noting that if Facebook's revenue is used as a proxy for its value, then it is undeniable that the value of the network has grown exponentially relative to the steady linear growth of its user base.

I will list below business models based on the network effect. It should be noted that these business models form the basis of the success of a significant part of the companies created in the last few decades.

Social media platforms:

Facebook, Twitter, and LinkedIn are examples of social media platforms where the value of a network increases as more users join because there are more people to interact with and share content with.

Messaging apps:

WhatsApp, Telegram and WeChat are messaging apps that are becoming increasingly valuable as more people join them, as they allow users to communicate with a wider network of friends, family and colleagues.

Online Markets:

eBay, Amazon, and Etsy are examples of online marketplaces where buyers and sellers come together to transact. The more sellers, the more diverse the product offerings, and the more buyers, the more potential clients for sellers.

Sharing platforms:

Uber and Lyft are ride-sharing platforms where the network effect benefits both drivers and passengers. More drivers mean shorter wait times and better coverage, and more passengers mean more demand and driver income.

Online dating apps:

Tinder, Bumble and OkCupid are examples of dating apps that rely on the network effect: the more users on the platform, the higher the chances of finding a suitable match.

Collaboration Tools:

Slack, Microsoft Teams, and Google Workspace are examples of collaboration tools that become increasingly valuable as more people join them, as they make it easier to communicate, share knowledge, and collaborate in large groups.

Software as a Service (SaaS):

Salesforce, HubSpot, and Dropbox are examples of SaaS platforms that benefit from network effects because the more users they have, the more valuable their service becomes in terms of integrations, partnerships, and third-party add-ons.

Crowdfunding platforms:

Kickstarter, Indiegogo, and Patreon are examples of crowdfunding platforms that leverage network effects. The more users contribute, the more projects receive funding and the more successful projects, the more attractive the platform becomes for both creators and supporters.

Peer-to-peer lending and financial services:

LendingClub, Prosper and Zopa are examples of peer-to-peer lending platforms where borrowers and investors benefit from network effects. More borrowers mean more lending opportunities for investors, and more investors mean better access to credit for borrowers.

Online games and virtual worlds:

Fortnite, League of Legends, and Roblox are examples of online gaming platforms and virtual worlds that leverage network effects. The more users join, the more interesting and varied the gaming experience, which contributes to the growth of both the player base and revenue.

It appears that Metcalfe's Law will continue to play a leading role in shaping business models in the future, including for artificial intelligence applications.

According to Metcalfe, the critical mass of a network depends on the cost of a new connection (for example, the cost of acquiring a user) and the number of users. This pattern describes several dependencies that are key to network effects. For example, the lower the connection cost, the fewer users you will need to reach critical mass, and the same goes for higher connection counts.

Andrew Chen, general partner at Andreessen Horowitz, concluded that the mechanics of Metcalfe's Law are not only key to the growth of companies like Facebook, Twitter and Snap, but can also lead to the implosion of networks if user retention is not high enough.

The term "death spiral" in the context of Metcalfe's Law refers to a negative network effect that can occur when the value of a network decreases as users leave it.

Metcalfe's Law states that the value of a network is proportional to the square of the number of users on the network. Therefore, a larger network has exponentially more value than a smaller one. Conversely, when users leave a network, its value decreases exponentially, which can cause a vicious cycle of even more users leaving.

A death spiral can occur for a variety of reasons, such as poor service quality, increased competition, security breaches, or loss of trust. As the network loses value, it may become less attractive to users, forcing them to look for alternatives. This, in turn, causes even more users to leave the network, further reducing its value and accelerating its downward spiral. In extreme cases, this can lead to the collapse of the entire network.

For example, if a social media platform experiences massive data leak, users may lose trust in it and begin to abandon it. As more users leave, those who remain see the platform as less valuable because there are fewer people or organizations to interact with and share content with. This is what exponential network collapse looks like.

To avoid a death spiral, businesses that rely on network effects must focus on maintaining a high-quality user experience, maintaining strong security measures, and continually evolving to remain competitive and relevant in their industry.

Below I will list circumstances that can lead to a decrease in users on the network and lead to undesirable consequences.

Network congestion: As the number of users increases, the network may experience capacity, latency, and data processing issues, which may degrade the quality of service for users.

Reduced content quality: In some cases, such as user-generated content platforms, increasing the number of users can lead to a decrease in the quality of content offered, which in turn can turn off some of the audience.

Increase in spam and fraud: More users can lead to more spam, scams, or other unwanted activity, which negatively impacts how users interact with a product or service.

Degraded user experience: If there are too many users on a platform or application, the level of complexity may increase, making the product or service difficult for new or less experienced users to use.

Problems with moderation: An increase in the number of users can make it difficult to moderate content, which can lead to violations of online rules and regulations, as well as negatively impact the overall experience of a product or service.

Privacy and Security Issues: A large number of users can increase the risk of data leaks, privacy breaches, or cyber attacks, which can damage a startup's reputation and cause a loss of trust among users.

Increased competition: An increase in the number of users may attract competitors to offer alternative products or services, which may result in a loss of market share and weakening network effects.

Along with famous stellar examples of the operation of Metcalfe's law, it is also appropriate to cite famous failures.

Company Friendster was one of the first social networks launched in 2002. At one time, the service was very popular and attracted many users. However, due to problems with scaling and network congestion, as well as the emergence of competitors such as MySpace and Facebook, Friendster gradually lost its audience and was forced to close.

Company Yik Yak was an anonymous messenger and geolocation-based social network. The service allowed users to exchange messages with other people in their geographic area. Despite its initial success and viral spread among students, Yik Yak has faced content moderation issues and a deteriorating user experience. As a result, the service closed in 2017.

Company Path was a personal social networking service that emphasized privacy and more intimate connections between users. By limiting the number of friends per user to 150, Path attempted to create an alternative to other major social networks. However, due to weak monetization, lack of user acquisition, and competition from larger platforms like Facebook, Path eventually folded.

What should early-stage startups with Metcalfe's Law apply to their business model? Companies must have a clear plan that outlines a number of points critical to success.

Successful online businesses must actively attract new users to increase your audience. This can be achieved through viral marketing, referral programs, or providing unique value that motivates users to join the network.

They must formulate from the very beginning existing user retention program. To ensure that network effects are realized, online businesses must also create real value for their users. This can be done by providing unique opportunities for information exchange, interaction or transactions between network participants.

You should prepare from the very beginning service scaling plan taking into account the necessary development of the software and hardware base. This means creating solutions that can easily adapt to growing network needs and resources.

Community management and moderation are important components of the success of online businesses. This includes ensuring user safety, complying with rules and regulations, and promoting positive and constructive interactions among network participants.

Any business is created for the purpose of making a profit. For long-term success, online businesses must develop effective monetization strategies, which not only generate profits, but also support sustainable growth without disrupting user experience and network value.

Finally, you should always be aware of competition. Monitoring competitors' actions and preparation competitive strategy - always and for any business is an integral part of its management system.

In conclusion, I will once again list the main dependencies of Metcalfe’s law.

Network value: The value of a network is proportional to the square of the number of its users. This means that as the number of users of a network grows, its value increases exponentially.

Balance between connection cost and network value: Connecting to a network may incur certain costs, such as hardware costs, installation costs, or subscription fees. To maximize the value of a network to users, the cost of connectivity must be balanced to attract the maximum number of users while offsetting the costs of building and maintaining the network.

Reduced connection costs for network expansion: The lower the cost of connecting to a network, the more potential users can join it. This can lead to increased network effects and increased overall network value. On the other hand, if the cost of connection is too high, it can limit the number of users and reduce the potential value of the network.

Optimal network size: According to Metcalfe's Law, the optimal size of a network is reached when the maximum number of users join it and network effects reach their peak. However, as the network grows, negative network effects may occur, such as network congestion, degraded service quality, or moderation issues. In this case, the optimal network size is achieved when positive network effects are maximized and negative network effects are minimized.

Network adaptability: Optimal network sizes and connection costs may change over time due to changes in technology, competition, or user needs. Network businesses must be ready to adapt to these

The effects of Metcalfe's Law are one of the most important dynamics for business in the 21st century. Its proper use in business is the key to success. Many of the most valuable companies of the last few decades, from Microsoft to Facebook to Airbnb to Uber, have succeeded in part due to the power of network effects. Don't forget this.