The network effect on wealth creation

Networks aren’t just critical infrastructure. They can be the difference between a company winning big and becoming irrelevant.

We live in a network-centric world, and network laws are beginning to govern business models and even global economics. When you understand these laws, you begin to understand why we live in a world where new network-centric business models (think Google, Facebook, Amazon, Airbnb, etc.) become de facto monopolies that result in incredible wealth creation.

More important, you might be able to figure out how to put these same network effects to work for your business to spur growth and increase customer and shareholder value.

Metcalfe’s Law and network effects

The first law to understand is Metcalfe’s Law. As you probably know, Bob Metcalfe is the co-inventor of Ethernet. I’ve met Bob a few times in my career. He’s smart, kind and very intuitive. Back in the dawn of networking, he made an observation about how networks work, and he put an equation behind it. That equation has come to be known as Metcalfe’s Law. Here’s how it goes and why it’s critical for modern business models, not just for the networks that underpin them.

Metcalfe's Law states that the value of a network is proportional to the square of the number of connected users of the system (n2). A single phone, for example, has limited value, but as soon as your friend has a phone, you both realize value, even though that phone itself hasn’t changed. As more phones are added to the network, each additional phone represents value for you, as well as everyone else in the network.

People and things want to be connected.

When you connect things together you can create value.

Think Facebook, Airbnb and the internet itself.

When you put Metcalfe’s Law at the center of your business model, a magical thing happens: the more customers you get, the more valuable your business is to all of your existing customers, so you get even more customers.

Reed’s Law and compounding network effects

In a network-centric world you can create a compounding effect. There’s a law for this, too. It's called Reed’s Law, named after David Reed.

Reed's Law adds the dimension of Group Forming Networks (GFNs). The law says networks get more valuable when people can easily form subgroups to collaborate and share information. These GFNs create value that scales exponentially with the number of connections.

This exponential value creates increasing returns as scale increases. The network effect of potential group membership can dominate the overall economics of the system.

Network effect and your business

What does all of this have to do with your business? 

Networks are now at the center of everything. They are the foundation of our modern economy. They underlie every business, city, government agency, covert organization and teen social circle. Physical, virtual and social networks are central to how work gets done, information is communicated, relationships are made and maintained, and funds are transferred. For a more involved discussion of the impacts of network effects on business today and tomorrow, the book The Seventh Sense by Joshua Cooper Ramo is a powerful read.

But not every business puts a network model at the center of its business model. In fact, most old business models are hub and spoke. The value is exchanged between the company and the customer. So, these businesses scale linearly. As digital transformation sweeps through different industries, you have to ask one critical question:

How do I get a network effect working within my business?

You figure out how to create value among your customers. The more customers you have in aggregate, the more value you create for each individual customer. In the old world, companies created products or services for customers. In the digital world, companies create value with customers, and customers create value with and for each other. Co-creation is at the heart of the network effect for many industries and companies.

Usually this means some type of digital connection, application or service that you and your customers use to engage with each other—thus the term digital transformation. And if you’re going to create a new type of digital business, you will need a new and agile infrastructure to support that business. You’ll also need a new type of network to enable it all.

Networks: Power, not plumbing

The next time someone in your company refers to the network as just “pipes and plumbing,” please have the courage to correct their misperception. Networks aren’t just critical infrastructure; networks can be the difference between winning big and becoming irrelevant. Networks are at the heart of the transition to digital business. And yes, I mean both types of networks: the social kind where you digitize a service or application to create value, and the underlying physical network that makes it all work.

Networks were the driving force behind the disruption that swept through every industry 20 years ago with the introduction of the internet, and they are the driving force behind the disruption sweeping through every industry today. Cloud services, mobile applications, IoT, security enhancements, big data analytics and new business models can’t thrive on the old IP infrastructure that was designed two decades ago. Today’s world of computing and connecting is dramatically different and requires a different kind of network architecture: a New IP network architecture.

Networks have power. While some companies will struggle to survive the transition to digital business models, those that harness and exploit network effects will put fundamental network laws to work for their business. The people who understand the power of the network to transform business models and create exponential value through co-creation are the new power players in every company and every industry.

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Copyright © 2016 IDG Communications, Inc.