Beginner’s Guide to Marketplace Network Effects
Buzzwords like “Marketplaces” and “Network Effects” are often tossed around like empty promises on a campaign trail, but these terms are often used without fully understanding what they mean.
In this article, I attempt to simplify marketplace network effects by breaking down the following questions:
- What are marketplaces?
- What makes network effects valuable?
- Who controls value in a marketplace?
- Why should I care?
If you like this article, please share with your friends! Also, let me know if you have any suggestions for future strategy-related topics. Now, let’s dive in.
What Are Marketplaces?
Marketplaces bring together customers and suppliers, simultaneously arranging the supply and demand for products or services.
When we talk about marketplace network effects, we are referring to a self-reinforcing cycle in marketplaces: as more suppliers join a service and compete, the service becomes more efficient and less expensive, attracting more customers, which increases the demand for the service and incentivizes more suppliers to join the marketplace. Ideally, the cycle continues and the number of users grows exponentially.
Amazon is a ~prime~ example of this phenomenon. Amazon focused on offering low prices, which drew more customers to the better customer experience, attracting more suppliers, leading to a wider range of products and better price selection, and further improving the customer experience.
Repeat that virtuous cycle, among other things, and now you have a $1.7 trillion company.
What Makes Network Effects Valuable?
The curious thing about about network effects is that the value to users (usually) increases proportionally to the number of users. As more hosts join Airbnb, more rental options are added to the platform. Airbnb, offering more destinations for your next vacation, becomes a more valuable service for you as a renter.
Similarly, the concept of “stickiness” further adds to the value of network effects, making it costly for suppliers or customers to switch to a competing platform.
After its initial launch around the time of the dot-com bubble, OpenTable set up its own proprietary terminals in restaurants as it expanded the supply of dining options available on the platform. Essentially the only reservation service of its kind at the time, many early adopters of online reservation services chose OpenTable. Having several years of a head start and the terminals already set up in existing restaurants made it costly for restaurants to switch to a competitor, allowing OpenTable to offer higher prices as the market leader. The question today becomes: Is OpenTable safe from disruptive competitors when it comes growing and adding new restaurants to its platform?
The key takeaway is that stronger marketplace network effects usually make the product or service difficult to disrupt, thus providing a sustainable competitive advantage. However, there are definitely some exceptions, such as MySpace being disrupted by Facebook in the early 2000s.
Who Controls the Value in a Marketplace?
A common rule-of-thumb has been, “Whoever generates the demand captures the value.”
Take Uber, whose platform has become nearly an essential service (at least pre-COVID). Uber captures around 25% of the value in every transaction, where drivers (essentially commodities) are often barely breaking even.
In the case of Airbnb, demand is generated in part by the platform, but also by the hosts, with a greater differentiation in products among suppliers (many different home sizes, prices, types of homes, locations, etc.). Airbnb captures ~12% of a transaction through fees.
Lastly, not to belabor the point, but Apple takes 30% of profits from its App Store marketplace. The key question here becomes: Does Apple actually drive the demand for the apps it offers? Maybe in some cases, but Epic Games leaving the platform this past week creates an interesting experiment where Epic Games (through its incredibly differentiated Fortnite product offering) is betting that it is actually generating the demand, not Apple. Epic has decided that it does not need the App Store to effectively distribute its service and cannot justify paying essentially a 30% tax to a platform that is providing minimal value.
Will other companies with highly differentiated products follow in Epic Games’ shoes, like Netflix or Spotify? Stay tuned to find out.
What about Generating Supply?
We talked briefly about the importance of generating demand, but some marketplaces have successfully built their platform the opposite way: by starting with supply.
As I mentioned earlier, OpenTable built up a massive base of restaurants before even adding a single customer to its platform. After amassing a strong base of restaurants, lots of choices attracted more consumers, which increased business for restaurants already on the platform, making it more compelling for new restaurants to join.
Similarly, Zillow spent over ten years aggregating its supply, gathering data on homes for sale to refine its algorithm, before even listing single house! Now, they have over 110 million properties in their database, have more than doubled their revenue in the previous 12 months compared to the year before, and are approaching a $20 billion market cap.
Four Key Questions for Capitalizing on Marketplace Network Effects
Before building a new marketplace, or when analyzing an existing one, you should be sure to ask yourself these four questions:
- Does the platform generate new demand or merely capture existing demand?
- Does the cost to acquire more users decrease with scale?
- Does the customer experience improve as the platform grows?
- What does it “cost” the customer (money, time, convenience, etc.) to switch to a competing platform?
Some Closing Thoughts
As we enter an increasingly digital world, businesses across all industries and sizes should understand marketplaces and the potential threats and opportunities they pose to their respective competitive landscapes. Even as a consumer who uses many of these products on a daily basis, it’s important to understand how they work.
What do you think? Is it more sustainable for an aggregator to begin by offering strong demand in order to attract suppliers, such as in Uber’s case? When does it make more sense to start with supply, like OpenTable and Zillow did?
Another often overlooked question: How important is capital-raising for early-stage marketplace businesses to kick-start network effects through marketing and promotion? We’ve seen how important timing can be to establish a foothold, and the rate at which new companies can immediately grow are often limited to their pool of financial resources. Understanding past successes and failures is crucial for truly grasping how marketplaces work.
Let me know what you think — would love to hear your thoughts and any suggestions for future topics!
