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 / Winter 2003 / Issue 33(originally published by Booz & Company)


The Big, the Bad, and the Beautiful

Pursuing size under an assumption that you will gain scale economies in businesses with flat scale curves offers no advantage and can in fact lead to decreasing margins if the incremental size is gained through lower prices. And even where a steep slope is possible, scale advantages don’t just happen. A company must seek them out and exploit them. Examples like Wal-Mart and Amazon highlight the specific sources of scale and how companies have gained competitive advantage from it.

Network Effects
Network effects came to the fore of business strategy during the height of the Internet boom to justify the phenomenal valuations of dot-com startups. Stock analysts applied the logic that the value of a network grows proportionately to the square of the number of users, a property of networks asserted by Bob Metcalfe, developer of Ethernet, a technology for connecting computers in a local area network, and the founder of the 3Com Corporation. Following what became known as Metcalfe’s Law, a company’s value quadrupled when the number of users doubled. Or if the number of users quadrupled, the value grew 16-fold. Given the exponential growth of the Internet population, the projected value gains were simply astronomical.

Unfortunately, even though a customer connects to a company’s Web site via a computer network, the business itself does not necessarily exhibit network effects. To better understand why, we need to return to the economic arguments that predated the hype.

Economists noted the existence of “network externalities” in their research covering everything from ATMs to electricity to software. Formally, a network externality occurs when the value of participation in a network depends on how many other parties or which parties already belong to the network. Accordingly, a network effect is a demand-side argument for size versus the supply-side argument for scale economies.

Reflect on the early days of the telephone. In 1876, after participating in a demonstration call between Washington, D.C., and Philadelphia, President Rutherford B. Hayes commented: “That’s an amazing invention, but who would ever want to use one?” President Hayes failed to understand the network possibilities of the nascent tool. A phone connecting a central user in one city to another offered little advantage over the existing telegraph technology. But unlike telegraphy, a telephone required no special training to use, and, accordingly, the network grew to encompass many individual users. And, as more individuals acquired telephones, the value of having a phone increased for everyone connected to the network. More recently, the Internet has produced the same effect.

Economists argue that a market leader can gain a monopolistic position from the network effect by erecting “switching barriers.” A competitor with a smaller network has trouble enticing customers to join its alternative network because it offers lower network value. Microsoft’s dominance of the market for personal computer operating systems and ultimately PC application software offers an excellent example. Although alternative operating systems such as Unix, Linux, and Apple OS have challenged Microsoft’s DOS and Windows systems, none have displaced them — even though some proponents claimed their alternatives offered superior functionality. Why? Because PC users value the ability to exchange files with other users without risk of compatibility problems. The largest network (in this case a virtual one) offers more value to the user. Similarly, the large base of Windows users drives application developers to tailor their products to Microsoft first. This also creates greater value for the users of the dominant network.

Among Internet-based companies, eBay exhibits the most powerful network effect. As more people list items for sale on eBay, the site attracts more buyers. The more buyers who bid on an item, the greater its value to the seller. This, in turn, attracts more sellers. For comparison, consider that has the same number of customers as eBay, but its business model generates nominal network effects. Amazon customers benefit from the product ratings of other customers, and the acquisition of more customers improves Amazon’s ability to mine its sales data to create customized purchasing recommendations, but the impact of this network effect is relatively small compared to eBay’s.

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