A Brief Lesson on Network Economics

Today I delivered a lecture on network economics. Network economics is a principle for competitive advantage within information technology strategy. I thought that I’d jot down a few ideas from that lecture for the blog.

Imagine a world with only one fax machine. The value of that fax machine is practically worthless: there is nobody to fax to. Add one additional fax machine and the fax becomes more valuable – now you have somebody to fax to. Then, add 10 more fax machines. Add 100. Add 1,000. And the value of your fax machine has increased exponentially. There is now a network of other nodes (fax machines) to interact with.

This is one illustration of the multiplier effect of a network economy. There is increasing value in numbers. We could apply this principle to the number of computers connected to the Internet; the number of hotspots in a city; the number of iPods in a marketplace; the number of books in Amazon’s digital catalog. The Kindle, for example, becomes infinitely more valuable with more content from Amazon; the iPod with more features and content from iTunes; wireless technologies with more spaces to achieve connectivity; the Internet with more participants. This is another facet of networked economics: more content and interconnectivity increases value.

Another idea is the concept of economy of scale, inverse scale, and marginal cost. Let’s take Moore’s Law. You might be familiar with this. Moore’s Law is a 40-year old computing axiom that states computing power will double every 18 months while the price drops by half. This means that – if you and I invested in an online business – the price for that computing infrastructure comes closer and closer to zero every year. Plus, what we built can manage not one user, not a hundred users, but thousands of users, all at the same price. Therefore, we have a huge economy of scale capable of supporting an exponential volume of business that keeps getting cheaper to offer every year. Some would even say our marginal costs would be so low within three years that we’re running our business for free.

Free. That’s a powerful word these days and free is all around us. It’s a component of network economics, too. Why is it that companies like Google, Amazon, Microsoft, and hundreds of others do offer and will offer software and other digital content for free? Why? Because of network economics, it’s virtually costless to maintain on a server, virtually costless to distribute, more users adds more value, and more users generate more content - which, by the way, is practically costless to maintain and adds yet more value to your product. Hence, Google offers incredible functionality (email, picture management, spreadsheets, word processing, maps, telephony)… free. To Google, what they build becomes practically costless to maintain within three years, extends value to all, interconnects all, and generates more content on the Internet; more content means more search; and the more search means more revenue for Google. So why offer so much for free? Because it’s the fastest way for those exploiting network economics to make money. It’s also an interesting way to quickly build a brand.

Look at your business model. In spaces where friction is necessary to increase volume, you cannot take advantage of network economics. In that model - the traditional model of business – the more money you make is dependent upon the more volume you sell, and volume may be entirely dependent upon labor, space, utilities, taxes, distribution costs, oil – overhead. More overhead introduces long term expenses which erode profitability, unless you get bigger, to handle more volume, and become increasingly dependent upon growth to achieve earnings attractive to capital investors. Friction denies you passage on the network economics highway.

Getting bigger is, in fact, unsustainable. The bigger you get, the more spread out you become, the more you rely upon economies of scale to reduce expenses and contain the cost of your growth. If your business model is totally dependent upon growth to attract capital, you need either one of two things: a dramatic change in technology to afford ever-astounding capabilities to lower costs, or, more overheads. Otherwise, growth is unsustainable precisely because it can’t take advantage of network economics. And newsflash: sustainability is a big strategic idea these days.

Now imagine your frictionless business model. How can you leverage technology to connect to more people, interact in a costless way to build marketing presence and buzz, to build a community of interested followers, to lower transactional costs and achieve higher economies of scale, to reduce marginal costs to zero, and reduce friction? I’m thinking social media, business process automation, open source, cloud computing, Internet connectivity and interoperability, mobility, telecommuting, and electronic communities. It is the impact of becoming frictionless. Doing so will allow you to master the problem of network economics and exploit technology as a strategic tool. Now _that’s_ the competitive application of technology.

R

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