Network effect

A network effect means that a service becomes more useful to each user as more people use it. In a ride-hailing app, more drivers mean shorter waiting time for riders, which brings more riders, which brings more drivers. This loop is why, in each market, a few large apps usually win while small ones struggle.

Here is how it works in general. A service has two or more groups of users who need each other, such as drivers and riders, sellers and buyers, or senders and receivers of messages. When one group grows, the service becomes better for the other group. The second group then grows, which makes the service better for the first. The loop keeps repeating. A new competitor must offer something better for both groups at the same time, and with few users on either side it cannot. This is also called a marketplace or a platform effect.

There are two kinds. In a same-side effect, such as a messaging app, every user gains from other users of the same kind. In a cross-side effect, such as a ride-hailing app, one group gains from the other. The effect is often local. A ride-hailing app that is strong in one city has to build supply again in the next city, so different apps can win in different cities. There are limits too. Drivers who use two apps at once, called multi-homing, make it easy for riders to switch. So a network effect helps a service to grow, but it does not guarantee a monopoly.

Take, for example, a ride-hailing app in Bengaluru. With thousands of drivers, a rider waits three minutes for a cab, so riders prefer it, and drivers choose it because they find rides quickly; see ride-hailing apps. Consider a messaging app. It is useful only if your friends use it too. Imagine a freight app where truck owners and shippers meet; see freight marketplaces.

Such a market is often decided by who grows first, so companies spend heavily on discounts at the start. The result may be one or two big players and workers who rely on them, as described in gig workers. The same idea is used in marketplaces, EV charging apps and paying to move.

How is it different from installed base? In a network effect, people join because others are already there. In an installed base, customers stay because leaving is costly.