In our newsletters, blogs and 3L&3S, we have attempted to understand and bring to light the power of network effects, both at the economy level and for individual businesses. At the economy level, India is experiencing the benefit of networking through the expansion of its highway network, financial inclusion and the even more rapid penetration of telecom. But the world of business has been even more disrupted by new age companies basing their core competitive advantage on network effects. For a deep dive into network effects, you might want to dig into this. But this contrarian article in the FT highlights the limitations of networks. It starts with debunking the Metcalfe’s law.
“One of the reasons most often given for the dominance of Big Tech companies is Metcalfe’s Law, which explains the value of networks. As originally written by the computer scientist Robert Metcalfe in the 1980s, the law states that the “systemic value of compatibly communicating devices grows as a square of their number.” In other words, if a network of 100 computers doubles in size, then the number of possible connections (and their assumed value) almost quadruples.
The formula is more of a mathematical observation than a hard-and-fast economic law. But it has been widely cited as justification for pouring billions of dollars into companies that benefit from such supposed network effects, including Google, Facebook, Uber, Airbnb, Tinder and Clubhouse. The trouble is that in many cases Metcalfe’s Law is self-evidently nonsense.
To take two obvious objections: no two networks are the same, and the value of individual connections varies. The law’s shortcomings have been expertly picked apart by Andrew Chen, a partner at the VC firm Andreessen Horowitz and author of a new book The Cold Start Problem. As a former head of rider growth at Uber and now an investor in several platform companies, Chen has seen how networks work in all their real-life messiness. They can be incredibly powerful but also surprisingly fragile. “Metcalfe’s Law tells you that networks become more and more valuable and they go up to infinity. But this is not what happens in practice,” he tells me.”
He cites Chen’s ecological analogy of how a meerkat population needs a threshold to grow exponentially yet there is a limit beyond which it is self-threatening.
“Look at Uber, for example. Although it would appear to be one global network benefiting from vast economies of scale, it is more accurately understood as a network of networks. As Chen describes in his book, Uber’s war room in San Francisco focused on hyperlocal competition in each and every one of its locations, figuring out ways to outsmart rival taxi firms and exploit regulatory loopholes. But now that Uber has achieved critical mass in most of its markets and is nudging up prices to recoup its massive investments, it is in danger of overeating bugs and fruits. “They are focusing on efficiency and profitability. But if you are a city-by-city network you can be picked off by competitors,” says Chen, pointing to the threat from hungrier food delivery rivals, such as DoorDash and Gopuff.
This year, Uber has had to offer big driver incentives to preserve its services in some cities, such as London. The company’s networks may be further threatened by regulatory raptors, too. This week, the UK High Court ruled that it was illegal for a private hire vehicle operator to act as an agent between a driver and passenger. The EU is also drawing up new legislation to strengthen the employment rights of gig workers. These moves could put a big dent in Uber’s business model, which has only just turned a tiny profit (on an adjusted basis) after racking up staggering losses for more than a decade.”
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