Network Effects in New Markets — Who Profits Most?

By: New Markets Advisors

A New York start-up called Vringo aims to become the next big trend among young people seeking to express themselves. Providing a twist on the relatively longstanding practice of downloading ringtones to your cellphone, Vringo allows its users to choose the ringtones that will play when they call their friends.

Is your phone ringing with a tune from Motley Crue? Pick up some hairspray and get ready to rock. Your friend could even send you a video to play during the ringtone — perhaps of him playing air guitar.
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It’s a neat idea — some people’s need to express themselves is almost never satiated, and the business builds on an already established behavior of paying for ringtones. There’s just one problem: both phones need to have Vringo’s software installed. It would be wonderful (for Vringo) if everyone had their software, but it’s unclear how the company will arrive at that destination.
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This is shortcoming associated with many early movers. Network effects in new markets can be very strong. There is big potential to create innovative interactions among groups of people — a field that has generally been under-targeted by marketers compared with their efforts to change the behavior of individuals. When firms win at creating networks, the payoff can be huge. Think of eBay, SMS, Facebook, “dark pools” of liquidity for investment banks, and Microsoft Office. By creating a critical mass of users, firms providing these innovations made the usefulness of their offerings stand out from competitors. Once leaders emerged, they tended to gain strength as their networks grew, creating a virtuous cycle of growth.

This Nirvana can tempt many start-ups to adopt a business model based upon network effects. Yet it is extremely challenging to get the network started. Typically it happens only under a few set conditions:

• The network is already latent and just needs to be activated (SMS capability shipped with all 2G cellphones)
• A firm can laser-target a small foothold market that then bridges into other markets (eBay’s first winning network lay in fans of Pez dispensers, and Facebook first triumphed with college students)
• The minimum size of a viable network is modest (“dark pools” first targeted commonly traded securities traded in large lot sizes, where only a few market makers were needed)
• Customers foresee the development of the network and rush to belong so that they don’t miss its benefits (Microsoft has this enviable position with its Office franchise)
• A firm owning another type of network can create a new network

This last circumstance is likely Vringo’s best hope. Telecom carriers such as Verizon or Vodafone have the muscle to push innovations out to their subscribers. They need to choose carefully what to market, as consumers have only so much capacity to absorb new offerings, but one might imagine a concerted push of Vringo to certain demographics.

The problem for Vringo is that the carrier is likely to demand the lion’s share of the profits in exchange for creating the network. If Vringo balks, the carrier can very easily find other applications to take its place, e.g. friend finder services like Foursquare that show people’s physical locations. The carrier wants to sate demand for a general job that consumers are trying to get done, e.g. have fun or express myself. There are a great many ways that this need could be satisfied.

In short, early movers seeking network effects need to consider which archetype of network creator they seek to be. If their success is dependent on aligning owners of other networks, the road to market creation may be a rough one.

Story by Steve Wunker.