The Economics of Network Effects: Case Study of Social Media Platforms

Social media platform owners and supporters understand the power of mass numbers. Ask Elon Musk why he spent $44 billion purchasing Twitter to reimage and rebrand as X. Social media is a clear example of the network effect in action. The more people that use a particular platform, the more time that any user is likely to spend on that platform and the wider the uses people find for the platform. So, what are the economics of network effects, how does social media help drive this, and are there limits to these market effects?

What Are Network Effects?

The term network effect refers to situations when having more users of a good or service increases its value to all users. New users of the good or service act like salespersons, spreading the word and promoting its worthiness. In turn, the increased user base provides an incentive to further develop and improve what the good or service has to offer.

We see the network effect in operation in many places. These include:

• The telephone – initially only a few rich people and businesses communicated via telephone. Over time, access to the telephone improved, more people used the devices, telephone networks expanded, and people found increased usage for their telephones.
• Online marketplaces such as Amazon, eBay, and Shopify bringing buyers and sellers together, gained popularity, which encouraged more sellers, and in turn buyers.
• Food Delivery platforms such as Just Eat, Deliveroo, and Uber Eats have encouraged people to order more food online, encouraging other cafes, restaurants, and takeaway providers to offer delivery services, in turn encouraging more people to order their takeaways delivered. These have enabled small food suppliers to offer delivery that would have otherwise been unviable.

The Network Effects of Social Media

The network effect is perhaps most visible with social media platforms. Without mass numbers, these platforms lack the “social” part of their name. You can only do so much with a social account if few people see your posts. As more people join the social platform, they create and share content. They bring their friends along to consume that content. In turn, those friends create new items and bring a wider network of friends to the platform. Over time, people spend more time on those platforms where their social peers hang out, and interact with their friends.

To sustain an ever-increasing level of popularity, social networks continually changed to keep people’s attention. They have had to constantly update and improve their apps to cope with increased usage. They have focused on finding additional ways to improve the user experience – attracting new people without alienating existing users.

One way that social networks have managed to expand their offerings is by separating off specific features and making them stand-alone apps, e.g. Facebook splitting out Facebook Messenger from the core Facebook platform. Another tactic has been social media companies acquiring other related platforms. For example, Facebook purchased competitors Instagram and WhatsApp. The original Chinese TikTok received a massive network effect when they bought the US-owned Musical.ly, calling that app TikTok in the West, and rebranding their original app as Douyīn in China.

Once social networks get to a certain size, they typically add advertising to their platforms. Indeed, the annual advertising revenue of Meta platforms worldwide in 2023 was $131,948 million across all the company’s social platforms. TikTok didn’t have an advertising network for its first few years in the West. It trialed advertising in 2020 and only launched personalized advertising in June 2022.

The Network Effects Are Not Unlimited

In 2021, Marco Iansiti published a Harvard Business School paper Assessing the Strength of Network Effects in Social Network Platforms. In this paper, he examined the network effects of social media, with a particular focus on the growth of Facebook.

Perhaps surprisingly, Iansiti suggested that social media’s network effects are generally overstated, particularly by those calling for increased regulation. In particular, he found that with social media network effects do not necessarily increase with network size. He posited that network structural traits may weaken overall network effects depending on the degree of clustering on the network. Iansiti suggests that highly clustered platforms are particularly susceptible to competition.

This has become most evident for the largest social networks like Facebook. Eventually, it becomes increasingly difficult for platforms to attract new users, with most potential users already having an account.

Iansiti found that the more tightly clustered a network is, and the more segregated these clusters are, the easier it is for competitors to enter the market. Facebook (and most other social media networks) have many relatively small and largely separate local clusters. Most people only follow a relatively small number of accounts.

TikTok has tried to get around this issue by making the FYP (For You Page) the default starting place when somebody opens the app. This displays a personalized feed of recommended video content, most of which comes from people the user doesn’t know. The Facebook feed now appears to contain more content from strangers than from friends.

Multi-homing (being on more than one social network) is the norm now, meaning fewer people rely on just one social network.

Younger audiences have become less interested in Facebook in recent years, seeing it as their parents’ platform. As a result, many Generation X and Alpha people prefer to use TikTok regularly. They may have a Facebook account but rarely use it, meaning the network benefits of their membership are relatively minimal.

Wrapping Things Up

Andre Redelinghuys argues that despite the Network Effect, social media platforms grow weaker at the same time as they grow stronger – “a network with 10 of your close friends is worth much more than a network of 1000 strangers.” When a user adds a connection to a social network it has the obvious quantitative impact we’ve described above. However, over time they add all your favourite people and then diminishing marginal returns set in. Eventually, a person’s network can grow so big and impersonal that negative marginal returns can set it —with the addition of a contact they lose more than they gain.

As much as regulators may worry about the power of today’s giant social networks, they probably don’t need to over-regulate – nature will take its course and people move on to the next great social network in due course.