Network Effects

 
Introduction
The ascent of man from simple hunter/gatherer to progenitor of global economy can be directly attributed to our innate and profound ability to build profitable and self-sustaining networks.  And as with all complex and dynamic systems, information is just as important a constituent in any man made network as the more tangible economic nodes such as buyers, sellers, goods and physical infrastructure.
To recap: Ancient trade networks helped us to survive harsh prehistoric times, and in turn contributed to the advancement of language.  More complex networks then gave rise to nation-states, artisan crafts and the elite classes for whom information was both privilege and power.  Even more complex networks eventually manifested through the industrial revolution to give us the enterprise, wherein information was monetized as intellectual property and principals of mass production.
But within the past century, parallel developments in Information Theory and digital technology, along with massive increases in computing power, have sparked a new paradigm—the information revolution.  In this new age, information is equally critical for production as other traditional commodities, and contributes directly to the value of products and services.
The dawn of the Information Age “can be seen globally as the surreptitious replacement of citadels—which tend to restrict the flow of information—by less viscous environments, and the subsumption of information within capital.”[i]In few industries is this as evident as insurance, where information derived from voluminous amounts of data drives every key decision from the boardroom to the underwriter’s desk.
The information revolution—powered by instantaneous modes of communication—has justly prompted a major shift in the very fabric of capitalism, such that we are now largely operating within a network economy.  Whereas ownership over physical property and ideas belonged solely to the enterprise during the industrial era, products and services are now created and value is added through large scale social networks. Economies of scale stem from the size of networks instead of the enterprise, and the value of centralized decision making and expensive bureaucracies is greatly diminished.
Newer, more agile business models are supplanting formerly rigid power structures as more pervasive networks blur the line between a business and its environment.  Value is now intrinsically tied to connectivity and the openness of systems.
In the network economy, “Understanding how networks work will be the key to understanding how the economy works.”[ii] Such an undertaking is greatly simplified when one understands network effects and Web 2.0.
Network Effects
A network effect (sometimes also referred to as a network externality) is simply the effect that a user of a product or service has on the value of that product or service to other users.  A product or service displays positive network effects when more usage of the product by any user increases the product’s value for other users, and sometimes all users.
The importance of such effects in building enhanced and profitable economic networks was spurred by 19^th and 20^th century innovations in communications, which gave us the telephone, the ethernet and the internet.
Bell Telephone employee N. Lytkins demonstrated the term network externality in a 1917 paper covering the importance of network effects in building the telephone industry.  The paper explained how more users of the relatively new invention would increase the value of owning a telephone for all users.
Robert Metcalfe, inventor of the Ethernet, furthered the study of network effects through Metcalfe’s Law, which states that the value of a communications network is proportional to the square of the number of connected users of the system (n²).
Network scientist David Reed; however, postulates that there are even greater values to be exploited, as explained in Reed’s Law.  According to Reed, the effects are more akin to 2ⁿ as opposed to n² since benefits increase on the basis of the combinations among the users and the total many-to-many possibilities, made possible by the internet.
Metcalfe’s Law, according to Reed, only accounts for one-to-one possibilities.  In Reed’s Law, the utility of networks and social networks in particular, can scale exponentially with the size of the network.  Thus the internet is now the prime amplifier of network effects.
There are multiple types of network effects:

• Direct network effects are the simplest type to recognize, wherein the value of a good or service increases as more people use it.  The most classic example of a direct network effect involves the telephone.  As the network of people using telephones swells, so too does the value of owning a telephone since there are more people available to call.
• Indirect network effects are activated when the usage of a good spawns the production of complementary goods, which in turn adds value to the original product or service.  For instance, the addition and increasing quality of web-enabled software increases the value of the internet itself.
• Cross-network effects are also referred to as two-sided network effects since increases in usage by one set of users increases the value of a complementary product to another divergent set of users.  Google exemplifies this effect since any increase in the number of users raises the value of placing advertisements on Google.  In turn, Google takes the money from advertisers and invests in additional services for the users.
• Social network effects are also sometimes referred to as local network effects.  In this model, the value of products or services is not necessarily increased by the number of users.  Rather, each consumer is influenced by the decisions of a subset of other consumers connected through a social or business network.  The extent of network clustering and amount of information each customer possesses becomes relevant in this model.  Progressive’s MyRate program employs social network effects by enabling policyholders to compare their driving habits online to those of similar policyholders.

Such effects—especially when compounded—drastically improve the efficacy of n-sided markets, or those that connect two or more different groups of customers/users to sellers/partners.
The insurance industry is a prime example of an n-sided market.  Consider therein the multitude of networked mechanisms including insurance groups and companies, agencies, brokerage firms, risk retention groups, departments of insurance, technology providers, business consultants and policyholders – just to name a few.
Consider also the industry’s absolute reliance on data, the massive amount of potential information contained within that data, and the fact that information contributes to the overall value of goods, and therefore the collective system.  The amount of intrinsic information/value then in such a system is inherently vast, but that value can be further amplified and exploited by applying positive network effects.
And no other school of thought is enabling the application of positive network effects better than Web 2.0.
Web 2.0
The term “Web 2.0” refers to the current evolutionary stage of web principals and practices that amplify online collaboration and empower end-users to create valuable networks of shared information. Tim O’Reilly, well-recognized Web 2.0 thought leader, further explains that:

Web 2.0 is the business revolution in the computer industry caused by the move to the internet as a platform, and an attempt to understand the rules for success on that new platform. Chief among those rules is this: Build applications that harness network effects to get better the more people use them.[iii]

The emergence of Web 2.0 was not planned. Rather, it’s core conceptual and technological underpinnings were derived from closely examining internet companies that survived the dotcom bubble of the late 1990’s and ultimately emerged as clear market leaders and innovators over the span of the last decade. But the recent codification of Web 2.0 principals and practices is enabling a bustling new era of user-centric, network enabled software applications. This Web 2.0 systemization dictates strategic positioning of the web as a platform, user positioning wherein users control data, and a broad set of core competencies, which include:

• Cloud Computing, which describes the provision of computing resources (software applications, networks, servers and data storage) as a service delivered through the internet. This can be viewed in sharp contrast to more conventional and dated means of provisioning, wherein businesses manage their own networks, servers and data stores, and IT staff is required to install, update and trouble-shoot software on individual devices. There are three basic service models for cloud computing:
  • Software as a Service (SaaS), wherein a consumer uses a service provider’s software applications on-demand, running on a cloud infrastructure. In this model, consumers do not manage the underlying infrastructure of networks, servers, data stores, operating systems or individual application capabilities. Users can, however, control software configuration settings and add modular software components. Google Apps is a key example of SaaS.
  • Platform as a Service (PaaS), wherein a consumer uses a service provider’s cloud infrastructure to deploy software applications. In this model, consumers do not manage the underlying infrastructure of networks, servers, data stores or operating systems. Consumers do retain control over the deployed software applications and hosting environment configurations. To this end, SalesForce.com enables developers to create new applications that can either add to existing SalesForce.com functionality, or create new functionality.
  • Infrastructure as a Service (IaaS), wherein a consumer utilizes the fundamental computing resources of a service provider, including data storage and network capabilities. In this model, the consumer can deploy and run any software of its choosing, including operating systems and applications. The consumer has little control, however, over the infrastructure itself, except with respect to select networking components such as firewalls. Many companies, such as Google, provide this infrastructure in tandem with use of their software. Other providers simply provide this service via data centers. This model can be likened to renting physical warehouse space, wherein the consumer has complete control over physical goods, as well as itemization and inventory techniques and shipping mechanisms. The consumer has very little say though as to how the warehouse is operated by its owner.
• Software above the level of a single device, which postulates that applications that are limited to a single device, such as a personal computer, are far less valuable than applications that integrate services across any device that provides internet access. Software that serves multiple platforms displays positive network effects.
• Architecture of participation, which describes the nature of systems that are designed for user contribution. One of the fundamental tenants of Web 2.0 is that users create value by contributing information to systems as a side-effect of ordinary usage. End-users contribute by creating hyperlinks to connect disparate information sources, and by adding to online information bases and SaaS feature-sets. Programmers are also enabled to contribute to cheaper and more agile open-source code and software standards through the architecture of participation.
• Harnessing collective intelligence, which involvesthesystematic collection, categorization and analysis of broad sets of usage patterns and user contributions to create actionable intelligence and increase value for all users. Collective intelligencesystems tap the expertise of a group rather than an individual for decision making purposes.  For example, PredictWallStreet.com focuses one million unique monthly visitors on predicting whether a stock will close up or down. Resulting algorithms are able to outperform the market, which individual analysts typically can’t do. Diversity of opinion, independence, decentralization and aggregation are required to effectively harness the wisdom of crowds.
• The importance of data, which describes the increasing significance of proprietary data and associated databases as a core competitive advantage, as opposed to storage and transfer technologies. Such technologies are becoming cheaper, more agile and more ubiquitous by the day, enabling companies to produce more accessible and more participatory data sources that can be quickly and continuously augmented to increase their value.
• Rich User Experience, which makes clear that web applications must be able to provide a user interface and base functionality that perform just as well as –  or better than – more traditional, device-dependent software.  Recent advances in mainly open-source technologies such as AJAX are enabling developers to build web applications that accomplish this directive. And by using the web as its platform, Web 2.0 systems are able to provide an enhanced set of network enabled, value generating features not typically found in non-web native software, including:
  • Blogs, or Web logs, which are online journals or diaries hosted on a Web site and often distributed to other sites or readers using RSS, or syndicated feeds. Blogs may be of a personal nature, or intended for a business audience. When used for business purposes, blogs are prime, easy to use enablers of thought leadership. Blogging software, such as WordPress.com and Blogspot.com, is often free, and enables blog subscribers or readers to post comments in an open environment for further discussion.
  • Mash-ups combine content from existing online sources to create new services.  For example, a mash-up might retrieve policyholder data from a networked database and display the locations of the policyholders elsewhere on a web-enabled Google map.
  • Podcasts are a multimedia form of a blog, typically containing audio or video content.  Podcasts are a method of broadcasting that does not depend on scheduled broadcasting times.  Rather, podcasts can be streamed or downloaded and played on demand.  iTunes is the most popular aggregator of podcasts. Because iTunes and the iPod were early enablers, the term “podcast” is a mash-up of the terms “broadcast” and “iPod.”
  • RSS (Really Simple Syndication) allows internet users to subscribe to online distributions of news, blogs, podcasts, or other information. Aggregators such as iGoogle and MyMSN combine RSS feeds from multiple sources to provide personalized access from a single portal.
  • Social networking refers to sites such as LinkedIn, which allow members to communicate, form groups, and access other members’ personal information, skills, talents, knowledge or preferences. Such sites have experienced explosive growth within the past few years, and collectively boast membership in the hundreds of millions. Social networking concepts can also be applied to other types of web applications.
  • Web services enable communication between disparate systems in order to automatically pass information and conduct transactions.  For instance, an insurer and an insurance agent might use web services to communicate over the internet and update each others’ various systems without the need for multiple, manual updates.  Web services also enable service oriented architecture (SOA) which builds interoperable services around business processes.
  • Wikis are systems for collaborative publishing, which allow many authors to contribute to an online document or discussion.  The foremost example of a popular wiki is Wikipedia, which greatly exemplifies the principals of architecture of participation and harnessing collective intelligence.

Also fundamental to Web 2.0 is the ability for users to create hyperlinks and post comments. To this end, Web 1.0 can be considered “read-only” from the end-users’ perspective. In the former model, web masters prescribed static hyperlinks to connect disparate web sites, or to navigate to different pages within the same website. Additionally, end-users were merely provided access to site content, lacking the ability to provide open and transparent feedback by way of comments and replies. This model ultimately reflected the limited role of consumers during the industrial and mass-media dominated eras.
Conversely, Web 2.0 can be considered “read-write” from the end-users’ perspective. In this model, users are afforded the ability – and indeed imbued with the obligation – to create hyperlinks. Or as the aforementioned Tim O’Reilly so elegantly writes:

As users add new content, and new sites, it is bound to the structure of the web by other users discovering the content and linking to it. Much as synapses form in the brain, with associations becoming stronger through repetition and intensity, the web of connections grows organically as an output of the collective activity of all web users.[iv]

Web 2.0 end-users are also provided dialectically transparent feedback mechanisms packaged with site content, typically in the form of commenting functionality. Most Web 2.0 site content, and almost all blogs, includes the ability to post comments, thus removing the barriers between author and reader and between all readers. As such, content consumers can initiate further, elucidated discussion, and keep authors and content providers honest. Further to this, many web applications that enable users to share hyperlinks also provide mechanisms for commenting on the hyperlinked content.
Deriving Value from Web 2.0 Enabled Network Effects
Much as been written (and even lamented) about the insurance industry’s apparent sluggishness to adopt and implement new technologies, particularly in the realm of Web 2.0. In fairness, the insurance industry represents a massive and necessarily risk adverse n-sided market, subject to more rigorous standards and complexities than most other industries.
But we have reached a tipping point where much of the risk involving Web 2.0 has already been assumed by leaders such as Google and Amazon.com. Web 2.0 companies are thusly beginning to target the insurance industry with new technologies and methodologies at break-neck speed, and it is widely believed (for a variety of reasons) that companies who do not make the switch to Web 2.0 will ultimately suffer, mired in decreased competitive positioning. So let us discuss some of the ways in which insurers can derive value from web 2.0 enabled network effects:

• Embrace the cloud. Cloud computing represents a sea change in modern business operations, and one which the insurance industry must embrace sooner rather than later. As it is, modern businesses must concentrate, first and foremost, on their core competencies. And no other facet of insurance operations is more distracting than maintaining dedicated, internal resources for software maintenance, network and server architecture, and data storage. Cloud computing provides software and operating platforms  locked in states of perpetual beta, in which improvements are constantly made and rolled out without interruption to the end-user. Additionally, the storage of data off site negates the need, almost entirely, for companies to employ and manage network administrators, and actually keeps data far more secure than any insurance company is capable of. The development of cloud computing now also means that business objectives are no longer limited to IT objections based on the availability of limited, internal technology or IT competencies. In past decades, such restrictions enabled IT staff to dictate the ultimate reach of many business decisions. But cloud-based systems are malleable, built and customized directly in support of business operations, not IT proficiency. Lastly, and perhaps most importantly, insurers in today’s economy must operate leaner and meaner than in more fiscally liberal times. Resources must be dedicated to business imperatives, and not unnecessary software, server and data storage licensing costs and expenditures. Cloud computing ultimately presents companies with enormous potential for cost savings. (To this end, the City of Los Angeles will save $13 million in software licensing and manpower costs over the next five years, simply by adopting Google Apps hosted solutions.)
• Mobilize your workforce. Web 2.0 software that serves multiple devicestranscends geographic limitations, thus drastically increasing productivity and improving collaborative business processes. So make sure that your workforce is capable of performing any base function from anywhere (reasonably speaking) in the world. For instance, mobile claims adjustors, who can process claims real time and on-site, present drastic improvements in efficiency. Furthermore, any member of a workforce should be able to access and edit information or internal documents directly from a database through the web. This stands in start contrast to the former models of e-mailing documents back and forth between onsite and offsite workers, or downloading documents from the company’s server for use on a different device, which effectively creates new versions of the documents for each instance of use.
• Establish architecture of participation. Again, one of the most beneficial aspects of Web 2.0 is user generated content, given that users create value. So implement systems that support and employ this effect. Encourage all nodes in your network, including consumers, to contribute to your total information base through wikis and other forms of online discussion. Enable your end-users the ability to comment on and create hyperlinks to all pertinent web pages and information bases, and watch the value of your systems and inherent information grow exponentially.
• Harness collective intelligence. Collective intelligence is market intelligence, so make sure that your systems are capable of collecting and analyzing usage patterns, user feedback and other data created through use of your systems. A simple example to consider is the ease in which online surveys can be created, conducted and analyzed entirely online. Savvy companies are relying increasingly more on such efficient mechanisms to gather user feedback, and turn the wisdom of crowds into actionable business intelligence.
• Focus on creating unique, hard-to-duplicate sources of data. Again, the increasing ease and ubiquity of data collection, storage and analysis is enabling companies to instead focus on the production of richer, deeper data sets as a competitive advantage. And in addition to using such data sets for improved rating and underwriting techniques, insurance organizations can leverage valuable data sets to sell to other organizations. Although this activity centers mainly on service providers, the potential spans all organizational types in an industry that views data as one of its most important and valuable assets.
• Provide a rich user experience. Consumers are relying more and more on the internet to locate coverage options, receive and compare quotes and manage their policies all online in real-time. Further to this, consumers are looking for quicker, easier means of self-service, which Web 2.0 is enabling far better than past methods. So a rich user experience, when done right, can contribute both to new customer acquisition, and customer retention. Additionally, Web 2.0 is proving to be the most effective tool available to an organization’s branding and marketing wings. Contemporary, successful marketing and branding smartly focuses its attention to blogs, podcasts and other forms of interactive social media to reach target audiences faster, more efficiently, and cheaper than ever before. And by making the branding and marketing processes two-way, consumers are feeling more comfortable and providing more direct feedback in a climate where consumers otherwise cynically view non-inclusive marketing techniques as indifferent to their actual wants and needs. Furthermore, Web 2.0 enabled marketing techniques enable real-time analysis of the ultimate success of marketing efforts. And finally, with Web 2.0 web applications providing user interfaces that rival those of traditional software, replacing legacy systems becomes a much easier sell.

Conclusion
This article by no means attempts to provide a final, definitive resource for network effects and Web 2.0, nor does it claim to provide an exhaustive list of all pertinent elements and methodologies. This article does aim; however, to highlight the benefits of Web 2.0 enabled network effects for an industry that is primed and ready for major innovation.
The article’s author would urge the reader to use this information as a starting point – either for debate, or for new considerations for operational excellence. Readers who wish to pursue this topic further would be well served by reading Amy Shuen’s Web 2.0: A Strategy Guide.
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