The Sunday Drip #9 | How network effects and switching costs impact web3
Everyone is saying web3 is going to be different, but it feels like we've seen this film before, and we didn't like the ending.
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Kallaway already wrote about network effects in his Crypto Therapy post here, but network effects for web3 are really really important. Really important. So I am going to keep talking about them today, but with a focus on how web3 achieves network effects. If they can achieve them…it’s still a big question for me.
Some background info on network effects.
Kallaway used the Investopedia definition, “the network effect is a phenomenon whereby increased numbers of people or participants improve the value of a good or service.”
Simply put, network effects happen when more users make the platform more valuable.
Additionally, I want to call out that there are direct and indirect network effects that are also important to separately define (thank you business school classes):
Direct Network Effects: (Customers) Value of product increases with number of users. (Dating Apps, Apps)
Indirect Network Effects: (Complementary) Value of product increases with number of complements. (Video game consoles and video game titles, App stores and apps)
These are also very important to know and be able to identify in web3. A big problem with network effects is that network effects increase the inherent value of a product irrespective of the product’s quality. It’s a huge problem in web2 and it’s also true in web3. But I’ll get to OpenSea later :)
Web2 network effects were all about losing money.
Web2 had a very predictable playbook when it came to achieving network effects.
Step 1: Acquire as many customers as possible
Step 2: Attract VC money to develop a product
Step 3: Profit… off your customer base
Some of this strategy was about achieving scale, cost efficiencies, and building a moat/increasing the barrier of entry for competitors. But, every major web2 company started by losing a sh*t ton of money in an effort to acquire customers to achieve that strategy.
Amazon lost money acquiring customers and building warehouses for over 15 years. Uber lost (is still losing?) money attracting drivers and riders. Netflix might still be losing money acquiring content and customers. Facebook attracted users, and acquired Instagram, before turning on their advertising engine. Spotify, Wayfair, Lyft, Tesla, Nikola, Snap, TikTok and literally every major tech company.
It’s not their fault though. Web2 rewarded that behavior.
Web2 encouraged companies to build moats and honeypot their users into their ecosystems. Web2 rewarded sh*tty behavior. It sucks, but these companies are not incentivized to take the high road, so they don’t. They spend all of their time and money blocking competitors from entering their space and they do everything they can to stop you from leaving their platform.
Instagram gets you on to the platform with a great experience and cool ways to interact with your friends. Instagram creates tools for companies and influencers to make money by selling ads and pays them by the view. Most people don’t realize that we, the user, are Instagram’s product. Instagram advertises to us and sells our data and makes a ton of money doing that. Google, Apple, TikTok, and Amazon too. We collect our likes on Instagram and they cash out. Think of Spotify too. More listeners on the platform helps Spotify pay artists less per play. What? They give Drake an exclusive launch, to drive more listeners to Spotify, to pay less per stream. (S/O Joe Budden for rallying against exclusive launches)
These companies all make it impossible to get off of their platforms too. You’re locked in by your playlists on Spotify, your friends (and data and pictures) on social media sites, your email on google, and so on. Apple shames your android friends with green text bubbles. Smarter people with more time could come up with better examples. Web2 marries you to companies and you get stuck with them and a declining product that only they can build on.
I’m not even going to touch the fact that most companies build products on open source code and don’t contribute to it at all. Also, I don’t know the B2B world very well, but the lock-in for B2B is 100x worse.
Web2 rewards the worst behavior. But you’re probably asking yourself…
Is web3 going to be any different?
Let’s look at NFT darling OpenSea.
The first major player in the web3 space that looks anything like a FAANG company is OpenSea. OpenSea is basically at this point the Amazon of digital goods. It is thee NFT marketplace, and is growing larger and faster than any other marketplace for digital products. It was born in web3 but is quickly looking like a web2 company.
OpenSea quickly achieved massive network effects with the number of users on their platform. More users means sharper prices and faster sales of NFTs for the users on their marketplace. OpenSea takes a 2.5% cut of every sale, but none of that money seems to be able to help them stay online. OpenSea is funded by VCs and other investors, andddd the users don’t own any part of it..
Fc*k. We did it again.
How did we, the NFT buying, web3 maxi, decentalized degens, let this happen again? Of all people? Us? We use Discord and operate anonymously! But now we’re lining the pockets of VCs and getting nothing in return.
I might have intentionally led us astray in an effort to build literary suspense. I am a writing genius, I know. OpenSea hasn’t gotten away with anything yet.
Web3 is a little different.
While it’s true that everyone is using OpenSea just because everyone else is using OpenSea (network effects!), this is different because of how web3 crypto wallets work. Crypto wallets like MetaMask hold all of our NFTs (not OpenSea) and they allow us to unplug from OpenSea in an instant. Crypto wallets create low switching costs for users.
You could probably do this with your etrade account, but you don’t because it is unnecessarily complicated. In the music world, there are even businesses that popup like TuneMyMusic, that help you overcome these switching costs that Spotify builds up, by helping you switch your playlists between services. This composability that web3 wallets have is an extremely important difference.
Public data is another key difference in web3.
Take a look at the way the NFT marketplace LooksRare launched. LooksRare used what is called a “Vampire Attack” launch strategy. Since all of the sales data on OpenSea is public and on the Ethereum blockchain, LooksRare tried to poach all of the existing OpenSea users by airdropping them LooksRare tokens, which essentially act as shares in the new marketplace. The amount wasn’t insignificant either, my $LOOKS were valued at around $10k within the first week and I am no where near a top OpenSea spender.
Could you imagine if you could just unplug all of your tweets, Instagram pictures, or even your bank account information and switch over to a new service? Especially one that would financially incentivize you? Comcast is shaking in their boots.
OpenSea is aware of the low switching costs of their product. They will address it. Don’t you worry.
OpenSea hired Lyft’s Brian Roberts to help them launch an IPO (oh wait). When news of this spread through the crypto world, the users of OpenSea revolted, expressing their feelings all over Twitter and threatening to leave. Because of low switching costs, users of OpenSea have leverage against the company and can demand that they be financially rewarded for the company’s success. Maybe they will demand a site that works occasionally. Maybe web3 is the solution to the billionaire situation. We’ll see as more of these large web3 companies need to make major funding decisions in the future.
I’m getting ahead of myself. The low switching costs are somewhat specific to NFT marketplaces, and companies will figure out how to lock users into their products. Web3 is slightly different and users can demand more from companies, their data is public and private all at the same time, and those are big steps in the right direction.
But that’s only the small point I wanted to make (again, writing mastermind over here). The network effects will change with web3.
Web3 network effects will be all about complements and composability.
The other half of network effects are the indirect network effects, aka the value of product increases with number of complements. This is something we are already seeing with the Ethereum blockchain. When companies, NFTs, other cryptocurrencies, metaverses (you get it), build on Ethereum, it becomes more valuable. There are more and more complements being built on the Ethereum blockchain every single day. Many of them making it better and
easier cheaper to use, such as layer 2 solutions like Polygon and the Matic Network.
It’s not just the blockchain where complements are being built. Take a look at gaming in the crypto space. Players can earn tokens and buy NFTs to be used in several different games. Everything doesn’t have to roll up into a single main company like Epic. Check out $MAGIC, the cross game currency, where a game developer can launch a game that accepts $MAGIC.
Of course, I couldn’t get through a whole article without talking about RTFKT. Check out the early plans that RTFKT has for their Space Pod ecosystem. Oh no, ecosystems? Don’t worry, these are closer to opensource ecosystems than they are to trying to convert from a PDF to Word (special f*ck you goes out to Adobe and Microsoft).
RTFKT hints, “this is the start of something much bigger and we aren't be the only ones building.” That is awesome. They are even encouraging all users to start learning how to use 3D modeling tools like Blender. This is composability. RTFKT won’t be charging a percent for other companies to use their metaverse like the Apple app store or Google search results or Amazon search results (can we stop acting like these aren’t pay-to-play?). This is progress.
One major question I don’t have an answer for is on funding. Companies and VCs with massive bankrolls will want to create the web3 Amazon. It’s good business for them. Web3 unicorns are good for them. Allowing the masses to switch off of their platforms they invested billions into is bad for them.
These investors are going to be the bad guys in web3. We need to be aware of this and swat them away.
What’s the verdict? Is web3 different?
This is my way of saying “what’s the point?” Like I do in my other articles. Masterclass in writing and web3 commentary right here.
Yes. Web3 is different, but we need to be diligent with how it is designed. Web3 has many built in differentiators like crypto wallets and public blockchain data. It gets to call itself different. Users are given more leverage by owning their own data in their crypto wallets. Tokens enable companies to incentivize and reward users when companies profit off of them. And switching costs are lower with web3, but not zero.
BUT. The community and users of products need to be wary of web3 companies building up switching costs. This is my warning. If we get locked into products, we will quickly find ourselves with no equity and a billionaire founder charging us 5% for every transaction in their metaverse. The network effects will attract us and switching costs will trap us.
Web3 is our fresh chance to build an opensource, composable internet. We need to be ready for honeypots and we need to support the companies that build open ecosystems.
Oh and we probably need to listen to Jack. Damnit.
Agree? Disagree? Comments? Questions? Let me know! Possibly some typos.