Regulating against network effects: six ideas

Birds on the wire

I recently wrote about network effects, which are well described in the book Blitzscaling by Reid Hoffman and Chris Yeh. The approach the authors advocate is rather controversial and the ills it can lead to were recently outlined by Tim O’Reilly, who claimed this approach has gone from “premise to doctrine” in Silicon Valley.

To recap: network effects result in the winner taking it all, meaning there is a huge incentive to take capricious risks. The winner must not only put their and their investors‘ well-founded reservations aside but pay little regard to societal and other ethical concerns. Or so says the charge sheet.

Andrea Nahles, the General Secretary of Germany‘s Social Democratic Party, proposed a “data for all” policy in the Handelsblatt last August. Justus Haucap, an expert in the field of competition regulation, welcomed the suggestion and stated the challenge in broader terms: you need to open access to the resource that is the cause of monopolistic advantage in the same way transport and telecom networks have been opened up in the past.

Alas, only some network effects are the result of “big data” and I think this is a crucial point missing both in Nahles’ proposal and Haucap’s evaluation of it. Most network effects are a result of an extremely loyal user base with little incentive to leave but every incentive to stay. Who would favour a WhatsApp clone if no-one else used it, or boycott PayPal if few shops offered an alternative form of payment? Future regulation strategies must take this into account as much as data. Treating access to databases of users like power lines or transmission frequencies will open up a can of worms with data protection written all over it.

But there are things we can do – here are some ideas from an interested non-expert.

0. Do nothing

Yes, this is always an option to be considered.

There was an article in Die Zeit over Christmas outlining Peter Thiel’s philosophy on competition. He says competition is a bad thing because people should be encouraged to covet things others don’t, instead of fighting over limited resources. While there is some truth to this – see my previous article on overblown promises – the problem with network effects is the type of competition they encourage, not just the competition they suppress. In the beginning, the competitors engage in a scorched earth battle for dominance – a competition to exclude competition. It’s not necessarily the eccentric free-thinker who wins but whoever can raise the most money and execute ruthlessly.

Moving so fast that authorities can’t uphold regulations, buying up innovative competitors, angering customers, frazzling piles of cash, working inefficiently: these are all features, not bugs, of Blitzscaling and network effects incentivise this.

But that’s still not to say that state regulation is the answer. Even Tim O’Reilly concludes with a catalogue of pleas addressed to the investment community not the state.

After all, companies like Airbnb, Uber, Lyft, Spotify and others have yet to prove their strategy is ultimately a profitable use of investors’ money. Perhaps in ten years it will have proven itself as crazy as it appears? The dotcom boom was enough to make investors wary of tech for tech’s sake and perhaps the perils of pursuing network effects will equally become a lesson from history.

Nevertheless, let’s do this the European way and get our regulatory rubber gloves on while keeping in mind those two important things: blue ocean thinking is more innovative and arguably less aggressive than needless competition, and network effects may have a limited shelf life that limits the risk worth taking in pursuit of them.

1. Data for all

This is not my idea, but Andrea Nahles’. It would go some way to addressing those network effects that are a result of access to data. For example, Netflix’ and Amazon’s recommendation engines use big data coupled with artificial intelligence to predict what people will want to watch or buy next. Not having access to that data means you can offer less attractive services, attracting fewer customers, and less data. Nahles’ proposal is to force a player to give competitors access to a representative sample of anonymised data if their market share goes above a certain size. This presents data-protection challenges and doesn’t address the problem of user loyalty based network effects.

2. Ban acquisitions of competitors 

Facebook and Google becoming overwieldy is a common gripe. But I don’t understand exactly what breaking them up is intended to achieve (which doesn’t mean it’s a bad idea). I can only imagine it means breaking up individual services, but also stopping acquisitions of competitors in the way that Facebook acquired Instagram and WhatsApp. The argument for this course of action would be that by acquiring competitors, incumbents can throttle competition. However, I’m not sure that is the case. Arguably Instagram and WhatsApp are “blue ocean” products that go in a different direction from Facebook. Facebook’s strategy appears to be covering all bases in future, so instead of getting overtaken by new innovations, they can channel their existing users into them. I think this is damaging because it enables Facebook to gain long-term value out of their user base, shutting out potential competitors to Instagram and WhatsApp, which might have done the same thing better and more innovatively, but stacking the odds in favour of their own services. Similarly, in cloning, for example, SnapChat’s features in Instagram and Facebook Messenger, Facebook makes innovation less rewarding: Facebook and its acquired or copycat products succeed because of their user-based network effect, not because they are innovative or offer a better service.

Is breaking up Facebook necessary? I don’t think it is the only way to deal with this problem. The real problem is Facebook seamlessly passing on users to new products, whether acquired, copied or even invented itself. This protects it from a from-scratch competition for users in exactly the same way Microsoft tried to advantage its own Internet Explorer by packaging it with Windows.

3. Ban user profile sharing

Bearing in mind the above, there is another way. You could say that Facebook, Google and the rest can have as many products as they like, and they can acquire them if they want. But they should not be allowed to tip the odds in their favour by using their existing user base to establish a network effect from the beginning. This should include nudging users to connect their existing account to a newly acquired service (such as Instagram) – instead, the competition for users should begin on equal terms. All the users Facebook acquired with Instagram or WhatsApp could, of course, remain on that service but merging them would be a no-no.

This could be a pain in the posterior for users though. Imagine a Facebook user having to sign up again and submit all their data and reconnect with all their friends to user Facebook Messenger. I would argue, however, that Messenger was a feature for a long time, and part of Facebook just like groups. But when you start spinning it off into a separate product with its own app, this is where it becomes uncompetitive.

4. A level playing field of user portability

There is a solution for moving users though: if platforms think convenience is more important than shutting out the competition.

The exception to idea 3 would be if a service offered an interface where people could port their profile to competitors just as easily, and with just as much nudging and advertising, as the company’s own products. So if Facebook were to give users the opportunity to join WhatsApp with one click (or vice versa), this would only be permissible if a similar opportunity with just as much advertising and nudging were available for all competitors in the product category.

This way, if a company with an existing network effect tried to take their advantage with them to another product (which can be quite convenient for users who don’t want to sign up several times), then users would immediately be given a choice and the competition would have a big opportunity to compete on equal terms.

5. Open standards for mature products/features

I haven’t thought this one through right up to the end, but I think there could be an opportunity around opening up products that have stopped innovating. These products would be standardised in a way that would enable other providers to access users in the same way you have email clients that work to a common standard, but nevertheless innovators such as Gmail who add functionality on top. It would mean I can use Messenger to communicate with people who aren’t on Facebook. I am aware that this is by no means a panacaea – the email standard, because it is in so wide use, hasn’t really been updated for a long time. It certainly doesn’t support native encryption, which was an oversight right at the beginning that hasn’t been satisfactorily rectified even now.

6. A shorter shelf-life for network effects

All in all, I don’t think we are going to be able to take the traditional approach to monopoly aversion, i.e. identifying a resource and making it available to everyone. We can, though, take a Thiel-style approach of encouraging innovation in a manner whereby new entrants do truly different things, and accept that they will, for a while, enjoy a user-based network effect because one of the great things about the internet is that you can use it to contact pretty much anyone. However, reducing the value of these network effects by making them less portable (stopping someone with a network effect taking it with them to prop up an inferior product), and giving them a shelf-life, is possible without reducing usability. This would be regulation doing what it is there to do: letting the market do what it does best (which is what we learned from O’Reilly’s approach), while guaranteeing a level playing field for true innovation.

Yes, the winner would still take it all, but only for a limited time. This would devalue network effects, with the pleasant side effect of making so-called Blitzscaling less attractive. Making the titans a little sluggish and electrifying the minnows.

Photo by Slava Bowman on Unsplash


Originally from Birmingham, UK. Studied Law at Exeter and Saarbrücken from 2001 - 2005. Moved to Hamburg in 2010.