The power of defaults

There are several types of network effect that should be properly understood:

• Direct network effects: they occur when the number of users has a direct impact on the value of a product.
• Indirect network effects: they occur in two-sided (or multi-sided) products where the size of one user group affects how valuable the product is to another user group.
• Data network effects: describes products which become better with more users via the data those users generate.

Switching costs describe how difficult or expensive it is for a user to switch from one product to another.

Multihoming costs explain how easy or likely it is to use multiple competing networks simultaneously.

In general, the higher the switching and multihoming costs, the more defensible a network typically becomes.

Telephone and railroads companies are more defensible than companies such as Facebook and Google because their business mainly relies on atoms instead of bits.

In contrast to bits, atoms have marginal costs. You can copy and paste a piece of software at virtually zero cost, but producing an additional piece of hardware has all sorts of marginal costs associated with it. This means that atom-based network effect businesses have switching and multihoming costs.

Value chains are horizontal visualizations of all the value-adding business activities involved in creating a product or service from start to finish.

Value chains are great to analyze traditional businesses and industries but they are not a very useful framework for tech companies.

If you want to understand the power dynamics between different platforms, aggregators and other players in a tech ecosystem, it’s better to look at them as a vertical stack with different layers.

On each layer of the stack, companies are trying to create value and to capture value. The lowest layers of the stack are typically the most powerful. If you are able to take control of a layer, you can dictate the terms of most of the value creation and value capture that is happening in the layers above you.

As a result of the vertical stack, companies are trying to:

1. Create layers on top of their business (everyone wants to be a platform)
2. Move down the stack to get closer to the base layer (to increase defensibility)

The base layer is the final interface between the stack and the end user – which is typically an operating system tied to a piece of hardware.

But what if the end of the stack isn’t an interface? What if the lowest possible layer in the stack is actually the user itself?

Identity is a crucial component of almost every single layer in the stack. Every network is just a collection of nodes and if you want to build connections between those nodes you need an identity layer. Even in a pseudonymous network, each user has a consistent identifier.

Unsurprisingly, dozens of companies are trying to become the default identity layer.