In-depth Analysis of Web3 Network Effects: Five Mental Models

Compilation: ChinaDeFi, Planet Daily

In the past decade, network effects have driven the rise of Web2 platforms, establishing their dominance while igniting the imagination of builders and investors. Some believe that network effects will be even stronger in Web3, while others argue that Web3 will stifle network effects.

Amid all the hype surrounding Web3 discourse today, the answer to this question lies in reshaping our mental models of network effects. What we learned in the Web2 world may not directly apply to the Web3 world. To understand network effects in the Web3 world, it is helpful to rethink network effects from first principles and understand what changes when we transition from Web2 to Web3.

This article will delve into five mental models.

Network Effects in Web2 and Web3: Four Key Differences

To understand network effects in the Web3 ecosystem, we first need to delineate the differences between the Web2 and Web3 ecosystems and understand how these differences affect the emergence of network effects.

First, in the Web2 ecosystem, market infrastructure is created by platform providers. In contrast, in the Web3 ecosystem, market infrastructure is not provided by platform providers but needs to be built by the ecosystem, either through resource commitments (such as storage capacity commitments) or through infrastructure development. Therefore, creating and scaling network effects presents unique challenges for the Web3 ecosystem, requiring not only the coordination of market activities (as with Web2 platforms) but also the coordination of market infrastructure development.

Second, token value provides an additional leverage for initiating and expanding network effects. Market activities are managed through tokens. Producers may be incentivized to supply the platform early in exchange for tokens that appreciate in value as market activity increases. Similarly, developers responsible for building market infrastructure may be incentivized to create core infrastructure components in exchange for tokens. Tokens provide a new incentive mechanism that is absent in the Web2 ecosystem.

Third, the portability of data and reputation, combined with technological interoperability, significantly reduces the defensibility of network effects in Web3. Even if the Web3 ecosystem quickly establishes network effects, they cannot extract residual value from user data as effectively as Web2.

Finally, the Web2 ecosystem is primarily composed of market participants. The Web3 ecosystem must consider not only participants at the market layer but also those at the infrastructure layer, financing layer, and governance layer. Web2 markets like Etsy are open to third-party sellers but primarily create core market infrastructure internally and manage funding and governance centrally. In contrast, Web3 business protocols need to:

• Organize the creation of market infrastructure around infrastructure layer protocols,

• Manage token liquidity to drive financing in the financing layer and token value appreciation (which in turn incentivizes all participants),

• In the governance layer, extend governance to ecosystem participants beyond the initial team.

Let’s break these down while discussing the various mental models surrounding Web3 network effects.

Mental Model #1: The Nature of Value

Web2 networks primarily rely on two sources of value: standalone/product value and network value. Web3 provides an additional leverage of value: token value. This is a crucial design leverage when planning Web3 network effects.

Standalone Value: The value that exists when no one is using a platform, derived solely from the underlying product, is referred to as standalone/product value. This is the value that users experience on the platform independent of other users using the platform. The first user on the platform can benefit from this standalone value. As more users join, the standalone value of the platform remains unchanged. Standalone value is typically presented in the form of value provided by platform technology.

Network Value: The value conferred to the platform due to the use of other users on the platform is called network value. This is the value created on the platform through the activities and usage of other users. When a platform starts with no users, it has no network value. The first user to log onto the platform does not benefit from network value. However, as the frequency of other users using the platform increases, the network value on the platform also grows.

On Web2 platforms, the community is primarily composed of platform users (producers and consumers). On Web3 platforms, network value is further enhanced because nearly all value creation in the Web3 ecosystem is driven by the user community.

There are many examples to illustrate the above differences. Instagram initially started as a standalone app with beautiful filters before it unlocked network value as a mature social network. Square was initially a tool to turn a phone into a credit card terminal before it began building network effects using the Square Cash app and other components of the Square ecosystem.

Token Value: The value generated from the native tokens associated with the protocol on Web3 platforms is referred to as token value.

As we mentioned earlier:

Protocols—more specifically, permissionless blockchain protocols—provide a new organizational and governance mechanism to organize participants in the ecosystem. Unlike platforms, protocols do not provide end-to-end market infrastructure nor internalize transaction oversight and verification. Since protocols themselves do not provide market infrastructure or internalize transaction oversight and verification, they need to offer economic incentives for other ecosystem participants to provide these services. They achieve this by issuing tokens to reward ideal behaviors within the ecosystem. As the value of market activity in the ecosystem increases, the token value associated with protocol usage also increases.

As the usage of the protocol increases, the value of the tokens associated with the protocol also rises. Early users (incentivized/rewarded by tokens) may benefit from the appreciation of token value over time. Therefore, token value provides an additional leverage to initiate and expand network effects.

Tokens provide strong incentives for creating network effects. However, as we will point out in subsequent articles in the coming weeks, tokens are not a panacea. Tokens need to be carefully designed to ensure they incentivize and restrain core actions that impact network effects.

Mental Model #2: Managing Market Activity vs. Market Infrastructure

Another distinction of Web3 networks is the definition of network composition. Web2 networks primarily consist of market participants involved in value creation and exchange: producers and consumers. While developers can extend Web2 platforms, the core market infrastructure is provided by platform owners.

In Web3, market infrastructure is created by participants. Resources (such as computing, storage, etc.) can be submitted by ecosystem participants rather than being centrally set. Developers build market infrastructure around protocols, providing functionalities for producers and consumers to participate in the market.

As explained in "Unbundling the Unbundlers":

In the Web2 world, market infrastructure and market governance are bundled together by platforms. Markets like Amazon, eBay, Upwork, Uber, and other similar platforms bundle market infrastructure (in Amazon's case, even the physical infrastructure through FBA and Amazon Logistics) with market governance.

In the Web3 world, market infrastructure is separated from market governance. While the core components of market governance are encoded into the protocol layer, the components of market infrastructure can be built by the ecosystem surrounding the protocol.

Since market infrastructure requires external construction, the building of market infrastructure needs to be synchronized with the scaling of market activities.

When managing network effects on Web2 platforms, platform managers need to manage the matching between supply and demand. For example, if Airbnb's early listings are all in Denver, but users are searching for listings in New York, then transactions will not occur. Web2 network effects require managing the overlap and matching between producers and consumers, while Web3 network effects management requires additional coordination and matching between established market infrastructure and supported market activities. For instance, if users on a Web3 platform seek a specific type of search interface, the platform may need to incentivize developers to participate in that specific project by offering rewards, encouraging innovation in search interfaces to meet those demands.

In summary, managing Web3 network effects requires not only initiating and managing market activities but also managing their coordination with the scaling of market infrastructure. When Web3 ecosystems achieve this balance, they benefit from a positive feedback loop that further amplifies these ecosystems:

Mental Model #3: Counteracting Churn, Building Defensibility

One of the key differences between Web2 and Web3 is that Web3 has relatively lower defensibility against network effects.

The defensibility of Web2 comes from four forms of stored/accumulated value: data acquired by the platform, content provided to the platform, reputation built on the platform, and influence created on the platform.

As I explained in a 2012 article:

Creative Content: Users invest in creating a portfolio of creative content, which is the basis for their interactions on the platform.

Reputation: Building a reputation on the platform requires consistently providing high-rated services, which may also need to meet some minimum standards set by the platform. Therefore, once a service provider establishes a reputation on one platform, it hinders their migration to a competitor's platform.

Usage Data: The more information users consume through the platform, the smarter the algorithms become at recommending relevant content to users.

Influence: As the number of followers increases, the stored value in the network and the motivation to maintain active participation also increase.

All four forms of accumulated value are tied to specific platforms in Web2, while in Web3, they can be easily transferred across platforms. New markets can easily aggregate available NFTs and draw users toward them. Users can easily transplant their data and activities to new platforms.

While Web3 has the potential to trigger an explosion of innovation, the ability of any single platform to retain innovation and sustain its appreciation is declining.

Any strategy for building network effects in Web3 needs to consider its lack of accumulated value. It also needs to account for the lower switching costs. As we will point out in upcoming articles, Web3 requires a new set of factors to provide defensibility for network effects.

Mental Model #4: The "Extraction" of Management

High switching costs create defensive network effects that lead Web2 platforms to indulge in (and benefit from) excessive extraction (whether through fees or data) and control (through bait-and-switch, lock-in, commoditization, etc.). As switching costs collapse, extraction will lead to the reverse disintegration of network effects.

Creating and managing network effects in Web3 requires addressing the ease of switching, thus needing to tackle the extraction issue. This is particularly important because, unlike Web2, market infrastructure and resources in Web3 are provided by the ecosystem. To provide resources and innovative capabilities, ecosystem participants need to ensure that their investments can yield appropriate returns and have sufficient institutional protections against commoditization and policy changes.

In the Web3 ecosystem, extraction is key to managing network effects. In a world of open-source protocols, excessive extraction will lead to forks, and the activities of ecosystem participants will drift away from the original protocol. Advanced coordination mechanisms in Web3 also allow ecosystem participants to abandon one protocol and organize around a forked protocol.

Mental Model #5: Managing Role Agency and Risks

High switching costs also enable Web2 platforms to bait-and-switch, change policies, and deprive ecosystem participants of their rights.

Given the lower switching costs in Web3, managing role agency will be crucial for managing and maintaining network effects.

Managing role agency is key to managing network effects. Governance bodies will need to build and distribute governance tokens to allocate agency, control, and management of the platform beyond the founding team (and other insiders).

As protocols become more successful, the associated governance tokens may become more valuable, further strengthening network effects, as key contributors holding tokens can benefit not only from returns but also have the ability to shape future roadmaps and organize resource allocation and corresponding participation incentives.

Conclusion

Web3 network effects are different. They bring new coordination challenges, support new incentive mechanisms, rewrite traditional rules of defensibility and extraction, and reconstruct the power balance between platforms and ecosystems. As illustrated by the five mental models above, Web3 network effects will require a completely new playbook: new onboarding and scaling models, new governance mechanisms, new sources of competitive advantage, and new forms of value capture.