Web3 network effects will require a whole new playbook.
Over the past decade, network effects have fueled the rise and dominance of the Web2 platform, while sparking the imagination of builders and investors. Some people believe that network effects will be stronger in Web3, while others believe that Web3 will kill network effects.
With all the hype that plagues Web3 discourse today, the answer to this question lies in reshaping our mental models of network effects. What we learn in the Web2 world may not apply directly to the Web3 world. To understand network effects in a Web3 world, it’s helpful to rethink network effects from the fundamentals and understand what changes when we move 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 define the differences between the Web2 and Web3 ecosystems and understand how these differences affect the generation of network effects.
First, in the Web2 ecosystem, the market infrastructure is created by platform providers. On the other hand, in a 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, not only in coordinating market activities (as the web2 platform does), but also in coordinating the development of market infrastructure.
Second, token value provides additional leverage of value for initiating and scaling network effects. Market activity is managed through tokens. Producers may be incentivized to supply the platform early in exchange for tokens that increase in value as market activity increases. Likewise, 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 not available in the Web2 ecosystem.
Third, the portability of data and reputation, coupled with the interoperability of technologies, makes network effects much less defensive in Web3. Even if the Web3 ecosystem rapidly builds up network effects, they cannot extract residual value from user data as effectively as Web2.
Finally, the Web2 ecosystem is mainly composed of market players. The Web3 ecosystem needs to consider not only players at the market layer, but also players at the infrastructure layer, financing layer, and governance layer. Web 2 marketplaces like Etsy are open to third-party sellers, but primarily create the core marketplace infrastructure in-house and centrally manage funding and governance. Instead, the Web3 business protocol requires:
Organizing the creation of market infrastructure around protocols at the infrastructure layer,
Manage token liquidity to drive funding layer funding and token value appreciation (which in turn incentivizes all participants),
At 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
The Web2 network relies primarily on two sources of value: standalone/product value and network value. Web3 provides an additional leverage of value: token value. This is a very important design lever when planning for web3 network effects.
STANDALONE VALUE: The value that exists when no one uses it on a platform, and only comes from the basic product. This value is called independent/product value. This is the value that users experience on the platform from using the platform independently of other users. The first users to use the platform can benefit from this independent value. As more and more users join, the independent value of the platform will remain the same. Independent value is often presented in the form of value provided by the platform technology.
Network Value: The value imparted to a platform due to its use by 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 without users, it has no network value. The first user to land on the platform does not benefit from the value of the network. However, as other users use the platform more often, so does the network value on the platform.
On the Web2 platform, the community is mainly composed of platform users (producers and consumers). On the Web3 platform, network value is further enhanced because almost all value creation in the Web3 ecosystem is driven by the user community.
There are many examples that illustrate the above differences. Instagram started out as a stand-alone app with pretty filters before unlocking network value as a full-fledged social network. Square started out as something that turned a cell phone into a credit card terminal before starting to build a network using the Square Cash app and other components of the Square ecosystem.
Token Value: On the Web3 platform, the value generated in the native token associated with the protocol is called the token value.
As we said before:
Protocols—more specifically, permissionless blockchain protocols—provide a new organization and governance mechanism to organize participants in an ecosystem. Unlike platforms, protocols do not provide end-to-end market infrastructure, nor do they internalize transaction supervision and verification. Since protocols themselves do not provide market infrastructure or internalize transaction regulation and verification, they require economic incentives for other ecosystem participants to provide these services. They do this by issuing tokens to reward desirable behavior in the ecosystem. As the value of market activity in the ecosystem increases, so does the value of tokens tied to protocol usage.
As the usage of the protocol increases, so does the value of the tokens associated with the protocol. Early adopters (incentivized/rewarded by the token) may benefit from an increase in token value over time. Thus, token value provides an additional leverage of value to initiate and amplify network effects.
Tokens provide powerful incentives for creating network effects. However, as we will point out in a follow-up article in the coming weeks, tokens are not a one-size-fits-all solution. Tokens need to be carefully designed to ensure that they both incentivize and disincentivize core actions that affect network effects.
Mental Model 2: Managing Market Activity vs Market Infrastructure
Another difference in Web3 networking is the definition of what constitutes a network. The Web2 network mainly includes market participants involved in the creation and exchange of value: producers and consumers. While developers can extend the Web2 platform, the core market infrastructure is provided by the platform owners.
In Web3, market infrastructure is created by participants. Resources (e.g. compute, storage, etc.) can be committed by ecosystem participants rather than centrally set up. Developers build market infrastructure around the protocol, providing the ability for producers and consumers to participate in the market.
As explained in Unbundling the unbundlers:
In a Web2 world, market infrastructure and market governance are tied together by platforms. Amazon, Ebay, Upwork, Uber, and other similar marketplaces tie together marketplace infrastructure (in the case of Amazon, even physical infrastructure through FBA and FBA) and marketplace governance.
In a Web3 world, market infrastructure is separated from market governance. While the core components of market governance are coded into the protocol layer, components of market infrastructure can be built from an ecosystem around the protocol.
Since market infrastructure requires external construction, the construction of market infrastructure needs to be synchronized with the scale management of market activities.
When managing network effects on a Web2 platform, platform managers need to manage the matching between supply and demand. For example, if Airbnb’s early listings were all in Denver, but users searched for New York listings, the transaction wouldn’t happen. While Web2 network effects require managing the overlap and matching between producers and consumers, Web3 network effects management requires additional coordination and matching between the established market infrastructure and supported market activities. For example, if users on a web3 platform seek a particular type of search interface, the platform may need to encourage innovation in search interfaces to meet those requirements by offering incentives to attract developers to that particular project.
In summary, managing Web3 network effects requires not only initiating and managing marketing campaigns, but also managing their coordination with the scale of the market infrastructure. When Web3 ecosystems reach this balance, they benefit from a positive feedback loop that further amplifies these ecosystems:
Mental Model 3: Confronting Transformation, Building Defenses
One of the key differences between web2 and web3 is that web3 has relatively low defenses against network effects.
The defensive capabilities of Web2 are derived 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 that is the basis for their interactions on the platform.
Reputation: Building a reputation on the platform requires consistently delivering high-rated services and possibly meeting some minimum standards set forth by the platform. Therefore, once a service provider has established a reputation on one platform, this prevents her from migrating to a competitor’s platform.
Usage data: The more information users consume through the platform, the more intelligent the algorithm is to recommend relevant content to users.
Influence: As the number of user followers increases, so does the store of value in the network and the incentive to maintain active participation.
All four forms of cumulative value, tied to a specific platform in web2, are easily transferable across platforms in web3. New marketplaces can easily aggregate available NFTs and pull users in their direction. Users can easily port their data and activities to the new platform.
While web3 has the potential to spark an explosion of innovation, the ability of a single platform to retain innovation and allow it to continue to add value is declining.
Any strategy for building network effects in web3 needs to take into account its lack of cumulative value. Lower switching costs also need to be considered. As we will point out in an upcoming article, Web3 requires a new set of factors to provide defenses against network effects.
Mental Model #4: The “Extraction” of Management
Defensive network effects of high switching costs allow Web2 platforms to indulge (and benefit from) over-extraction (whether in fees or data) and control (through bait-and-switch, lock-in, commoditization, etc.). With switching costs collapsing, decimation will lead to a reverse breakdown of the network effect.
The creation and management of network effects in Web3 requires solving the problem of ease of switching and therefore the problem of extraction. This is especially important because, unlike Web2, the market infrastructure and resources in Web3 are provided by the ecosystem. To provide resources and innovation capacity, ecosystem players need to ensure that their investments are rewarded appropriately and that there are adequate institutions in place to protect these returns from commoditization and policy changes.
In the Web3 ecosystem, abstraction is key to managing network effects. In a world of open source protocols, excessive extraction will lead to forks, and ecosystem participants will move away from the original protocol. Advanced coordination mechanisms in Web3 also allow ecosystem participants to abandon a protocol and organize around a forked protocol.
Mental Model #5: Managing Role Agency and Risk
High switching costs also allow Web2 platforms to lure and switch, change policies, and disenfranchise ecosystem participants.
With lower switching costs in Web3, managing role agency will be key to managing and maintaining network effects.
The agency of management roles is the key to managing network effects. Governing bodies will need to build and distribute governance tokens to distribute agency, control, and governance of the platform outside of the founding team (and other insiders).
As the protocol becomes more successful, the associated governance tokens may become more valuable, further strengthening network effects, as key contributors who hold tokens not only benefit from rewards, but also have the ability to shape future Develop a roadmap and organize resource allocation and corresponding incentives for participation.
The network effects of Web3 are different. They bring new coordination challenges, support new incentives, rewrite traditional rules of defense and extraction, and reshape the balance of power between platforms and ecosystems. As the 5 mental models above illustrate, Web3 network effects will require a whole new playbook: new onboarding and scaling models, new governance mechanisms, new sources of competitive advantage, and new forms of value capture.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/deep-dive-into-web3-network-effects-five-mental-models/
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