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Pick a Business Model with Leverage.html
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<p>![[Naval-Ep24.mp3]]</p>
<p>
An ideal business model has network effects, low marginal costs and scale
economies
</p>
<p>Scale economies: the more you produce, the cheaper it gets</p>
<p>
<strong>Nivi:</strong> One more question about leverage. Do you think a
choice of business model or a choice of product can also bring a kind of
leverage to it?
</p>
<p>
For example, pursuing a business that has network effects. Pursuing a
business that has brand effects. Or other choices of business model that
people could manipulate that just give you free leverage.
</p>
<p>
<strong>Naval:</strong> Yeah, there’s some really good microeconomic
concepts that are important to understand.
</p>
<p>
One of those is scale economies, which is the more you produce of
something the cheaper it gets to make it. That’s something that a lot of
businesses have, Basic Economics 101.
</p>
<p>
You should try and get into a business where making Widget Number 12 is
cheaper than making Widget Number 5, and making Widget Number 10,000 is a
lot cheaper than the previous ones. This builds up an automatic barrier to
entry against competition and getting commoditized. That’s an important
one.
</p>
<p>
<strong
>Zero marginal cost of reproduction: producing more is free</strong
>
</p>
<p>
Another one is, and this is along the same lines, but technology products
especially, and media products, have this great quality where they have
zero marginal cost of reproduction. Creating another copy of what you just
created is free.
</p>
<p>
When somebody listens to this podcast or watches a YouTube video about
this, it doesn’t cost me anything for the next person who shows up. Those
zero marginal cost things, they take a while to get going because you make
very little money per user, but over time they can really, really add up.
</p>
<p>
Joe Rogan is working no harder on his current podcast than he was on
Podcast number 1, but on Podcast number 1,100 he’s making a million
dollars from the podcast whereas for the previous one he probably lost
money; for the first one. That’s an example of zero marginal cost.
</p>
<p>
<strong
>Network effects: value grows as the square of the customers</strong
>
</p>
<p>
Then, the most subtle but the most important is this idea of network
effects. It comes from computer networking. Bob Metcalfe, who created
Ethernet, famously coined Metcalfe’s Law, which is the value of a network
is proportional to the square of the number of nodes in the network.
</p>
<p>
If a network of size 10 would have a value of a 100, a network of a size
100 would have a value of 10,000. It’s not just 10 times more, it’s 100
times more, because of the square; the difference is the square.
</p>
<p>
You want to be in a network effects business, assuming you’re not number
two. If you’re number one in network effect business, you win everything.
Example: if you look at Facebook, your friends and family social
networking protocol. Who’s their competitor? Nobody, because they won
everything through network effects. Which is why when people say, “Well, I
can just switch away from Facebook,” they don’t realize that network
effects create natural monopolies. They’re very, very powerful things.
</p>
<p><strong>Network effect businesses are natural monopolies</strong></p>
<p>
One of the dirty secrets of Silicon Valley is that a lot of the winning
businesses are natural monopolies. Even ride-sharing tends towards one
winner-take-all system.
</p>
<p>
Uber will always have better economics than Lyft, as long as it’s moving
more drivers and more riders around. Something like Google, there’s
basically only one viable search engine. I do like DuckDuckGo, privacy
reasons, but they’re just always gonna be behind because of network
effects. Twitter: where else would you go for microblogging? Even YouTube
has weak network effects, but they’re still powerful enough that there’s
really no number two site that you go to, to consume your video on a
regular basis. It even turns out in e-tail, Amazon Prime and kind of the
convenience of stored credit cards and information creates a powerful
network effect.
</p>
<p>
<strong
>In a network effect, each new user adds value to the existing
users</strong
>
</p>
<p>
What is a network effect? Let’s just define it precisely. A network effect
is when each additional user adds value to the existing user base. Your
users themselves are creating some value for the existing users.
</p>
<p>
The classic example that I think everybody can understand is, language.
Let’s say that there’s 100 people living in the community and speak 10
different languages, and each person just speaks one of those 10. Well,
you’re having to translate all the time; it’s incredibly painful. But if
all 100 of you spoke the same language, it would add tremendous value.
</p>
<p>
The way that community will play out is, 10 people start off speaking 10
languages, and let’s say one extra person learns English. Well, now all of
a sudden, 11 people know English, so the next person comes in to learn a
new language is probably going to chose English. At some point, let’s say
English gets to 20 or 25 people, it’s done. It’s just going to own the
entire language marketplace, and the rest of the languages will get
competed out.
</p>
<p>
Which is why, long-term, the entire world is probably going to end up
speaking English and Chinese. China’s closed off on the Internet, but the
Internet itself is a great leveler, and people who want to communicate on
the Internet are forced to speak English because the largest community of
people on the `Internet speaks English.
</p>
<p>
I always feel bad for my colleagues who grew up speaking foreign languages
in foreign countries, because you don’t have access to so many books; so
many books just haven’t been translated into other languages. If you only
spoke French, or you only spoke German, or you only spoke Hindi, for
example, you would be at a severe disadvantage in a technical education.
</p>
<p>
Invariably, if you go and get a technical education, you have to learn
English just because you have to read these books that have this data that
has not been translated. Languages are probably the oldest example of
network effect.
</p>
<p>
Money is another example. We should all probably be using the same money,
except for the fact that geographic and regulatory boundaries have created
these artificial islands of money. But even then, the world tends to use a
single currency as the reserve currency at most times; currently, the US
dollar.
</p>
<p>
<strong
>Zero marginal cost businesses can pivot into network effect
businesses</strong
>
</p>
<p>
Network effects are a very powerful concept, and when you’re picking a
business model, it’s a really good idea to pick a model where you can
benefit from network effects, low marginal costs, and scale economies; and
these tend to go together.
</p>
<p>
Anything that has zero marginal costs of production obviously has scale
economies, and things that have zero marginal costs of reproduction very
often tend to have network effects, because it doesn’t cost you anything
more to stamp out the thing. So then you can just create little hooks for
users to add value to each other.
</p>
<p>
You should always be thinking about how your users, your customers, can
add value to each other because that is the ultimate form of leverage.
You’re at the beach in the Bahamas or you’re sleeping at night and your
customers are adding value to each other.
</p>
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