Pick a Business Model With Leverage

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? 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?

Yeah, there are some really good microeconomic concepts that are important to understand. One of those is scale economies, which is the more you produce something, the cheaper it gets to make. But that's something that a lot of businesses have basic economics 101, and 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 sort of barrier to entry against competition and getting commoditized, so that's an important one.

Another one, 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. So, creating another copy of what you just created is free. So, when somebody listens to this podcast or watches a YouTube video about this, it doesn't cost me anything. But the next person who shows up, those zero marginal cost things take a while to get going because you make very little money per user. But over time, they can really, really add up.

So, Joe Rogan is working no harder on his current podcast than he was on podcast number one, but on podcast number 1100, he's making a million dollars for the podcast, whereas for the previous one he probably lost money. For the first one, that's an example of zero marginal cost.

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. So, if a network of size 10 would have a value of a hundred, a network of a size 100 would have a value of 10,000. It's not just 10x more; it's a hundred x more because of the square.

So, the difference is in the square. You want to be in a network effects business, assuming you're not number two. If you're number one in a network effect business, you win everything. So, for example, if you look at Facebook, right? Your friends and family social networking protocol—who's their competitor? Nobody. Because they want everything through network effects.

This 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. One of the dirty secrets of Silicon Valley is that a lot of the winning businesses are natural monopolies. Even ride sharing tends towards a one winner-take-all system. Like 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, you know, for privacy reasons, but they're just always going to be behind because of network effects. Twitter, right? Where else would you go for microblogging? Even YouTube has weak network effects, but they're still powerful enough. There’s really no number-two site that you go to consume your video on a regular basis.

It even turns out in detail that Amazon Prime and convenience store credit cards and information create a powerful network effect. So, what is the 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.

The classic example that I think everybody can understand is language. Let's say that there's a hundred people living in the community and speaking ten different languages, and each person just speaks one of those ten. Well, you’re having to translate all the time. It's incredibly painful. But if all hundred of you spoke the same language, it would add tremendous value.

And so, the way that community will play out is ten people start out speaking ten languages. So, let's say that one extra person learns English. Well, now all of a sudden, eleven people know English. So, the next person comes in to learn a new language—is probably going to choose English at some point. Let's say English gets to twenty or twenty-five people; it’s done. It’s just going to own the entire language marketplace, and the rest of the languages will get competed out.

Which is why, long term, the entire world is probably going to end up speaking English and Chinese. China is 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.

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. 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.

So, languages are probably the oldest example of a network effect. 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 most times—currently, the US dollar.

So, network effects are a very powerful concept. When you're picking a business model, it's really a good idea to pick a model where you can benefit from network effects, low marginal costs, and scale economies. These tend to go together. Like anything that has zero marginal cost 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. We 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 on the beach of the Bahamas, or you're sleeping at night, and your customers are adding value to each other.