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April 22, 2005

As the Phone World Turns Part 3 – Metcalfe’s Law

Bob Metcalfe, the inventor of Ethernet, is also credited with Metcalfe’s Law: the value of a network is proportional to the square of the number of endpoints.  Making Metcalfe’s Law work for you (or not) is the key to success (or not) in establishing a communication services company. A network with 50 endpoints is 100 times as valuable as a network with only 5 endpoints.  Huge networks have huge value.  But, and this is the problem, small networks have infinitesimal value.

The success of Internet phone companies like Skype and Vonage depends on how successfully they harness network effect so it’s important to understand how Metcalfe’s Law operates before looking at these two companies’ very different strategies.

Suppose you invented the world’s first phone.  Who’s your first customer?  There’s nobody to talk to.  This was a real problem after Alexander Graham Bell’s invention.  The first market for phones was the kind of closed network that a company might establish to link its offices because a single purchasing decision to buy a bunch of phones established an instant network and instant value.  A residential market didn’t develop until there were already some phones to talk to.  Then it developed a town at a time.  But value mushroomed when the towns were interconnected through a hierarchy of human operators and switchboards.

The math is intuitive.  The value of a network is actually proportional to the number of connections you can make using it.  To keep things simple, let’s assume these are all two party connections between people.  If you have one person in your network, she has nobody to talk to and the network has no value to her.  If you have two people, they can talk to each other so that’s one possible connection.  If you have three people, there are three possible two party connections.  But, if you have four people there are six possible connections; with ten people, 45 possible connections, 100 people means 4950 possible connections and so on.  If you like formulae, the number of unique two-party connections is (n)(n-1)/2 where “n” is the number of endpoints.

It took one hundred years between the time that fax was invented and people started asking “what’s your fax number?” rather than “do you have a fax machine?”  It took that long because of Metcalfe’s Law.  Fax machines can only talk to other fax machines and so there had to be lots of small networks set up before there was any value in buying a single fax machine.

It took roughly 20 years to go from “what’s email?” to “do you have email?” to “what’s your email address?”  Evslin’s corollary to Metcalfe’s law is that network nirvana is reached when it is assumed that everyone you meet will have an address on that network.

THE reason for the enormous value and success of the Internet is that it is a network of networks.  When networks are connected, there are huge increases in network value.  We can prove it with Metcalfe’s law.  If there are 10 networks with 100 people (endpoints) each which are NOT connected to each other there are 4950 possible connections on each network or 49,500 possible connections altogether.  Now suppose you connect these networks so that everyone can reach everyone else regardless of which network he or she is attached to.  Now there are 499,500 possible connection.  There is a ten-fold increase in value from connecting the networks even though NO new subscribers were added!  That’s what the Internet did by connecting tens of thousands of networks for email and other functionality.

Let’s get back to starting a communication company.  You cannot escape Metcalfe’s Law so you have to figure out how your service can get to having a large enough number of possible connections to attract anyone as a customer.

The easier approach is to make sure your network connects to an existing network.  That’s what mobile phone people did, for example.  It was relatively easy to sell the first mobile phone because it could connect with everyone who had a landline phone.  You didn’t have to wait until someone bought the second mobile phone to have someone to talk to.  Notice that features like text messaging and picture phones couldn’t evolve until there actually were a critical mass of mobile phones which supported them. (Why such features never evolved on landline phones is all about monopoly and regulation, the world’s most effective antidotes to innovation.)

Instant messaging, on the other hand, was an entirely new network.  ICQ (I Seek You), the first Internet instant messaging network, was invented in Israel by Yossi Vardi.  The software was available for free download and enough people downloaded it to create network value.  Yossi is famous for saying ''creating revenue is a big distraction."  He sold his company Mirabilis to AOL for close to $400 million at the beginning of the first dot.com boom.  It had never had a penny of revenue but it did have network value.

The first approach, add on to an existing network, is the safer one and can have revenue immediately.  But it doesn’t create any proprietary network value.  The second vendor of mobile phones used to connect to the landline network is not disadvantaged by the fact that the first vendor already has some subscribers since those subscribers can be reached from any phone.  That’s why mobile companies have to create artificial network value by providing “free” onnet calling.  This approach is the one Vonage is taking.

The second approach, create a new network, is far riskier.  If you want to reach critical mass within a single lifetime (unlike fax), you have to give initial access away since it has so little value when the network is new and small.  The Internet does, however, make it very, very cheap to distribute whatever is needed for access and MOST IMPORTANT, allows a new network of clients to be connected without any incremental investment in infrastructure. Successfully creating a network with millions of users who can all connect to each other is a home run because of the enormous value of the billions of possible connections.  This is Skype’s approach.

More specifics on Skype and Vonage strategies next week.

The first post in this series is everything you ever wanted to know about legacy access charges.

The second is about the cost of “free”.

The fourth is about Skype’s success in building a closed network.

The fifth is monetizing Skype’s network value with SkypeOut.

The sixth is about Skype reproducing the OLD telephony business model with SkypeIn.

The seventh is a summary of Skype features.

The eighth begins coverage of Vonage’s strategy.

A related post contains a very short abstract of what Skype founder Niklas Zennstrom said at VON (Voice On the Net) Canada and a way to download the slides of my talk there.

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