--:-- Steph: Hey, A16C Podcast listeners, this is Steph. But today we actually have a very special treat, which is longtime showrunner, Sonal Choksi, returns for this episode and she is joined by Scott Commoners. And together, they discuss a subject very near and dear to A16C, network effects.
--:-- Steph: They discuss so much, including the misconceptions when it comes to network effects, how to effectively kickstart them and bring in the right types of users early, and also how competitive forces change with Web3. For example, protocols can be immediately forked and users can exit more easily. So how do you build something that's really sticky?
--:-- Steph: Scott makes a wonderful point on developing a new lens on loyalty. So make sure to listen in for that. And even though this focuses on Web3, in the AI era, understanding competitive forces and how to build a real moat is as important as ever.
--:-- Steph: All right. I hope you enjoyed this episode from our sister podcast, Web3 with A16Z. And if you want to hear more from Sonal and other A16Z crypto team members just like Scott, make sure to go subscribe to Web3 with A16Z wherever you get your podcasts.
--:-- Steph: Oh, and I have to tell you this. We have an amazing episode dropping next week. Without giving too much away, I got to try a technology that I have been waiting for, for no joke, no exaggeration, over a decade. You know, I've been at A6NZ for now over a year, and honestly, this was one of my favorite experiences yet. So I hope you'll tune in. And if you really cannot wait until then, you can head over to our YouTube channel to see a teaser that we just released.
--:-- Steph: All right, Sonal, Scott, take it away.
--:-- Sonal Choksi: Welcome to Web3 with A6 and Z, our show about building the next generation of your internet. I'm your host, Sonal Choksi. And while this show is for anyone working on or interested in blockchains and crypto, whether entrepreneur or creator or policymaker, today's all new episode is also relevant to all kinds of technology businesses because it's a deep dive on the business strategy behind competitive advantage, network effects, moats, and more, covering both basic foundations, as well as the tricky nuances in a new world of open source, including Web3.
--:-- Sonal Choksi: As a reminder, none of the following is investment, business, legal, or tax advice. Please see a16z.com slash disclosures for more important information, including a link to a list of our investments.
--:-- Sonal Choksi: Our expert guest today is A16Z crypto research partner, Scott Commoners, who is also a professor at Harvard Business School, a faculty affiliate in Harvard's Department of Economics, and advises several companies on marketplace development, incentive design, and more, as well as advises and is directly involved in several NFT communities. Scott teaches on these topics both at Harvard and also recently at our Crypto Startup School, so be sure to subscribe to our playlist for those talks on YouTube under A16Z Crypto to get updates as we release more videos.
--:-- Sonal Choksi: In the first half of this discussion, we cover foundational business concepts and questions such as the nature of competition and how it really changes in Web3, as well as how network effects really work. And then in the second half, in case you want to skip ahead, we cover mindsets and general guidance for builders.
--:-- Sonal Choksi: So Scott, the focus of this episode is all about business strategy for Web3. That is a meaty topic and that's a lot to cover. But this episode is really meant to be both for existing business leaders seeking to understand new strategies and where the future is going, as well as people who are already in Web3 and trying to figure things out. To start things off, what would you give us as a framing mindset for how to think about business strategy for Web3?
--:-- Scott Commoners: Absolutely. So almost every Web3 business is an example of a platform. And I use a very broad general definition of platform. A platform isn't just a two-sided marketplace where there are sellers on one side and buyers on the other, and the platform is mediating between them. Rather, platforms are any context in which a business is engaged in enabling people to interact with each other, but it's characterized by network effects. The more people or users on the platform, the more powerful and higher quality the average interaction is.
--:-- Scott Commoners: I should emphasize that platforms are not a novel business model to the internet. Credit cards are platforms. The more people have a credit card, the more firms want to use it and vice versa. The more firms will accept a credit card, the more people want to use it. And very broadly, Bitcoin is a platform. It's a network for sending value from one person or entity to another. An NFT project like the Bored Ape Yacht Club is a platform. That's a community, a brand as a platform, a way to connect people with a similar aesthetic and shared interests and enthusiasm with each other. And it has network effects. The more awesome people are in an NFT community, the more valuable it is to be in that community.
--:-- Scott Commoners: So all of these businesses, virtually all of them, are in fact platforms. And a lot of classical platforms have managed network effects by creating walled gardens. But Web3 is about doing the opposite. Web3 platforms operate on blockchains which are public and according to technology standards which are interoperable. So if you create content on your platform, it can typically be seen on the blockchain by anyone and then transferred or utilized or referenced by other platforms.
--:-- Sonal Choksi: Yeah, it is the opposite of a walled garden. It is a public garden.
--:-- Scott Commoners: Exactly. It's actually like trying to be as open as possible.
--:-- Sonal Choksi: Wow, I don't think I've ever heard that term in reference there, but we should totally use it. The opposite of a walled garden is a public garden. Well, it's dangerous though, because it has allusions to the whole history and origin of the tragedy of commons work back in the day in Central Park. So we can get into some weedy areas if we go too far down the analogy, but it works for the purpose of what we're trying to say here, which is great.
--:-- Sonal Choksi: Cool. And then it's not a walled garden. This necessitates a very different thinking about what your platform is and how it's going to work. You typically can't maintain network effects by locking in users if most of your platform data is stored publicly and the users have control over their data assets and can just take them from one platform to another. So on one hand, almost every Web3 business is fundamentally building a platform. On the other hand, we're in an environment where maintaining platform dominance has gotten much harder. And so you have to think very carefully about what your strategy for value creation is and then also how you manage value capture. How do you actually get value out of your business in the end?
--:-- Scott Commoners: Great. So before we dive into specific nuances of network effects in crypto, and I do want to go into that for sure, I also want to talk about some other classic models and contrast them to Web3. One great example is a classic. I mean, you're a professor at Harvard Business School. Of all people, you should know all about Michael Porter's Five Forces. But that is a common mental model that comes up often in thinking about strategy in any business. Can you walk us through what that is? Because what I want to do is set up a lot of the frameworks that are common foundational thinking and how they contrast in Web 2 and Web 3, and then we can dive into others more deeply.
--:-- Scott Commoners: Yeah, so Michael Porter's Five Forces is one of the most influential business frameworks, a condensed way of thinking about how do you find and maintain a competitive advantage. And competitive advantage is a term that gets thrown around casually a lot. People say, "Oh, this is my competitive advantage. My business does this." But first, let's be really clear about what it means. In Porter's view of the world, competitive advantage is a distinction of your firm relative to others. And it's measured in terms of value creation.
--:-- Scott Commoners: Competitive advantage isn't like saying, "I'm really good at software engineering. That's my competitive advantage." Because the question isn't, "Are you good at this thing?" But rather, "How does it map into the output?"
--:-- Sonal Choksi: The value creation.
--:-- Scott Commoners: The value creation. Does the fact that you are good at software engineering enable your firm to deliver a superior product or a lower cost product or both? Have you expanded the value that is created by your business operation? It's about performance. It's not just, "Are you good at this thing?" But rather, "How does that affect your performance and enable you to outperform your competitors in some way?"
--:-- Scott Commoners: And secondarily, it's key that it's relative. It's all relative to competitors. Competitive advantage is not absolute. It depends on who else is in the market, who is competing with you and what their relative expertise and abilities are.
--:-- Sonal Choksi: Which means it could change depending on which categories you're stacking up, which competitor is against, or if your business has multiple categories, or it can change, obviously, as a market changes.
--:-- Scott Commoners: That makes a lot of sense.
--:-- Sonal Choksi: And then what are the nuances when it comes to thinking about a model like Porter's Five Forces and sources of competitive advantage and where platforms come in to Web3?
--:-- Scott Commoners: Great question. Okay, so from competitive advantage, what are the five forces? The five forces shape competition in that industry and affect how easy it is to attain competitive advantage. First of all, there's just general competition among your rivals. There's the static state of what are all the businesses building similar products, competing for the same users. How strong is that rivalry? How intense is it? And what are those firms? This is usually represented with a circle in the center, which is competition among current rivals. The other four forces are usually oriented around it, like a compass rose.
--:-- Scott Commoners: The circle in the center is the current competitive landscape. On one side of that is new entrants. If this is a particularly valuable market, or if someone invents a new technology that enables them to enter, they might show up and become a new competitor. The new entrants is west and east is substitute products. Not someone who does what you do, but someone who does something that the customers want as a replacement.
--:-- Scott Commoners: Think about this with the social media wars. One ongoing threat to the competitive advantage of any social media company is the possibility, not that somebody new will come and compete with them directly. It's proven in many contexts to be very hard to compete with the dominant social media platform with a given function because the network effects are so strong. But new functions evolve, competing for the usage share of social media.
--:-- Sonal Choksi: To me, the best example of this is Facebook as a social network versus Instagram. It's a substitute and they could see people engaging actively there in a very different way.
--:-- Scott Commoners: Exactly. Another example might be cable. You could have new entrants in the form of more cable providers, but then you have a threat of a substitute like on-demand streaming.
--:-- Sonal Choksi: On-demand streaming. Perfect. Beautiful illustrations.
--:-- Scott Commoners: So that's West and East. Then North and South, think about a supply chain. Above there's the bargaining power of your suppliers, and below there's the bargaining power of your customers. If something happens that gives the customers more bargaining power, it could be a change in law, a change in the demand structure. Maybe the customer's bargaining power could go down if they discover they really need it. Something that was previously social becomes a critical work function. The other forces that shape competition are these relative levels of bargaining power. How well can you bargain relative to your suppliers, to whom you're paying, and your customers who are paying you?
--:-- Sonal Choksi: Right. So those are the five forces. And they're called forces because each of these forces exert pressure onto that industry.
--:-- Scott Commoners: Yes, exactly.
--:-- Sonal Choksi: And then how does that apply to Web3?
--:-- Scott Commoners: So blockchain-based platforms store their data in public, which means that a new platform can leverage a lot of that data. By the way, this is an oversimplification. A lot of platforms store some of their data in public and some of it in private, but a lot of their critical information, user identity, reputation, the stuff that we think of as most valuable, is often stored in public on the blockchain. Because that's a lot of the advantage that the blockchain is giving Web3. It creates this ledger upon which many different things can build and interact.
--:-- Scott Commoners: But that means it becomes easier for an entrant to show up because they can build on the code base that's available. They can build on all the content networks. So that West point on the compass rose is getting more intense. There's more competitive pressure there. Meanwhile, on East, that was our availability of substitutes. Suddenly now with decentralized protocols, there's often an immediate substitute available, which is just a fork of the original protocol.
--:-- Sonal Choksi: Yeah, that's true in any open source context.
--:-- Scott Commoners: Exactly. And then on bargaining power, on both the buy and sell side, one thing that we're seeing is that because users of the platform, a lot of the critical data and information is stored in their crypto wallet and under their control, they have more ability to move from place to place. They can freely pick up all of their data assets and just move them to another platform simply by connecting their crypto wallet. There's more of a threat that people will leave. So on both sides, north and south, for bargaining power, the bargaining power of your users is often getting stronger.
--:-- Sonal Choksi: Right. Because they have more direct control.
--:-- Scott Commoners: And then finally, that circle in the center. Because the users can get up and leave, we're seeing lots of strategies whereby platforms try and incentivize users to switch. There's been more intense competition for users because of this relative low switching cost, this flexibility of moving across platforms. On every one of these dimensions, there's at least one pressure that makes the competitive forces stronger.
--:-- Sonal Choksi: In Web3, it sounds kind of bleak.
--:-- Scott Commoners: But, exactly, yeah. Two really important things to keep in mind. First of all, on the customer and supplier side, there is something really good going on too. You have this opportunity to create what my co-authors, Jan Esbr and I, and Christian Catalini and I, have written about. We call it community cohesion. There's an opportunity when you convert your users into people who have a true preference for your platform. They actually want to use your platform over competitors.
--:-- Scott Commoners: Ironically, that comes through the same thing that creates this lack of switching costs. Giving users a slice of digital ownership, controlling assets that come from their interaction with the platform and often give them some degree of governance or advanced user privileges, causes people to want to participate in a given platform. It's not that we've locked the users in, but we've actually given them a preference for staying with the platform through shared ownership. That's really powerful. That's the thing that we didn't have a way to do previously, at least not at the scale that we're talking about in Web3.
--:-- Scott Commoners: But remember, I said there were two saving graces. One is that there is this completely new way to maintain your network effect, which is maintaining a network of personally invested users. The second thing is, while competition is maybe getting more intense in a lot of dimensions, those personally invested users also have a strong incentive to create a lot of value. The ideal of Web3 is not that you have these platforms that have locked in a bunch of users and are just extracting value from them. To the contrary, you have engaged users who are, in a real sense, part of the platform. Often literally, they're making governance decisions for the platform.
--:-- Scott Commoners: That doesn't just make them want to stay with your platform, but actually make them want to help it succeed. There's this possibility of growing the pie far, far larger than classical platform design, because now you have this highly engaged user base, everyone who wants the platform to succeed because they succeed along with it.
--:-- Sonal Choksi: I love that. I really do. But to take a step back and just kind of pulse check where we are in all this and this broader context of business strategy for Web3, what I'm really hearing you say is it's hard. It's much more competitive. It's open source. That's the whole point. It's a feature and a bug in some ways. But you have a greater potential for a lot of these other things and we'll dive deeper into what builders can do.
--:-- Sonal Choksi: So now let me dive deep on some of these questions. I want to push a little harder on this idea of competition. What you painted feels so bleak to me. And to be clear, I'm hopeful just as you are, that this is just a beginning and we're going to see a lot of experiments play out. But in terms of the value capture piece of it, the value creation, I have no doubt about. That is actually the easy half of the equation. But the value capture part, however, I have to ask, is there really such thing as competition in this world? I know that sounds like a really basic question, but is it going to be some kind of co-opetition or cross-pollination? I just wonder if there really is such thing as competition.
--:-- Scott Commoners: It's a great question. First of all, it's important to note as we talk about value capture, that value capture is also to some degree about value creation. If there's no way to capture value, then people are actually not going to invest in doing the value creating activities. It's not like we're focusing here just on how do you extract value from the ecosystem. It's more like, no one's going to build the ecosystem if they can't extract at least enough value to keep running.
--:-- Sonal Choksi: That's actually a really important point because that is a fundamental mindset shift from Web 2 to Web 3 for sure. That doesn't happen in Web 2 as easily because you have no rights to the value you create for the platforms at all. You're just captured. What do they say? There's that line that if it's free, you're the product.
--:-- Scott Commoners: Yes. If it's free, you're the product.
--:-- Sonal Choksi: Yeah.
--:-- Scott Commoners: No, in fact, my coauthor Steve Kaczynski says in Web 1 you were the consumer, in Web 2 you were the product, and in Web 3 you are the brand.
--:-- Sonal Choksi: That's a nice framing. On to your point though, it's funny because I fell into the Web 2 trap right there. I almost was like, yeah, we don't have to think about this half of the equation as if it's separate. But your point reminding that just in general business strategy, there's obviously a loop between the two. But the nuance in Web 3 that, in fact, the users can also be the owners and are incentivized to do so. Our colleague, Tim Sullivan, frames it as Web 2 was very much about the relationship between platforms and users being predominantly extractive. Whereas in Web 3, value is much more shared. Platforms and users grow and co-create together and share value together. Feeding that into this value creation and capture loop, it's especially important if you're relying on your users to help build your platform with you, that both the platform and the users in the end be able to capture value or else no one actually has the incentive to build.
--:-- Sonal Choksi: So given that, how would you answer the question?
--:-- Scott Commoners: Yeah, so I think there really is competition. I think there's a lot more cooperation than there might have been in previous iterations of technology platforms. There's very much a sense in which it's platforms all the way down. It's a little bit like turtles all the way down. Every piece of core infrastructure is a platform. A wallet like MetaMask is a platform. An NFT trading platform like OpenSea is a platform. MetaMask benefits from the existence of these NFT trading platforms and from all the people who are creating NFTs. The NFT creators benefit from the availability of MetaMask, and users interact with all of these different systems.
--:-- Scott Commoners: All of these things are cross-pollinating and cross-operating platforms in a way that is much less centralized. There's always been some degree of cooperation of this form. Think about payment processing companies. The invention of a more efficient web-based payment processor fostered growth of lots of different types of consumer web platforms that couldn't have happened without payment processing infrastructure and vice versa. That's the relationship I've been describing with MetaMask and the NFT platforms.
--:-- Sonal Choksi: It reminds me of the early days of the API economy as well.
--:-- Scott Commoners: Yes. And the thesis was that there would be all these different companies that have a specific core competence, and they would focus on that core competence and then pull in APIs for everything else, which supersized your powers. To be able to do that, it was like this interlocking set of APIs.
--:-- Scott Commoners: But here, the scope of every one of these innovations is much broader. The process of integrating one of these platforms into yours or embedding features is much faster and easier. It has less friction. There's sort of an infinitely public API for most of the core content. In that sense, there's a lot more composition and collaboration among different players in an ecosystem.
--:-- Scott Commoners: So going back to that diagram, as I mentioned on the West and East, it's much easier for new entrants to appear, and it's much easier for substitute products to be created in many contexts. If you build something that works really well, there's a much greater threat in Web3 that your entire network could just get moved to a competitor. Could even be a copy. Some new entrant can try to capture all of that activity by directly incentivizing users to switch. This is referred to colloquially as a vampire attack.
--:-- Sonal Choksi: It's a funny name, of course, because vampire attacks are actually like...
--:-- Scott Commoners: Blood sucking. Exactly. It's like trying to suck the lifeblood out of your competitor. Of course, that's good from a competition policy perspective a lot of the time. We actually like more competition among platforms. We'd like users to be less locked in so that competitors can show up. A competition policymaker would say, "We really want to incentivize more vampires in this market."
--:-- Sonal Choksi: They'd be like, "Really? You're sure you don't mean you want to buy more garlic?"
--:-- Scott Commoners: Yeah, totally.
--:-- Sonal Choksi: Now, fun little fact that you don't know, Scott, is I'm actually super into vampire lore and fantasy literature, which we both have shared an interest in and talked about.
--:-- Scott Commoners: I admit, I didn't know that specifically, but if you asked me how much money I was willing to bet on that fact, it would have been a very large amount.
--:-- Sonal Choksi: You know me well. But basically, it's funny because one of the things that does come up pretty often in vampire lore is that nature balances the powers of the vampires. That's why, for instance, they come out at night. There's certain things they can't do. They can't procreate. There's all these funny rules of vampire lore that cuts across many pieces of vampire literature.
--:-- Scott Commoners: That's awesome.
--:-- Sonal Choksi: Yeah. And it's funny because it actually applies here. If you think about it, a company can do a vampire attack. But that very thing you described earlier, that there can be community cohesion as a defense. That is where the nature of Web3 is providing a check and balance in a way. But I think it's yet to be seen how that plays out, just to be very precise here, because I don't want to overstate it.
--:-- Scott Commoners: Absolutely. And I do want to ask you a little bit more about community cohesion. But before we do, you have mentioned network effects a number of times. Just to give the listeners context, we have covered network effects a lot at A6NZ Crypto and A6NZ. And I've worked on all of that content in the past. In particular, we used to have a deck that was just explaining network effects because there's actually so much confusion and misconceptions around it. But just super quickly, you define network effects earlier, but to super simply put, it's the value of the network becomes more valuable for the participants as more users join. And the key idea there is valuable for users. I think people often treat network effects as more users and forget the other half of it, which is adding value for the rest of the users. They forget that it's actually about value creation.
--:-- Scott Commoners: And an important footnote on that is that the value doesn't have to go up for all users equally. And it doesn't even have to be the case that all the users get a positive value boost for more users joining the platform. It's the net total value going up.
--:-- Sonal Choksi: Interesting. Such a good nuance.
--:-- Scott Commoners: So if you think about it, we use credit cards as an example earlier. With credit cards in general, we think of the network effects as being positive all around. If there are more holders of a given credit card, it's more valuable for a merchant to take it. If more merchants accept that credit card, as the individual, it's more valuable to get that credit card instead of some other one. Having more merchants doesn't really crowd out other merchants. If anything, maybe it helps. Mostly the network effect of a credit card is cross-platform. It goes from holders to merchants and vice versa, and it's strictly positive.
--:-- Scott Commoners: By contrast with newspapers, the more readers the newspaper has, the more valuable it is to be an advertiser. The more advertisers the newspaper has, the more annoying it might be as the reader to read the newspaper because you eventually get to this position where every other page is some gigantic ad. You really want to finish the article that you're reading and instead you have to flip through three pages of advertisements. There are actually some negative platform externalities as well. The advertisers exert a negative externality on users and a negative externality on each other. But it can still be the case that the overall network grows as we add more users. The net value creation goes up as we add users on either side of the platform, readers and advertisers, even if there are actually some negative effects on the margin for some of them.
--:-- Scott Commoners: The point being that you have to look at the value of the total and not worry so much only about creating this super pedantic definition of value for all users. It's creating value for all users in aggregate.
--:-- Sonal Choksi: Not necessarily for each user individually.
--:-- Scott Commoners: Although note that if your platform gets really unpleasant for any given user, they might leave. And by the way, users will leave if they can overcome the switching costs and there's a good enough outside option. Users' ability to respond to negative network externalities, to things that make the network potentially less pleasant for you as the individual, even though its net value in aggregate might be higher, is much harder in Web2. There's a really high barrier to exit. It's hard to exit. That means you're kind of locked in, which means you have very little bargaining power. And so that's how we get to this extractive equilibrium.
--:-- Scott Commoners: Web3 is, as we've been saying, in a lot of ways, the opposite.
--:-- Scott Commoners: You have all of your network sort of embedded with you. I have lots of NFT communities I'm a part of. And any platform I connect to, they can see all the communities I'm part of. And anyone who's part of those communities on the platform can find me immediately. I was totally stunned when I joined my first Web3 enabled social media. It was Farcaster. And I could search by community. I could go and find the people who held – there's a network of content I'm really into. These are all people who are a lot like me. That's why we're all in the same NFT community in the first place. And that was sort of wild. I had brought this external network affiliation directly into a platform and taken all of that connection with me.
--:-- Sonal Choksi: Totally. Just a pause on what you're really saying there, because I think this is so profound. In Web3, you're saying that it's not just that you can take your data with you, but you can actually take your reputation, history, interactions – there's so many other things, that kind of embeddedness. But the more profound idea here, I just wanted to sharpen that nuance, is platforms previously were never portable. And you're almost saying that the user themselves are the platform and that is now portable. That's so fascinating.
--:-- Scott Commoners: Absolutely. And this goes directly to this community cohesion structure. Christian Catalini, in an article we published about 12 months ago, we talk about the network effect now accruing to the asset rather than to the platform or the portal. That's what's going on here. A Loot Skulls NFT, or a Sup Ducks, or a Bored Ape – the network is embedded in the collective of people who own these assets. So there's a new game about trying to be the platforms whose assets are the ones that people want to attach to their identity and use across the internet. When you think about Web3 social media design at a very high level, Farcaster directly encourages the development of many different clients – different ways of displaying, remixing, and serving the information that lives in the protocol. In Web2, that would be dangerous. Here, that's actually very powerful because it draws more and more activity and value back to the underlying Farcaster protocol. It becomes more embedded.
--:-- Sonal Choksi: Right. And it goes back to your earlier point. It's increasing the size of the pie for everyone. I just want to quickly mention that in that article, which I'll link to in the show notes – this was the article you guys published in Competition Policy International, right?
--:-- Scott Commoners: Yeah, CPI Tech Reg Chronicle. "Can Web3 bring back competition in digital platforms?"
--:-- Sonal Choksi: You do point out that Web3 could reduce the fundamental costs of verification, the cost of interoperability and portability, and the cost of composability, which is exactly what you're talking about there.
--:-- Scott Commoners: Yeah.
--:-- Sonal Choksi: But it's funny because going back to my original question, I still haven't really heard – it's definitely good in terms of bringing back competition to digital platforms, as your article posits, in terms of making them less concentrated and consolidated among a central few. But it doesn't answer the question of who and how those people get the advantage. So I finally understand what you meant when you asked about whether this is reducing competition or really creating competition at all.
--:-- Scott Commoners: So I think it's changing the character of competition.
--:-- Sonal Choksi: Oh, say more.
--:-- Scott Commoners: We've seen over the last year extremely intense competition among NFT trading platforms on fees and on features. We've seen intense competition in various DeFi trading contexts. People writing algorithms that will move someone's assets from one liquidity pool on one platform to another automatically. We've seen aggregators that make it easy to price compare across all the different places you could place a given trade. That's what we often think of classically as competition. If you think about classical competition policy, a lot of it was about pricing or degradations in quality. You're often asking, will this reduce the quality of the customer experience? Will they pay more because prices go up with fewer competing companies? Or will quality go down because there's less incentive for the firm to innovate? That type of competition is rife in Web3. But the question is where would that go? What it really turns into is platforms having to work to retain consumers, to create an environment where the customer wants to stay rather than switch to a competitor. That's what I think of as particularly virtuous competition – development of features, rewards and loyalty programs, various infrastructure that improves the customer experience. And often that comes through mixing and matching, aggregating all the best features from all the different platforms.
--:-- Sonal Choksi: I got my answer. Thank you. I didn't know what the answer was, by the way. I was just trying to genuinely understand it.
--:-- Scott Commoners: No, it was a great question. This is how you actually learn stuff.
--:-- Sonal Choksi: Yeah, exactly. You push on a thing and I'm like, oh, I get it. There's your answer.
--:-- Steph: One thing we haven't talked about is this idea of composability. Chris Dixon has a great line – composability is to crypto what compounding is to finance. It's this idea that it's like an exponential force. You've talked about in your work, Scott, this idea of compounding innovation as one of the benefits that can come out of Web3. I want to dig in on what it is and why it matters, and move us beyond what can come off as platitudes in the public discourse to really understand the value behind those words, because it can be a little jargony.
--:-- Scott Commoners: Totally. First of all, what is composability? It has a technical meaning in the context of software. You're embedding existing software components into new ones, using their operations as inputs to whatever your software is supposed to do. But at a business level, it means you can build on top of other things that have been created. It's not just about software functions sitting in smart contracts on the blockchain. It's also every other digital asset. Composability is if you have an NFT and somebody else builds a new game where that NFT manifests as an avatar. There's a massive NFT ecosystem around some very simple NFTs called Loot, which are basically just lists of various adventure game items – bag of holding, rod of wrath, stuff like that. People are building entire games that embed the Loot assets. If you show up with a given Loot bag, you'll have those assets in the game and now they do things. That's a form of composition as well.
--:-- From a business perspective, why do we care that you could even do that? It speeds up innovation. It allows people to innovate in ways they couldn't before. Maybe someone is really good at one type of business function and not others, and now there's a whole library they can pull from. We saw this with all the Web2 infrastructure platforms. Once there were out-of-the-box web platform creators, if you had a really good idea, you didn't need to be a ridiculously good software engineer at the beginning. You could integrate a bunch of tools together and launch a minimum viable product with almost no complex software engineering. Web3 is just that, but for everything. It's that for the underlying software that runs the platforms. It's that for all the brands and identity formation people are doing. It's that for reputation markers. It's that for our personal data. It's all of that rolled into one big snowball. You can combine all of this stuff however you want. So we've got this snowball rolling down the hill, getting super gigantic. And at the bottom, we have a gigantic snowball and we can carve out any little bits of it we want to create our business.
--:-- Steph: That's funny. The analogy I was trying to think of was a bit like a primordial soup. The reason that came to mind is, do you remember back in the early days of Google when Hal Varian, the chief economist there, wrote about combinatorial innovation? It's so jargony of a phrase, but the idea is really fascinating. You're a mathematician – you know combinatorial math. Permutations and combinations grow quickly. When you mentioned Loot, it's obviously one of my favorite examples too. What I found so fascinating about the Loot example is it doesn't have to be full-featured, which is a big difference from the early days versus now. You have literally primordial ingredients that aren't fully baked and fleshed out because there is this innate ability for these ingredients, people, and communities to form quickly and bottom-up, to move around them and put them together without having to have full-featuredness.
--:-- Scott Commoners: That's such a cool point. You're exactly right. Imagine if 10 years ago someone said, "I'm going to launch a product which is basically just the foundational items for an adventure game, and then some people are going to build the game around it." Makes no sense. Whereas here you can do that. You can say, "I've got this cool set of items. I want to enable a game or multiple game ecosystems around them. Let me put the items out into the world and invite people to build." So it's possible to have these micro components. People can launch products where the product is basically just some tiny input that goes into everything else. By the way, AI will play a big role in this when you think of creative AI.
--:-- Steph: Totally. Even in the early days of Web2, it was only meant to be like, "What are you doing?" And then the users came up with games. Chris Messina came up with the hashtag. Other people came up with "so-and-so on Thursday." The community did all that and they got nothing for it in creating that value. Coming full circle, another difference here: it's not like these platforms didn't allow it, although to your point, here we're talking about everything being composable, not just one element.
--:-- Scott Commoners: Yep.
--:-- Steph: But two, there was no way for the community to capture and participate in that value.
--:-- Scott Commoners: Yeah, you're totally right. To the extent that value capture for the user or the community existed, it often came through these very arcane things that were then delinked from the platform. How did people capture value from hashtags? They came up with other platforms that would have hashtags in them. There were all these disconnects because you had to go off platform. You had to drive people to your website to do something. Whereas Web3 invites everyone to do this stuff actively and makes it all cleanly interlinked.
--:-- Sonal Choksi: Yeah, totally agree. And now let's switch into tactical.
--:-- Steph: Let's get tactical.
--:-- Scott Commoners: Let's get tactical.
--:-- Sonal Choksi: Tactical. Sorry. Do you guys remember that song from Olivia Newton-John? "Let's Get Physical." Let's get tactical.
--:-- Scott Commoners: Oh my God. That's so good. My voice doesn't go that high.
--:-- Sonal Choksi: That was really funny to hear you try to do that.
--:-- Scott Commoners: My voice doesn't go that high. Sorry.
--:-- Sonal Choksi: Great. So now I want to spend the rest of the time going into what does anybody do with all this information? If we don't have answers, let's share mindsets. In terms of breaking this down, a good place to start for the builders and the audience is: how would you help them understand the key aspects of network effects? And then how do they think about it depending on what type of thing they're building in Web3?
--:-- Scott Commoners: Cool. First of all, at the high level, I like to think about network effects in terms of their strength, their valence, and their source.
--:-- Sonal Choksi: Ooh, cool.
--:-- Scott Commoners: Strength is exactly as it sounds. How strong is the network effect? How much pull do users exert on each other? Does the platform achieve over time? Note, there's absolute strength and then there's marginal strength. How much, when we add a new user, does that affect the network effects in general? It might vary by user. Some users benefit a lot from there being a lot of people in the network. If you're an online job search platform, people looking for jobs benefit a lot from having many jobs available. People who aren't actively looking might also benefit some – think about all the inbounds one gets on LinkedIn – but they might not benefit as much. There might be dispersion among users. Another key factor in terms of strength is whether the network effects are local or global. There's a different bike share company in almost every city. It's an exceedingly local network effect. You want enough users biking around that bikes are available at all the pickup and drop-off spots. But the fact that you're a bike share customer in Boston has very little implication for whether you have any interest in bike shares in New York or San Francisco. And it doesn't matter whether it's the same company. You can buy a one-week contract or a la carte. It has very strong local network effects but very weak global network effects.
--:-- Sonal Choksi: Can we address the nuances of strength for Web3 and how you would advise people to think about it?
--:-- Scott Commoners: We've already implicitly been talking a lot about the strength of network effects in Web3. There's good news: a lot of network effects have suddenly become global. Even a brand or a fandom can have network effects. If you're a huge Taylor Swift fan and you're wearing a Taylor Swift T-shirt, and you walk by another Swifty wearing their shirt, you can connect. But you don't have a lot of interaction by default with Taylor Swift fans in other countries, despite there being a lot of them worldwide. With Web3, a lot of those localized network effects suddenly become global. You can be part of a brand community, interacting with and making friends with people from everywhere. All the NFT communities I'm in are fundamentally global. If they become really popular in South Korea, I gain some value from that because there are people creating cool content that supports the product and more people at the virtual meetup. By creating this global network infrastructure layer – the blockchain is like a big network of networks – a lot of network effects have gotten stronger at the core level, those fundamental assets to which the network effect accrues. But on the other hand, there's been a lot of network effect dilution with platform contexts that used to be walled gardens. There might be a stronger core network effect to the underlying protocol for a Web3 social media platform, but a much weaker network effect than before for any individual app that serves that protocol.
--:-- Sonal Choksi: I need a bottom line.
--:-- Scott Commoners: The bottom line is that Web3 has strengthened a lot of classical network effects, but it's also moved where they reside. The strong network effects are often tied to the digital assets, to the networks that sprawl across the blockchain, rather than to any individual platform that operates on top of those assets.
--:-- Sonal Choksi: Yes, this goes back to that profound insight that Web3 often allows these network effects to be portable, tied to a different entity. Okay, the first dimension was strength, and that was super helpful. Then you also mentioned valence, which I don't even know what that word means. I vaguely remember it from chemistry.
--:-- Scott Commoners: Yeah, valence is like positive, negative. I don't really remember my chemistry classes either. But it's about direction and positive versus negative orientation relative to strength. How it applies here is valence is about direction. In Web3, we're seeing a lot of new opportunities for positive network effects. This goes back to the composability point. There are so many more ways to leverage all the information and architecture to drive new value to whatever you're building and back to the underlying assets or protocols. To the extent that we've created new forms of network effects, most of those are new positive network effects. But when you're thinking about this as an entrepreneur or builder, you have to think about your entire ecosystem and where the positive and negative network effects are. It's not just about how strong your network effects are, but also: are they going to drive more value for everyone? Are they going to make some people want to quit your platform, requiring you to reward them more to stick around? The message on valence is mostly the same as it was in Web2. You need to understand which network effects are positive or negative for which users. The Web3 opportunity that's special here is through composability, there are many new opportunities for aggregating positive network effects, either yourself or through partners and future developers who build on top of what you've created.
--:-- Sonal Choksi: And then the last one you mentioned: source. Talk to me about what that is in this context of dimensions of network effects for builders, and then the application to Web3.
--:-- Scott Commoners: Source is in some sense the most self-explanatory of the three. Source is just where the network effects come from. Why do we care about that? Strength and valence are really about value creation. They tell you how much value your network will create and how that value will grow as you bring in new users and add new functionality. Source is about understanding how specifically you foster that network effect and, relatedly, how defensible it is. Does your network effect come from liquidity? That could be the presence of lots of drivers and riders in a ride-hailing platform, so you can ensure that if you're out driving, you'll have people to pick up, and if you're looking for a ride, you'll find a driver. Or an NFT trading platform – are you going to be able to find the specific asset you want when you show up? It could be about liquidity, data, or user know-how. There are lots of different sources for network effects. Those sources define the pathway that often answers the strength and valence question. How does where the network effect comes from determine how strong it is and who benefits the most? Segueing back to the competition discussion, it also tells you how defensible it is. In a lot of Web2, the network effect defense came from having aggregated massive amounts of proprietary data, user reputation, and user content that was very difficult for users to take with them to get a similar quality experience elsewhere. In Web3, we're seeing a lot of those old sources of network effects become much less defensible.
--:-- Sonal Choksi: And the bottom line?
--:-- Scott Commoners: The bottom line on source is you have to understand the source. You have to actually understand the mechanism of network effects. It's not enough to say, "Oh, we have a network that's growing in value, so you should join and invest in our network." That's not how it works. You have to understand the pathway through which the network generates that increased value. And you have to understand how to protect it and whether it's protectable. If your network is totally indefensible, you might have the opportunity to create a lot of value but not be able to capture any of it. You're not just looking for network effects necessarily, but defensible and buildable network effects.
--:-- Steph: Question on this one. People often say in Web3, when you mention moats, that the moats they have are things like design. And earlier you mentioned community cohesion. But what's your take on moats, Scott? I feel like people bandy that about a little too casually and easily for my satisfaction.
--:-- Scott Commoners: It's funny, one of my longest-term collaborators on Web3, Chad Esbert – he was one of my former students in my MBA class, one of the strongest students I've ever taught – he and I have been trying to clearly express how we think about moats in Web3. Still work in progress. But the core insight, like with our conversation about the five forces earlier, is that most things have gotten much harder. Previous sources of platform competitive advantage, platform moats, were the core network effect. It might be that you have all the liquidity on your platform and competitors don't have nearly as much, or you have all this proprietary information. It might be economies of scale – you're a used car platform and you can offer really cheap insurance because you have a lot of know-how about the cars, or network insight like Amazon with its logistics operation, moving products to places before people place orders because it knows what will be ordered when. Platforms can create defensibility through standalone value, technical advantages, things they do that are just superior. You asked about design – possibly even through partnerships, and sometimes through multi-homing costs. You might have a defensible competitive advantage simply because it's hard for users to deal with using multiple platforms at once. Maybe it's easier to only search on one online restaurant platform. Those were all core sources of competitive advantage in platforms, all of which, by and large, is often going to be an open book on the blockchain. Similarly, technical advantages – so much of the operations of a platform are public, they're going to erode faster than they used to.
--:-- Steph: Although I would argue a counter to that is actually the talent. The technical advantage is not just the features baked into the protocol, but the ability of that team behind it to really innovate. That is going to be a bit of a moat.
--:-- Scott Commoners: Absolutely. No, I totally agree. That's not platform specific, but it is a very important source of competitive advantage. Remember, we talked about higher quality or lower cost. Both of those things are influenced by the quality of your talent. Talent has always been a competitive advantage, especially in complex and high-tech firms. As Web3 is more complex and often more high-tech than anything that's come before it, the talent moat has widened and deepened.
--:-- Steph: Yeah, totally.
--:-- Scott Commoners: But the core platform competitive advantages have mostly weakened. There's one, though, that really stands out as having strengthened tremendously, which is embeddedness.
--:-- Sonal Choksi: Say more about that. You've mentioned that a few times.
--:-- Scott Commoners: Another way that platforms achieve dominance is by being embedded into everything. If you think about Gmail as the login to so many different web platforms, many people don't know their account credentials for those websites. All they do is connect Gmail and it propagates credentials for them. That's embeddedness. That makes Gmail a necessary service. Even if you didn't have all your emails stored in Gmail, the network effect comes from proprietary data and having all your content stored there in a way that's difficult to port. But even if you took all of that away – if tomorrow all email became flexibly transportable between Gmail and Outlook – people would still have so many accounts managed through Gmail that they'd have to keep logging into it.
--:-- Sonal Choksi: This is where wallets have a lot more potential for embeddedness. Absolutely. Even in fintech, we talk a lot about not only wallet interfaces. Connie Chan and I did a piece around WeChat and the idea of payments and Alibaba and Alipay. It was both payments and messaging combined that became the interface to everything in the world. Granted, that was a very locked, walled garden because it's not open to anybody but the people on those platforms, and it was in China so it's even more walled. But the example that comes to mind in Web3 is how identity becomes the interface for decentralized identity. There's a lot going across the board on that embeddedness point.
--:-- Scott Commoners: Indeed. The Alipay example is perfect. That's a classic Web2 style platform that maintains a lot of its advantage through embeddedness. It's used in so many different services. Web3 opens that up. And again, it opens it up to everything. Your crypto wallet can be embedded in many different services, but also so can your NFTs, so can your digital diploma, so can a simple function protocol you wrote. Something like Disperse.cash can become part of many different finance products. That software embeddedness – you mentioned open source earlier – this was also true in open source. How did individual open source software products become most successful? People built lots of stuff on top of them, so much so that those products became essential.
--:-- Steph: Totally. Although one quick precision note on that one. As you know, I'm the open source history person. It's really interesting when you compare the Linux Foundation and the model they set up with something like NPM, the Node Package Managers, and the Node.js community. It's also interesting when you think about other components like SSH – three people maintained it and it led to serious vulnerabilities in hospital system software because a lot of people began using open source. So just a quick contrast nuance: it is very similar except very different because that lacked the economics of participation.
--:-- Scott Commoners: Yes. And therefore no incentive.
--:-- Steph: Yeah, no, you're totally right.
--:-- Scott Commoners: Right.
--:-- Steph: Somehow now you have that same embeddedness opportunity, but with an incentive to build and maintain.
--:-- Scott Commoners: Yes. Build and maintain. Spot on.
--:-- Steph: And then just one quick other one. You've mentioned community cohesion a bunch of times, and that's one of the other things you put forth as one of the stronger benefits of competitive advantage in Web3. I want to have you answer the second part of that question – you already answered the first part. Same for community. What are the nuances there? How much of a moat is it really?
--:-- Steph: Pulse check it for me.
--:-- Scott Commoners: Great question. So first of all, I should emphasize that, to me, embeddedness was a classic model of platform competitive advantage, and it's gotten much stronger in Web3. This community cohesion thing, I tend to think is pretty new. Not that it never existed before, but at least in the classic platforms that I've looked at, I have never seen it, to my recollection, as a central part of the business model. In some sense, I think that's because they lacked the ability to do so, or they lacked good tools to do so.
--:-- Scott Commoners: Web3 makes it possible to turn your consumers or your users into people who are personally invested in the platform's success and who often interact and interface with each other towards the goal of the platform's success and in the process of using the platform. NFT communities are a great example of this, but we also see it for far less branded platform contexts. Think about everyone who participates in governance on a DeFi platform or something, to calibrate the protocol and decide how it will run. That comes out of this shared ownership, and it also comes out of the opportunity for your digital assets to drive new forms of quality and experience.
--:-- Scott Commoners: A platform can build a moat around a user base that really wants to attach to it, that wants to use its product rather than a competitor's, or rather than building their own, and even better, wants to contribute to making what they do higher value. We haven't really seen these things play out at scale yet because it's just too early. But we've seen really powerful examples of it, at least in play already. It reflects a desire to publicly and personally identify with the brand attached to the NFT. It's like a sports or a music or whatever fandom. You see the other people in this group as akin to you, and you want to engage with them, not just to hang out, but to hang out in reference to and more deeply engage with the assets.
--:-- Steph: Yeah. I've been thinking a lot about the nuances while you're sharing all this. How is this different than a fandom? How is this different than any other community? Is it just more of a matter of degree than kind? I think I've kind of landed on what you just said, Scott. It almost feels – God, this is really an exaggeration – but like a tribe and even a religion, where you have artifacts that you engage in. Again, I don't want to say that with all the negative connotations.
--:-- Scott Commoners: No, it's funny you say this. There's this concept of a shared text.
--:-- Steph: Yes, yes, exactly. Shared artifacts, shared symbols. Exactly. It's modern meaning making, actually, if you were to really take it to the next level. When you say cohesion, that's like a fabric, the way people describe social cohesion and things that tie people together. That's often how people also think about religion. So it's not some abstract concept, like strong ties versus weak ties versus interest graphs and affiliate interests. It's actually really kind of core meaning at the heart of it.
--:-- Scott Commoners: Yeah, exactly. And it's going to sound absurd, but imagine a universe in which people went around the internet self-identifying as platform users. It's like, "I get up in the morning and I am proud to be on Facebook." Saying that sounds a little bit hilarious. But I was a really early Facebook user. It had launched just before I got to Harvard as an undergraduate, and so we were proud to be on Facebook. We almost felt like we were building the product. We were finding weird errors and glitches and things, and you would submit bug reports and they would go and fix the very unusual bug that you would notice. It was a totally different experience of the platform.
--:-- Scott Commoners: Web3 is trying to take that type of experience and make it not just a small platform thing, but giving people that sense of pride and ownership and contribution in the platforms at every scale.
--:-- Steph: Okay, so let's shift more now into advice for builders and how to really think about your strategy design and market design for Web3. At a high level, we're not going to cover everything in this podcast, obviously. But I'm going to take some questions from Tim Sullivan, who's a great former editorial director at HBR, and he was executive director of UC Press and is now on my editorial team here and works with you as well closely.
--:-- Steph: I actually think this is a very interesting question, particularly the second half, which is the adoption cycle. Consumer demand drives tech advances and investment. Where are we in the Web3 space with regard to this dynamic? And how does this inform the space in which projects are making strategic decisions? I want to address the second part of Tim's question, which I found even more interesting: how this informs projects making strategic decisions. The variation that I'm most fascinated with here is this question: start niche first and then grow? Do they try to go mainstream faster, or do they do a bunch of niches and aggregate those? How to think about that strategically? Do they go in thinking, "Here's what we should do"? I just wonder if you have a quick answer.
--:-- Scott Commoners: Yeah, it's a great extension of a macro question. You're actually asking a micro question. First of all, there's a general piece of advice I often give in platform design: a lot of successful marketplaces and platforms more broadly start with a very broad approach, discover a specific vertical or version of the product that works very well, narrow to that and optimize it like crazy, and then expand out again.
--:-- Scott Commoners: So one part of the answer on platforms is you often are, in fact, neither going niche nor broad. You're actually doing both, but in sequence. The idea is, think about early testing and minimum viable products. You might not know precisely who your customer is or what the most viable use case for your product is at the outset. You've launched a crowdfunding platform and you don't really know whether it's going to be most effective for crowdfunding for art projects or for finance education. You have no idea what it's going to be useful for. So you might start by trying all those different types of campaigns, a small number of them, and see which stick.
--:-- Scott Commoners: Then you discover that it's working really, really well for crowdfunding large-scale theater performances or something like that. You say, "Okay, let's scope to that now and really work on this theater vertical and figure out how we can optimize the product for that." Once you have a really strong theater vertical, that's your beachhead. Now you have a regular user base, regular customers, and you can go to the people who are funding the theater performances and say, "You don't just do theater, right? What else would you want to see on the platform?" Maybe they say, "I also like various design and tech." You say, "Great, let's do design and tech." You start trying to find some campaigns in design and tech, and you do user crossover from your theater vertical. So you start broad, discover what fits, narrow, focus on that, and then build out.
--:-- Scott Commoners: Let me add one other footnote that's Web3 specific. The other thing that's very special about Web3 in this context is that the build-out component becomes much easier. Again, because your core users are invested in the platform's success, there's a sense in which initial value can be fostered among a very small initial community. Then they help it broaden, literally. They'll find other people who want the theater vertical, and they'll be suggesting stuff like, "My friends who are into theater are also into design and tech." They might even help you build that or recruit that sort of additional community. The value of a core community of users has grown dramatically relative to before, because they're not just your evangelists, but they're also the people who help build and broaden your use cases as you go.
--:-- Steph: It also kind of ties back to your community cohesion point, because they're not building for themselves, they're building for all. Their interaction effects also strengthen in turn their ties to that community, which then further feeds it.
--:-- Scott Commoners: Exactly. Spot on.
--:-- Steph: Yeah, that's super fascinating. Okay. He has another question: how do you optimize a platform for growth or some other goal when it doesn't align with your power users' desires, and your power users actually have voting rights like in direct governance? This is a really interesting question because we're not going to talk about decentralization because that's too big of a topic and it's a through line through all of this. Obviously no individual can make a decision on behalf of a community or a network. That's part of the whole advantage of Web3. But the idea is that at least in the early days, or before a platform has progressively decentralized, there are some early decisions that some of the community early decision makers may make to help set up that platform as it evolves. The real question here is: how do you think about strategy and growth when you have this very unique case of Web3? You don't have a classic manager that Porter was talking to back in the day.
--:-- Scott Commoners: Oh, absolutely. It's a very real issue. When you have partially or fully decentralized governance, or even when you have centralized governance, a platform's short-term incentives are often not aligned with the long-term incentives. That's honestly why a lot of Web 2.0 has become so extractive. In the short run, it's always better to extract more today. But in the long run, that means the users leave your platform at the earliest opportunity they actually manage.
--:-- Scott Commoners: Similarly, think about a big community with a treasury. One thing you could do is invest the treasury in building and bringing in the next 100,000 users. Another thing you could do is throw a big party for everyone in the community this week. It's not actually incorrect for people to have a preference for being at a party rather than doing some very complicated abstract thing for a potential future return. This alignment problem is hard. It's been hard in companies historically, and it's hard with governance in Web3 platforms as well.
--:-- Scott Commoners: One advantage in Web3 towards this is that token holders, in effect, share some alignment with the overarching platform's goals. Even if all the token is the arcade token that can be used in all the different minigames the platform is building out, those tokens are more useful to you if the platform can build a lot of really cool minigames. So there is a sense in which you at least have some incentive to vote in alignment with the platform's long-term interest. But it's still very hard. Even just the communication piece is hard. It's not always clear that everyone agrees on what the platform's best long-run interest is. So even if you didn't have the incentive challenge of people wanting to extract value today, you might have the issue that people still don't know what the right direction is. Startups are in a haze of massive uncertainty.
--:-- Steph: Right, and then you add Web3.
--:-- Scott Commoners: Exactly. But on top of that, as you say, there's this incentive to vote your own private optimum rather than what is best for everyone. We're going to have to see how this plays out. But the strongest technique we have for this is shared ownership. That strengthens their incentive to want the platform to succeed, not just in terms of their creating and contributing to it, but also trying to guide the platform in what they at least believe is the best direction.
--:-- Steph: Yeah, totally. So a couple more quick things. When you're launching a marketplace or a particular platform, do you go after supply first or go after demand first? That's a common question. There's also this common question about the bootstrapping problem, the chicken and egg problem. What advice would you give to Web3 builders for how they should think about launching their platform?
--:-- Scott Commoners: You hear all the time about the chicken and egg problem of platform launches. This is not specific to Web3 at all. It's a general principle of platform business that you have to figure out how to get your initial users and start creating that network effect. People frequently talk about platform launching in these vague and very doctrinaire terms: go after supply first, go after demand first. I want to emphasize that for an individual platform, if someone is advising you on an individual platform that you are launching, going after supply first or going after demand first might actually be the correct instruction. But there are people who just tell you, "It's always harder to get supply. You should always get supply first. Just make that work. If no one's going to supply on your platform, forget it."
--:-- Scott Commoners: But fundamentally, it's not what economics has taught us. Rather, this harkens back to a lot of Tom Eisenmann's work, a lot of classical economics and strategy research on how to grow two-sided and multi-sided platforms. The real question to ask is: who do you have to subsidize? And who is going to pay you to use the platform? It's really about recruiting users who create the most value for everybody else. To launch your platform, you want to bring in some users who will kickstart a really strong network effect. Maybe go to your initial developers or your initial liquidity providers and say, "Look, we need you for this platform to succeed. We're going to give you tons of discounts or early access, or even pay you to develop for us initially."
--:-- Scott Commoners: Meanwhile, that activity draws in users. That kickstarts the network effect. Now there's a way for users to actually use the platform, and so you might then charge users. But the key is that these roles don't necessarily stay static over time. Once you're a thriving ecosystem, maybe you only subsidize certain marquee developers, whereas everybody else actually pays to use the platform or pays to have access. The chicken and egg problem is not a rigid "it's always the suppliers, it's always the developers, it's always the demand side." It's who creates value for others, who grows that network effect as quickly as possible. And how much value do they put on using the platform? If you have to convince them to use it, you're subsidizing them. If they have intrinsic demand for it, then maybe you don't need to.
--:-- Steph: And quick bottom line on this: where is this really kind of different or more nuanced in Web3?
--:-- Scott Commoners: The way I think about the big change here in Web3 is you have many new ways to subsidize. It used to be that the form of subsidization was usually giving discounts, or literally paying somebody to show up.
--:-- Steph: I was thinking of paying celebrities to show up, and that feels very not really sustainable because they pretty much leave after that.
--:-- Scott Commoners: Exactly. It's super unsustainable. Here there's this opportunity, at least in principle, where you can subsidize people by giving them tokens that give them more value aligned with the activity they're conducting. If you give your initial developers or liquidity providers or whomever a bunch of tokens, then not only does this drive them to participate right now, but it actually gives them much more of a reason to stay on the platform and keep participating in the future. The value of those tokens goes up if they provide liquidity or develop software or features that attract a lot of users. And if it's successful – because obviously it could also go down, it could go both directions, to be really clear – but the key point is that there is a mechanism for that alignment now.
--:-- Steph: Exactly. There's alignment with the activity that they're undertaking and hopeful success of the platform and value creation.
--:-- Steph: Another quick tactical question. This is based on your paper with John William Hatfield. It's a working paper: "A Simple Theory of Vampire Attacks." The point you made is that not only do vampire attacks facilitate price competition, we obviously know that. But the most interesting part is that Web3 platforms face even more competitive pressures when they have loyalty programs, where a classic traditional platform would not face that same type. What would be your one key advice for how builders in Web3 should think about this particular nuance?
--:-- Scott Commoners: Great question. We talked about vampire attacks earlier, and I mentioned that vampire attacks leverage on-chain data and often involve a new entrant or an existing platform directly incentivizing an incumbent's top users to switch. If you think about it like airline points, an airline keeps you locked in by giving you status on that airline. You get perks, you get cheaper seats, you get fancier seats, and that's a form of lock-in. But it's actually not quite as locked in as we might expect because airlines also have a thing called status match. If you have high status on United and you call up Delta and say, "Hi, I'm a platinum user on United, and I'd like to switch to Delta," Delta might say, "Great," and send you a contract, ask you to provide proof that you're a United platinum member. It's very hard to verify. Most people find it a lot of work to do this. Most people don't.
--:-- Scott Commoners: Web3 makes that type of status immediately verifiable. If I'm a new competitor launching a new NFT marketplace, I can just see who all the big NFT traders were because it's all on the blockchain. I can tell all of them, "Look, come to my platform instead. I'm going to give you platinum tier status where you get to use all the fancy features." Full stop. You don't have to fax me a copy of your United ID card. I can see it. I know you're high status. I want you to be high status on my platform. So it's strengthened the vampire attack strategy because now there are much lower costs to doing it.
--:-- Scott Commoners: But ironically, loyalty is still, to some degree, the defense. It just takes a different form. Loyalty is not just about giving people stuff. It's easy to replicate. Loyalty now becomes integrating people into the brand. It takes on purpose and identity for you. An NFT trading platform wants their users to want to use them and to feel attached to the platform. It can do that in part through giving them premium features, sure. But it mostly has to do that by leveraging them as a group together and forming identity around the platform.
--:-- Steph: That's fantastic, Scott. That is so interesting. Thank you. But I do want to take a step back and say, it sounds to me like what you're also saying is it's kind of still early days for business strategy for Web3. Absolutely. There's this unbounded Web3 value in theory, but to make it practicable, we actually have to solve these strategy questions to figure out how value capture is going to work.
--:-- Steph: Even though we have ideas of how they may play out, it feels like at some point we may have to abandon a lot of these old frameworks and models and come up with entirely new first principles-based ones. I think it's unprecedented in human history that we have ever built businesses in this manner at this scale. Ever. I don't know. You can check me if I'm wrong. Even past open source projects have never monetized in the way that the type of composability and interoperability and all these things we're talking about. I don't think we've seen that before.
--:-- Scott Commoners: No, I don't think we have. I think you're right. You say early days. It's really early days.
--:-- Scott Commoners: Michael Porter's thinking was a reflection on the history of modern business to date. Even most of the things we know about various eras of the web and web platforms are still relatively recent and still transforming and morphing all the time. A lot of our early understanding of platforms and platform dynamics did not foresee the modern tech and media giants. So absolutely, I think we're going to need completely new business frameworks. How do you even start to define general principles for value creation and capture in Web3? And how do they relate to what we understood about previous incarnations of the web and other related product movements like open source software? This is a super interesting space. General call to people who hear this podcast: please think about it. If you have cool ideas, please let me know.
--:-- Steph: I did have one last kind of crazy question. One of the people I've worked with at Xerox PARC was Brian Arthur. He wrote that seminal paper back in 1996 on increasing returns in the new world of business. He began his paper saying how his understanding of markets and business was based on stuff from centuries ago. Then the shift occurred where the underlying mechanisms that determine economic behavior shifted from diminishing to increasing returns. That was a very seminal moment.
--:-- Steph: I feel like in economics, especially for economics applied to technology behaviors and software in particular, because that's where things really get kind of jiggered up. I feel like we're in a similar moment in Web3. Particularly when it comes to this question. By the way, we've had Brian on the podcast because I had him talk with me and Mark a few years ago. He actually talked about how increasing returns can also stop after time, and you have to think about the long-term sustainability. I was wondering, what would the analog be for you if you were to kind of come up with a frame, or just even a phrase, that you would think about for capturing whatever the effect is in Web3?
--:-- Scott Commoners: This is all very rough, and I don't have what I would call a coherent or complete economic theory around this. As an economic theorist, I'm always wary of declaring a theory that I can't at least visualize the theorem. But my rough instinct is that what we see in Web3 is what you might call "expanding returns." Every new thing that's created creates a new ecosystem of possibilities, which is a little bit loosely like what's called an expander graph in graph theory.
--:-- Scott Commoners: But stay tuned. Maybe we'll do that in a future episode.
--:-- Steph: Oh, my God. I love that. That's a perfect note to end on. Awesome. Well, Scott, thank you so much for joining this episode. That was so much fun.
--:-- Scott Commoners: Thank you. No, it was so much fun for me, too.
--:-- Sonal Choksi: Thank you for listening to Web3 with a16z. You can find show notes with links to resources, books, or papers discussed, transcripts, and more at a16zcrypto.com. This episode was produced and edited by Sonal Choksi. That's me. This episode was technically edited by our audio editor, Seven Morris. Credit also to Moonshot Design for the art, and all thanks to support from a16z Crypto. To follow more of our work and get updates, resources from us and from others, be sure to subscribe to our Web3 weekly newsletter. You can find it on our website at a16zcrypto.com. Thank you for listening and for subscribing. Let's go.
