Value of Networks

In the early 1980s, Robert Metcalfe at 3Com was trying to sell Ethernet cards to his enterprise customers. At the time, these cards were expensive ~$1000 per card and the cost scaled linearly — to install N cards, the enterprise customer had to spend $1000 x N. This was expensive. However, Metcalfe argued that the value of connecting computers in an enterprise would grow as N² . So, if the enterprise decided to connect 2000 computers, the cost would be $2M but the value would be $4M.

Image Credits: https://amplitude.com/blog/2017/06/13/network-effect-product-growth

This network effect which came to be known as Metcalfe’s law says that the value a network user derives from the network grows as N². It works for all kinds of scenarios where value depends on connectivity between nodes. A single phone is useless; as the number of phones increases, the value to a phone user grows quickly.

Do supply networks follow Metcalfe’s law?

In today’s highly inter-connected world, economic value gets created by firms collaborating with each other. This results in the creation of economic (business) networks. The most obvious example of such business networks are supply chains. Actually, the name supply chain is a misnomer since real world suppliers and vendors form a network.

Image Credits : Kito et. al. (2014)

The figure above shows a conceptual overview of Toyota’s network segregated into tiers based on whether a firm supplies to Toyota directly or indirectly (i.e. to another of Toyota’s supplier). The figure on the right shows the actual Toyota supply network of over 2000 companies. Here, each node represents a sub-network (group) consisting of several firms. An edge between sub-network represents supply-procure relationship across firms in those two sub-networks. Both figures are from a recent publication. The simple takeaway — real world supply chain are often complex networks.

It is interesting then to ask if such supply networks follow Metcalfe’s law?

Does the value that a firm derive from its business networks grow as N² — super-linearly in the number of firms in the network?

The answer — it depends.

Metcalfe’s law says that the value a network user derives from the network grows as N² because in a network of N nodes, there are N² potential links (edges) that can be created. The value derives from the fact that each of the N nodes can communicate with any of the other N-1 nodes.

Image Credits: https://www.nfx.com/post/network-effects-bible

Consider the supply network of the leftmost figure: a single buyer in the center with N suppliers. The value derived by the buyer in the center is N. The suppliers do not derive any other value because they don’t trade with each other.

Now, consider the supply network of the center figure: each firm in the network can trade with any other firm in the network. The value derived by every firm is N; since every firm derives this value, the network value is N x N = N². The Toyota supply network is an example of this. Note that Toyota also benefits from the fact that its suppliers trade with each other e.g. Toyota may be able to negotiate better contract terms, have deeper oversight and get better insights into its supply & procurement.

Finally, consider the supply network of the rightmost figure: each firm in the network can trade with any other firm in the network. But this network goes further. Unlike the center figure, a trade in this network may involve more than two firms: Firms A, B & C may decide to build a product where A and B supply raw material to C who then assembles them to create the final product. Such groups are useful, for example, in contract manufacturing and multi-tier logistics networks. Networks which allow such group collaboration can lead to network values as high as 2ᴺ — a network effect known as Reed’s law.

The key observation is that the value of a supply network depends fundamentally on how decentralized the network is. If each firm in the network can trade with any other firm and form collaborative groups, the value of the network grows exponentially — benefiting every group member.

Cost of Networks

There is however a catch. Back to Metcalfe’s law — it talks both about the value of the network and the cost of the network. The law explains how the value of the network exceeds the cost.

Coordination Cost in Supply Network

What are the costs of creating a supply network? Economists call them Transaction Costs. These include (i) search and information costs such as in determining that the required good is available, which firm offers the lowest price, etc. (ii) bargaining costs required to come to an acceptable agreement with the other firm, drawing up an appropriate contract and so on and (iii) policing and enforcement costs in making sure the other firm(s) sticks to the terms of the contract, and taking appropriate action if this turns out not to be the case.

As the number of nodes in the network grows, transaction costs increase due the complexity of managing these collaborations: multiple suppliers, suppliers-of-suppliers, enforcing the contractual terms, monitoring performance, reconciling payments etc.

Image Credits: https://bhc3.com/2010/01/

Creating high value supply networks while keeping the cost of managing these networks low creates the need for scalable methods for collaboration.

Today’s B2B networks are managed using a variety of mechanisms (e.g. contracts) and tools (e.g. ERPs). Transfers of value (products, services, payments) between firms are carefully recorded by each organization (e.g. in an ERP). As the long-lived transactions proceed, information is exchanged by emails, phone calls or chat messages.

The challenge is that the tools we use today to manage supply networks are outdated. B2B contracts are still written in text— enforcement thus requires manual interpretation. This can lead to disputes & in the worst case may require legal recourse The information required to verify contract terms is replicated across ERPs; this must be reconciled before payments can be settled.

Despite efforts like EDI, processes relying on emails, spreadsheets & pdfs are still common — the primary challenge with such processes is that each party has a “copy” of the transaction e.g. purchase orders, invoices, and payments. Given the complex workflows, these copies can get out-of-sync. Transactions that are not in agreement require time consuming research, repair, revision, reconciliation, negotiation and hopefully settlement.

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With distributed ledger technologies (Blockchains) and Smart Contracts, a lot of this is about to change. The data reconciliation function of EDI comes built-in with Blockchains — each node keeps a copy of the ledger. Smart contracts can go a step-further: they enable not only data synchronization among ERPs in a B2B network but also process synchronization and the enforcement of Service Level Agreements. These capabilities can be used to improve B2B coordination, ensure compliance & align incentives.

Blockchaining a Supply Network

With Blockchains, there is today an opportunity to significantly reduce the transaction costs in supply chain and significantly increase the value. With marketsN, we are building a solution specifically to address this challenge.

Our aim is to enable the creation of B2B networks whose value grows as 2ᴺ but where transaction costs grow only as N.

With exponential value at linear costs, the true value of business networks can be realized. marketsN is a Blockchain & AI based, cloud hosted solution for organizations to integrate their business networks. It offers a technology solution which incentivizes adoption by every organization in an economic network so as to reduce transaction costs & improve market efficiencies. marketsN uses automated smart contracts to reduce transaction costs, embedded finance to reduces risk & a distributed ledger to improve supply chain visibility.

The five key features that we focus on are:

  1. Automated contracts to reduce transaction costs & prevent billing fraud
  2. Embedded finance to increases trust in trade finance
  3. Wider supply network visibility to creates real time accountability & enable better planning
  4. Built-in AI to learn from distributed data & improve performance over time
  5. Product provenance to ensure compliance & protect against counterfeits

If you want to explore Blockchains for your enterprise, feel free to reach out to us at info@marketsn.com