Coordination problems1 are hard to solve. We know this, but how can we use that to make money?

Well, a classic coordination problem presents people with a choice between conforming and defecting. You pay a small cost for conforming, and a large cost for defecting unless all the other participants defect as well. Structures with “network effects” behave like this. If you leave but everyone else stays, then you suffer from being excluded from the network; but if everyone leaves then you’re not going to miss out on the latest gossip/music/gerbil video.

So, a recipe for exploiting coordination problems goes like this:

  • Make a network
  • Encourage people to join
  • Unilaterally impose a small cose for participating in the network

Then members are faced with a choice between paying up (and retaining the network benefits) or leaving - which is only profitable if everyone else does the same.

In modern parlance, this translates to:

  • Start a social media company
  • Offer it for free to get users
  • Start charging once you have a lot of users

I think this makes partial sense of the otherwise baffling mania for startups with no revenue, but a large user-base. What they sell is not a revenue stream, but a network of users who are ripe to be extorted via this sort of coordination problem.

  1. A coordination problem is any problem where the optimal solution for all participants requires some or all of the participants to choose the same strategy.