In
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
, a network effect (also called network externality or demand-side economies of scale) is the phenomenon by which the
value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...
or
utility
As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosoph ...
a user derives from a
good
In most contexts, the concept of good denotes the conduct that should be preferred when posed with a choice between possible actions. Good is generally considered to be the opposite of evil and is of interest in the study of ethics, morality, ph ...
or
service depends on the number of users of compatible products. Network effects are typically positive, resulting in a given user deriving more value from a product as more users join the same network. The adoption of a product by an additional user can be broken into two effects: an increase in the value to all other users ( "total effect") and also the enhancement of other non-users' motivation for using the product ("marginal effect").
Network effects can be direct or indirect. Direct network effects arise when a given user's utility increases with the number of other users of the same product or technology, meaning that adoption of a product by different users is complementary.
This effect is separate from effects related to price, such as a benefit to existing users resulting from price decreases as more users join. Direct network effects can be seen with
social networking services, including
Twitter
Twitter is an online social media and social networking service owned and operated by American company Twitter, Inc., on which users post and interact with 280-character-long messages known as "tweets". Registered users can post, like, and ...
,
Facebook
Facebook is an online social media and social networking service owned by American company Meta Platforms. Founded in 2004 by Mark Zuckerberg with fellow Harvard College students and roommates Eduardo Saverin, Andrew McCollum, Dustin M ...
,
Airbnb
Airbnb, Inc. ( ), based in San Francisco, California, operates an online marketplace focused on short-term homestays and experiences. The company acts as a broker and charges a commission from each booking. The company was founded in 2008 b ...
,
Uber
Uber Technologies, Inc. (Uber), based in San Francisco, provides mobility as a service, ride-hailing (allowing users to book a car and driver to transport them in a way similar to a taxi), food delivery (Uber Eats and Postmates), packa ...
, and
LinkedIn
LinkedIn () is an American business and employment-oriented online service that operates via websites and mobile apps. Launched on May 5, 2003, the platform is primarily used for professional networking and career development, and allows job se ...
;
telecommunication
Telecommunication is the transmission of information by various types of technologies over wire, radio, optical, or other electromagnetic systems. It has its origin in the desire of humans for communication over a distance greater than that fe ...
s devices like the
telephone
A telephone is a telecommunications device that permits two or more users to conduct a conversation when they are too far apart to be easily heard directly. A telephone converts sound, typically and most efficiently the human voice, into e ...
; and
instant messaging
Instant messaging (IM) technology is a type of online chat allowing real-time text transmission over the Internet or another computer network. Messages are typically transmitted between two or more parties, when each user inputs text and trigge ...
services such as
MSN
MSN (meaning Microsoft Network) is a web portal and related collection of Internet services and apps for Windows and mobile devices, provided by Microsoft and launched on August 24, 1995, alongside the release of Windows 95.
The Microsoft Net ...
,
AIM or
QQ. Indirect (or cross-group) network effects arise when there are "at least two different customer groups that are interdependent, and the utility of at least one group grows as the other group(s) grow".
For example, hardware may become more valuable to consumers with the growth of compatible software.
Network effects are commonly mistaken for
economies of scale
In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced per unit of time. A decrease in cost per unit of output enables ...
, which describe decreasing average production costs in relation to the total volume of units produced. Economies of scale are a common phenomenon in traditional industries such as manufacturing, whereas network effects are most prevalent in
new economy
The New Economy refers to the ongoing development of the American economic system. It evolved from the notions of the classical economy via the transition from a manufacturing-based economy to a service-based economy, and has been driven by ...
industries, particularly
information and communication technologies. Network effects are the
demand side counterpart of economies of scale, as they function by increasing a customer's willingness to pay due rather than decreasing the supplier's average cost.
Upon reaching critical mass, a
bandwagon effect
The bandwagon effect is the tendency for people to adopt certain behaviors, styles, or attitudes simply because others are doing so. More specifically, it is a cognitive bias by which public opinion or behaviours can alter due to particular act ...
can result. As the network continues to become more valuable with each new adopter, more people are incentivised to adopt, resulting in a
positive feedback
Positive feedback (exacerbating feedback, self-reinforcing feedback) is a process that occurs in a feedback loop which exacerbates the effects of a small disturbance. That is, the effects of a perturbation on a system include an increase in the ...
loop. Multiple equilibria and a market
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
are two key potential outcomes in markets that exhibit network effects. Consumer expectations are key in determining which outcomes will result.
Origins
Network effects were a central theme in the arguments of
Theodore Vail
Theodore Newton Vail (July 16, 1845 – April 16, 1920) was president of American Telephone & Telegraph between 1885 and 1889, and again from 1907 to 1919. Vail saw telephone service as a public utility and moved to consolidate telephone networks u ...
, the first
post-patent president of
Bell Telephone
The Bell System was a system of telecommunication companies, led by the Bell Telephone Company and later by the American Telephone and Telegraph Company (AT&T), that dominated the telephone services industry in North America for over one hundre ...
, in gaining a monopoly on US telephone services. In 1908, when he presented the concept in Bell's annual report, there were over 4,000 local and regional telephone exchanges, most of which were eventually merged into the
Bell System.
Network effects were popularized by
Robert Metcalfe
Robert Melancton Metcalfe (born April 7, 1946) is an engineer and entrepreneur from the United States who helped pioneer the Internet starting in 1970. He co-invented Ethernet, co-founded 3Com and formulated Metcalfe's law, which describes the e ...
, stated as
Metcalfe's law
Metcalfe's law states that the value of a telecommunications network is proportional to the square of the number of connected users
of the system (''n''2). First formulated in this form by George Gilder in 1993, and attributed to Robert Metcalf ...
. Metcalfe was one of the co-inventors of
Ethernet
Ethernet () is a family of wired computer networking technologies commonly used in local area networks (LAN), metropolitan area networks (MAN) and wide area networks (WAN). It was commercially introduced in 1980 and first standardized in 198 ...
and a co-founder of the company
3Com
3Com Corporation was an American digital electronics manufacturer best known for its computer network products. The company was co-founded in 1979 by Robert Metcalfe, Howard Charney and others. Bill Krause joined as President in 1981. Metcalfe ex ...
. In selling the product, Metcalfe argued that customers needed Ethernet cards to grow above a certain
critical mass
In nuclear engineering, a critical mass is the smallest amount of fissile material needed for a sustained nuclear chain reaction. The critical mass of a fissionable material depends upon its nuclear properties (specifically, its nuclear fi ...
if they were to reap the benefits of their network. According to Metcalfe, the rationale behind the sale of networking cards was that the cost of the network was directly proportional to the number of cards installed, but the value of the network was proportional to the square of the number of users. This was expressed algebraically as having a cost of N, and a value of N
2. While the actual numbers behind this proposition were never firm, the concept allowed customers to share access to expensive resources like disk drives and printers, send e-mail, and eventually access the Internet.
The economic theory of the network effect was advanced significantly between 1985 and 1995 by researchers Michael L. Katz, Carl Shapiro, Joseph Farrell, and Garth Saloner. Author, high-tech entrepreneur
Rod Beckstrom
Rod Beckstrom (born February 1961) is an American author, high-tech entrepreneur, and former CEO and President of ICANN. He previously served as Director of the National Cybersecurity Center.
Education and early work
Beckstrom received his BA ...
presented a mathematical model for describing networks that are in a state of positive network effect at BlackHat and Defcon in 2009 and also presented the "inverse network effect" with an economic model for defining it as well. Because of the positive feedback often associated with the network effect,
system dynamics can be used as a modelling method to describe the phenomena.
Word of mouth
Word of mouth, or ''viva voce'', is the passing of information from person to person using oral communication, which could be as simple as telling someone the time of day. Storytelling is a common form of word-of-mouth communication where one pe ...
and the
Bass diffusion model are also potentially applicable. The next major advance occurred between 2000 and 2003 when researchers
Geoffrey G Parker,
Marshall Van Alstyne
Marshall W. Van Alstyne (born March 28, 1962) is a professor at Boston University and research associate at the MIT Initiative on the Digital Economy. He co-developed the theory of two-sided markets with Geoffrey G Parker. His work focuses on the ...
, Jean-Charles Rochet and
Jean Tirole
Jean Tirole (born 9 August 1953) is a French professor of economics at Toulouse 1 Capitole University. He focuses on industrial organization, game theory, banking and finance, and economics and psychology. In 2014 he was awarded the Nobel Memori ...
independently developed the
two-sided market
A two-sided market, also called a two-sided network, is an intermediary economic platform having two distinct user groups that provide each other with network benefits. The organization that creates value primarily by enabling direct interactions ...
literature showing how network externalities that cross distinct groups can lead to free pricing for one of those groups.
Evidence and Consequences
![Online Diversity](https://upload.wikimedia.org/wikipedia/commons/d/d9/Online_Diversity.jpg)
While the diversity of sources is in decline, there is a countervailing force of continually increasing functionality with new services, products and applications — such as music
streaming services (Spotify),
file sharing
File sharing is the practice of distributing or providing access to digital media, such as computer programs, multimedia (audio, images and video), documents or electronic books. Common methods of storage, transmission and dispersion include r ...
programs (Dropbox) and
messaging platforms (Messenger, Whatsapp and Snapchat). Another major finding was the dramatic increase in the “infant mortality” rate of websites — with the dominant players in each functional niche - once established guarding their turf more staunchly than ever.
On the other hand, growing network effect does not always bring proportional increase in returns. Whether additional users bring more value depends on the
commoditization
In business literature, commoditization is defined as the process by which goods that have economic value and are distinguishable in terms of attributes (uniqueness or brand) end up becoming simple commodities in the eyes of the market or consum ...
of supply, the type of incremental user and the nature of
substitutes. For example, social networks can hit an inflection point, after which additional users do not bring more value. This could be attributed to the fact that as more people join the network, its users are less willing to share personal content and the site becomes more focused on news and public content.
Economics
Network economics refers to business economics that benefit from the network effect. This is when the value of a good or service increases when others buy the same good or service. Examples are website such as
EBay
eBay Inc. ( ) is an American multinational e-commerce company based in San Jose, California, that facilitates consumer-to-consumer and business-to-consumer sales through its website. eBay was founded by Pierre Omidyar in 1995 and became ...
, or
iVillage
iVillage, Inc. was a mass media company that operated the ”most popular female-oriented sites” on the internet in the 1990s. In addition to ivillage.com, the company operated iVillage UK, Astrology.com, GardenWeb, and the NBC Digital Health ...
where the community comes together and shares thoughts to help the website become a better business organization.
In
sustainability
Specific definitions of sustainability are difficult to agree on and have varied in the literature and over time. The concept of sustainability can be used to guide decisions at the global, national, and individual levels (e.g. sustainable livi ...
, network economics refers to multiple professionals (architects, designers, or related businesses) all working together to develop sustainable products and technologies. The more companies are involved in environmentally friendly production, the easier and cheaper it becomes to produce new sustainable products. For instance, if no one produces sustainable products, it is difficult and expensive to design a sustainable house with custom materials and technology. But due to network economics, the more industries are involved in creating such products, the easier it is to design an environmentally sustainable building.
Another benefit of network economics in a certain field is improvement that results from competition and networking within an industry.
Adoption and competition
Critical mass
In the early phases of a network technology, incentives to adopt the new technology are low. After a certain number of people have adopted the technology, network effects become significant enough that adoption becomes a
dominant strategy
In game theory, strategic dominance (commonly called simply dominance) occurs when one strategy is better than another strategy for one player, no matter how that player's opponents may play. Many simple games can be solved using dominance. The ...
. This point is called critical mass. At the critical mass point, the value obtained from the good or service is greater than or equal to the price paid for the good or service.
When a product reaches critical mass, network effects will drive subsequent growth until a stable balance is reached. Therefore, a key business concern must then be how to attract users prior to reaching critical mass. Critical quality is closely related to consumer expectations, which will be affected by price and quality of products or services, the company's reputation and the growth path of the network.
Thus, one way is to rely on extrinsic motivation, such as a payment, a fee waiver, or a request for friends to sign up. A more natural strategy is to build a system that has enough value ''without'' network effects, at least to
early adopters
An early adopter or lighthouse customer is an early customer of a given company, product, or technology. The term originates from Everett M. Rogers' '' Diffusion of Innovations'' (1962).
History
Typically, early adopters are customers who, in add ...
. Then, as the number of users increases, the system becomes even more valuable and is able to attract a wider user base.
Beyond critical mass, the increasing number of subscribers generally cannot continue indefinitely. After a certain point, most networks become either congested or saturated, stopping future uptake. Congestion occurs due to overuse. The applicable analogy is that of a telephone network. While the number of users is below the congestion point, each additional user adds additional value to every other customer. However, at some point, the addition of an extra user exceeds the capacity of the existing system. After this point, each additional user decreases the value obtained by every other user. In practical terms, each additional user increases the total system load, leading to
busy signal
Reanno Devon Gordon (born 24 January 1979), better known by his stage name Busy Signal, is a Jamaican dancehall reggae artist.
Biography
Reanno Devon Gordon p/k/a Busy Signal was born in Saint Ann Parish,Johnson, Carolyn (2006)A Very Busy Chi ...
s, the inability to get a
dial tone
A dial tone is a telephony Signaling (telecommunication), signal sent by a telephone exchange or private branch exchange (PBX) to a terminating device, such as a telephone, when an off-hook condition is detected. It indicates that the exchange is ...
, and poor
customer support
Customer support is a range of services to assist customers in making cost effective and correct use of a product. It includes assistance in planning, installation, training, troubleshooting, maintenance, upgrading, and disposal of a product. Reg ...
. Assuming the congestion point is below the potential market size, the next critical point is where the value obtained again equals the price paid. The network will cease to grow at this point if system capacity is not improved.
Peer-to-peer
Peer-to-peer (P2P) computing or networking is a distributed application architecture that partitions tasks or workloads between peers. Peers are equally privileged, equipotent participants in the network. They are said to form a peer-to-peer ...
(P2P) systems are networks designed to distribute load among their user pool. This theoretically allows P2P networks to scale indefinitely. The P2P based telephony service
Skype
Skype () is a proprietary telecommunications application operated by Skype Technologies, a division of Microsoft, best known for VoIP-based videotelephony, videoconferencing and voice calls. It also has instant messaging, file transfer, deb ...
benefits from this effect and its growth is limited primarily by
market saturation
In economics, market saturation is a situation in which a product has become diffused (distributed) within a market; the actual level of saturation can depend on consumer purchasing power; as well as competition, prices, and technology.
Theory ...
.
Market tipping
Network effects give rise to the potential outcome of market tipping, defined as "the tendency of one system to pull away from its rivals in popularity once it has gained an initial edge". Tipping results in a market in which only one good or service dominates and competition is stifled, and can result in a
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
. This is because network effects tend to incentivise users to coordinate their adoption of a single product. Therefore, tipping can result in a natural form of market concentration in markets that display network effects. However, the presence of network effects does not necessarily imply that a market will tip; the following additional conditions must be met:
# The utility derived by users from network effects must exceed the utility they derive from differentiation
# Users must have high costs of
multihoming
Multihoming is the practice of connecting a host or a computer network to more than one network. This can be done in order to increase reliability or performance.
A typical host or end-user network is connected to just one network. Connecting ...
(i.e. adopting more than one competing networks)
# Users must have high switching costs
If any of these three conditions are not satisfied, the market may fail to tip and multiple products with significant market shares may coexist.
One such example is the U.S. instant messaging market, which remained an oligopoly despite significant network effects. This can be attributed to the low multi-homing and switching costs faced by users.
Market tipping does not imply permanent success in a given market. Competition can be reintroduced into the market due to shocks such as the development of new technologies. Additionally, if the price is raised above customers' willingness to pay, this may reverse market tipping.
Multiple equilibria and expectations
Networks effects often result in multiple potential market equilibrium outcomes. The key determinant in which equilibrium will manifest are the expectations of the market participants, which are self-fulfilling.
Because users are incentivised to coordinate their adoption, user will tend to adopt the product that they expect to draw the largest number of users. These expectations may be shaped by path dependence, such as a perceived
first-mover advantage
In marketing strategy, first-mover advantage (FMA) is the competitive advantage gained by the initial ("first-moving") significant occupant of a market segment. First-mover advantage enables a company or firm to establish strong brand recognitio ...
, which can result in
lock-in. The most commonly cited example of path dependence is the
QWERTY
QWERTY () is a keyboard layout for Latin-script alphabets. The name comes from the order of the first six Computer keyboard keys#Types, keys on the top left letter row of the keyboard ( ). The QWERTY design is based on a layout created f ...
keyboard, which owes its ubiquity to its establishment of an early lead in the keyboard layout industry and high switching costs, rather than any inherent advantage over competitors. Other key influences of adoption expectations can be reputational (e.g. a firm that has previously produced high quality products may be favoured over a new firm).
Markets with network effects may result in inefficient equilibrium outcomes. With simultaneous adoption, users may fail to coordinate towards a single agreed-upon product, resulting in splintering among different networks, or may coordinate to lock-in to a different product than the one that is best for them.
Technology lifecycle
If some existing technology or company whose benefits are largely based on network effects starts to lose market share against a challenger such as a
disruptive technology or
open standards
An open standard is a standard that is openly accessible and usable by anyone. It is also a prerequisite to use open license, non-discrimination and extensibility. Typically, anybody can participate in the development. There is no single definitio ...
based competition, the benefits of network effects will reduce for the incumbent, and increase for the challenger. In this model, a tipping point is eventually reached at which the network effects of the challenger dominate those of the former incumbent, and the incumbent is forced into an accelerating decline, whilst the challenger takes over the incumbent's former position.
Sony's Betamax and
Victor Company of Japan
JVC (short for Japan Victor Company) is a Japanese brand owned by JVCKenwood corporation. Founded in 1927 as the Victor Talking Machine Company of Japan and later as , the company is best known for introducing Japan's first televisions and for ...
(JVC)'s
video home system (VHS) can both be used for
video cassette recorders
A videocassette recorder (VCR) or video recorder is an electromechanical device that records analog audio and analog video from broadcast television or other source on a removable, magnetic tape videocassette, and can play back the recordin ...
(VCR), but the two technologies are not compatible. Therefore, the VCR that is suitable for one type of cassette cannot fit in another. VHS's technology gradually surpassed Betamax in the competition. In the end, Betamax lost its original market share and was replaced by VHS.
Negative network externalities
Negative network externalities, in the mathematical sense, are those that have a negative effect compared to normal (positive) network effects. Just as positive network externalities (network effects) cause
positive feedback
Positive feedback (exacerbating feedback, self-reinforcing feedback) is a process that occurs in a feedback loop which exacerbates the effects of a small disturbance. That is, the effects of a perturbation on a system include an increase in the ...
and
exponential growth
Exponential growth is a process that increases quantity over time. It occurs when the instantaneous rate of change (that is, the derivative) of a quantity with respect to time is proportional to the quantity itself. Described as a function, a q ...
, negative network externalities create
negative feedback
Negative feedback (or balancing feedback) occurs when some function (Mathematics), function of the output of a system, process, or mechanism is feedback, fed back in a manner that tends to reduce the fluctuations in the output, whether caused by ...
and
exponential decay. In nature, negative network externalities are the forces that pull towards equilibrium, are responsible for stability, and represent physical limitations keeping systems bounded.
Besides, Negative network externalities has four characteristics, which are namely, more login retries, longer query times, longer download times and more download attempts. Therefore, congestion occurs when the efficiency of a network decreases as more people use it, and this reduces the value to people already using it.
Traffic congestion that overloads the freeway and
network congestion
Network congestion in data networking and queueing theory is the reduced quality of service that occurs when a network node or link is carrying more data than it can handle. Typical effects include queueing delay, packet loss or the blocking of ...
on connections with limited bandwidth both display negative network externalities.
Braess's paradox
Braess's paradox is the observation that adding one or more roads to a road network can slow down overall traffic flow through it. The paradox was discovered by the German mathematician Dietrich Braess in 1968.
The paradox may have analogies in ...
suggests that adding paths through a network can have a negative effect on performance of the network.
Interoperability
Interoperability
Interoperability is a characteristic of a product or system to work with other products or systems. While the term was initially defined for information technology or systems engineering services to allow for information exchange, a broader defi ...
has the effect of making the network bigger and thus increases the external value of the network to consumers. Interoperability achieves this primarily by increasing potential connections and secondarily by attracting new participants to the network. Other benefits of interoperability include reduced uncertainty, reduced lock-in,
commoditization
In business literature, commoditization is defined as the process by which goods that have economic value and are distinguishable in terms of attributes (uniqueness or brand) end up becoming simple commodities in the eyes of the market or consum ...
and competition based on price.
Interoperability can be achieved through
standardization or other cooperation. Companies involved in fostering interoperability face a tension between cooperating with their competitors to grow the potential market for products and competing for market share.
Compatibility and incompatibility
Product compatibility is closely related to network externalities in company's competition, which refers to two systems that can be operated together without changing. Compatible products are characterized by better matching with customers, so they can enjoy all the benefits of the network without having to purchase products from the same company. However, not only products of compatibility will intensify competition between companies, this will make users who had purchased products lose their advantages, but also proprietary networks may raise the industry entry standards. Compared to large companies with better reputation or strength, weaker companies or small networks will more inclined to choose compatible products.
Besides, the compatibility of products is conducive to the company's increase in market share. For example, the
Windows
Windows is a group of several proprietary graphical operating system families developed and marketed by Microsoft. Each family caters to a certain sector of the computing industry. For example, Windows NT for consumers, Windows Server for serv ...
system is famous for its operating compatibility, thereby satisfying consumers' diversification of other applications. As the supplier of Windows systems,
Microsoft
Microsoft Corporation is an American multinational technology corporation producing computer software, consumer electronics, personal computers, and related services headquartered at the Microsoft Redmond campus located in Redmond, Washing ...
benefits from indirect network effects, which cause the growing of the company's market share.
Incompatibility is the opposite of compatibility. Because incompatibility of products will aggravate
market segmentation
In marketing, market segmentation is the process of dividing a broad consumer or business market, normally consisting of existing and potential customers, into sub-groups of consumers (known as ''segments'') based on some type of shared charact ...
and reduce efficiency, and also harm consumer interests and enhance competition. The result of the competition between incompatible networks depends on the complete sequential of adoption and the early preferences of the adopters. Effective competition determines the market share of companies, which is historically important. Since the installed base can directly bring more network profit and increase the consumers' expectations, which will have a positive impact on the smooth implementation of subsequent network effects.
Open versus closed standards
In communication and information technologies,
open standards and interfaces are often developed through the participation of multiple companies and are usually perceived to provide mutual benefit. But, in cases in which the relevant communication protocols or interfaces are closed standards, the network effect can give the company controlling those standards monopoly power. The
Microsoft
Microsoft Corporation is an American multinational technology corporation producing computer software, consumer electronics, personal computers, and related services headquartered at the Microsoft Redmond campus located in Redmond, Washing ...
corporation is widely seen by computer professionals as maintaining its monopoly through these means. One observed method Microsoft uses to put the network effect to its advantage is called
Embrace, extend and extinguish
"Embrace, extend, and extinguish" (EEE), also known as "embrace, extend, and exterminate", is a phrase that the U.S. Department of Justice found that was used internally by Microsoft to describe its strategy for entering product categories involvin ...
.
Mirabilis is an Israeli start-up which pioneered
instant messaging
Instant messaging (IM) technology is a type of online chat allowing real-time text transmission over the Internet or another computer network. Messages are typically transmitted between two or more parties, when each user inputs text and trigge ...
(IM) and was bought by
America Online
AOL (stylized as Aol., formerly a company known as AOL Inc. and originally known as America Online) is an American web portal and online service provider based in New York City. It is a brand marketed by the current incarnation of Yahoo! Inc. ...
. By giving away their
ICQ product
for free
"For Free" is a song by American musician DJ Khaled featuring Canadian rapper Drake. It was released on June 3, 2016 by We the Best Music Group and Epic Records as the lead single from DJ Khaled's ninth studio album, ''Major Key''. The song wa ...
and preventing interoperability between their client
software
Software is a set of computer programs and associated documentation and data. This is in contrast to hardware, from which the system is built and which actually performs the work.
At the lowest programming level, executable code consists ...
and other products, they were able to temporarily dominate the market for instant messaging. The IM technology has completed the use from the home to the workplace, because of its faster processing speed and simplified process characteristics. Because of the network effect, new IM users gained much more value by choosing to use the Mirabilis system (and join its large network of users) than they would use a competing system. As was typical for that era, the company never made any attempt to generate profits from its dominant position before selling the company.
Network effect as a competitive advantage
Network effect can significantly influence the competitive landscape of an industry. According to
Michael E. Porter
Michael Eugene Porter (born May 23, 1947) is an American academic known for his theories on economics, business strategy, and social causes. He is the Bishop William Lawrence University Professor at Harvard Business School, and he was one of ...
, strong network effect might decrease the threat of new entrants, which is one of the
five major competitive forces that act on an industry. Persistent barriers to entry a market may help incumbent companies to fend off competition and keep or increase their
market share, while maintaining profitability and return on capital.
These attractive characteristics are one of the reasons that allowed platform companies like Amazon, Google or Facebook to grow rapidly and create shareholder value. On the other hand, network effect can result in high concentration of power in an industry, or even a
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
. This often leads to increased scrutiny from regulators that try to restore healthy competition, as is often the case with large technology companies.
Examples
The Telephone
Network effects are the incremental benefit gained by each user for each new user that joins a network. An example of a direct network effect is the telephone. Originally when only a small number of people owned a telephone the value it provided was minimal. Not only did other people need to own a telephone for it to be useful, but it also had to be connected to the network through the users home. As technology advanced it became more affordable for people to own a telephone. This created more value and utility due to the increase in users. Eventually increased usage through exponential growth led to the telephone is used by almost every household adding more value to the network for all users. Without the network effect and technological advances the telephone would have no where near the amount of value or utility as it does today.
Financial exchanges
Stock exchange
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for th ...
s and
derivatives exchanges feature a network effect.
Market liquidity
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
is a major determinant of
transaction cost
In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike pro ...
in the sale or purchase of a security, as a
bid–ask spread
The bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a market maker) is the difference between the prices quoted (either by a single market maker or in a limit order book) for an immediate sale ( ask) and an immediate pur ...
exists between the price at which a purchase can be made versus the price at which the sale of the same security can be made. As the number of sellers and buyers in the exchange, who have the symmetric information increases, liquidity increases, and transaction costs decrease. This then attracts a larger number of buyers and sellers to the exchange.
The network advantage of financial exchanges is apparent in the difficulty that startup exchanges have in dislodging a dominant exchange. For example, the
Chicago Board of Trade has retained overwhelming dominance of trading in
US Treasury bond futures despite the startup of
Eurex
Eurex Exchange is an international exchange which primarily offers trading in European based derivatives. It is the largest European futures and options market. The products traded on this exchange vary from German and Swiss debt instruments to E ...
US trading of identical futures contracts. Similarly, the
Chicago Mercantile Exchange has maintained dominance in trading of Eurobond interest rate futures despite a challenge from
Euronext.Liffe
Euronext N.V. (short for European New Exchange Technology) is a pan-European bourse that offers various trading and post-trade services.
Traded assets include regulated equities, exchange-traded funds (ETF), warrants and certificates, bonds, de ...
.
Cryptocurrencies
Cryptocurrencies such as
Bitcoin
Bitcoin ( abbreviation: BTC; sign: ₿) is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. Bitcoin transactions are verified by network nodes through cryptography and recorded in a public distr ...
, also feature network effects. Bitcoin's unique properties make it an attractive asset to users and investors. The more users that join the network, the more valuable and secure it becomes. This method creates incentive for users to join so that when the network and community grows, a network effect occurs, making it more likely that new people will also join. Bitcoin provides its users with financial value through the network effect which may lead to more investors due to the appeal of financial gain. This is an example of an indirect network effect as the value only increases due to the initial network being created.
Software
The widely used computer
software
Software is a set of computer programs and associated documentation and data. This is in contrast to hardware, from which the system is built and which actually performs the work.
At the lowest programming level, executable code consists ...
benefits from powerful network effects. The software-purchase characteristic is that it is easily influenced by the opinions of others, so the customer base of the software is the key to realizing a positive network effect. Although customers' motivation for choosing software is related to the product itself, media interaction and word-of-mouth recommendations from purchased customers can still increase the possibility of software being applied to other customers who have not purchased it, thereby resulting in network effects.
In 2007
Apple
An apple is an edible fruit produced by an apple tree (''Malus domestica''). Apple fruit tree, trees are agriculture, cultivated worldwide and are the most widely grown species in the genus ''Malus''. The tree originated in Central Asia, wh ...
released the
iPhone followed by the
app store
An App Store (or app marketplace) is a type of digital distribution platform for computer software called applications, often in a mobile context. Apps provide a specific set of functions which, by definition, do not include the running of the c ...
. Most iPhone apps rely heavily on the existence of strong network effects. This enables the software to grow in popularity very quickly and spread to a large userbase with very limited marketing needed. The
Freemium business model has evolved to take advantage of these network effects by releasing a free version that will not limit the adoption or any users and then charge for premium features as the primary source of revenue. Furthermore, some software companies will launch free trial versions during the trial period to attract buyers and reduce their uncertainty. The duration of free time is related to the network effect. The more positive feedback the company received, the shorter the free trial time will be.
Software companies (for example
Adobe
Adobe ( ; ) is a building material made from earth and organic materials. is Spanish for ''mudbrick''. In some English-speaking regions of Spanish heritage, such as the Southwestern United States, the term is used to refer to any kind of e ...
or
Autodesk
Autodesk, Inc. is an American multinational software corporation that makes software products and services for the architecture, engineering, construction, manufacturing, media, education, and entertainment industries. Autodesk is headquartere ...
) often give significant discounts to students. By doing so, they intentionally stimulate the network effect - as more students learn to use a particular piece of software, it becomes more viable for companies and employers to use it as well. And the more employers require a given skill, the higher the benefit that employees will receive from learning it. This creates a self-reinforcing cycle, further strengthening the network effect.
Web sites
Many
web site
A website (also written as a web site) is a collection of web pages and related content that is identified by a common domain name and published on at least one web server. Examples of notable websites are Google, Facebook, Amazon, and Wikip ...
s benefit from a network effect. One example is web marketplaces and exchanges. For example,
eBay
eBay Inc. ( ) is an American multinational e-commerce company based in San Jose, California, that facilitates consumer-to-consumer and business-to-consumer sales through its website. eBay was founded by Pierre Omidyar in 1995 and became ...
would not be a particularly useful site if
auction
An auction is usually a process of buying and selling goods or services by offering them up for bids, taking bids, and then selling the item to the highest bidder or buying the item from the lowest bidder. Some exceptions to this definition ex ...
s were not competitive. As the number of users grows on eBay, auctions grow more competitive, pushing up the prices of bids on items. This makes it more worthwhile to sell on eBay and brings more sellers onto eBay, which, in turn, drives prices down again due to increased supply. Increased supply brings even more buyers to eBay. Essentially, as the number of users of eBay grows, prices fall and supply increases, and more and more people find the site to be useful.
Network effects were used as justification in
business model
A business model describes how an organization creates, delivers, and captures value,''Business Model Generation'', Alexander Osterwalder, Yves Pigneur, Alan Smith, and 470 practitioners from 45 countries, self-published, 2010 in economic, soci ...
s by some of the
dot-com companies
A dot-com company, or simply a dot-com (alternatively rendered dot.com, dot com, dotcom or .com), is a company that does most of its business on the Internet, usually through a website on the World Wide Web that uses the popular Generic top-level d ...
in the late 1990s. These firms operated under the belief that when a new
market
Market is a term used to describe concepts such as:
*Market (economics), system in which parties engage in transactions according to supply and demand
*Market economy
*Marketplace, a physical marketplace or public market
Geography
*Märket, an ...
comes into being which contains strong network effects, firms should care more about growing their
market share than about becoming
profitable
In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs.
It i ...
. The justification was that market share would determine which firm could set technical and marketing standards and giving these companies a
first-mover advantage
In marketing strategy, first-mover advantage (FMA) is the competitive advantage gained by the initial ("first-moving") significant occupant of a market segment. First-mover advantage enables a company or firm to establish strong brand recognitio ...
.
Social networking websites are good examples. The more people register onto a social networking website, the more useful the website is to its registrants.
Google uses the network effect in its advertising business with its
Google AdSense
Google AdSense is a program run by Google through which website publishers in the Google Network of content sites serve text, images, video, or interactive media advertisements that are targeted to the site content and audience. These advert ...
service. AdSense places ads on many small sites, such as
blog
A blog (a truncation of "weblog") is a discussion or informational website published on the World Wide Web consisting of discrete, often informal diary-style text entries (posts). Posts are typically displayed in reverse chronological order ...
s, using Google technology to determine which ads are relevant to which blogs. Thus, the service appears to aim to serve as an exchange (or ad network) for matching many advertisers with many small sites. In general, the more blogs AdSense can reach, the more advertisers it will attract, making it the most attractive option for more blogs.
By contrast, the value of a news site is primarily proportional to the quality of the articles, not to the number of other people using the site. Similarly, the first generation of
search engine
A search engine is a software system designed to carry out web searches. They search the World Wide Web in a systematic way for particular information specified in a textual web search query. The search results are generally presented in a ...
s experienced little network effect, as the value of the site was based on the value of the search results. This allowed
Google
Google LLC () is an American multinational technology company focusing on search engine technology, online advertising, cloud computing, computer software, quantum computing, e-commerce, artificial intelligence, and consumer electronics. ...
to win users away from
Yahoo!
Yahoo! (, styled yahoo''!'' in its logo) is an American web services provider. It is headquartered in Sunnyvale, California and operated by the namesake company Yahoo Inc., which is 90% owned by investment funds managed by Apollo Global Man ...
without much trouble, once users believed that Google's search results were superior. Some commentators mistook the value of the Yahoo! brand (which does increase as more people know of it) for a network effect protecting its advertising business.
Rail gauge
![Rail gauge world](https://upload.wikimedia.org/wikipedia/commons/5/5d/Rail_gauge_world.svg)
There are strong network effects in the initial choice of
rail gauge, and in
gauge conversion decisions. Even when placing isolated rails not connected to any other lines, track layers usually choose a standard rail gauge so they can use off-the-shelf rolling stock. Although a few manufacturers make rolling stock that can adjust to different rail gauges, most manufacturers make rolling stock that only works with one of the standard rail gauges. This even applies to
urban rail
Urban rail transit is an all-encompassing term for various types of local rail systems providing passenger service within and around urban or suburban areas. The set of urban rail systems can be roughly subdivided into the following categories ...
systems where historically
tram
A tram (called a streetcar or trolley in North America) is a rail vehicle that travels on tramway tracks on public urban streets; some include segments on segregated right-of-way. The tramlines or networks operated as public transport are ...
ways and to a lesser extent metros would come in a wide array of different gauges, nowadays virtually all new networks are built to a handful of gauges and overwhelmingly
standard gauge.
Credit cards
For
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
s that are now widely used, large-scale applications on the market are closely related to network effects. Credit card, as one of the currency payment methods in the current economy, which was originated in 1949. Early research on the circulation of credit cards at the retail level found that credit card
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s were not affected by macroeconomic interest rates and remained almost unchanged. Later, credit cards gradually entered the network level due to changes in policy priorities and became a popular trend in payment in the 1980s.
Different levels of credit cards separate benefit from two types of network effects. The application of credit cards related to external network effects, which is because when this has become a payment method, and more people use credit cards. Each additional person uses the same credit card, the value of rest people who use the credit card will increase.
Besides, the credit card system at the network level could be seen as a
two-sided market
A two-sided market, also called a two-sided network, is an intermediary economic platform having two distinct user groups that provide each other with network benefits. The organization that creates value primarily by enabling direct interactions ...
. On the one hand, the number of cardholders attracts merchants to use credit cards as a payment method. On the other hand, an increasing number of merchants can also attract more new cardholders. In other words, the use of credit cards has increased significantly among merchants which leads to increased value. This can conversely increase the cardholder's credit card value and the number of users. Moreover, credit card services also display a network effect between merchant discounts and credit accessibility. When credit accessibility increases which greater sales can be obtained, merchants are willing to be charged more discounts by credit card issuers.
Visa
Visa most commonly refers to:
*Visa Inc., a US multinational financial and payment cards company
** Visa Debit card issued by the above company
** Visa Electron, a debit card
** Visa Plus, an interbank network
*Travel visa, a document that allows ...
has become a leader in the electronic payment industry through the network effect of credit cards as its competitive advantage. Till 2016, Visa's credit card
market share has risen from a quarter to as much as half in four years. Visa is benefit from the network effect. Since every additional Visa cardholder is more attractive to merchants, and merchants can also attract more new cardholders through the brand. In other words, the popularity and convenience of Visa in the electronic payment market, lead more people and merchants choose to use Visa, which greatly increases the value of Visa.
See also
References
External links
Coordination and Lock-In: Competition with Switching Costs and Network Effects Joseph Farrell and Paul Klemperer.
S. J. Liebowitz, Stephen E. Margolis.
Arun Sundararajan
Arun Sundararajan (Tamil language, Tamil: அருண் சுந்தர்ராஜன்) (born in the United Kingdom) is the NEC Faculty Fellow, Professor of Technology, Operations, and Statistics and a Doctoral Coordinator at the St ...
.
The Economics of Networks Nicholas Economides.
Network Economics: An Introductionby
Anna Nagurney of the
Isenberg School of Management
The Isenberg School of Management is the business school at the University of Massachusetts Amherst, the flagship campus for the University of Massachusetts system, located in Amherst, Massachusetts, United States. The Isenberg School is accre ...
at
University of Massachusetts Amherst
The University of Massachusetts Amherst (UMass Amherst, UMass) is a public research university in Amherst, Massachusetts and the sole public land-grant university in Commonwealth of Massachusetts. Founded in 1863 as an agricultural college, ...
Supply chain network economicsby
Anna Nagurney
{{DEFAULTSORT:Network Effect
Business models
Economics effects
Monopoly (economics)
Networks
Technological change
Transport economics