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Network effect

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The network effect means that a good or service is such that the value of the good or service to a potential customer is dependent on the number of customers already owning that good or using that service. Equivalently, it means that the total value of a good or service that possesses network effects is roughly proportional to the square of the number of customers already owning that good or using that service.

One consequence of a network effect is that the purchase of a good by one individual indirectly benefits others who own the good - for example by purchasing a telephone a person makes other people's telephones more useful. This type of side effect in a transaction is known as an externality in economics, and externalities arising from network effects are known as network externalities.

Network effects were used as justification for some of the business strategy for dot-coms in the late 1990s. These firms operated under the belief that when a new market comes into being which contains strong network effects, firms should care more about growing their market share than about becoming profitable. This was believed to be rational because market share will determine which firm can set technical and marketing standards and thus determine the basis of future competition. A good example of this strategy was that deployed by Mirabilis[?], the Israeli start-up which pioneered instant messaging and was bought-out by AOL. By giving away their product (ICQ) for free and preventing interoperability between their client software and other products, they were able to corner the market for instant messaging. 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 using a competing system. As was typical for that era, the company never made any attempt to generate profits from their dominant position before selling out.

Network effects become significant after a certain subscription rate has been achieved, 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. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the positive utility / price ratio. Until this point has been achieved, however, only early adopters will subscribe.

The increasing number of subscribers does not continue indefinitely however. After a certain point, the network becomes 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 signals, the inability to get a dial-tone, and poor customer support. The next critical point is where the value obtained equals the price paid again. The network will cease to grow at this point, and the system must be enlarged. The congestion point may be larger than the market size.

Network effects are commonly mistaken for economies of scale, which result from business size rather than interoperability.

Examples

There are very strong network effects operating in the market for widely-used computer software. Take for example Microsoft Office. For many people choosing an office suite, a prime consideration is how valuable having learned that office suite will prove to potential employers. That is, since learning to use an office suite takes many hours, they want to invest that time learning the office suite that will make them most attractive to potential employers (or consulting clients, etc).

Similarly, finding already-trained employees is a big concern for employers when deciding which office suite to purchase or standardize on. The lack of cross-platform standards results in a situation in which one firm is in control of almost 100% of the market.

However, network effects need not lead to market dominance by one firm, when there are standards which allow multiple firms to interoperate. This is the case with PC hardware, where there are extremely strong market pressures to interoperate with pre-existing standards, but in which no one firm dominates in the market. The same holds true for the market for long-distance telephone service[?] within the United States. In fact, the existence of these types of networks makes it very hard for one company to dominate the market, as it creates pressures which work against one company attempting to establish a proprietary protocol or to even distinguish itself by means of product differentation.

In cases where the relevant communication protocols are under the control of a single company, however, the network effect can give the company monopoly power. The Microsoft 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.