Network Effect

In financial aspects and business, a Network Effect (likewise called system externality or interest side economies of scale) is the impact that one client of a decent or administration has on the estimation of that item to other individuals. At the point when a system impact is available, the estimation of an item or administration is subject to the quantity of others utilizing it.

The exemplary illustration is the phone. The more individuals who own phones, the more profitable the phone is to every proprietor. This makes a positive externality in light of the fact that a client may buy a phone without aiming to make esteem for different clients, however does as such regardless. Online interpersonal organizations work similarly, with locales like Twitter and Facebook turning out to be more appealing as more clients join.

The expression “system impact” is connected most regularly to positive system externalities as on account of the phone. Negative system externalities can likewise happen, where more clients make an item less profitable, however are all the more usually alluded to as “clog” (as in movement blockage or system clog).

Over time, positive network effects can create a bandwagon effect as the network becomes more valuable and more people join, in a positive feedback loop.


Network Effects were a central theme in the arguments of Theodore Vail, the first post patent president of Bell Telephone, 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.

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.

Network effects were popularized by Robert Metcalfe, stated as Metcalfe’s law. Metcalfe was one of the co-inventors of Ethernet and a co-founder of the company 3Com. In selling the product, Metcalfe argued that customers needed Ethernet cards to grow above a certain critical mass if they were to reap the benefits of their network.

According to Metcalfe, the rationale behind the sale of networking cards was that (1) the cost of the network was directly proportional to the number of cards installed, but (2) 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 N². While the actual numbers behind this definition were never firm, the concept allowed customers to share access to expensive resources like disk drives and printers, send e-mail, and access the Internet.

Rod Beckstrom 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.


Network effects become significant after a certain subscription percentage 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 value exceeding the price.

A key business concern must then be how to attract users prior to reaching critical mass. 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. 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 signals, the inability to get a dial tone, and poor customer support. The next critical point is where the value obtained again equals the price paid. 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. New Peer-to-peer technological models may always defy congestion. Peer-to-peer systems, or “P2P,” are networks designed to distribute load among their user pool. This theoretically allows true P2P networks to scale indefinitely. The P2P based telephony service Skype benefits greatly from this effect (though market saturation will still occur).

Network effects are commonly mistaken for economies of scale, which result from business size rather than interoperability. To help clarify the distinction, people speak of demand side vs. supply side economies of scale. Classical economies of scale are on the production side, while network effects arise on the demand side. Network effects are also mistaken for economies of scope.

The network effect has a lot of similarities with the description of phenomenon in reinforcing positive feedback loops described in system dynamics. System dynamics could be used as a modelling method to describe phenomena such as word of mouth and Bass model of marketing.

Network effect is a benefit to society as a whole because it positively relates to and affects the Intellectual Commons, Property Rights, and Cultural Commons of the world. One form of network externality is social media, which is a peer-to-peer network ran by a privately held for profit business. Although the creation of a large network creates a barrier to entry according to Porters five forces and may prevent a few from creating a new form of P2P networking, it largely benefits society as whole and provides a new form of a common-pool resource solargely scalable that the entire world has the ability to use it. Although the barrier to entry may be high, there is no true form of monopoly in the P2P social sharing market. For example, Facebook holds a large stake in the P2P social sharing market, but it is not mutually exclusive, meaning users can have an account on Facebook and also have an account on Twitter. Furthermore, there becomes no true critical mass in this space due to the ability for technology and innovation to constantly adapt to different environments, market for underdeveloped countries to integrate with social sharing is unlimited.

Network effect relates to the intellectual commons in a positive way. Through P2P networks users are able to share their intellectual property in a way that can benefit society as a whole.The sharing of intellectual property ultimately relates to, economic growth due to the ability for creators to share information and still possibly benefit financially from it. Through P2P networks people are able to share types of education like scholarly articles, becoming a new form of public commons. Network externality like is an example of how intellectual commons with the use of network externality benefits society as a whole. Those who present intellectual property at Ted conferences are sharing their education on a public forum that benefits whoever will listen. Therefore, the larger network becomes positively correlates to those who benefit from its common-pool resources.

P2P networks positively affect property rights. In reference to property rights, it enables those who create the intellectual property: The right to use the good, The right to earn income from the good, The right to transfer the good to others, The right to enforcement of property rights. Through P2P networks those who provide intellectual property not only have these rights, but they also possess the right to claim their information on a public forum. Due to these rights sharing benefits the intellectual property holders and promotes P2P sharing in a positive way. Those who consume the intellectual property also benefit positively from the sharing of it because they are able to use the information freely with respect to the person who created it. An example of this system in effect is a company called Music Vault. Music Vault operates on the P2P network Facebook, enabling users who create music to openly and freely collaborate with other artists content. This is a form of remixing that benefits both parties. This is an example of how a P2P network positively affects the sharing of property rights. In Joseph E. Stiglitz essay Prizes, Not Patents, he suggests that the creation of intellectual property should be rewarded with by social gratification and rewards instead of patents preventing others from duplicating the creation and sharing it as a common-pool resource. This can be related to P2P networking because it creates a greater incentive for those who create intellectual property to share it is a common-pool resource. As a P2P sharing network becomes larger the gratification of being rewarded on a global public forum would compete with a patent. It is through large P2P networks and network externality that humans can create a reward system large enough to deter seekers of patents to be rewarded in different ways.

Network Externality positively affects the cultural commons in many ways. The reward for being part of a group, society, and even the world through a P2P network is one of the greatest benefits that a modern common-pool resource can provide.The ability to connect and create with people from different cultures, ethnicities, and beliefs is something thought to be impossible 100 years ago. Without network externality this form of communication would have been impossible. Through P2P sharing the world as a culture are able to learn and teach each other through public forums. In Sugata Mitra’s Ted talk, “The child-driven education” he placed a computer in the a third world town and left it there to see what would happen. To his amazement children were able to quickly figure out how to use the computer and educate themselves on its inner workings. This example is a benefit to society for several reasons. The first is the relationship between Sugata Mitra and the P2P network which led him to place the computer in a third world town, along with the ability to present his findings on a public forum. Secondly, it is those who consumed his ted talk and benefited from the knowledge that those in third world countries just need a chance to learn and they will take it. This experiment as a whole brings the culture of the world together and connects us with those we thought impossible due to the P2P network and network externality that led individuals to the Ted talk.

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 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.

Types of network effects

There are many ways to classify networks effects. One popular segmentation views network effects as being of four kinds:

Two-sided network effects: An increase in usage by one set of users increases the value to and participation of a complementary and distinct set of users, and vice versa. An example is developers choosing to code for an operating system with many users, with users choosing to adopt an operating system with many developers. This is a special case of a two-sided market.

Direct network effects: An increase in usage leads to a direct increase in value for other users. For example, telephone systems, fax machines, and social networks all imply direct contact among users. In two-sided networks, a direct network effect is called a same-side network effect. An example is online gamers who benefit from participation of other gamers as distinct from how they benefit from game developers.

Indirect network effects: Increases in usage of one product or network spawn increases in the value of a complementary product or network, which can in turn increase the value of the original. Examples of complementary goods include software (such as an Office suite for operating systems) and DVDs (for DVD players). This is why Windows and Linux might compete not just for users, but for software developers. This is more accurately called a cross-side network effect in order to distinguish network benefits that cross distinct markets.

Local network effects: The structure of an underlying social network affects who benefits from whom. For example, a good displays local network effects when rather than being influenced by an increase in the size of a product’s user base in general, each consumer is influenced directly by the decisions of only a typically small subset of other consumers, for instance those he or she is “connected” to via an underlying social or business network. Instant messaging is an example of a product that displays local network effects.

Additionally, there are two sources of economic value that are relevant when analyzing products that display network effects:

Inherent value: I derive value from my use of the product

Network value: I derive value from other people’s use of the product

Negative network effects

Negative network effects, in the mathematical sense, are those that have the opposite effect on stability compared to normal (positive) network effects. Just like positive network effects cause positive feedback loops and exponential growth, negative network effects create negative feedback and exponential decay. In nature, negative network effects are the forces that pull towards equilibrium, are responsible for stability, and are the physical limitations preventing states from reaching infinity.

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 over limited bandwidth both display negative network externalities.

Braess’ paradox occurs when the following counterintuitive phenomenon: removing edges from a selfish routing network can decrease the latency incurred by all of the traffic at equilibrium.

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