Network effect
In economics, a network effect (also called network externality or demand-side economies of scale) is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products. Network effects are typically positive feedback systems, resulting in users deriving more and 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).[1]
For the 2020 novel, see Network Effect (novel).
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.[2] 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, Facebook, Airbnb, Uber, and LinkedIn; telecommunications devices like the telephone; and instant messaging services such as MSN, AIM or QQ.[3] 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".[4] For example, hardware may become more valuable to consumers with the growth of compatible software.
Network effects are commonly mistaken for economies of scale, 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 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.[5]
Upon reaching critical mass, a bandwagon effect 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 loop. Multiple equilibria and a market monopoly are two key potential outcomes in markets that exhibit network effects. Consumer expectations are key in determining which outcomes will result.
Interoperability[edit]
Interoperability 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 and competition based on price.[31]
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.[32]
Compatibility and incompatibility[edit]
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.[33]
Besides, the compatibility of products is conducive to the company's increase in market share. For example, the Windows system is famous for its operating compatibility, thereby satisfying consumers' diversification of other applications. As the supplier of Windows systems, Microsoft benefits from indirect network effects, which cause the growing of the company's market share.[34]
Incompatibility is the opposite of compatibility. Because incompatibility of products will aggravate market segmentation 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.[35] Effective competition determines the market share of companies, which is historically important.[36] 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.
Network effect as a competitive advantage[edit]
Network effect can significantly influence the competitive landscape of an industry. According to Michael E. Porter, 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.[39]
These attractive characteristics are one of the reasons that allowed platform companies like Amazon, Google or Facebook to grow rapidly and create shareholder value.[40] On the other hand, network effect can result in high concentration of power in an industry, or even a monopoly. This often leads to increased scrutiny from regulators that try to restore healthy competition, as is often the case with large technology companies.[41]
Examples[edit]
Telephone[edit]
Network effects are the incremental benefit gained by each user for each new user that joins a network.[42] 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.[43]
Financial exchanges[edit]
Stock exchanges and derivatives exchanges feature a network effect. Market liquidity is a major determinant of transaction cost in the sale or purchase of a security, as a bid–ask spread 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.[44] 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 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.
Cryptocurrencies and blockchains[edit]
Cryptocurrencies such as Bitcoin and smart contract blockchains such as Ethereum also exhibit 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 the asset becomes and the more secure the network 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.[45]
Smart contract blockchains can produce network effects through the social network of individuals that uses a blockchain for securing its transactions. Public infrastructure networks such as Ethereum and others can facilitate entities that do not explicitly trust one another to collaborate in meaningful way, incentivizing growth in the network. However, as of 2019, such networks grow more slowly due to missing particular requirements such as privacy and scalability.[46]
Software[edit]
The widely used computer software 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.[47]
In 2007 Apple released the iPhone followed by the app store. 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.[48]
Software companies (for example Adobe or Autodesk) often give significant discounts to students.[49] 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[edit]
Many web sites benefit from a network effect. One example is web marketplaces and exchanges. For example, eBay would not be a particularly useful site if auctions 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 models by some of the dot-com companies 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. The justification was that market share would determine which firm could set technical and marketing standards and giving these companies a first-mover advantage.[50]
Social networking websites are good examples. The more people register onto a social networking website, the more useful the website is to its registrants.[51]
Google uses the network effect in its advertising business with its Google AdSense service. AdSense places ads on many small sites, such as blogs, 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 engines experienced little network effect, as the value of the site was based on the value of the search results. This allowed Google to win users away from Yahoo! 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.