The network effect occurs when a good or service becomes more valuable as more people use it.
Network effect explained
If you own a telephone, but no one else does, the good is of no value. As more people join the telephone network, the more valuable the telephone becomes to yourself.
If you buy a telephone, you get a benefit, but also your friends see an increase in value of their telephone because they can now ring. There is an external benefit of getting this kind of good.
For a good with network effects, the difficulty is often getting established. Early users of social networking sites don’t have many people to interact with. But, as everyone joins a group like Facebook, it creates a bandwagon effect with people feeling the need to join. You want to join the social network where all your friends are on.
A network effects involves a positive feedback loop
Some products with network effects don’t quite reach the critical mass and so fade away. For example, the mini-disc never really caught on.
Sometimes people refer to a network effect as a demand-side economy of scale.
Network effects and barriers to entry
Substantial network effects can create an effective barriers to entry and therefore degree of monopoly power.
For example, it would be inefficient to have two or three different types of telephone which couldn’t communicate.
Initially, there were two types of Video recorders (VHS and betamax) But, there were strong network effects from concentrating on one type of video. Eventually VHS came to dominate and Betamax faded away.
When one type of technology dominates, it is very hard for a new firm to enter the market with different technology.
Network effects and new entry
It should be noted network effects don’t always preclude entry of new firms.
Facebook created a dominant position in social networking, in large part to network effects and being an early mover (one of first social networking sites). However, new firms have still been able to enter the market, by exploiting a slightly different segment of the market. For example, we saw the rise of:
For young people, Facebook’s ubiquity made it lose its coolness factor. With everyone on Facebook and its increased commercialistion, it was an incentive for people to look for alternatives, which did certain things better.
Examples of network effects
- Social media – you need people to communicate with.
- Telephones – you need other people to have a telephone to receive call.
- Microsoft office – If other people have compatibility, you can more easily share documents.
- Apple operating system and Apps – As more people choose an Apple iPhone, it becomes more attractive for business to promote Apps. This makes the Apple iPhone more desirable. This is a two way network effect as the growth in Apple iPhone makes producing Apps more profitable. Both Apple and App developers benefit from the growth of the other.
- Bitcoin – digital money. The more people use and accept bitcoins, the more attractive this digital money becomes.
Network effects and new trade theory
If a country specialises in a particular industry, there may be positive network effects, which make the whole industry more efficient. Therefore, there are gains to trade from specialising in a particular industry / firm.
Network effects are very similar to the concept of external economies of scale. (Economies of scale which accrue from a whole industry getting bigger. E.g. computer firms specialise in Silicon valley, leading to improved pools of skilled labour and infrastructure