LeoGlossary: Network Effect
A phenomenon where a product or service goes in value as more people utilize it. This often occurs in an exponential manner.
For example, if one person has a telephone, it does not have much value. As soon as a second person is added, we see the value jump. This continues with each new phone added to the system.
Over time, when millions of people have a phone, the network effort generated something that is worth billions of dollars.
The process is faster within the digital world since there is less friction. Social media platforms become extremely valuable due to this. As more users signed up for a particular social media site, the appeal to others grew. This is how some ended up with more than a billion users.
We see a parallel with currency. One of the values of the USD is that it has the greatest network effect in the world. When compared to other currencies, the separation is evident.
This is one of the focuses of cryptocurrency. Proponents realize that success can only be achieved through the adoption of large number of users.
The concept of network effect goes back to the early days of the telephone industry.
Theodore Vail discussed this idea back in 1908 when talking about the different phone exchanges throughout the United States and how much more profitable it would be if under one umbrella. It was the basis for the argument for a monopoly of the telephone networks, which eventually became Bell Systems.
Robert Metcalfe popularized this ideas in what became known as Metcalfe's Law. He help to develop ethernet and was one of the originators in 3Com. His approach was to sell network cards. He opined 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 N².
Whether the math was accurate was not the main focus. The idea of network cards is that it allowed users to access:
There is no clear cut answer to whether network effects take place. At most, we can see it applicable up to a point. There does appear, however, a level where each new user does not necessarily add to the value of the network. An example of this is Facebook and the family of applications that have near 3 billion users.
That said, we can see how music with Spotify and file storage with the likes of Dropbox certainly experience a positive impact from growing numbers of users. For music, the more songs that are there, the greater the appeal to customers. As the latter grows, there is incentive for artists to have their songs there.
It is possible that network effects are responsible for the technology phenomenon called "winner take most". This is something that was observed with a major winner in the digital world in each segment. Unlike many industry where there are two or three corporations that are leading the industry, within this realm, we see a major player with nobody even a close number 2.
Disruptive technology can radically affect an industry. When a company is the dominant player, if another starts to gain in popularity with a new technology, it can start to affect the incumbent. Here is where the network effect starts to operate in reverse.
Open source technologies also can have the same impact.
In the world of operating systems on servers, Microsoft was the dominant player. This was disrupted by LINUX who now holds more than a 95% market share.
Negative Network Effects
From an infrastructure standpoint, the increase in the number of users could potentially have a negative effect on the network. If it is not scaling properly we see four areas where network congestion arises.
This can happen in these four areas:
- more login retries
- longer query times
- longer download times
- more download attempts
It is likely that network effects, especially in the digital world, are a competitive advantage. In the Internet era, companies such as Amazon, Google, and Twitter were able to leverage this to their advantage.
One of the advantages presents is new entrants are deterred from going into that market. This created a great deal of shareholder value while also pushing a high concentration of power in the hands of one company.
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