If you see a lot of people in a restaurant, you may expect the restaurant offers good food. Consequently, you give it a try since all of those people can’t be wrong! Similarly, if a lot of your friends are on Facebook, you might join hoping to connect with them! If after you join, you post quality content that leads to many people enjoying the experience; it’ll boost engagement, creating a network effect.

A network effect is a phenomenon wherein every new user signing up for a product or service increases its value and utility for current and future users. In other words, value and utility of a product or service in a network effect will increase as its user base grows. Imagine you own a telephone but no one else does. The good is of no value to you. However, as more people join the telephone network, the more valuable the telephone becomes to you. If you buy a telephone, you are benefited. But along with you, your friends see an increase in value of their telephone because they can now ring you. Basically, greater number of users means greater value of the good or service. Some of the most impactful and notable companies in the world are PayPal, Microsoft, Facebook, Uber and Twitter. Each one is different in so many aspects, but there is one similarity that defines all of them and one common property that lies behind their success. That is network effects.

Network Effects exist in different ways and their dynamics keep changing according to its application.

Direct Network Effects:

It is when the value of a product or service to a user changes rapidly with the number of the other users using the same product or service. For example, owing a telephone is only useful if the people that you need to reach also have one. As more people have phones, the more useful it is to have one yourself.

Indirect Network Effects:

Here, increase in usage of the product increases the production of increasingly valuable complementary goods, which in turn results in an increase in the value of the original product. Although direct network effects are associated with Windows, the indirect network effects that arise from the increased quality and availability of complementary applications software are probably much more significant!

Two-sided Network Effects:

It means increase in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa. In many cases, indirect network effects are considered as a one-directional version of two-sided network effects. This is the type of Network Effect that determines marketplaces for Airbnb, Uber, and Zaarly. For instance, more riders will not necessarily improve one’s Uber experience but it does attract more drivers, which will improve Uber for us.

Local Network Effects:

When each user is influenced directly by the decisions of only a small subset of other users that are in touch via an underlying social or business network, then the product displays local network effect. Instant messaging is a great example.

Network Effect vs. Network Externality

Network effects and network externalities are although similar yet they have distinct differences. Network externality describes how the demand for a product is dependent on the demand of others buying that product. In other words, a consumer’s decision to buy a product is influenced by others purchasing that product. For example: Trends in fashion. It is based on the buying patterns of consumers. Fashion goes out of style primarily on the basis of consumer’s buying decision. A Positive network externality leads to a network effect. The classic example is the telephone. A positive externality is created even though a person purchases a telephone without intending to create value for other users, but does so regardless. Online social networks also work on the same line. Twitter, Facebook and WhatsApp increase their value to each member as more users join.

The network effect is said to create a bandwagon effect as the network becomes more valuable and more people join, resulting in a positive feedback loop.

Usage of network effects:

Financial exchanges

Stock exchanges and derivatives exchanges highlight a network effect. With the increase in number of buyers and sellers on an exchange, liquidity increases and transaction costs tend to decrease. Subsequently this attracts a larger number of buyers and sellers to the exchange.

Software

Computer software is yet another example where strong network effects operate in the market. Back in 2007 Apple released the iPhone followed by the app store. To a great extent, iPhone apps depend on the existence of well-built network effects. This is the reason why the software grows in popularity in no time and extends to a large user base with minimal marketing requirements.

Web sites

Most of the websites benefit from a network effect. One such example is web marketplaces and exchanges. For example, ebay. If auctions were not competitive, Ebay would certainly not be a useful site. As its user base increases, auctions become more competitive that shoot up the prices of bids on products. This makes the website more advantageous and brings more sellers onto eBay, which in turn pushes the prices down again due to increased supply. Due to increased supply even more buyers start using eBay.

In the late 1990s, business models of the dot-com companies used network effect as a justification. These firms believed that with the coming of a new market which contains strong network effects, firms should care more about growing their market share than increasing their profits. The justification here was that market share would decide which firm could set technical and marketing standards and giving these companies a first-mover advantage.

Google also came up with its Google AdSense service in an attempt to create a network effect in its advertising business. Basically, this service is to place ads on many small sites, such as blogs, using Google technology to determine which ads are relevant to which blogs. Its aim is to serve as an exchange for matching many advertisers with many small sites. The more blogs Google AdSense can reach, the more advertisers it will attract, making it the most attractive option for more blogs, and so on, making the network more valuable for all participants.

Criticism of the Network Effect

Any good or service that uses the network effect faces a main hurdle in attracting enough users initially. Critical mass is the minimum number of users required for significant network effects. Once critical mass is attained, the good or service attracts many new users because the network now offers utility or benefits to the consumer.

Alongside, network congestion can occur if too many people start using a good or service. Congestion is marked as a negative network effect as more consumers make a product less valuable. If too many users start using the same network service, the speed of the network slows down, decreasing the benefit for every user. While using a network effect, providers of goods and services must ensure that capacity of the network can be increased sufficiently to accommodate all users.

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