Network effect

Definition

In economics and business, a network effect (also called network externality) is the effect that one user of a good or service has on the value of that good or service to other people. When network effect is present, the value of a good or service increases as more people use it.

Overview

The classic example is the telephone. With only one user, it is basically worthless, but as more people come to own phones, the more valuable the telephone is to each owner. This creates a positive externality because a user may purchase their telephone without intending to create value for other users, but does so in any case.

The expression "network effect" is applied most commonly to positive network externalities as in the case of the telephone. Negative network externalities can also occur, where more users make a product less valuable, but are more commonly referred to as "congestion" (as in network congestion).

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.

There are both direct and indirect network effects.

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In the case where the product in question is a communications network, the value associated with the growth of the network can be classified as direct: the more people that become part of the network, the more people one can communicate with, and hence, the more valuable the network is to a given user. An alternative possibility however, is that the positive network effect is indirect, as is usually the case with consumer electronics technology and computer systems. As more individuals purchase CD players or a given operating system, suppliers of technological compliments (e.g., CDs or software) recognize the increased value associated with the network and increase the production of these necessary components accordingly."

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See also

• Metcalfe's Law
• Network externalities