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, resulting in a given user deriving more value from a product as other 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]

Diagram illustrating the network effect in a few simple phone networks. The lines represent potential calls between phones. As the number of phones connected to the network grows, the number of potential calls available to each phone grows and increases the utility of each phone, new and existing.

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 market tipping are two key potential outcomes in markets that exhibit network effects. Consumer expectations are key in determining which outcomes will result.