Summary: Network Effects describes the phenomenon how the value of a good or service increases as more people start to use that good or service.
Originators: Theodore Vail (1845-1920), Robert Metcalfe (1946-Present)
Keywords: network externality, demand-side economies of scale, marketing, customer base, value, monopoly, social media, congestion, good, service
Certain products only have value if a large number of people are using them. A classic example is that of technology used for communication such as a phone or fax machine. Critical mass is needed — these devices are only valuable if lots of other people have phones that you can call and machines you can fax.
This phenomenon was first described by Theodore Vail in 1908. Vail used the concept of Network Effects to build AT&T into a monopoly of telephone communication in the early 1900s. Later, Robert Metcalfe described Network Effects related to the importance of more people engaging in use of the Internet for it to become beneficial to everyone.[i]
Both the Internet and the telephone are examples of Direct Network Effects, in which more customers directly increase the value of a product or service. There are also Indirect Network Effects, which occur when more customers indirectly increase the value of a product of service. For example, when more people use Uber, this does not directly make Uber more valuable. However, the more people who use Uber, the more Uber is motivated to improve the quality of their service, which ends up indirectly impacting the value of this service.[ii]
Another prime example of Network Effects can be found in various social media services, such as Facebook. The more people who use Facebook, the more valuable Facebook becomes. This in turn, attracts more people to Facebook, as people do not want to miss out on a service that so many other people are using. Thus, Facebook continues to increase in value and attract more people at the same time.
Using Network Effects to Improve Businesses
Businesses who succeed at utilizing Network Effects can gain a competitive advantage in their industry. Consider two ways in which this can happen:
- Businesses can harness the power of Network Effects through engaging with products that are already highly valuable. They can consider what products are being used by a large number of people and consider utilizing those products within their business.
For example, Visa is a type of credit card used by over 2.9 billion people. Businesses can make a point to accept Visa credit cards and gain more customers who might have gone elsewhere if the business only accepted cash.
Businesses can harness the power of social media through advertising via various media platforms that are already popular and attract large numbers of people.
- Businesses can create network effects within their own products and services through encouraging high engagement, interacting with customers, and providing high quality products.
The reason many social media platforms developed high network effects is because they are engaging and interactive. This is a means of drawing new customers in and building up a client base to build value within the business.
Once people engage with a product or service, businesses can focus on keeping products and services as high quality as possible. This keeps people engaged in the long run.
[i] Easley, D. & Kleinberg, J. (2010). Networks, crowds, and markets. Reasoning about a highly connected world. Cambridge University Press.
[ii] Clements, M. T. (2004). Direct and indirect network effects: Are they equivalent? International Journal of Industrial Organization, 22(5), 633-645.