Network effect

Also known as: Network effect, network externality

The network effect is a term from economics and describes a positive external effect. It shows the relationship between the usefulness of a good and its number of users.

Definition / explanation

The usefulness of certain goods (products or services) grows with the number of its participants. For an individual, this good has no value. This applies, for example, to telephony or stock trading, but also to standards such as MP3.

A phone only makes sense if you can call someone else. The more people can be reached via a means of communication (cell phone, smartphone, e-mail, etc.), the greater the benefit and the more people will be interested in it.

In this context, one speaks of positive feedback. Once a critical mass has been reached, the number of participants increases exponentially.

Direct network effects

Advantages that arise as soon as two participants are physically connected in the network are referred to as direct network effects. With each new participant, the benefit grows disproportionately.

Indirect network effects

Advantages that result from the growth of the network as a whole and independent of direct communication connections between two participants are called indirect network effects.

These include complementary goods such as gasoline or petrol stations, but also the Internet: Its usefulness grows with the amount of content; however, these are generated by an increasing number of participants.

Even social networks only work with a large number of people who participate - the more there are, the greater the benefit for the individual.

Path dependency

Standardization plays a major role in the network effect. It enables the problem-free exchange of documents or smooth communication.

It is easy to stick to established solutions, even if these have long been overtaken by other technical possibilities. This is known as path dependency.
Different standards, technologies or offers often cannot exist side by side, as this increases the organizational and financial effort for the participants.

For example, people will avoid engaging in multiple social networks and instead prefer the community in which they find most of their friends.

Risk of monopolies

Monopolies often arise in markets that are determined by network effects. Especially when the positive effects are very strong, after a while one provider will dominate the market with its standard or its technology (for example Microsoft with the Windows software and MS Office), while others tend to serve a niche (Apple Macintosh). Many market participants or products will then disappear completely from the market.

Summary

  • the network effect characterizes the relationship between the number of users of a good and its use
  • direct network effects arise directly from a communication link between two participants
  • indirect network effects arise from the growth of the overall network
  • Standardization enables network effects
  • Markets determined by network effects tend to form monopolies
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