Of Scale) Is The Phenomenon by Which The

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]
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.
Contents
 1Origins
 2Adoption and competition
o 2.1Critical mass
o 2.2Market tipping
o 2.3Multiple equilibria and expectations
 3Technology lifecycle
 4Negative network externalities
 5Interoperability
 6Compatibility and incompatibility
 7Open versus closed standards

 8Examples
o 8.1Financial exchanges
o 8.2Cryptocurrencies
o 8.3Software
o 8.4Web sites
o 8.5Rail gauge
o 8.6Credit cards
 9See also
 10References
 11External links
Origins[edit]
Network effects were a central theme in the arguments of Theodore Vail, the first post-
patent president of Bell Telephone, in gaining a monopoly on US telephone services. In 1908,
when he presented the concept in Bell's annual report, there were over 4,000 local and regional
telephone exchanges, most of which were eventually merged into the Bell System.
Network effects were popularized by Robert Metcalfe, stated as Metcalfe's law. Metcalfe was one
of the co-inventors of Ethernet and a co-founder of the company 3Com. In selling the product,
Metcalfe argued that customers needed Ethernet cards to grow above a certain critical mass if
they were to reap the benefits of their network.[6] According to Metcalfe, the rationale behind the
sale of networking cards was that the cost of the network was directly proportional to the number
of cards installed, but the value of the network was proportional to the square of the number of
users. This was expressed algebraically as having a cost of N, and a value of N2. While the
actual numbers behind this proposition were never firm, the concept allowed customers to share
access to expensive resources like disk drives and printers, send e-mail, and eventually access
the Internet.[7]
The economic theory of the network effect was advanced significantly between 1985 and 1995
by researchers Michael L. Katz, Carl Shapiro, Joseph Farrell, and Garth Saloner.[8] Author, high-
tech entrepreneur Rod Beckstrom presented a mathematical model for describing networks that
are in a state of positive network effect at BlackHat and Defcon in 2009 and also presented the
"inverse network effect" with an economic model for defining it as well.[9] Because of the positive
feedback often associated with the network effect, system dynamics can be used as a modelling
method to describe the phenomena.[10] Word of mouth and the Bass diffusion model are also
potentially applicable.[11]
Adoption and competition[edit]

This section needs additional citations
for verification. Please help improve this article by adding
citations to reliable sources. Unsourced material may be
challenged and removed. (March 2018) (Learn how and when to
remove this template message)
Critical mass[edit]
In the early phases of a network technology, incentives to adopt the new technology are low.
After a certain number of people have adopted the technology, network effects become
significant enough that adoption becomes a dominant strategy. This point is called critical mass.
At the critical mass point, the value obtained from the good or service is greater than or equal to
the price paid for the good or service.[12]
When a product reaches critical mass, network effects will drive subsequent growth until a stable
balance is reached.[13] Therefore, a key business concern must then be how to attract users prior
to reaching critical mass. Critical quality is closely related to consumer expectations, which will
be affected by price and quality of products or services, the company's reputation and the growth
path of the network.[2] Thus, one way is to rely on extrinsic motivation, such as a payment, a fee
waiver, or a request for friends to sign up.[14] A more natural strategy is to build a system that has
enough value without network effects, at least to early adopters. Then, as the number of users
increases, the system becomes even more valuable and is able to attract a wider user base.[15]
Beyond critical mass, the increasing number of subscribers generally cannot continue
indefinitely. After a certain point, most networks become either congested or saturated, stopping
future uptake. Congestion occurs due to overuse. The applicable analogy is that of a telephone
network. While the number of users is below the congestion point, each additional user adds
additional value to every other customer. However, at some point, the addition of an extra user
exceeds the capacity of the existing system. After this point, each additional user decreases the
value obtained by every other user. In practical terms, each additional user increases the total
system load, leading to busy signals, the inability to get a dial tone, and poor customer support.
Assuming the congestion point is below the potential market size, the next critical point is where
the value obtained again equals the price paid. The network will cease to grow at this point if
system capacity is not improved. Peer-to-peer (P2P) systems are networks designed to distribute
load among their user pool. This theoretically allows P2P networks to scale indefinitely. The P2P
based telephony service Skype benefits from this effect and its growth is limited primarily
by market saturation.[16]
Market tipping[edit]
Network effects give rise to the potential outcome of market tipping, defined as "the tendency of
one system to pull away from its rivals in popularity once it has gained an initial edge".[17] Tipping
results in a market in which only one good or service dominates and competition is stifled. This is
because network effects tend to incentivise users to coordinate their adoption of a single product.
Therefore, tipping can result in a natural form of market concentration in markets that display
network effects.[18] However, the presence of network effects does not necessarily imply that a
market will tip; the following additional conditions must be met:
1. The utility derived by users from network effects must exceed the utility they
derive from differentiation
2. Users must have high costs of multihoming (i.e. adopting more than one
competing networks)
3. Users must have high switching costs
If any of these three conditions are not satisfied, the market may fail to tip and multiple products
with significant market shares may coexist.[4] One such example is the U.S. instant messaging
market, which remained an oligopoly despite significant network effects. This can be attributed to
the low multi-homing and switching costs faced by users.
Market tipping does not imply permanent success in a given market. Competition can be
reintroduced into the market due to shocks such as the development of new technologies.
Additionally, if the price is raised above customers' willingness to pay, this may reverse market
tipping.[4]
Multiple equilibria and expectations[edit]
Networks effects often result in multiple potential market equilibrium outcomes. The key
determinant in which equilibrium will manifest are the expectations of the market participants,
which are self-fulfilling.[2] Because users are incentivised to coordinate their adoption, user will
tend to adopt the product that they expect to draw the largest number of users. These
expectations may be shaped by path dependence, such as a perceived first-mover advantage,
which can result in lock-in. The most commonly cited example of path dependence is
the QWERTY keyboard, which owes its ubiquity to its establishment of an early lead in the
keyboard layout industry and high switching costs, rather than any inherent advantage over
competitors. Other key influences of adoption expectations can be reputational (e.g. a firm that
has previously produced high quality products may be favoured over a new firm).[19]
Markets with network effects may result in inefficient equilibrium outcomes. With simultaneous
adoption, users may fail to coordinate towards a single agreed-upon product, resulting in
splintering among different networks, or may coordinate to lock-in to a different product than the
one that is best for them.[2]

Of Scale) Is The Phenomenon by Which The

Uploaded by

Copyright:

Available Formats

Of Scale) Is The Phenomenon by Which The

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Of Scale) Is The Phenomenon by Which The

Uploaded by

Copyright:

Available Formats

In

economics, a network effect (also called network externality or demand-side economies

 2Adoption and competition

o 2.3Multiple equilibria and expectations

 4Negative network externalities

 6Compatibility and incompatibility

 7Open versus closed standards

Adoption and competition[edit]

You might also like

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.