Network effect: Difference between revisions

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The '''network effect''' means that a good or service is such that the value of the good or service to a potential customer is dependent on the number of customers already owning that good or using that service. Equivalently, it means that the total value of a good or service that possesses network effects is roughly proportional to the square of the number of customers already owning that good or using that service.

One consequence of a network effect is that the purchase of a good by one individual indirectly benefits others who own the good - for example by purchasing a [[telephone]] a person makes other people's telephones more useful. This type of side effect in a transaction is known as an [[externality]] in [[economics]], and externalities arising from network effects are known as '''network externalities'''.

== Network effect business models ==

Network effects were used as justification for some of the [[business model]]s for [[dot-com|dot-coms]] in the late [[1990s]]. These firms operated under the belief that when a new market comes into being which contains strong network effects, firms should care more about growing their market share than about becoming profitable. This was believed to be rational because market share will determine which firm can set technical and marketing standards and thus determine the basis of future competition. A good example of this strategy was that deployed by [[Mirabilis]], the [[Israel|Israeli]] start-up which pioneered [[instant messaging]] (''IM'') and was bought-out by [[AOL]]. By giving away their product ([[ICQ]]) [[Free_as_in_beer|for free]] and preventing [[interoperability]] between their client [[software]] and other products, they were able to corner the market for [[instant messaging]]. Because of the network effect, new IM users gained much more value by choosing to use the Mirabilis system (and join its large network of users) than they would using a competing system. As was typical for that era, the company never made any attempt to generate profits from their dominant position before selling out.

Network effects become significant after a certain subscription rate has been achieved, 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. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the positive utility / price ratio. Until this point has been achieved, however, only early adopters will subscribe.