Network effect: Difference between revisions

Revision as of 15:23, 15 April 2004

Revision as of 15:32, 19 May 2004

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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 effectsexternality 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 [[diffusion (business)|early adopters]] will subscribe.

The increasing number of subscribers does not continue indefinitely however. After a certain point, the network becomes 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. The next critical point is where the value obtained equals the price paid again. The network will cease to grow at this point, and the system must be enlarged. The [[congestion point]] may be larger than the [[market size]].