Network Effects in Theory and Practice

The term network effect popularly refers to a business principle that applies to certain kinds of products and services. In economics, a network effect can alter the value of a product or service to a consumer depending on how many other customers it has.  Other kinds of network effects also exist. The name comes from historical developments in communications and networking.

Key Concepts in a Network Effect

Network effects only apply to certain businesses and technologies.

Standard examples include telephone networks, software development ecosystems, social network sites, and advertising-driven Web sites. For products and services subject to network effects, the essential elements include:

  • Critical mass.  As more consumers adopt (purchase or subscribe to) the product or service, its value tends to increase. A critical mass of customers is achieved when the product value exceeds the cost for more new customers to adopt. In business, this can often trigger a tipping point in consumer behavior where adoption rates quickly accelerate.
  • Congestion. Network effects result in decreased value if the addition of new customers degrades product quality. For example, an Internet hotspot decreases in value when it becomes overloaded with data traffic.
  • Saturation. The network effect stops adding value when the number of customers cannot be further increased in any meaningful way. This can occur either when the total available market has been served or when the product has hit fundamental limits of usefulness.

    Simple models of network effects assume that each customer equally drives value. In more complex networks including social networks, smaller subsets of the population tend to generate much more value than others, be it through content contribution, recruiting new customers, or overall time spent engaged.

    Customers who sign up for free services but never use them arguably add no value. Some customers can even generate negative network value, such as by generating spam.

    History of Network Effects

    Tom Wheeler of the U.S. Federal Communications Commission outlined much of the history behind network effects in his 2013 whitepaper Net Effects: The Past, Present, and Future Impact of Our Networks. He identified four revolutionary developments in communications:

    • Printing press
    • Railroads
    • Telegraph
    • Digital communication

    From these historical examples Mr. Wheeler describes three resulting network effects on our world today:

    1. Information now flows to individuals rather than people needing to travel to the information sources
    2. The speed of information flow is continually increasing
    3. Decentralized and distributed economic development is increasingly possible

    In computer networking, Robert Metcalfe applied network effects thinking to the early days of Ethernet adoption.  Sarnoff’s Law, Metcalfe’s Law and others all contributed to advancing these concepts.

    Non-Network Effects

    Network efforts are sometimes confused with economies of scale. The ability of a product maker to scale up their development process and their supply chain does not relate to the impact from consumers adopting those products.

    Product fads and bandwagons likewise happen independently of network effects.