Definition of network effect

A network effect (also known as a network externality) exists when a product’s value to the user increases as the number of users of the product grows. The classic example is the telephone. The more people own telephones, the more valuable the telephone network is to each owner. If there are N owners, each one of them can call the other N - 1 owners: a total of N(N-1) communications can be made. Thus the network’s value grows with the number of possible connections, in the order of N squared. This insight is the basis of Metcalfe’s law that states that the value of a network is proportional to the square of the number of members within the network.

When you buy a DVD player and some DVDs, you encourage an industry, and thus more DVDs are put on the market. In fact, the concept can easily extend: perhaps the most dominant network effect is language. If you write a web page in Inuktitut, not many people can read it. If your only audience is that community, that is fine. But if you want to get attention, you will probably write it in English: scientific journals, for example, are now overwhelmingly in English, especially because the internet amplifies network effects.

Network effects have fundamental importance for business strategy, intellectual property, and technical change in a wide range of industries. For instance, it becomes very important to establish early on in a market. [1]

Example

Amazon lost money for years establishing itself as the main source for online books, in direct competition to Barnes & Noble and eventually driving Borders out of the market.

Over time, positive network effects made the network more valuable and the business more succesful.

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