Categories: Presentations, Seminar SS08
Network effects (externalities)
What are Network effects?
A product displays positive network effects if more usage of the product by any user increases the product’s value for other users (and sometimes all users). Although network effects and network externalities differ from each other, and the two terms are still used interchangeably. The interchangeable use of the terms is caused by the theory which underlines that network effects were developed to study network externalities, but strictly speaking network effects is a more general concept than network externalities. If consumers are willing to pay more because of an expected rising number of network participants, a so-called network effects appears.
Historical Background
Network effects were first studied in the context of long-distance telephony in the early 1970’s. Today, they are widely recognized as a critical aspect of the industrial organisation of IT industries, and are prevalent in a wide variety of sectors, including software, media, microprocessors, telecommunications, e-commerce and electronic marketplaces. Empirical evidence of network effects were proved in many product categories.
Types of network effects
1. Direct network effects:
The most simple network effects are direct: increases in usage lead to direct increases in value. The consumer benefits directly from the network he belongs to.
Example: Telephone network
The more consumers have a telephone and are connected the greater the benefit of the telephone. This principle corresponds to the railway system or the internet.
2. Indirect network effects:
Network effects may also appear in an indirect way, if the usage of the product spawns the production of increasingly valuable complementary goods, and this results in an increase in the value of the original product. The benefit rises if the size of another connected network grows.
Example: Microsoft Windows
For instance, wheras some direct network effects are associated with Windows (arising out of file compatibility), indirect network effects which arise from the increased quality and availability of complementary applications software are probably much more important.
3. Two-sided network effects:
Network effects can also be two-sided: increases in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa. Hardware/software platforms, reader/writer software pairs, marketplaces and matching services display this kind of network effects. In many cases, indirect network effects are associated with a one-directional version of two-sided network effects. Two-sided-markets are defined by some industries which are typically offering a platform for two market participants. These participants are able to collaborate or contract on this specific stage.
Example: Relation between Advertiser and Readers
The advertisers of a newspaper cash in on lots of consumers joining the network of the newspaper-readers because this acquires more awareness for theirs ads. On the other hand, the readers benefit from many advertising customers because the newspaper usually gets cheaper or is able to spend more money for a better quality.
Impact of network-effects
Network effects become significant when a certain subscription percentage 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 when 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.
Download the presentation (English only)
Dominik Oswald
14 Juni 2008 admin