The Network Effect is a phenomenon where present users of a product or service benefit in some way when the product or service is adopted by additional users. This effect is created by many users when value is added to their use of the product. The largest and best-known example of a network effect is the Internet. The Internet, as we know, is a network of networks where people connect to each other.
Much of the early work done regarding the Network Effect was based on Metcalf’s Law. Metcalf’s Law states that the value of a telecommunication network is proportional to the square of the number of connected users. The modern Network Effect theory was developed based on the research of Joseph Farrell, Michael L, Carl Shapiro, and Garth Saloner in the 1990s. These researchers coined the concept using the telephone as an example.
Understanding Network Effect
The network effect takes place with every new user’s addition to the old network, thus, increasing the value for all existing users. We can observe in the image below that the network starts off with a small number of users, after which it grows and connects more users in the chain, and attains a stage of critical mass. The speed of this network effect then increases exponentially with co-creation, where the users automatically subscribe for the additional value that they are getting.
Direct network effect or same-side network effect arises when users directly benefit from the addition of new users. A direct network effect is directly proportional to the users of the original product. For instance, existing users on the Internet will benefit from the addition of new online users.
Indirect network effect or cross-side network, on the other hand, arises when users of the original product increase not because of any direct gain but due to the effect of some complementary product that triggers the use of additional products. For instance, existing users on the Internet will benefit from the addition of new users that are created by inexpensive laptops being available on the market.
A bilateral network effect arises when there is an increase in users of a complementary product and users of that product benefit. For instance, the number of users on the Internet increase because of the increase in smartphone users. The complementary relation of both products boosts the number of users of the internet.
When a user’s gain is affected by a small group of members rather than the whole set of members, then it is called a local network effect. For example, a user of instant messenger will benefit if his/her friends signed up for the same instant messenger app, but he will not gain anything from an increase in users in general.
Economic Consequences of a Network Effect
Sales in the market are significantly affected by the increase in the value of the network due to the addition of new users. When the value of the product obtained is higher than the price of the product, the consumer base is expected to increase. The higher consumer base happens once subscriptions reach a certain level of critical mass. New subscribers are attracted to the product because of the extra value they are getting.
Companies can attract new users to their network in various ways, such as fee waivers, discounted rates, free trials, etc.
Modern stock exchanges experience a network effect. The effect arises due to the volatile nature of stock prices. The forces of supply and demand that determine prices are ever-changing and depend heavily on the number of users. When the demand is low, prices fall, which attracts more investors to invest. As they invest, the rising price of the stock invites even more people. Then comes the downfall when people lose their confidence in the stock and sell it off, bringing prices down. The network effect is working when more people buy a certain stock, as everyone benefits from its rising price.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To learn more and continue advancing your career, see the following free CFI resources: