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In economics, a network effect (also called network externality or demand-side economies of scale) is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products.

Network effects are typically positive feedback systems, resulting in users deriving more and more value from a product as more users join the same network. The adoption of a product by an additional user can be broken into two effects: an increase in the value to all other users (total effect) and also the enhancement of other non-users' motivation for using the product (marginal effect). Direct network effects arise when a given user's utility increases with the number of other users of the same product or technology, meaning that adoption of a product by different users is complementary. This effect is separate from effects related to price, such as a benefit to existing users resulting from price decreases as more users join. Direct network effects can be seen with social networking services, including Twitter, Facebook, Airbnb, Uber, and LinkedIn; telecommunications devices like the telephone; instant messaging services such as MSN, AIM or QQ; or even Wikipedia itself. Indirect (or cross-group) network effects arise when there are "at least two different customer groups that are interdependent, and the utility of at least one group grows as the other group(s) grow". Network effects are commonly mistaken for economies of scale, which describe decreasing average production costs in relation to the total volume of units produced. Economies of scale are a common phenomenon in traditional industries such as manufacturing, whereas network effects are most prevalent in new economy industries, particularly information and communication technologies. Network effects are the demand side counterpart of economies of scale, as they function by increasing a customer's willingness to pay due rather than decreasing the supplier's average cost. As the network continues to become more valuable with each new adopter, more people are incentivised to adopt, resulting in a positive feedback loop. Multiple equilibria and a market monopoly are two key potential outcomes in markets that exhibit network effects.

According to Metcalfe, the rationale behind the sale of networking cards was that the cost of the network was directly proportional to the number of cards installed, but the value of the network was proportional to the square of the number of users. Author, high-tech entrepreneur Rod Beckstrom presented a mathematical model for describing networks that are in a state of positive network effect at BlackHat and Defcon in 2009 and also presented the inverse network effect with an economic model for defining it as well.

Network economics refers to business economics that benefit from the network effect.

If some existing technology or company whose benefits are largely based on network effects starts to lose market share against a challenger such as a disruptive technology or open standards based competition, the benefits of network effects will reduce for the incumbent, and increase for the challenger.

Negative network externalities, in the mathematical sense, are those that have a negative effect compared to normal (positive) network effects. Just as positive network externalities (network effects) cause positive feedback and exponential growth, negative network externalities are also caused by positive feedback, resulting in exponential decay.

Interoperability has the effect of making the network bigger and thus increases the external value of the network to consumers.

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 use a competing system.

Network effects are the incremental benefit gained by each user for each new user that joins a network. An example of a direct network effect is the telephone.

Quick Facts

• Network effects are typically positive feedback systems, resulting in users deriving more and more value from a product as more users join the same network.
• The adoption of a product by an additional user can be broken into two effects: an increase in the value to all other users (total effect) and also the enhancement of other non-users' motivation for using the product (marginal effect).
• Direct network effects arise when a given user's utility increases with the number of other users of the same product or technology, meaning that adoption of a product by different users is complementary.
• 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 use a competing system.
• Network economics refers to business economics that benefit from the network effect.

Source material: Wikipedia - "Network effect". Adapted and summarized for DiscoverScroll. Original contributors are credited through the linked Wikipedia article. Read original on Wikipedia. CC BY-SA 4.0. Changes were made from the original.