4. Network Effects

links to Part 1, Part 2 and Part 3

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The prisoner’s dilemma of the last post was a particular case of negative externalities. This post covers a particular type of positive externalities known as network effects.

Wikipedia, as always, is here to helpfully summarize:

In economics and business, a network effect (also called a network externality) is the effect that one user of a good or service has on the value of that product to other people.

The classic example is the telephone. The more people own telephones, the more valuable the telephone is to each owner. This creates a positive externality because a user may purchase their phone without intending to create value for other users, but does so in any case.

The expression "network effect" is applied most commonly to positive network externalities as in the case of the telephone. Negative network externalities can also occur, where more users make a product less valuable, but are more commonly referred to as "congestion" (as in traffic congestion or network congestion).
Over time, positive network effects can create a bandwagon effect as the network becomes more valuable and more people join, in a positive feedback loop.

So I make a transaction with the phone company that is a win-win for me and the phone company and also for everyone else (a positive externality) who already has a deal with the phone company. The size of my win in the transaction with the phone company depends on how many existing users there are, so after I sign up, the next person to sign up gets an even bigger win, and so on.

In addition to actual networks, standards often have the same structure. If I am using a particular computer file format, every other person who uses that format helps me since I can look at their files without needing to change the format first. The same goes for operating systems, where Windows was able to become the de facto standard for so many years. One of the reasons there is a strong push for open standards in many areas is to avoid having one individual or group extract monopoly rents from all those using the standard in the same manner that Bill Gates became the wealthiest man in the world.

Note that in situations with network effects, there is an initial phase in which relatively small investments / ideas / luck can tip the scales between various people attempting to set up the new standard and then a later phase when one (in some cases two or three) network has emerged victorious and it would take a huge investment of resources or a significant change in the situation in order to remove them from their leadership position.

This is one way to understand the internet gold rush of the 90's. Investors understood that the internet opened up new situations where network effects were strong and that initial investments in money losing companies could pay off later if they were able to win the battle to become the standard. Ebay (the best example of network effects since if you're selling something you want to use the site with the most buyers and vice-versa so every new user benefits all the other users) founder Pierre Omidyar is now a multi-billionaire, much like Bill Gates.