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5.1 Introduction

Learning Objectives

After studying this section you should be able to do the following:

  1. Define network effects.
  2. Recognize products and services that are subject to network effects.
  3. Understand the factors that add value to products and services subject to network effects.

Network effectsAlso known as Metcalfe’s Law, or network externalities. When the value of a product or service increases as its number of users expands. are sometimes referred to as “Metcalfe’s Law” or “Network Externalities.” But don’t let the dull names fool you—this concept is rocket fuel for technology firms. Bill Gates leveraged network effects to turn Windows and Office into virtual monopolies and in the process became the wealthiest man in America. Mark Zuckerberg of Facebook, Pierre Omidiyar of eBay, Caterina Fake and Stewart Butterfield of Flickr, Kevin Rose of Digg, Evan Williams and Biz Stone of Twitter, Chris DeWolfe and Tom Anderson—the MySpace guys—all of these entrepreneurs have built massive user bases by leveraging the concept. When network effects are present, the value of a product or service increases as the number of users grows. Simply, more users = more value. Of course, most products aren’t subject to network effects—you probably don’t care if someone wears the same socks, uses the same pancake syrup, or buys the same trash bags as you. But when network effects are present they’re among the most important reasons you’ll pick one product or service over another. You may care very much, for example, if others are part of your social network, if your video game console is popular, if the Wikipedia article you’re referencing has had prior readers. And all those folks who bought HD-DVD players sure were bummed when the rest of the world declared Blu-ray the winner. In each of these examples, network effects are at work.

Not That Kind of Network

The term “network” sometimes stumps people when first learning about network effects. In this context, a network doesn’t refer to the physical wires or wireless systems that connect pieces of electronics. It just refers to a common user base that is able to communicate and share with one another. So Facebook users make up a network. So do owners of Blu-ray DVD players, traders that buy and sell stock over the NASDAQ, or the sum total of hardware and outlets that support the BS 1363 electrical standard.

Key Takeaway

  • Network effects are among the most powerful strategic resources that can be created by technology-based innovation. Many category-dominating organizations and technologies owe their success to network effects, including Microsoft, Apple, NASDAQ, eBay, Facebook, and Visa. Network effects are also behind the establishment of most standards, including Blu-ray DVD, wi-fi, and Bluetooth.

Questions and Exercises

  1. What are network effects? What are the other names for this concept?
  2. List several products or services subject to network effects. What factors do you believe helped each of these efforts achieve dominance?
  3. Which firm do you suspect has stronger end-user network effects: Google’s online search tool or Microsoft’s Windows operating system? Why?
  4. Network effects are often associated with technology, but tech isn’t a prerequisite for the existence of network effects. Name a product, service, or phenomenon that is not related to information technology that still dominates due to network effects.