Network effects arise when the value of a product grows as more people use it, directly, as in messaging apps, or across groups, when one side attracts the other. The challenge for platforms is to reach critical mass.
Network effects occur when the value of a product or service changes as the number of participants grows. In direct effects, each new user widens the possibilities of interaction for the others, as happens in messaging apps and communication networks. In indirect or cross-side effects, the growth of one group attracts participants from another. A mobility platform, for example, becomes more attractive to drivers when it gathers more passengers and more useful to passengers when the supply of drivers grows.
Metcalfe’s law is a heuristic often used to illustrate the expansion of potential connections. In a network with N users there are N(N − 1)/2 possible pairs, which is why the value of the network is usually represented as proportional to N². This formulation should not be treated as an empirical law. Not all connections carry the same relevance, and other approximations, such as N log N, may describe certain contexts better.
The main challenge for a new platform is to reach critical mass. Before that point, the small number of participants reduces the usefulness of the service and makes new adoption harder. After it, growth can acquire some capacity to feed itself. This process helps explain why firms subsidise early users, ease invitations and lower entry barriers.
The same effects that create value can raise switching costs and produce technological lock-in. Leaving a network can mean losing contacts, reputation, history or compatibility with other users. This dynamic favours concentration and makes interoperability a relevant issue for competition policy, since communication between networks can reduce dependence on a single supplier.
In short, network effects are central to explaining growth, concentration and user retention in digital markets. Studying them makes it possible to distinguish the value created by the expansion of the network from the risks that stem from dependence, switching costs and reduced competition.
Further reading
- Katz, M. L.; Shapiro, C. (1985). “Network Externalities, Competition, and Compatibility”. American Economic Review, 75(3), 424–440. — The founding paper of the network-externalities literature.
- Katz, M. L.; Shapiro, C. (1994). “Systems Competition and Network Effects”. Journal of Economic Perspectives, 8(2), 93–115. doi:10.1257/jep.8.2.93 — An accessible, open-access version.
- Farrell, J.; Klemperer, P. (2007). “Coordination and Lock-In: Competition with Switching Costs and Network Effects”. In: Handbook of Industrial Organization, vol. 3, pp. 1967–2072. doi:10.1016/S1573-448X(06)03031-7
- Metcalfe, B. (2013). “Metcalfe’s Law after 40 Years of Ethernet”. Computer, 46(12), 26–31. doi:10.1109/MC.2013.374
- Briscoe, B.; Odlyzko, A.; Tilly, B. (2006). “Metcalfe’s Law is Wrong”. IEEE Spectrum, 43(7), 34–39. doi:10.1109/MSPEC.2006.1653003 — The critique that proposes N log N.
- Shapiro, C.; Varian, H. R. (1999). Information Rules, chapter 7 (“Networks and Positive Feedback”).
Websites to explore
- Journal of Economic Perspectives: the American Economic Association’s open-access journal — includes Katz and Shapiro (1994).
- Cetic.br — ICT Households: data on the adoption of apps and networks in Brazil, useful for thinking about critical mass.
