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The network effect is a characteristic that causes a good or service to have a value to a potential customer dependent on the number of customers already owning that good or using that service. more...

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One consequence of a network effect is that the purchase of a good by one individual indirectly benefits others who own the good - for example by purchasing a telephone a person makes other telephones more useful. This type of side-effect in a transaction is known as an externality in economics, and externalities arising from network effects are known as network externalities. The resulting bandwagon effect is an example of a positive feedback loop.

Network effect business models

Network effects were used as justification for some of the dot-com business models in the late 1990s. These firms operated under the belief that when a new market comes into being which contains strong network effects, firms should care more about growing their market share than about becoming profitable. This was believed because market share will determine which firm can set technical and marketing standards and thus determine the basis of future competition.

A good example of this strategy was that deployed by Mirabilis, the Israeli start-up which pioneered instant messaging (IM) and was bought by America Online. By giving away their ICQ product for free and preventing interoperability between their client software and other products, they were able to corner the market for instant messaging. 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 using a competing system. As was typical for that era, the company never made any attempt to generate profits from their dominant position before selling the company.

Network effects become significant after a certain subscription percentage has been achieved, called critical mass. At the critical mass point, the value obtained from the good or service is greater than or equal to the price paid for the good or service. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the positive utility:price ratio.

A key business concern must then be how to attract users prior to reaching critical mass. One way is to rely on extrinsic motivation, such as a payment, a fee waiver, or a request for friends to sign up. A more natural strategy is to build a system that has enough value without network effects, at least to early adopters. Then, as the number of users increases, the system becomes even more valuable and is able to attract a wider user base. Joshua Schachter has explained that he built Del.icio.us along these lines - he built an online system where he could keep bookmarks for himself, such that even if no other user joined, it would still be valuable to him. It was relatively easy to build up a user base from zero because early adopters found enough value in the system outside of the network aspects. The same could be said for many other successful websites which derive value from network effects, e.g. Flickr, MySpace.