Network effect

The Network effect results from positive feedback, where success begets success and economies of scale undermine the competition. The effect can be observed with Ebay, Microsoft, or even the largest local newspaper. Once Ebay had established itself as the site to visit in order to sell things, this attracted even more sellers as they realized it had the largest audience. So why bother to list on another site? The process snowballs and provides a barrier to competition.

Microsoft has network economies with both the Windows operating system and Microsoft Office. In addition, complementary products provide an important reinforcement to the network. For example, a video game producer will obviously want to develop the program for Windows and if the game is a hit, this provides the end-user with another benefit from the Windows platform.

This powerful network effect was encapsulated by Bob Metcalf, the inventor, of Ethernet. He stated that if there are n people in a network, and the value of the network to each of them is proportional to the number of other users, then the total value of the network (to all the users) is

proportional to n*(n-1) = n2 — n.

If the value of a network to single user is $1 for each other user on the network, then a network of size 10 has a total value of roughly $100.

In contrast, a network of size 100 has a total value of roughly $10,000. A tenfold increase in the size of the network leads to a hundredfold increase in its value.

‘The Little Book That Builds Wealth’, by Pat Dorsey:

The bottom line is that you’re most likely to find the network effect in businesses based on sharing information, or connecting users together, rather than in businesses that deal in rival (physical) goods… this is not exclusively the case, but it’s a good rule of thumb.