Understanding the Network Effect

Time for a proper post on Network Effects. A network effect occurs when the value of a good or service to a potential customer is dependent on the number of customers already owning that good or using that service. Equivalently, it means that the total value of a good or service that possesses network effects is roughly proportional to the square of the number of customers already owning that good or using that service.

Many different examples come to mind. Can you think of any?

Network effects can be expressed in a mathematical formula according to Metcalfe's Law.

The network effect of the web - which TBL compares to a Bobsled - is particularly strong. The web is very generic, neutral, and open - it can be used in so many different ways. So...as new web servers began to spring up, as new web browsers were created, as new hardware platforms were supported (NeXT, Unix, Mac, and Windows), as new gateways were added (to previously existing databases for example), and as more protocols (i.e. FTP) were incorporated into the web, more functionality was enabled and more and more users gained access and a network effect took off. The Bobsled began to glide.

As the story of the evolution of train tracks tells us, the driving factors behind network effects can be complex. It is often more important for a technology be interoperable with others than to be best-in-class. Network effects occur because people believe a new standard is being forged - so they buy something that will provide them greatest benefit for least investment. Much of the power of the web lies in its popularity as an open standard