What are Network Externalities?

Network externalities is an economics concept that describes the circumstances where the value of a product or service changes as the number of users increases or decreases. According to the traditional economic theory, as the supply of a product increases the price of the product falls and becomes less valuable. In certain circumstances the opposite might happen, the value of a product or service may rise with the increase in the number of users. This is called the positive network externalities or the network effect. A mobile network is an example where this concept applies. The more users a mobile service provider has the higher its value. The telephone is a classic example where a greater number of users increases the value to each. When a customer purchases a telephone, a positive externality is created. The online social network is another example where the value is increased with each new user.

Back to: ECONOMIC ANALYSIS & MONETARY POLICY

How does Network Externalities Work?

The term network effect refers to positive network externalities, where the value of a product or service increases with the rise in the number of users. Negative network externalities are where more users decrease the value of a product, but it is commonly referred to as congestion. The network effects reach a significant level only when a certain number of people subscribe to the service or purchase the good. This certain subscription percentage is known as the critical mass. After the critical mass point is reached, the value obtained from the product or service exceeds the price of the same. The value of the good is determined by the user base, so after a certain number of people subscribe to the product, additional people will subscribe to it as the value exceeds the price. It is important to reach the critical mass point for achieving success in such businesses. Companies implement various promotional tactics including to attract the early users. The companies may offer a fee waiver or a request for friends to sign up in order to attract the customers. The safest and natural strategy is to build a system that has enough value without network effects, at least to early users. Then the value of the system increases with the rise in the number of users and even more, users are attracted to the service. After reaching the critical mass point, the rise in the number of subscribers generally cannot continue forever. The networks generally get saturated or congested after a certain point of time. Overuse leads to congestion. Say for mobile networks after a certain point each new user decreases the value of the service for other existing users. The network gets overloaded and that leads to disruption in the service and poor connectivity.

Related Topics

• Network Externality
• Pigovian Tax
• Coase Theorem
• Agglomeration Diseconomies