Network Externalities – Definition

Network Externalities Definition

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 circumstance 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.

A Little More on What is a Network Externality

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.

References for Network Externalities

Academic Research on Network Externalities

Network externalities, competition, and compatibility, Katz, M. L., & Shapiro, C. (1985). The American economic review75(3), 424-440. This research paper explains the network externalities, Compatibility and competition affecting a firm. These factors were all considered as hurdles that possess setbacks to an industry.

Technology adoption in the presence of network externalities, Katz, M. L., & Shapiro, C. (1986). Journal of political economy94(4), 822-841. This research paper studies the adaptation of technology in industries where network externalities are counted as being significant. The manner of adaptation of these technologies according to this paper depends on whether the technologies are sponsored or not. According to this study, the major findings include the compatibility trends to be undersupplied by the market whereas excessive standardization can take place. The findings also include the absence of sponsors although the superior technology today has a strategic advantage and is likely to take over the market completely. Etc.

Network effects without network externalities, Chou, C. F., & Shy, O. (1990). International Journal of Industrial Organization8(2), 259-270. It was described in this study that the increasing returns to scale found in the production of matching products can be interchanged with the network externalities assumption. According to this paper, a model for the computer industry was developed in which the production of these matching software needs a large fixed cost of development compared to the cost of marketing and duplicating the software. This study, however, postulated that an increase in the return to scale in the production of this software gives rise to the behaviour of consumers in which it is very similar to those of consumers that have preferences which exhibit network externalities.

Product introduction with network externalities, Katz, M. L., & Shapiro, C. (1992). The Journal of Industrial Economics, 55-83. According to this paper, the introduction of a new product in a market that exhibits various network externalities was studied and discussed. This paper assumes there is a common presumption that such markets exhibit as part of their characteristic what is termed as “excess inertia” which means they are biased as regards the existing product. However, this study provides a condition under which equilibrium could be involved as insufficient friction meaning there is a tendency to rush into modern incompatible technologies. This paper also studies the firms’ incentives which helps to make their product more compatible and this paper also explains that firms introducing new technologies are mostly biased as far as compatibility is in play.

Why people use social networking sites: An empirical study integrating network externalities and motivation theory, Lin, K. Y., & Lu, H. P. (2011). Computers in human behaviour27(3), 1152-1161. In other to consider factors that are affecting users joining SNS, this research paper applies the motivation theory and the network externalities to explain why people should not stop joining the SNS. According to this paper, an online questionnaire was used to conduct empirical and comprehensive research, over 402 sample data were collected and analyzed by adopting the use of the structural equation approach (SEM). The result from this analysis indicates that enjoyment is one of the most common factors inasmuch as people will have to continue joining the SNS, followed by the number of peer groups and their usefulness. This paper also performed various analysis (clustering analysis by gender) which yielded a negligible difference in both numbers of members and the number of peers between men and women.

Complementary network externalities and technological adoption, Church, J., & Gandal, N. (1993). International journal of industrial organization11(2), 239-260. This paper shows that they are various ways in which technology has been found useful inasmuch as network externalities and network compatibilities are in play. This paper explains that these networks are characterized by the complementary product produced by the different firms in the econo9my. This study also shows that when the software companies are Bertrand competitors, the hardware technology that has a much lower cost of software development is adopted for a lot of parameter values which is totally optimal to make use of other technology.

Network externalities in microcomputer software: An econometric analysis of the spreadsheet market, Brynjolfsson, E., & Kemerer, C. F. (1996). Management Science42(12), 1627-1647. According to this research paper, the rate at which a software program triumphs may depend on its similarities and conformance to the norms of the industry standards as well as in part on stalled based. This paper constructs a scientific model to examine the rate and effect of the network externalities, intrinsic features, standards and a time trend using a microcomputer spreadsheet software price. according to this model, a sample data gotten from 1987-1992 was analyzed using this model and four main results were obtained. Hence, this paper explains in details the result obtained from the test and how these results have been useful as far as network externality is concerned.

Network externalities, complementarities, and invitations to enter, Economides, N. (1996).  This paper explains the incentives of a high-class holder of technology to be shared with the competitors in a market having network externalities. It was assumed in this study that the high expected sale is a cause of the increase in the willingness to pay for the good supplied. This phenomenon is known as the “network effect”. It, therefore, must be noted that if the network effect is very sufficient and strong, a quantity leader must possess an incentive which would be used to invite entry and also incense his technology without any charge. However, this paper mentioned that if the quantity leader has the chance to make use of lump sum license fee, he will be able to invite a large number of competitors. Hence, this study shows that the result remains under uncertainty and when the post entry competition is Cournot.

Entrepreneurship and network externalities, Minniti, M. (2005). Journal of Economic Behavior & Organization57(1), 1-27. This academic paper studies the agglomeration that indicates the economic characteristics only explains little regarding the variance of entrepreneurship rate across several regions. This paper, however, argues that entrepreneurship tends to concentrate on geographic zones because of their social environment. This paper also suggests that when making decisions, individuals follow the social cues and most times are influenced by what others (past leaders mostly) have chosen especially when faced with difficult situations. This analysis, however, adopts the use of a non-linear stochastic model; this is a model of entrepreneur dynamics that indicates while communities having initial economic similarities as their major characteristics end up with different stages of entrepreneurial activities.

The desirability of compatibility in the absence of network externalities, Economides, N. (1989). The American Economic Review, 1165-1181. This paper compares the incentive that firms have developed in individual components which are found to be compatible with components of other producers instead of the system made up of parts that are incompatible with components of other competing manufacturers. This study shows that even in the absence of positive consumption externalities (which are also known as the network externalities), profits and prices will be much higher in the regime of compatibility. This paper also explains that the equilibrium total surplus could be much higher in either regime.

 

Monopoly pricing with network externalities, Cabral, L. M., Salant, D. J., & Woroch, G. A. (1999). International Journal of Industrial Organization17(2), 199-214. This paper explains the intuition as to how, when and why introductory pricing might occur in the presence of network externalities. This paper takes into consideration the incomplete information about the demand and the asymmetric information about the cost of these externalities as being necessary for the introductory pricing to take place in equilibrium when consumers are minimal.

Spatial economic analysis of telecommunications network externalities, Brock, G. W. (1996). Journal of Economic Literature34(1), 170. According to this academic paper, the spatial economic analysis of most telecommunication network externalities was considered and explained.

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