What is network effect

Network effect

The so-called network effect is playing an increasingly important role in a multimedia world. Basically, this effect says that the usefulness of a network increases as the number of participants grows. So something is of no use to an individual.

Only when many participants have found each other does that mean added value for everyone. It's about one positive external effect.

Unfortunately, there is a not inconsiderable risk of the network effect in the economy Monopoly formation. But why is that and what current practical examples are there for a network effect?

Differentiation - direct & indirect network effects

There are basically two different types of network effect. For one thing, there is direct and on the other hand the indirect network effect. With the direct network effect, a participant benefits immediately if the network is used by several participants - mostly through direct communication between the participants. The increase in benefit is therefore primarily explained by the communication relationship between the participants.

It is different with the indirect network effect: Here the participants do not benefit from the benefits of communication relationships. So the benefit has a different origin. Example:Complementary goods (= several goods that are mutually beneficial, such as gasoline and cars)

Examples of network effects

The network effect can be found in many places in our social coexistence these days. Many “networks” only make sense or are of benefit to the participants if there are a corresponding number of users. The following examples of the network effect are particularly popular:

Example 1: phone / cell phone / SMS

A typical example of the network effect is the telephone. A subscriber alone would be of no use through the telephone, since he could not call anyone. The benefit for the participants is increasing because more and more people are using the telephone and cell phone as a means of communication with one another. Since the benefit for all participants increases accordingly, one speaks of positive feedback.

Example 2: Internet

Another example of the network effect is the Internet. The more people use the Internet as a source of information and publish information there, the greater the benefit for everyone. It is similar with social networks. This also increases the benefit for each individual, when the number of participants increases.

Risk of monopoly formation

However, there are not only positive sides to the network effect. Basically, it must be stated that every market in which this effect plays a role, very vulnerable before monopolies is. And that is also very easy to understand: The goal of every network is to steadily increase the number of users, as this also increases the overall benefit for each individual. Conversely, this also means: Every operator or provider of such networks strives to achieve a monopoly over the maximum benefit to attain for the participants.

Again briefly summarized:

  • With the network effect, the benefit for each individual increases as the number of participants increases
  • The network effect is a positive external effect
  • A distinction is made between direct and indirect network effects
  • There is a high monopoly risk with the network effect
  • Practical examples are cell phones, faxes and the Internet
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The article "Network Effect" is in the category: Microeconomics