Network effect

Network effect is the phenomenon by which the value of a product or service to each user increases as the number of users grows, creating positive feedback loops where adoption drives further adoption (Katz M.L., Shapiro C. 1985, p.424)^[1]. The first fax machine was worthless—nobody to fax. The second made the first useful. By the time millions existed, the network became indispensable. That's a network effect. The telephone, the internet, Facebook, WhatsApp—each became more valuable as each additional person joined.

Network effects have restructured entire industries. They explain why markets often tip toward dominant players, why platform businesses achieve astronomical valuations, and why some technology standards win while equally good alternatives disappear. The economics are counterintuitive: instead of decreasing returns to scale, network effects create increasing returns. Success breeds success. The rich get richer.

Types

Network effects take different forms:

Direct network effects

Same-side value. Direct effects occur when users benefit directly from other users of the same product. More telephone users make telephones more valuable. More WhatsApp users make WhatsApp more useful^[2].

Communication networks. Phone networks, messaging apps, and social networks exhibit strong direct effects.

Indirect network effects

Complement availability. Indirect effects occur when more users attract more complementary products or services. More Windows users attracted more software developers, which made Windows more valuable to users.

Two-sided platforms. Credit cards, operating systems, and gaming consoles depend on indirect effects between users and complementors^[3].

Cross-side network effects

Platform dynamics. In platform businesses, more users on one side attract more participants on the other. More Uber riders attract more drivers; more drivers attract more riders.

Chicken-and-egg. Platforms must solve initial coordination problems—getting both sides simultaneously.

Economic implications

Network effects create distinctive market dynamics:

Increasing returns

Bigger is better. Unlike traditional industries where growth eventually yields diminishing returns, network effects produce increasing returns. Each additional user makes the network more valuable, attracting more users^[4].

Scale economies. Network effects combine with supply-side economies of scale (low marginal costs) to create powerful growth dynamics.

Winner-take-all

Market tipping. Markets with strong network effects tend to tip toward single dominant players. Users gravitate toward the largest network, reinforcing its dominance.

Critical mass. Reaching critical mass triggers accelerating adoption; failing to reach it leads to collapse.

Lock-in

Switching costs. Once invested in a network, users face high costs of switching—not just learning new systems but leaving behind network connections^[5].

Path dependence. Early advantages can persist even if superior alternatives emerge. The QWERTY keyboard endures despite alleged inefficiency.

Platform strategy

Network effects shape competitive strategy:

Subsidization

Getting to scale. Platforms often subsidize one side to attract critical mass. Uber offered low prices and driver bonuses to build density.

Money-side/subsidy-side. Successful platforms identify which side to monetize and which to subsidize for growth^[6].

Multi-homing

Competitive defense. When users easily participate in multiple networks simultaneously (multi-homing), winner-take-all dynamics weaken.

Exclusivity strategies. Platforms may create barriers to multi-homing through exclusivity requirements or integration features.

Quality maintenance

Curation. As networks grow, quality can decline. Social networks face spam and abuse. Marketplaces face fraudulent sellers. Maintaining quality becomes critical^[7].

Limitations

Network effects face constraints:

Congestion. At some point, more users create negative effects—crowding, noise, reduced quality.

Fragmentation. Networks may fragment into incompatible clusters that limit overall effects.

Disintermediation. Once connected, users may bypass the platform that introduced them^[8].

Examples

Notable network effect businesses:

Social networks. Facebook, LinkedIn, and Twitter derive value primarily from user connections.

Payment networks. Visa and Mastercard connect cardholders and merchants.

Operating systems. Windows, iOS, and Android benefit from application ecosystems.

Marketplaces. Amazon, eBay, and Etsy connect buyers and sellers.

Network effect — recommended articles

Platform business model — Economies of scale — Competitive advantage — Digital economy

References

• Katz M.L., Shapiro C. (1985), Network Externalities, Competition, and Compatibility, American Economic Review, 75(3), pp.424-440.
• Shapiro C., Varian H.R. (1999), Information Rules: A Strategic Guide to the Network Economy, Harvard Business School Press.
• Parker G.G., Van Alstyne M.W., Choudary S.P. (2016), Platform Revolution, W.W. Norton.
• Evans D.S., Schmalensee R. (2016), Matchmakers: The New Economics of Multisided Platforms, Harvard Business Review Press.

Footnotes

1. ↑ Katz M.L., Shapiro C. (1985), Network Externalities, p.424
2. ↑ Shapiro C., Varian H.R. (1999), Information Rules, pp.173-192
3. ↑ Parker G.G. et al. (2016), Platform Revolution, pp.45-62
4. ↑ Evans D.S., Schmalensee R. (2016), Matchmakers, pp.89-104
5. ↑ Katz M.L., Shapiro C. (1985), Network Externalities, pp.430-435
6. ↑ Parker G.G. et al. (2016), Platform Revolution, pp.112-128
7. ↑ Shapiro C., Varian H.R. (1999), Information Rules, pp.212-228
8. ↑ Evans D.S., Schmalensee R. (2016), Matchmakers, pp.156-172

Author: Sławomir Wawak