What are network effects (network economies of scale?)

Network economies of scale (also known as "network effects") refer to the phenomenon where the value of a product or service increases with the number of users of that product or service.

In other words, as more people use a product or service, the more valuable it becomes to each individual user.

Network economies of scale, also known as network effects or network externalities, refer to the phenomenon where the value of a product or service increases as more people use it. In other words, the more users a network has, the more valuable it becomes to each user.

These effects can be observed in various types of networks, including communication networks, social networks, and technology platforms. There are two primary types of network effects:

1. Direct Network Effects (Same-Side Network Effects): In this case, the value of a product or service increases for an individual user as more people adopt the same product or service. Examples include social media platforms, where the more friends or connections a user has, the more valuable the platform becomes.
2. Indirect Network Effects (Cross-Side Network Effects): Here, the value of a product or service increases for one group of users as the number of users on a complementary platform increases. An example is the compatibility between software and hardware; as more software developers create applications for a particular operating system, the operating system becomes more attractive to users, and vice versa.

Network economies of scale often lead to a winner-takes-all or winner-takes-most scenario, where a dominant player in the market attracts the majority of users, reinforcing its position and making it challenging for competitors to gain a foothold. This can create significant barriers to entry and contribute to the long-term success of certain products or services in the market.

Companies that successfully harness network economies of scale can build strong and sustainable competitive advantages, as the value of their offerings continues to grow with an expanding user base. Examples of industries where network effects are prominent include social media, online marketplaces, communication platforms, and operating systems.

Examples of network effects include:

• Social media platforms (e.g. Facebook, Instagram)
• Online marketplaces (e.g. Amazon, eBay)
• Communication platforms (e.g. WhatsApp, Zoom)
• Payment platforms (e.g. Visa, PayPal)
• Operating systems (e.g. Windows, iOS)
• Navigation apps (e.g. Google Maps, Waze)

Network effects can create significant barriers to entry for new firms, as it can be difficult for new products or services to gain a critical mass of users. This can lead to a situation where a small number of dominant firms control a market, making it hard for new firms to compete.