Network Effect
A network effect is the effect that the number of users of a product or service has on the value of that product or service to each user. Network effects are a central feature of platform markets and of industries with network characteristics.
Types
A direct network effect arises when the value of a product to each user increases with the number of users. A telephone network is the classic example, since the value of the network to each subscriber increases with the number of other subscribers.
An indirect network effect arises when the value of a product increases with the number of users of a complementary product or service. A platform that connects two groups, such as buyers and sellers, exhibits indirect network effects, since the value to each group increases with the number of users on the other side.
Negative network effects can also arise, when the value of a product declines with the number of users. Congestion is an example, since an increase in the number of users can reduce the quality of the service.
Implications for Market Structure
Network effects have implications for market structure. They tend to create a winner-takes-most outcome, since the firm with the largest network offers the greatest value and attracts more users, reinforcing its position.
The tendency towards concentration can create a situation in which a single firm or a small number of firms dominate the market, even in the absence of the traditional barriers to entry. The resulting market power raises concerns about pricing and about the behaviour of the firms.
The concentration is not necessarily permanent, since the market can tip from one firm to another if the entrant offers a sufficiently better product. The possibility of tipping raises questions about the sustainability of the positions of the dominant firms.
Standards and Compatibility
Network effects are closely related to the adoption of standards. When users benefit from compatibility, they tend to adopt the same standard, and the standard that is adopted may be determined by the history of the market rather than by its merits.
The adoption of standards can generate lock-in, in which users are committed to a technology that may not be the best available. The transition to a new standard may require coordination, and it may take time.
The analysis of standards is relevant to the design of policy, including the regulation of interoperability and the treatment of intellectual property in standards. The design of the framework affects the incentives to innovate and the diffusion of technology.
Policy
The policy issues raised by network effects concern the market power of platforms, the treatment of data, and the conditions of competition. The framework must address the risk that the dominant firms use their position to exclude competitors and to extract rents.
The instruments include the enforcement of competition law and the regulation of platforms. The design of the framework must balance the benefits of the networks against the risks of market power and must be robust to the rapid evolution of the technology.
Platform Markets
Platform markets are markets in which a firm provides an infrastructure that connects two or more groups of users. The platform intermediates the interactions between the groups, and its value depends on the participation of both sides.
The platforms exhibit strong network effects, since the value to each group increases with the participation of the other. The networks give the platforms a powerful advantage, since a platform with a larger network can attract more users on both sides.
The platforms may charge prices that differ across the groups, including prices below cost or even negative on one side, in order to attract participation and to generate the network effect. The pricing structure of the platforms is a distinctive feature of these markets.
The Chicken-and-Egg Problem
The platforms face the chicken-and-egg problem, since the value to each group depends on the participation of the other, and the platform must attract both sides to function.
The platforms address the problem through several strategies, including the subsidy of one side, the seeding of the network with content, and the formation of partnerships. The strategies are intended to create the initial participation that makes the platform viable.
The analysis of the problem informs the understanding of the dynamics of platform markets and of the strategies of the firms. The problem explains why some platforms succeed while others fail, and it informs the analysis of competition in these markets.
Regulation
The regulation of platforms addresses the market power that arises from the network effects. The issues include the pricing of the services, the treatment of competitors, and the use of data.
The instruments include the enforcement of competition law and the regulation of the platforms. The design of the framework must balance the benefits of the networks against the risks of market power, and it must be robust to the rapid evolution of the technology.
The regulation of interoperability is one approach, which requires the platforms to allow the users to interact across the platforms. The approach can reduce the advantage of the incumbents, though it raises issues of the incentives to invest.
Summary
Network effects are a central feature of platform markets, and they have implications for market structure, for pricing, and for regulation. The analysis of the effects informs the understanding of the digital economy.