EFA (49): Network effects

Can you remember the days when telecommunications companies tried to sell video phones? Maybe you were even one of the few people who bought one.

Or, rather, you bought two. Because the phones were normally sold in pairs. The reason for this was very simple: having a video phone is of no use to you unless someone else has one, too.

This is a classic example of what economists call a "network effect" or "network externality". These are the subject of the 49th and penultimate instalment of our Economics for Amateurs (EFA) series.

A network effect is the influence that one user of a good or service has on the value of that good or service to others. In the case of a positive network effect, the value of the product to an individual increases when a greater number of other people use the product.

Video phones never took off for private use. Many people thought the reason was that people didn't want to be seen while they were on the phone.

Now, we know that was not the real problem. Millions of people use Skype for free private (and business) video calls. The problem with video phones was the price, which in Germany, if I remember rightly, was around DM 2,000 for a pair. At such a price, there was never going to be a "critical mass" of buyers to create significant network benefits.

In fact, even normal telephones are a classic example of network effects. They are of no use unless others have them. The same is true of mobile phones if you want to send text messages. And, more recently, the success of social networking sites such as Facebook or Xing has been based on network externalities.

Often a virtuous circle or "bandwagon effect" is created: as more people use a product or service, it becomes more valuable, which encourages even more people to use it. This again makes the product more useful and so on. The explosive growth of Facebook membership is a case of such a bandwagon effect.

Negative externalities are also possible: as more people use a product, it becomes less valuable to others. Here, the classic example is roads and congestion. This is why such negative externalities are also called "congestion effects".

For more information about network effects, see this article on Wikipedia. The online encyclopedia is itself an example of network effects: as more people use the service, and add and edit articles, the higher the quality has become (in general), and so the more useful Wikipedia is.