Business Models and Architecture

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The network effects business model

The network effect causes a good or service to have a value to a potential customer dependent on the number of customers already owning that good or using that service. Metcalfe's law states that the total value of a good or service that possesses a network effect is roughly proportional to the square of the number of customers already owning that good or using that service.

One consequence of a network effect is that the purchase of a good by one individual indirectly benefits others who own the good - for example by purchasing a telephone a person makes other telephones more useful. This type of side-effect in a transaction is known as an externality in economics, and externalities arising from network effects are known as network externalities. This is also an example of a positive feedback loop.

Network effects were used as justification for some of the business models for dot-coms in the late 1990s. These firms operated under the belief that when a new market comes into being which contains strong network effects, firms should care more about growing their market share than about becoming profitable. This was believed because market share will determine which firm can set technical and marketing standards and thus determine the basis of future competition.

A good example of this strategy was that deployed by Mirabilis, the Israeli start-up which pioneered instant messaging ("IM") and was bought by America Online. By giving away their ICQ product for free and preventing interoperability between their client software and other products, they were able to corner the market for instant messaging. Because of the network effect, new IM users gained much more value by choosing to use the Mirabilis system (and join its large network of users) than they would using a competing system. As was typical for that era, the company never made any attempt to generate profits from their dominant position before selling out.

Network effects become significant after a certain subscription percentage has been achieved, called critical mass. At the critical mass point, the value obtained from the good or service is greater than or equal to the price paid for the good or service. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the positive utility:price ratio. Until this point has been achieved, however, only early adopters will subscribe.

The increasing number of subscribers cannot continue indefinitely. After a certain point, most networks become either congested or saturated, stopping future uptake. Congestion occurs due to overuse. The applicable analogy is that of a telephone network. While the number of users is below the congestion point, each additional user adds additional value to every other customer. However, at some point the addition of an extra user exceeds the capacity of the existing system. After this point, each additional user decreases the value obtained by every other user. In practical terms, each additional user increases the total system load, leading to busy signals, the inability to get a dial tone, and poor customer support. The next critical point is where the value obtained again equals the price paid. The network will cease to grow at this point, and the system must be enlarged. The congestion point may be larger than the market size. New Peer-to-peer technological models may always defy congestion. Peer-to-Peer systems, or "P2P," are networks designed to distribute load among their user pool. This theoretically allows true P2P networks to scale indefinitely. But market saturation will still occur.

Network effects are commonly mistaken for economies of scale, which result from business size rather than interoperability (see also natural monopoly). To help clarify the distinction people speak of demand side vs. supply side economies of scale. Classical economies of scale are on the production side, while network effects arise on the demand side. Network effects are also mistaken for economies of scope.
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