Network Effect Business Model

Network effect or externality can be described as an effect that a single user has regarding the value of the service or product to the other users. This can be very easily understood by applying its concept in the telephone network.

The network effect may have a negative externality or positive externality. For example the telephone network initially increases the value of network but as the number of subscribers increase, the externality tends to get negative as each user then begins to add on the congestion and as a result a network becomes less useful to other users leading to more hang –ups and busy tones.

The founder of Ethernet, Robert Metcalfe used the bandwagon effect of network model to popularize Ethernet and argued that the cost of each network card is equal to the number of users of Ethernet card but the value of network created by network card is equal to the square of the users of the Ethernet.

The proponents of this model use this effect to initially establish a business by propagating the value of the product and once the users of the product reach a stage referred to as critical mass i.e. when the benefit of the network of the product supersede the benefit of product, the product begins to be marketed by virtue of the strength of the network.

The key challenge here is to attract the users before reaching critical mass. A way to do this is to begin with fee –waiver, friend subscription, free sign up. However more prudent thing would be to build a product which is good enough to stand on its intrinsic value. For example the inventor of Del.icio.us, Joshua Schachter built it in such a way that even if no more users joined, it would be valuable still, at least to him.

Business examples of such a model can be found in following establishments

a) Foreign Exchange: Stock exchange feature network effect. Market liquidity is determined on the basis of number of people purchasing a particular stock and as the headcount increases the liquidity increases and transactional cost decreases.

b) Websites: Many websites feature network effect .Social networking sites like MySpace and Orkut thrive on the strength of positive network externality.

Negative externalities begin to become perceptible after a point of time when the cost and ease of maintaining the network and its efficiency overshoot the positives of benign network spread. These situations result in network fall-out as the users begin to wean away from the product due to dissatisfaction from the service.