What is the network effect? A network effect is when a product becomes more valuable as more people use it. Many products become obsolete or go out of use because they have few users or have little value as a service. Network effects occur when the demand for a project depends on the number of users it has. The more users, the greater the demand and added value of the product or service, resulting in the formation of strong user communities. The more consumers a product or service has, the greater the demand for it, both from suppliers and consumers. What are network effects?
This is an economic effect describing a product or service, in which additional users add value to the network. Thus, each new user adds value to the product by joining the network. This, in turn, incentivizes more users to join, adding more value to it, and so on. The network effect reaches a larger scale thanks to technological advances, the information society and globalization. The Internet makes it possible to boost the growth of a project in a short time due to its wide reach. When we talk about cryptocurrencies, it is very important to take network effects into account. The more people use a network, the more useful it can be as a service. So, what are network effects?
What are the network effects? Origin of the concept What are network effects?
The network effect is a fairly old concept, its origins are due to the fact that people have always wanted to be accepted and belong to a group. Therefore, if the members of the group they wanted to be part of consumed something, consuming it would also be a way of approaching this group. This phenomenon always occurred naturally until it began to be exploited in a more significant way with the emergence of technology. A clear example of the network effect is the telephone. In the early days of technology, very few people had telephones in their homes and, moreover, the infrastructure requirements were greater. As the technology became more mature, more and more people were able to afford a telephone, which in turn increased the value of the entire telephone network. As the number of users increased, so did the utility and value of the entire network. This would create a virtuous circle, where the more people joined, the more value was added to the network, coupled with exponential growth. With the advent and advancement of the technological infrastructure, network effects intensified and, more precisely, since 1994 – when the Internet reached a good number of users – online businesses were able to take advantage of this concept.
How do network effects influence consumer processes?
Any business that adapts to the characteristics of network effects can grow more easily than in other ways. Small companies, for example, can quickly become large businesses with this help. Users also gain great advantages, because with a larger network it is possible to get better service. With all this, the market is activated, facilitating the emergence of new business opportunities.
There is also a flip side: network effects are so powerful that they can turn these businesses into natural monopolies. As the network grows, both the value of participating and the cost of switching are high enough for all potential participants to consolidate into a single network.
Types of network effect
Primarily, there are two types of network effects: direct and indirect.
Direct network effects are like what we just discussed with the telephone, where an increase in usage adds value for all other users. Another example is social networks, where users tend to adopt services that their pre-existing social circles use. This incentivizes people to join the same platforms, so that a few services achieve a monopoly position. If other companies want to launch a new social network, it will be difficult for them to gain critical mass, because the network effects that the market leaders have generated give them a very important competitive advantage.
Indirect network effects, on the other hand, are not so easy to define. The term alludes to complementary and additional benefits that derive from the existence of such a network effect in the first place. For example, many cryptocurrencies that are open source. A project that has a strong value-add generates, in turn, a large network effect. This can attract many qualified developers who will audit your code to prove such added value. This effect starts to build up, which leads to dominant leaders that generate significant network effects with respect to their competitors.
Cryptocurrencies and network effects
Network effects are a very important consideration when we talk about blockchain projects. Bitcoin, for example, has some very desirable properties and also has a strong network effect. Miners support the security of the network and have great liquidity to maintain their operations. In addition, thanks to its launch at the right time, Bitcoin has unique properties that would be quite difficult to replicate.
In fact, an essay on the network effect in Bitcoin, written by financial consultant Lyn Alden, provides clues as to how this computer protocol and cryptocurrency is destined, by design, to endure over time and grow in its capabilities. As Alden argues, Bitcoin would grow because of the unlimited connectivity between network participants, as well as its security and robustness. Bitcoin would grow in the same way that technologies such as the telephone, the internet and social networks grew at the time, both in user base and value. He also argues that Bitcoin has achieved greater usability by constituting itself as a more complex structure than it appears, creating several layers of connectivity in a multi-layered interactive network. Second-layer solutions such as Lightning are an example of this layered growth on the technology side, while the growing adoption by both small users and large institutions exemplifies the network effect on the economic side.
Network effects are also an important aspect to consider in the decentralized finance (DeFi) space. If a product, service or smart contract generates a huge advantage, it can be hard for other projects to overcome. DeFi is in its early stages, so we have not yet seen a unique network effect.
Negative network effects
This is also an important consideration when it comes to blockchain design, as negative network effects work in the opposite direction. This means that each new user subtracts value from the network instead of adding it. If each user subtracts value instead of adding it, congestion will occur in the network.
A concrete example is Ethereum‘s gas system, which operates on an auction-style system. Each user bids for gas commissions to be paid by Ethereum miners. As more users are added and usage increases, gas commissions tend to get higher. Since gas commissions become too high, some users stop using the network altogether, as their activity would not be worth it with such high costs. That is why this would be a negative network effect.
There are solutions being developed for this: the ETH 2.0 updates could also greatly increase the throughput that the Ethereum network can support. This could help solve the problem of high gas fees at times of peak activity and congestion.
Network effects are present in many segments and industries, including cryptocurrencies and blockchain projects. New users add value to the network as they enter. Developers designing blockchain networks can benefit greatly by studying which mechanisms generate network effects. By incorporating them into their design process, new projects could scale faster. The blockchain industry continues to grow and expand, so we have yet to witness the network effects that may be generated by more and new projects.