Megan McArdle on network effects

A recent Bloomberg article by Megan McArdle does a great job of explaining network effects:

So just what is a network effect? The term describes a product that gets more valuable as more people adopt it, a system that becomes stronger as more nodes are added to the network. The classic example of network effects is a fax machine. The first proud owner of a fax machine has a very expensive paperweight. The second owner can transmit documents to the guy with the pricey paperweight. The thousandth owner has a useful, but limited, piece of equipment. The millionth owner has a pretty handy little gadget.

McArdle's article also does a nice job of explaining switching costs, and how they are different from network effects. Both concepts are covered in ECON100 at Waikato because of their importance to business decision-making. As McArdle notes, network effects are really important because they can create a situation where the equilibrium number of firms in the market is one (a monopoly), which confers a large degree of market power on that firm.

How does this arise? Normally, the demand curve for a good is downward sloping. Consider a good where each person can only buy one unit. At a given price, only the people that value it more than the price will buy. As the price falls, the number of buyers increases because the marginal value of the good to those additional buyers is now above the (lower) price.

However, a good with network effects works differently. The value to the buyer depends on two things: (1) the standard downward-sloping price effect described above; and (2) the number of other users, with value increasing as the number of users increases. So, the demand curve for a good with network effects looks like the figure below (MV is marginal value). For the first few buyers the value is low (but not zero - some people like to have expensive paperweights), but as more users buy the good its marginal value to each additional user rises. However, eventually the first effect offsets this (some potential users are not attracted by your product, no matter how many users it has), and we end up with the more standard downward-sloping demand curve.

Now consider how you choose to price the good with network effects. Let's say you priced your new network-effect good at the price P0. No consumer would buy this product. Why? Because the price is above the marginal value for the first consumer. Buying this product would make them worse off. This is why firms with network-effect goods often start by giving their product away for free. To get to the point where the marginal value is greater than the price of P0, you would need to give away at least Q0 units of the good. After that the marginal value for every additional buyer is greater than the price, until we get to the equilibrium quantity at Q1. In other words, once you've got past the tipping point, market demand for your network-effect good will accelerate, potentially generating large profit opportunities.

However, that's not the end of the story. McArdle cautions:

When your network is growing rapidly, things are splendid! Every new user increases the value of your network and encourages even more people to join. But there’s a small catch: What happens if your network starts shrinking? Suddenly, it’s getting less valuable, which means more people are likely to leave, which makes it even less valuable. Rinse and repeat all the way to the court-appointed receiver’s office.

So, while network effects can be a source of market power and monopoly rents, these benefits are not permanent, and not guaranteed. One look at the roll-call of failed network goods (MySpace, Bebo, Betamax tapes), or formerly successful network goods (Microsoft operating systems, landline telephones, VHS tapes) should be enough to tell you that.