NETWORK EFFECTS

From 2005 to 2008, MySpace was the largest social network site in the world. In June 2006, MySpace
surpassed Google as the most visited website in the United States. Then, from 2008 onwards Facebook
conquer a huge market share while MySpace almost failed.
What happened? We need to understand network effects and platform markets. Most entrepreneurial
activities revolve around platform markets today.
 
Positive consumption externalities
Direct network effect: utility you derive from consumption is increasing with the number of other people
using the same or compatible product. Utility increases when there are more users to communicate with.
Example: you are the only person to have a telephone  there is not much you can do with the phone
(e.g. Stand-alone value of telephone is = 0)
 
Indirect network effect: found in so-called system goods, utility raise thanks to the number of
complementary products available for a certain good (which in turn depends on the number of users of the
product).
Example: console and videogames (negative externality effect e.g. smoking)

From indirect network effects to two-sided markets

Two-sided (or in general multi-sided) markets are markets in which a platform enables interactions
between separate groups and actively tries to increase installed bases on all sides of the market.
Platforms connects buyers and sellers. Example of videogame developers: 10% of revenues goes to the
platform for which you develop the game. There is a contrast: if you are a game developer on one hand you
want more videogame developers developing for a certain platform but so there is more competition which
for you is bad, but it's also good at the same time because if there are more game developers available this
attracts more buyers.
Tradeoff: more game for a platform  more competition but also larger market potential

Charges fixed memberships and usage charges from both, and there are cross group externalities between B and S

If you are an entrepreneur and you are thinking to set up a platform you have to think what is the price
structure in my market that maximize my benefits?
Who pays more, buyers or sellers? One of the core characteristics for two-sided market or platform market
is that the overall traffic on platform does not depend on individual prices separately but on the
relationship between the prices that you charge. Who pays more? Depending which network effect is
larger. Which network effect is larger? Who benefit more from the other side? So, one of the core
challenges as entrepreneur in such a platform market is setting the price structure. Setting up a platform
means consider what is the price structure from which we can benefit the most.
 
Types of externalities in two-sided markets
Cross-side network effect
Positive externality: Users on one side of the market benefit from a large user base on the other side of the
market (e.g. credit cards)
Negative externality: One side would prefer only few users on the other side of the market. (e.g. TV
advertising)

Same-side network effect

Positive externality: Increasing the network on one side makes it more valuable for other users on this side
(e.g. game consoles that support online gaming)
Negative externality: Users on the same side rival for the other side (e.g. career platforms)
 
Utility functions and network effects
Components and shape
The utility u derived from a network good 𝑖 depends on:
• The stand-alone value of the network good (𝑠𝑖)
• The network effect, i.e. the number of users of the network 𝑖 (𝑛𝑖) and the strength of the network effect
𝛼
(𝛼)  𝑢𝑖 = 𝑠𝑖 + 𝑛𝑖
Utility of direct network effects: u(n)
Utility of indirect network effects: u(y(n))

Value of a traditional good vs value of a network good

Probability of purchase

In the beginning network effects are very high but are incremental decreasing over time (as more users join
you care less and less for new joining as the community is already large)
Why do we care about utility function? If you are an entrepreneur: both need each other entrepreneur and
consumer. You have to try to increase the standalone value of your good so that even if none has adopted
the platform yet, it becomes very attractive. Example of console: increase the number of activities the
console can do alone (watching films, listening to music, internet connection...)
You should also increase the number of complementary products.
How do we set the price structure? How do we deal with the network effect? How do we get people on
board? How much can we increase stand-alone value?
It is one way to get consumers on board. The great way is compatibility.

Differences in demand: different groups of adopters have different utility functions  the 3rd explanation
for the s-shaped diffusion

Which additional users would give you the highest utility? You just adopted the new network and you are
the only one. How happy would you be if the second person join the network? You are super happy. But if
there are already 1000 people you are not so happy if someone else join the network.
Pioneers  have a huge utility from the first adopters, they do not need a big network
Medium adopters  follow a s curve; we need a sizable network to encourage these people to pay
Late adopters  everybody is using it, uncertainty is reduced so they can enter into the market, they need
a big network
If we make an average of pioneers and late adopters we have the s curve  so s-curve depends on how
many pioneers and how many late adopters there are. People have differences in preferences for the
consumption of network goods.
 
From utility functions to market outcomes
Our goal is now turning predictions with the utility function into market outcomes.
Most platform markets (market with large network effects) tend to be dominated by a single firm (winner-
take-all markets) Android is the dominant firm in the smartphone industry
Winer-take-all markets
Markets with increasing rate of adoption (i.e. network effects) are often so-called winner takes all markets.
These markets show a tendency towards the dominance of a single product.
Positive and negative feedback: the strong firms becomes stronger and the weak one becomes weaker.
We generally think bad about monopolies: reduced innovation and higher prices
 
Are winner-take-all markets good for consumers?
Monopolies are supposed to be bad but in the case of network effects they can be beneficial.
Up to a certain network size the costs are below benefits: we lose some benefits (too high prices and
limited innovation) but you still benefit from network size. At one point in time actually the cost become
higher than the value and then a monopoly becomes bad.
Is a monopoly in a market with network effect a bad thing? Not at all. Up to the point in which costs > value
monopoly is good.
Can the network effect be so strong that consumers still purchase the good even though the cost is higher
than the utility? Absolutely, as long as value is higher than the cost they will buy.

Network externality benefits to customers rise with cumulative market share.

Potential for monopoly costs to customers (e.g., price increase) also rise with cumulative market share.
Curve shapes are different: Network externality benefits likely to grow as logarithm, while potential
monopoly costs likely to grow exponentially. Where monopoly costs exceed network externality benefits,
intervention may be warranted. Optimal market share is at point where lines cross.
 
In a winner-take-all-market a firm could earn huge profits if the market adopts its product! But there are
some problems:
• difficult to predict who will be the winner
• very difficult to reverse: lock-in and switching costs (once a firm gets an advantage is difficult to reverse)

Difficult to predict
Even if you offer the product with higher quality, you can still be outrivaled. Randomness plays an
important role.
Place 5 red balls and 5 black balls in a bucket. Randomly draw a ball from the bucket, then return it along
with another ball of the same color. In the long run one color will dominate the other. The color which
dominates at the end of the process is not necessarily color which dominated at the start
(for instance, start with 6 and 4)  Randomness plays an important role

In the beginning for example, consumers don’t distinguish products quality and one can spread even being
inferior, at that point it’s difficult to change the inertia. By randomly picking a product over another you are
giving it network effects which would encourage in the end its growth and possibility to affirm itself as the
best  what was a random process at the beginning becomes a dominant process then. At one point in
time the network size of one product is so large that everybody is going to buy product with the larger
network.
So, you might have the higher quality product but you can still be outcompeted by your rivals. 

Difficult to reverse
Lock in: if a better product appears on the market, for every given number of customers the value that you
could get is higher because it is a superior product. But if for example the established product has already
2000 customers, the problem is then that if the new product wants to provide the same value to the
customer, you need to have more customers. It takes many many customers before your superior product
becomes more attractive and the question is: why should people leave the established standard and join
the superior product? We have this problem in network goods: with a better product people are not
switching because the other product has more users.
The price structure of the market has important implication what is the incentive for people to join the
platform.

Is dominance of a single technology unavoidable?

Not necessarily, different standards may co-exist. Sometimes in certain industries you can still get network
externalities without being the only dominant firm. Example of the video game industry: while a larger
market share may increase network externalities so that customers have more games and more people to
play against, those benefits can be achieved without attaining a majority of the market.
So, why don’t we always have this winner-take-all market outcome? There are some factors promoting
multiple competitors in the market:
- Multi-homing costs are low i.e. users may subscribe to more than one platform
- Network effects are weak: you don't benefit so much from other consumers: the main utility you get
comes from the stand-alone value
- Consumers’ preferences are heterogeneous: stand-alone value may be relatively more important for
consumers than network effect (demand for variety). Example: PS3 and Xbox 360 were target hardcore
consumers while Nintendo Wii was targeting a different market.

one technology has a higher standalone value

Network effects and standards

Network effects often require standards. A standard is a specification that allows for interoperability, i.e. a
standard makes it possible for different components of a system to work together.
We distinguish full and partial compatibility: exactly the same standard vs partial compatibility (with a BNL
credit card and a Poste ATM not all functions are available).
When we think about network effect we have seen a bit of transition: make things compatible to each
other is the big challenge. So, network effect to happen we often require standard.
 
Standard setting
De jure standards: standard determined by institutions (government or committees).
Examples for standard setting organizations: International Organization for Standardization, the
International Electrotechnical Commission, and the International Telecommunication Union.
 
De facto standards: standard determined by the market
Sponsored standards: standards introduced by a single firm or by a joint venture between firms (Sony and
Philips with CDs)
Unsponsored standards: those which arise due to the larger installed base
 
Strategies for winning the war in a network market
- Move fast - Identify and court early adopters - Understand role of complementary
products
- Role of expectations - Role of credibility
 
So, why did MySpace fail?
MySpace was expanding too much, with verticals covering celebrity, fashion, sport and even books. They
spent hundreds of millions of dollars building its own content delivery network (CDN) instead of using a
cloud network like Amazon’s. They remained convinced that they would be able to create their own
products for some time. MySpace unleashed a lot of products that were buggy and dysfunctional. They
were dealing with a public image problem. The network had started to overflow with would-be celebrities,
filling the site with highly sexualized photos. They had strong pressure to make revenues.