Network Externalities: Bandwagon Effect and Snob Effect

In the analysis of demand, it is assumed that demand for goods of different individuals are
independent of one another. That is the demand for Pepsi by Amit depends on his tastes, his
income, price of Pepsi etc. and does not depend on Swati’s or Amitabh Bachchan’s demand
for Pepsi. The assumption of independence of demand of different individuals enabled us
to derive the market demand curve for a good by simply summing up horizontally the
demands of different individuals consuming a good. However, in real world, demand for
some goods of an individual depend on other individuals demand for them. In such cases
interdependence of demands of different individuals, economists say network externalities
are present. Network externalities may be positive or negative. Network externalities are a
special kind of externalities in which one individual’s utility for a good depends on the
number of other people who consume the commodity. For example, a consumer’s demand
for a telephone depends on the number of other people owning telephone connection so that
they can communicate with each other. If no one else has a telephone connection, it is
certainly not useful for you to demand a telephone connection. The same applies for the
demand for fax machines, mobile phones, modems, internet connections etc. Internet
connection is very useful to you if there are some other individuals or institutions that have
internet facilities with whom you can communicate.

Network externalities can arise through a fashion or stylishness. The desire or demand for
wearing jeans by girls is influenced by the number of other girls who have chosen to wear
them. Wearing jeans have become a fashion among college going girls at metropolitan cities
in India. To be in keeping with the fashion, more and more girls have opted for wearing
jeans. This has led to the increase in demand for jeans. However, it may be noted that
network effects here go two ways. It is better if there are some other who have adopted the
fashion, but if too many people go for this, the fashion falls out of style and this adversely
affects the demand for goods by others.

Bandwagon Effect
The existence of positive network externalities gives rise to Bandwagon effect. Bandwagon
effect refers to the desire or demand for a good by a person who wants to be in style because
possession of a good is in fashion and therefore many others have it. It may be noted that
bandwagon effect is important objective of marketing and advertising strategies of several
manufacturing companies who wish to go in for a good as it is in style and people are buying
it.

Let us explain how to derive a demand curve for a good incorporating the bandwagon effect.
This can be illustrated from the figure. The quantity demanded of Good X is represented on
the X axis, while its price is represented on the Y axis. The place where the demand for Good
X is studied is Delhi. When the price per unit of Good X is ₹ 125 per unit then a total of 10
thousand people in Delhi have purchased the good. This is a relatively small number
compared to the total population of Delhi. So other people have little incentive to purchase
Good X to satisfy their style quotient. However, some people may still purchase the good as
it has an intrinsic value for them. In this case the demand for the good is given by the demand
curve D10. The number of units of the commodity purchased is 10 thousand. But the people
who have purchased the good think that 20 thousand people have purchased it. This increases
the attractiveness of the good for them. As a result, they are induced to buy more of the good
to ensure that the style quotient remains with them. Hence a positive change in taste happens
leading to the entire demand curve shifting towards the right at the new position D20. If people
believe that 30 thousand people have purchased the good then this further increases the
attractiveness of the good and as a result the people’s demand for the good further shifts
towards the right, say to D30. Further if the people believe that 40 thousand people have
purchased the commodity thus further increasing its attractiveness and the demand for the
good further shifts to the right to the new position D40. Thus, a bandwagon effect is an
example of positive network externality, in which the quantity demanded of a good that
an individual buy increases in response to the increase in the quantity purchased by
other individuals.

However, in addition to bandwagon effect the quantity demanded of the good depends on the
price of the good. By reducing the price no doubt, the profit margin will fall and hence there
will be a drop in the revenue, but the expectation is that increased sales due to fall in prices
will result in increase in total revenue which will more than compensate the drop in revenue
due fall in profit margins provided all the other factors like cost of production, marketing cost
etc. are held constant. The price has been reduced from ₹ 125 per unit to ₹ 100 per unit. In
the absence of the positive externality i.e. if the demand curve remained at D10, the number of
units demanded would have increased to 15 thousand. But since due to the positive
externality and the bandwagon effect the number of units consumed has increased to 20
thousand. If the price had further fallen to ₹ 50, in the absence of the bandwagon effect the
quantity demanded would have increased to 25 thousand, but due to the presence of the
bandwagon effect the quantity demanded has increased to 40 thousand since the demand
curve has shifted to D40. While the increase from 10 thousand to 25 thousand is due to price
effect, the increase from 25 thousand to 40 thousand is due to bandwagon effect.

It is evident from this analysis that bandwagon effect makes the demand curve more elastic.
The demand curve DM which incorporates the bandwagon effect is more elastic than the
demand curve D10, D20, D30 and D40.
Snob Effect
In case network externalities are negative, snob effect arises. Snob effect refers to the desire
to possess a unique commodity having a prestige value. Snob effect works quite contrary
to the bandwagon effect. The quantity demanded of a commodity having a snob value, is
greater, the smaller the number of people owing it. Rare art work, especially designed sports
car, specially designed clothing made to order, very expensive sports car etc. all belong to
this category. For example, the utility one gets from a very expensive luxury car is mainly
due to the prestige and status value of it which results from the fact that only few others
own it.

In the figure on the X axis we measure the quantity demanded of a snob good and on the Y
axis the price of the good in lakhs (₹).

Suppose D1 is the relevant demand curve when people think that one thousand people own
the commodity having a snob value. Now suppose that people think that 20 thousand people
are having the good. Obviously, this reduces the exclusivity of the good and the snob value is
lowered along with it. As a result, an aversion for the good has developed followed by the fall
in demand. The negative taste developed for the good has resulted in the fall in the demand
for the good and the entire demand curve shifts to the left to a new position D2. Again, if
people believe that 30 thousand people happen to own the commodity, its snob or prestige
value is further reduced. As a result, desire or demand for it is further reduced and the
demand curve shifts to the left. Further, if it is thought that 40 thousand people possess the
good, the relevant demand curve is D4. Thus, as a result of the snob effect, the quantity
demanded of the good falls, as more people are believed to own it. Ultimately people come to
know how many people actually own the good. If we join the points A, B, C and E which
represents the quantity demanded at different number of people owning the commodity and
thus incorporating the snob effect we have the market demand curve DM.

It is important to note that snob effect makes the demand curve less elastic. Thus at a price of
₹ 35 lakhs per luxury car, the quantity demanded is 10 thousands. Now if the price is reduced
to ₹ 15 lakhs per luxury car its quantity demanded would have increased to 50 thousands per
year, if the snob effect was not present. But in the presence of snob effect the quantity
demanded increases from only 10 thousand to 30 thousand cars. Thus snob effect has reduced
the full effect of the fall in the price so that the net effect is the increase in quantity demanded
from 10 thousand to 30 thousand units.