Network Effect: What It Is, How It Works, Pros and Cons

What Is the Network Effect?

The network effect is a phenomenon whereby increased numbers of people or participants improve the value of a good or service. The internet is an example of the network effect. Initially, there were few users on the internet since it was of little value to anyone outside of the military and some research scientists.

However, as more users gained access to the internet, they produced more content, information, and services. The development and improvement of websites attracted more users to connect and do business with each other. As the internet experienced increases in traffic, it offered more value, leading to a network effect.

How the Network Effect Works

The network effect can lead to an improved experience as more people participate. It can also encourage new participants as they look to benefit from the network.

Network effects can be found throughout social media. For example, as more users post content such as links and media on X (formerly Twitter), the more useful the platform becomes to the public. The network effect has created exponential growth rates for networking platforms such as Facebook, YouTube, and Instagram.

Multiple network effects have occurred when individuals join social media platforms. As more users join and participate, companies looking to advertise their products and services rush to join these sites to capitalize on the trend. The increase in advertisers leads to more revenue for social media websites. As a result, the sites evolve and are able to offer more services to the consumer.

History of the Network Effect

The network effect concept originated in the early 20th century, with the advent of the telephone. Theodore Vail, the first post-patent president of Bell Telephone, used the network effect to argue why Bell Telephone should have a monopoly on telephone networks.

Later, Robert Metcalfe, the creator of Ethernet, helped to popularize the idea by introducing Metcalfe's law, which states that the value of a telecommunications network is proportional to the square of the number of connected users of the system.

Today, the network effect has everyday, real-world applications and value, as evidenced by social media companies like Meta, X, and LinkedIn. Typically, the more people with accounts on their social media sites, the more valuable both the product is to its users and the company is to shareholders.

Network Effect vs. Network Externality

Although similar, network effect and network externality have distinct differences. Network externality is an economics term that refers to how the demand for a product is dependent on the demand of others buying that product. In other words, the buying patterns of consumers are influenced by others purchasing a product.

For example, if you see a lot of cars in a restaurant's parking lot, you might assume the restaurant has good food. As a result, you give it a try since all of those people can't be wrong. Trends in fashion also influence the buying patterns of consumers. Clothes routinely go in and out of style based primarily on copycat buying and selling patterns of consumers.

Positive network externalities can lead to a network effect. If a lot of your friends are on Facebook, you might join hoping to connect with them, which is a positive externality. If after you join, you post quality content, and that leads to many people enjoying the experience, it'll boost engagement and create a network effect.

How the Network Effect Builds Businesses

The network effects that exist on the internet often benefit a variety of services-for-hire apps and websites. As more professionals, such as dog walkers, tutors, or electricians, list their services online, more customers rely on those online directories. E-commerce sites, such as Etsy and eBay, grew in popularity as more sellers joined those marketplaces and sold their products to consumers who embraced online shopping.

The network effect also played a role in the advance of ridesharing services. Companies such as Uber and Lyft evolved and grew through the support of participants who signed up and expanded the companies' reach across cities and states. As more drivers became part of Uber and Lyft, the two brands gained in market value.

How to Use the Network Effect to Your Advantage

Leveraging the network effect can help grow a business. If you understand the principles that drive the network effect, you can take advantage of them to increase demand for your product. Once the effect takes place, your users effectively act as salesmen, spreading news of the product far and wide by word of mouth.

In markets where there are network effects, businesses will often compete to be the first on the scene so that they can take advantage of this phenomenon. For example, have you ever been handed an item for free on the street from an unheard-of business? This is a tactic that is used to increase interest in the product so that people will buy it and spread word of it around. Then, as demand for the product grows, prices increase and people become willing to pay more. The more people who use your product, the more value your product has.

Network Effect and Pricing

If your business is in a market that's subject to the network effect, you may price your products differently when the business begins than you do when the network effect takes hold. As a business grows due to the network effect, it often makes sense to increase prices as demand for the product grows.

Businesses will often price their products at the highest price possible (without going higher than a customer is willing to pay for the product) in order to maximize profits. However, starting at a lower price (or in some cases, giving the product away for free, as mentioned above) and then increasing the price of the product as the network effect occurs will result in a larger user base.

Advantages and Disadvantages of the Network Effect

The chief hurdle for any company that seeks to benefit from the network effect is gaining traction or attracting enough users initially so that the network effect can take hold. The number of users required for a significant network effect is called the critical mass.

After critical mass is attained, the good or service attracts additional new users because of the utility or benefits to the consumer. In this way, the prospect of the network effect helps companies strive to become self-sustaining.

Another positive impact of the network effect is that it encourages entrepreneurs and creators of intellectual property to pursue more efficient and unique products to present to the public.

But there's a flip side. If too many people use a good or service, congestion can occur. Take the internet, for example. Having too many users on the same network service can slow the speed of the network, decreasing the benefit for users. Providers of goods and services that use a network effect must ensure that capacity can be increased sufficiently to accommodate all users.

Another potential pitfall of the network effect is that once a company achieves and maintains critical mass, it may begin to become less efficient and innovative because it knows it has a solid consumer base.

The Bottom Line

As the internet—one of the most prominent demonstrations of the network effect—becomes a bigger part of our lives, it will become increasingly important both for producers and consumers to have a firm grasp of the network effect and its benefits.

Most businesses can use the internet to take advantage of the network effect in one way or another and reap the benefits of growth in their business. However, the network effect doesn't only take place online, so taking advantage of it in all forms can help drive more users to a business.