The Washington Post states that network effect is one of the “most important business theorems of the past 50 years.” Simply put, it is the effect that one user of a good or service has on the value of that product to other people. For example, today, why would you get MySpace when you can get Facebook? The value of Facebook increases as its users increase. But you also want to use a good or service that the people in your network also use because why would you want to join Facebook if non of your friends are in it? You wouldn’t. That’s why we take into account the effect (or value) that your network has on the good or service.
This same reasoning applies to the model for network effects in the market of a good. This is when a potential purchaser takes into account both his own reservation price (or the maximum amount she is willing to pay for the good) and the total number of users of the good. When we account for network effects, there will exist three equilibrium quantities of purchasers that will be willing to buy the good at a fixed price.
First, if everyone expects that no one will buy the good, then everyone’s reservation price will be 0, and thus no one will buy the good. Why get Facebook if no one has Facebook, right? Next there is a low and high equilibrium labeled z’ and z”.
z’ is considered an unstable equilibrium and tipping point because if slightly more than a z’ fraction buys the good, then upward pressure will drive the demand of z’ all the way to the stable equilibrium z”. This is due to the fact that the reservation price of the people between z’ and z” is higher than the equilibrium price and thus they will want to buy the good at the price z”. But if less than a fraction z’ buys the good, then downward pressure drives the demand towards the stable equilibrium z=0 (where no one wants the good). This means that the people that bought the good, bought it at a price higher than their value for it and will thus regret it, driving demand down. Therefore, in order for a product to succeed, it must pass the tipping point.
z” on the other hand is considered a stable equilibrium because if more than z” people buy the good, then demand gets pushed back. This is because the people (above z”) that bought the good did so at a price higher than what they could pay. If a fraction less than z” buys the good, then demand gets pushed back to z”.
This model with network effects gives us (as the Washington Post suggests), the ability to create a powerful network (the people that buy your product) that can help your product dominate the market over previous leaders. This model thus gives us various tips on what to do if you want to get your product successfully into the market.
- Convince a large initial group to adopt your product which increases the chances that others will buy it.
- Price the good at a low price (maybe even below it’s value) and gradually raise it as more and more people use the product and you pass the tipping point.
- Attract the fashion leaders and convince them to adopt your product so that others will follow. For example, if you get a group of popular artists to use your product, then you can influence all of their followers to buy it.
Sources:
Washington Post, “Honoring Technology’s Power Couple: Moore’s Law and the Network Effect”
Networks, Crowds and Markets, Chapter 17. (Highly recommend this book!)