Bitcoin – Breaking the Network Effect
In class, we discuss the network effect which arises due to the presence of technology. It illustrates that as networked individuals, people tend to make decisions, depending on how other people behave. Specifically, the network effect indicates the utility a user obtains from a good or a service depends on the number of other people in the same network. According to the textbook, when consumers form an expectation that a faction of population uses the new product and it ends up with the exact same fraction of population uses it, the self-fulfilling expectations equilibrium exists based on the resulting quantity of purchasers. The stability of the self-fulfilling expectations equilibrium helps company to understand and interpret the trend of user demand and make decisions leading to long-term benefits.
A paper written by Nair and Cachanosky (2016) analyzes the issue of whether or not the market process is able to switch the incumbent currency to a new one in the presence of network effects favoring the status quo and the absence of contingencies. In this sense, the network effects here refer to the reluctance that people have to switch the traditional currency to bitcoin. The authors conservatively argue that the “marginal decisions” made by the “rational agents” like entrepreneurs and the early users of bitcoin are able to develop a motion of the gradual use of bitcoin, but whether it will fully come true still remains unknown.
First, I will use the concepts from class to explain the phenomenon. The market of bitcoin should have two self-fulfilling expectations equilibriums that indicate the trend of users except the zero equilibrium. One is the low equilibrium, and the high equilibrium. The low equilibrium is unstable, which means that if slightly more than the specific fraction buys the good, the demand gets pushed toward the high equilibrium; if slightly less than that fraction buys the good, then the demand gets pushed back toward 0. Thus, if the fraction of population exceeds the low equilibrium, we can expect it to be more popular over time. On the other hand, the high equilibrium is stable, which implies the fraction of population tends to settle down. Second, I will apply these concepts to the case of bitcoin. According to the analysis in the paper I read, it implies with the entrepreneurs who always seek to maximize the private profits will keep using it and influence more people to use, which may have led to the fraction of population that exceed the low equilibrium. Thus, we can expect the future popularity of bitcoin, which will offset the network effect of favoring the current status.
Reference:
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