Network effects occur when to an economic agent (e.g., a consumer of a firm), the utility of using a product or technology becomes larger as its network of users grows in size (Farrell & Saloner, 1985; Katz & Shapiro, 1985). The network effect may set in motion a positive feedback loop that will cause a product or technology to become more prevalent in the market. The presence of network effects may have large consequences for market outcomes (i.e., factors such as the speed of diffusion of products and technologies, the dynamics of the market shares of different competing products or technologies, and the predictability of market outcomes) (Arthur, 1989, 1996).
Key Terms in this Chapter
Multiple Equilibria: There are multiple possible market outcomes and it is ex ante unpredictable which of these will be selected
Path Dependence (or Non-Ergodicity): The early history of market shares, often the consequence of small events or chance circumstances, can determine to a large extent which solution prevails.
Excess Momentum: A market situation with explosive growth, in which the investments of some suppliers and customers lead to massive investments on behalf of others.
Social Interaction Effects: Occur when an economic agent’s preference for a product or technology is dependent upon the opinions or expectations of other economic agents. It is also referred to by others as social network effects or social contagion.
Market Inefficiency: The situation that a sub-optimal technology (from a social planner point of view) is selected.
Excess Inertia: A market situation with none of the competing technologies “taking off.”
Competition at Network Level: A situation where the network dimensions of competition, such as the availability of complementary products, compatibility of these products, size of the network or installed base, are more important for competitive dominance than the product dimensions, such as price, quality or features.
Lock-In: Describes a situation in which the cost of switching to another technology, even though it may be technically superior, is too large for the switch to take place.
Network Effects: occur when, to an economic agent (e.g., a consumer or a firm) the economic utility of using a product or technology increases as its network of users grows in size.