Every person living in the modern age has heard the phrase that “the world has become a global village.” This phrase implies that just about anyone can connect and engage with the people of the international community at any given time. The connectivity is made possible due to technologies like the internet that work as an interconnected web or a network.
The network effect is the quality or popularity of a certain service that generates from the number of users engaged in the service. The internet is a great example of the network effect. Due to the sheer number of people using the internet today, its presence has become crucial and highly valuable. It is not wrong to say that it is impossible to imagine the modern world without the internet.
There are already advanced technological options available as an alternative to the internet like Web3. However, most people are skeptical about the advantages of Web3 or any other internet alternatives due to the lack of a massive consumer base. In simple words, cases, where consumers measure the reliability of a service based on an enormous number of its existing clientele is the network effect.
What is a Network Effect?
According to Investopedia.com, the network effect is increasing the goodwill of a service based on the big community that it serves. The website also claims that the businesses that are unable to gain that critical mass of users often fail to sustain their business model for a long time even if they offer good services or better technology.
Wikipedia, the largest open-sourced information portal in the world, explains the network effect as the value of a service provider or manufacturer that increases with the number of users availing it. Wikipedia also explains that the engagement of a larger group of people using one service allows new users to feel more secure in making their purchases from the same network, which explains this phenomenon.
Economists define network effect as network externality that refers to the high demand for a particular trade commodity or service. The simple demand and supply dynamics of economics dictate that when demand for a service or product increases, its price or market value also goes up.
Psychologists study the network effect as part of the social conformity theory. In the 1950s, psychoanalyst Soloman Asch conducted a series of experiments to demonstrate that the individual opinion of a person is greatly influenced by a group due to the innate desire to fit into society. Therefore, when a person sees more downloads for an application or more purchases of a product online in comparison to other options, they prefer to purchase that product regardless of the reviews.
Business graduates and marketing majors also try to incorporate the dynamics of the network effect into their work. Marketers tend to identify the least common denominator of their targeted market and present their product or service as universally adaptable as possible for that particular stratum or prospective buyer group.
Different Types of Network Effect
There are two main types of network effect, i.e., direct and indirect network effect, taking into consideration the user or the services provider:
- Direct Network Effect
When the increasing number of users for a product or service directly increases the value of the service provider or the product, it is called the direct network effect. Smartphones are a good example of a direct network effect. When more people purchase a smartphone from a particular company like Apple or Samsung, the demand for that particular service goes up in the market, and more people wish to buy smartphones of the same brand.
- Indirect Network Effect
When a greater flow of user engagement creates greater traction for a related service or product, it is called the indirect network effect. This type of network effect is a little bit complex. Consider a scenario where people purchase or use product ‘A’, and as a result, the demand for a secondary product ‘B’ increases.
The indirect network effect is relevant in the case of online Ticket booking services, as more users join the website to book their tickets; it is the Airlines that are getting more value out of increased website users. There are many other examples of indirect network effects like Uber, Foodpanda, yelp, etc.
In terms of corporate dynamics, there are two more types of network effects.
- Two-Sided Network Effect
There are some cases where engagement of buyers as well as sellers results in increasing the value of the particular product or service. At present, countless E-commerce websites demonstrate this example. Take Amazon, eBay, or Alibaba, for example. In all these platforms, as the number of merchants goes up, more value for the end-user is generated by way of getting a greater variety of products. Meanwhile, the additional flow of buyers shopping from the platform encourages more purchasers to place new orders.
- Local Network Effect
The local network effect is the increase of the value of a business but on a smaller scale. Being part of the international community is great. However, every user is primarily part of a smaller community like their home town or their educational or cultural background, etc. A lot of people wish to create local and smaller communities where they can feel at home and connect with like-minded people.
There are thousands of micro-communities on social media platforms. Most users are part of a group that is related to their profession. Meanwhile, they are also part of numerous smaller communities like their alumni or college buddies, workplaces, cities, townships, and others. While these communities are comparatively smaller than international circles, the more relevant users join the group, the more value it ruminates.
Blockchain and Network Effect
Thus far, the esteemed reader has read about various aspects of the network effect and what it represents. However, to understand the network effect’s connection with blockchain, it is best to take into account what the technology is all about first.
Blockchain technology is a digital ledger that is hosted and verified by millions of users around the world without the presence of any centralized authority. Traditionally, people entrust their money and other financial deposits to a bank. Most regional banks run under the supervision of a centralized state regulator like the federal reserve.
The presence of a centralized authority requires people to share their personal information like user identification and residential address etc. Furthermore, both private and state centralized regulators reserve the right to revoke access to the user account at any time and track all their financial records. Therefore, many people prefer decentralized financial mediums such as blockchains.
However, without the presence of a considerable number of users in blockchain, most people will remain skeptical about using it. Take, for example, Bitcoin, which was met with skeptical remarks when it was first introduced 13 years ago. However, at its peak, Bitcoin prices reached $65K per unit in the 2021 bull market. The incredible market value of Bitcoin is a result of its popularity among users generating a positive network effect for it.
Positive and Negative Network Effects in Cryptocurrencies
- Positive Network Effect for Crypto
As mentioned above, Bitcoin is a good example of a positive network effect. It means that as more users buy the token, its demand and value increase among the users. Another aspect of the Bitcoin network effect is mining. Miners are the developers who decode encrypted transactions on the Bitcoin blockchain ledger for a fee.
Bitcoin miners benefit from its universal liquidity due to its international familiarity. The Bitcoin miners may also opt for other cryptocurrencies to earn higher mining rewards. However, if miners look at other cryptocurrencies, they may not find a liquidity pool as comprehensive as Bitcoin that grants them greater autonomy.
So, it is correct to assume that the availability of countless users in the Bitcoin ecosystem adds another layer of positive network effect by providing a widespread liquidity pool for Bitcoin miners. Since its conception, Bitcoin has managed to remain the most popular and most demanded cryptocurrency with the biggest market value.
- Negative Network Effect for Crypto
Sometimes, the addition of more users can take the value out of a particular business. In the case of some cryptocurrencies like Ethereum, the network effect can be seen working in the opposite direction. Ethereum is another blockchain network that depends on miners. However, the network requires users to pay charges to ETH miners, also called gas fees, to mine their blocks.
As a result, users try to bid higher than others to attract miners. Consequently, the more users are present on the network, the higher the gas fee they have to pay. As a result, the Ethereum network suffers from exorbitant gas fees. Many users can leave the network altogether due to the continuously inflating costs of the very transaction.
Therefore, Ethereum network developers are working on introducing solutions for this problem, like the EIP-1559 update. The Ethereum Improvement Proposal number 1559 or EIP-1559 can refurbish the gas fee bidding mechanism for the network. The CoreDev of Ethereum recently conducted a meeting to switch the network to the PoS consensus model that works without mining with the help of smart contracts.
How can a Blockchain Create a Positive Network Effect?
The high demand and market traction for Bitcoin comes from several factors in addition to network effect.
At present, there are more than 4 thousand cryptocurrencies available online. However, a large portion of these cryptocurrencies are only starting, and most investors do not know about their existence.
Whereas Bitcoin is an open-sourced project that any developer can edit without any legal barrier and base their new project on it. However, the main reason for massive traction in Bitcoin is its popularity among tech heavyweights and the biggest financial enterprises in the world. Bitcoin network was introduced to the masses with glaring reviews from IT sector leaders.
Since its conception Bitcoin network has never been reportedly hacked even once to date. Despite the issues like environmental concerns and heavy power intake Bitcoin continues to assert its dominance in the cryptocurrency sector. It is impossible to generate a good digital product on a global scale without making it resistant to all sorts of security threats.
For any good cryptocurrency project, the network should go through a rigorous technological audit first and foremost. Millions of people around the world were able to entrust their savings and income to Bitcoin due to its unquestionable reliability. On the other hand, the Bitcoin network also creates a massive incentive for its operators or miners.
Independent Bitcoin miners can work for random individuals around the world for a fee. The people who are getting incentives have big stakes in promoting Bitcoin in a positive light. In this manner, Bitcoin miners and users benefit from a two-sided network effect that is beneficial for both parties.
Advantages of Network Effect
The presence of the network effect can offer the stakeholders a host of benefits that otherwise would be impossible to gather. Here are some of the biggest merits that the effect offers:
- Natural Selection
The theory of Natural Selection is the idea that favors survival of the fittest. With network effect, the community weeds out faulty and lagging business models or blockchain projects automatically. As more people join a platform, its inherent qualities such as sustainability, security, and adaptability are put to the test. If the network can sustain the pressure of a massive audience, it automatically qualifies as a reliable platform.
- Building International Communities
The network effect creates a sense of community and unity among its users. The people who have joined the Bitcoin network share a collective interest. Therefore, Bitcoin community members are likely to be joining in their efforts to make the best decisions for the platform’s growth and prosperity and ignore their differences. As a result, network effect forces can bring people together beyond the factors like race, age, gender, nationality, etc.
- Creating Financial Prospects
The network effect has made some of the biggest tech companies like Google and Facebook reach their present-day success. These businesses, in turn, have created countless jobs throughout the world and created many opportunities for international and locally owned businesses. Furthermore, these tech giants were able to contribute to the economic development of their countries by paying millions of dollars in taxes.
- Better Backup
The network effect allows a business to become more universal among users. Under such a circumstance, the users are likely to get better aftersales support related to the said service or product. For example, people around the world prefer to purchase Toyota rather than an Audi. It is because car owners can find several dealerships for maintenance and the accessibility of the spare parts for the Toyota models in comparison to Audi.
Disadvantages of Network Effect
William Shakespeare quoted in his 1600 drama As You Like it, “Why then, can one desire too much of a good thing? In simpler words, it means that too much of a good thing can be bad sometimes. In the case of the network effect, the axiom is also applicable.
- Monopolies
With the network effect, a particular platform can become so big and popular that it acquires the position of a monopoly eventually. Under such circumstances, any other competitors cannot remain for a long time in the market, offering an alternative to the end-user. Monopolies also have the liberty to dictate the terms of services like charges and quality for their users at their discretion.
- Conflict of Interest
The network effect is the fastest way to make a business profitable. Therefore, many companies employ manipulative and harmful techniques to mimic the effect at the expense of their users. Facebook Papers leaks by former FB employee Frances Haugens are a glaring example of this detriment.
Haugens produced documented proof in 2021 about FB’s involvement in enticing violence, hate crimes, and unwarranted psychological experiments on its users to maintain their user base. There are many instances where the companies have resorted to unlawful or unethical means to expand their Network Effect.
- Reversion Towards Innovation
Marketing and advertisement are powerful tools that allow businesses to reach more people and increase their positive network effect. However, in some cases, companies with a massive marketing budget can outshine the businesses that offer greater value to the consumers.
In this way, the users are unable to hear about the better technology or service. There is a famous proverb in the business community that claims ‘money generates money. It can mean that innovative businesses with a smaller budget can get overshadowed by their deficient counterparts.
Conclusion
The network effect is characterized by continuous value appreciation for a service or product by the introduction of a massive number of users. The network effect makes use of several aspects of human life, such as psychology, economy, business, and technological innovation. There are four different types of network effects, i.e., Direct, Indirect, Two-way, and Local. Blockchain is a disruptive technology that inherently makes use of network effect by acting as a decentralized financial ecosystem.
For Bitcoin, the network effect works positively due to its universal presence and potent liquidity pool. For other blockchain projects like Ethereum, the network effect turns negative due to its bidding-based gas fee mechanism that generates a lot of inflation pressure for retail investors. Network effects can offer great advantages like promoting the best business models, supporting economies, and creating supportive communities. On the other hand, there are a few downsides to network effects, such as monopolies, malpractice, and lack of user independence.
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