By Mohammad Aminul Karim (MBA 651 – Fall 2007)

When you want to buy or sell something through an online auction place, the name that pops up in your mind is probably eBay. There are other online auctioneers that provide similar services as eBay, but you will not probably choose them because, the number of buyers and sellers in eBay is greater than those auction sites. As more people are using eBay, it is becoming more desirable. It is an example of network effects. Ebay created a strong network effect through it’s large number of members. . Network effects plays a significant role in many industries specially airlines, electric power, Internet and technology industries.

An Economic network is a group of agents who engage in repeated and enduring exchange relationships with one another (Rauch & Hamilton 2001). According to Michael Baye “A Network consists of links that connect different points (called nodes) in geographic or economic spaces”(Baye 2006, p. 494). So Network actually connects different nodes with same interests so that it can be beneficial for the users and at the same time for the business. Nodes can be people, services, firms etc. Nodes can be in same geographic spaces such as A telephone company’s network in a region or it can be on same economic space such as auctioneers at eBay.

Types of Network
Networks can be one-way network or two way network. In one way network services flow in only one direction. Electricity companies’ services are example of one-way network. In one way network, its value to each user does not directly depend on the number of users in that network (Baye 2006, p. 495). As an example, A subscriber from a television cable company doesn’t care how many other subscribers are there as long as his service is good. More users do not directly bring more value to a particular user. Of course, more users will help to reduce the cost but quality of services remains the same irrespective of number of users. On the other hand, it two way networks, the value to each user directly depends on how many other people are using the network (Baye 2006, p. 495). As an example, the more Banks are participating in Automated Clearing House (ACH) system, the greater the value of that system.

Figure 1: A two-way network
Both one-way and two-way network can create first mover advantage through economies of scale and scope.

Network Externalities / Effects
According to S. J. Liebowitz and Stephen E. Margolis “Network externality has been defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes”. If more and more people are using 3G mobile phones, a person’s 3G mobile service will be more valuable.

Network externalities can be positive or negative. If joining an additional node in the network creates a benefit for the whole network, it is called Positive Externalities. Positive externalities in a two-way network can be direct or indirect. Direct Network Externalities exist when users of a network enjoys benefits because other people are using it. Example, Telephone network. There is a principle of direct network externalities. “A two-way network linking n users provides n(n-1) potential connection services. If one new user joins the network, all the existing users directly benefit because the new user adds 2n potential connection services to the network” ”(Baye 2006, p. 496).


Figure 2: Additional nodes creating 2n potential connections.

Indirect Network Externalities
or Network Complementarities exist when the users enjoy the indirect benefits because of complementarities between the size of the network and the availability of complementary products or services. Such as, popularity of DVD players leading to an increase in the number of movie titles released on DVD in the market.
On the other hand, in Negative Externality, additional node creates disadvantage for the whole network. Such as bottlenecks in shared network of an Internet Service Provider (ISP) as the number of users in that network increases than an optimum level.

Network Externality and First Mover Advantage
Network externalities can create customer lock-in and hence first mover advantage. Adobe’s popular Portable Document Format (PDF) is a classic example of first mover advantage due to customer lock-in. By providing free Acrobat Reader software, Adobe created a network where millions of people are using PDF format to share their documents. As more and more people are using PDF format, Adobe’s earning is increasing from its expensive PDF writer software Adobe Acrobat. If any other software firm wants to enter the market, it will be very difficult for them to make the current PDF users switch from PDF to any other format.

New firms can use penetration pricing to make the users switch from incumbent firm’s services to it’s own services. Some times firm can give away services for free until it reaches a certain number of users when network effect will kick in. Yahoo Auctions used zero pricing strategy to gain sufficient number of buyers and sellers so that they can compete with first mover eBay and in January 2001, yahoo began charging all sellers a fee for listing items in its website (Baye 2006, p. 498).

Now the question is when and how the network will reach its critical mass when the network effect will kick in and the firm will be able to charge prices or benefit from it. According to Carl Shapiro and Hal R. Varian, Professors at University of California, Berkeley, it starts from zero, with a few users over time and as cost decrease, more and more users will join and at some point it will reach the critical mass and the system then zooms up to the high-level equilibrium. They showed the following using the number of fax machines shipped over a period of 12 years from 1977 to 1991 (Shapiro and Varian, 1998).

Figure 3: The number of users connected to the network is initially small, and increases only gradually as costs fall. When a critical mass is reached, the network growth takes off dramatically.
Source: --

Advantages and Disadvantages of Network Effect
Network effects provide benefits to firms as well as to society. It helps to create standards in technology industry. A common example is DVD industry. In the beginning, there were different DVD formats such as DVD-R, DVD-R+, DVD ROM, DVD RW, DVD RW+. As more and more people started to use DVD, each of these formats became compatible to one another and most of the DVD players today can read any of these formats.

Network effect can provide the benefit of economies of scale and scope. As additional user brings 2n more links to the network, the per user cost goes down. Imagine you are the only electricity user in a town. The fixed cost associated with the service will far exceed the price you can afford. As more and more users join the network, the per user cost goes down and services become affordable by large pool of users.

1. Rauch, James E. & Casella Alessandra, (2001), “Networks and Markets”, New York: Russell Sage Foundation.
2. Baye M., (2006), “Managerial Economics & Business Strategy”, New York: McGraw-Hill.
3. Liebowitz S. J. & Margolis Stephen E. , “Network Externalities (Effects)”,, accessed on 11/25/2007.
4. Shapiro Carl & Varian Hal R., (1998), “Network Effects”,, accessed on 11/25/2007.
5. //, Accessed on 11/24/2007.

Multiple Choice Questions

1. In _ way network services flow in only one direction.
a. One
b. Two
c. Three
d. Four

2. Which of the following firm mentioned in this article had the first mover advantage?

a. Yahoo
b. Intel
c. eBay
d. none

3. If one new user joins the network, all the existing users directly benefit because the new user adds ___potential connection services to the network
a. n
b. 2n
c. 3n
d. n(n-1)

4. Bottleneck is an example of

a. Positive externality
b. Negative externality
c. Neutral externality
d. None

5. Which of the following is strategy is used by followers to enter a market with first mover advantage?

a. Limit pricing
b. Penetration pricing
c. High pricing
d. none

Answers to Multiple Choice Questions

1.a. One – In one way network services flow in only one direction.
2. c. eBay.
3.b. 2n
4. b. Negative externality. Because it reduces the benefit if additional user joins the network.
5. b. Penetration pricing helps the follower to enter into a market where first mover has a positive network effect.