Network effects

Network effects occur when higher sales of a product (or a service) increase its value and therefore fuel further sales. One of the simplest examples is the telephone network. There would be no point in owning the only telephone in the world. If a few hundred people had telephones connected to the same network they would start to become useful. In reality, with well over a billion telephones in the world, they are indispensable.

Similar effects take place in other industries. It is difficult to sell a car that uses a non-conventional fuel as there are a lack of places to re-fuel, but no one will build a distribution system without the demand that would result from substantial number of cars already sold.

Network effects may favour a particular company, giving it monopoly pricing power, by imposing a barrier to competition. However, the effect may also be to favour a particular standard or technology that is nonetheless used by several competitors.

Perhaps the most important network effects at the moment are those in IT and media. In IT, this is actually a complex three layered effect where hardware, operating systems and application software all selling each other. Many software companies have successfully exploited network effects. Microsoft's success in using its position in operating systems to sell its office software and vice versa is a superb example of how to exploit network effects. There are many others in the industry.

Network effects in media are best illustrated by looking at formats for recorded media. For example, once VHS video tapes got significantly greater market share than Betamax, the latter disappeared. Similarly minidiscs and digital audio tape failed partly because they failed to gather enough momentum to challenge CDs.

Perhaps the best example of network effects is the internet. It was far more successful than any previous attempt to provide on-line information because its open nature (anyone could connect, anyone could publish using it, anyone could write software that would connect to it etc.) meant that it gathered critical mass that eluded proprietary services (those that required a subscription to a particular supplier who was the only publisher for that network).

In some industries regulators put a lot of effort into minimising network effects. If the dominant players in telecoms would be able to lock out competitors by refusing to allow them to connect to their networks, this would make it nearly impossible for new entrants to break in or for smaller networks to survive at all. Therefore telecoms regulators force networks to allow connections from other networks, and regulate the prices charged for doing so.

Regulators have been less effective at managing network effects in software and media. This may be due to the lack of the specialist regulatory framework that exists for telecoms.

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