Vorlesung 2: Network Effects

Question 1

Network Effects

Answer 1

Simply put, networks effects* occur when a product or service becomes more valuable to its users as more people use it.
*also known as: demand-side economies of scale

Question 2

Key properties & challenges in markets with network effects

Answer 2

Critical mass Product/platform launch
Winner-takes-it-all dynamics
Natural drift towards monopolies Anti-competitive tendencies
Lock-in effects
Direct vs. indirect effects

Question 3

Network effects: Basics

Answer 3

• External effects describe a situation in which an individual‘s behavior affects others
• Network effects (or network externalities) describe a special case of external effects: The utility gained from a product depends on the number of other users/customers of this product
• Direct positive network effects: The more users, the higher the individual’s utility (demand side scale effects)
• Typically decreasing marginal utility gains (concavity)

Question 4

Network effects: Basics

Metcalfe’s Law

Answer 4

Metcalfe’s Law: The value of a telecommunications network is proportional to the square of the number of users of the system (n2).
Two telephones can make only one connection, 5 can make 10 connections, and 12 can make 66 connections.
This implies: The value of being a member in the network to each user is n.

Question 5

Network market
Penguin effect

Answer 5

Question 6

Network market
Von demand demand Funktion zu Price demand

Answer 6

Question 7

Direct and indirect network effects

Answer 7

Direct network effects
A product‘s value increases due to the possibility of direct interactions with other consumers
Examples: Phone, Fax, in general: communication,

Indirect network effects
Increasing numbers of consumers yield complementary utility, which in turn increases the value of product
Examples: OpenOffice, Latex, any standard, …

Question 8

Competitive implications from network effects

Answer 8

If network effects exist, demand stimulation in early stages is essential
Common strategies include:
▪ Selling the product at prices below its production costs
▪ Massive initial marketing
▪ Starting locally
▪ Generate, buy, or simulate activity

If surpassing critical mass fails, the product will not retain Problem: How “large” is critical mass specifically?
Are there products with negative network effects?
▪ Luxury- or status goods (conspicuous consumption)
▪ Congestion-Markets: Internet, Autobahn, …
▪ Dilemma products: e.g., weapons

Question 9

Two-sided markets

Answer 9

Providers benefit from many consumers
(demand) – consumers benefit from many providers (supply, competition)
Examples: eBay, ride sharing, AppStore, … in general: Matching-Platforms with >= 2 roles (special case: positive competition effect also for providers)