Wednesday, August 20, 2008

The Network Effect of Websites

If you were the first person in the world with a computer able to send email, it would have been effectively worthless because of the inability for you to communicate with other people without email. As more people gained access to email, the value of email as a communication method rises sharply: the larger the network of users, the greater the value of the network.

A network effect exists when the value of a good or service increases as more people use that good or service. In a typical network, the addition of a new customer increases the willingness of all participants to pay for network services.

Metcalfe’s Law states that the value (V) of a network increases by the square of its nodes (n). Metcalfe’s formula states that V = n2– n. So a network of ten people has a value of ninety (100 – 10 = 90) but a network twice the size has a value three times higher (400 – 20 = 380). Metcalfe also stated that the costs are unlikely to rise as fast as the value of the network because after reaching some point of critical mass, value soars.

An innovation is said to reach critical mass when adoption begins to increase at an increasing rate. Even if a company stops actively promoting the innovation, the process of adoption continues. The innovation is self-sustaining, and it becomes nearly impossible for competitors to change the course i.e DVD's or Ipods.

Many web sites also feature a network effect and social networking websites are good examples of this concept. The more people register onto Facebook or MySpace, the more useful the social website is to its participants.

Another example of this concept is online marketplaces, in that the value of the marketplace to a new seller or buyer is relative to the number of other people in the market. For example, eBay as the number of participants join eBay, more people in the market to bid for a product, this has the effect of increasing the prices of bids on items. In turn this makes it more worthwhile to sell on eBay and introduces even more sellers into the marketplace, which then drives prices downward again as supply increases, while again bringing even more people onto eBay because there are more products being sold. Essentially, as the number of users of eBay grows, prices fall and supply increases, and more and more people find the site to be a useful marketplace.

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