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What is The Network Effect and How Does It Affect Blockchains?

A Network Effect is a phenomenon by which a product becomes more valuable as more people use it. Do you remember Orkut? Orkut was shut down in 2014 because not enough people were using it. Of course, other factors were involved, but it had little value as a service platform since it didn’t have many users.

The network effect is very important in cryptocurrencies, too. Blockchains organize users, and therefore, as more people use the blockchains, they can provide their users with more functions and applications.

What factors do determine whether a cryptocurrency project becomes a leading-project in a particular field? Usually, the market moves toward the best solutions in the long term, but this is not that simple, and many factors are involved. A project’s developers may focus on innovations, but if the launch time is not suitable, it may fail to attract enough attention and users. In some cases, projects with a lower technology level gain higher market share just because they were launched at the perfect time. Therefore, they were accessible to fulfill users’ needs. This is where network effects will be effective.

What is Network Effect?

The network effect is an economic term referring to a product or service that gains more value as its users’ number grows.  Once the network effect is in place, every new user entering the network will add more value to the product or service. As a result, encouraging new users to enter the network will add more value.

A good example of the network effect is the telephone. In the early days of telephone emergence, a handful of people had a telephone in their houses. Moreover, their houses had to be connected to each other by physical equipment in order to use the telephone network. As telephone technology developed, more

people could manage the service costs, and the total value of the network raised. As more people used the telephone service, the application and value of the total network increased. It created a positive feedback loop during which more people joined the network, and more value was added to the network. Simply put, the increased use of the telephone led to its exponential growth.

Another example of the network effect is cryptocurrencies. Cryptocurrencies like Bitcoin provide users with unique properties, and as more users join the network and invest in it, the coin becomes more and more valuable.

The network effect types

There are two network effect types, direct and indirect.

The direct network effect is the phenomenon explained in telephone or cryptocurrency examples. The rise in usage and number of users will result in increasing the value.

The indirect network effect occurs when there are at least two different customer groups that are interdependent, and the utility of at least one group grows as the other group(s) grow. For example, hardware may become more valuable to consumers with the growth of compatible software.

Some famous example of the network effect

There are numerous examples of the network effect in modern-world products. The most prominent one is social media platforms. Users tend to join platforms that their friends and family members have already joined. This tendency makes different people join the same platforms and will eventually make few platforms dominant. If a company decides to create a new social media to challenge some successful brands, it will have a challenging path to attract users because the network effect created by the previous companies gives them a competitive advantage. Google+, Google’s social media platform, is a good example. It was launched in 2011 to challenge Facebook, but it never succeeded in expanding its business and is widely seen as one of Google’s biggest failures.

Another example of the network effect is shared-rides companies. Companies such as Uber or Lyft have created the massive network effect over the years, making competition very difficult for small-size services with fewer users.

The list of modern products goes on and on; Amazon and eBay in online retailing, Google in search engines, AirBNB in vacation renting, Microsoft in operating systems, and apples in smartphones are all examples of companies creating a strong network effect. However, profitable companies with impressive business models are not the only ones that can achieve such a powerful network effect. Wikipedia is an open-source project that has created a significant network effect.

Network effect and cryptocurrencies

As mentioned earlier, the network effect is important in blockchains and cryptocurrencies. For example, miners secure the network in the Bitcoin blockchain. They also have good liquidity to continue their operation. Now, imagine if a new blockchain with similar functionality as Bitcoin is launched. Miners may receive more incentives, but they do not have as much liquidity as Bitcoin miners. They can take a risk hoping the liquidity improves in the future, or continue mining Bitcoin with a relatively high assurance that they will gain profits. This is how the network effect works. Even if the new blockchain is better in technology or offers higher incentives, it doesn’t mean it will be logical to transfer to the new network.

The network effect is important in DApps (decentralized application), too. Take DeFi as an example; even if a service or smart contract with higher technical advantages launches, it would not be easy to compete with DeFi. Although DeFi is still in its early stages of development, many users have acknowledged that there are no DApps with enough network effect to compete with DeFi.

The negative network effect

The negative network effect, or the reverse network effect, is the opposite of what has been explained. In this case, every user that enters the network will decrease its value. For example, congestion is a negative network effect whereby too many users can slow a network down, reducing its utility and frustrating network members.

This is very important in developing blockchains because they must be developed and created in a way to avoid the negative network effect. The Ethereum gas fee is an example of the negative network effect. Ethereum uses the auction-style system to price gas. Every user suggests their price gas to Ethereum miners. As more users enter the network, the price of gas will increase because every user is trying to offer a better price. As the price gas increases, some users leave the network and stop using it because of the high fees. That was the driving power behind the Ethereum 2.0 project, to reduce fees during the network’s high activity.

Final thoughts

The network effect is an economic term present in many business sectors. The network effect means that entering every user will add more value to the network. Blockchain developers can create a more efficient blockchain network based on this phenomenon. Coins and new tokens can grow faster by using and incorporating the network effect in the development process.

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