Originally Published: May 24, 2010

Network effects: The simple explanation

The web is re-shaping the way transactions take place. Understanding network effects theory is essential to understanding new commerce.

Here’s a simple drawing I made to represent the gist of network effects:

Seems fairly obvious, doesn’t it? Mark’s friends are predominantly on Facebook (as opposed to MySpace), so Facebook is the easy choice.

Let’s try another example: You are a business ordering new computers for an office of 30 employees. Should you go with Windows, Mac OSX, or some flavor of Linux? Basic research reveals that 90% of similar businesses use Windows, and that there’s a deep community of local businesses offering technical support services for Windows networks (which exists because so many businesses already use Windows). Though Mac OSX might offer a better user experience for your office’s employees, the value created by a large network of Windows owners firmly tugs you in that direction.

And that’s network effects theory. There’s not much to it: network effects create an environment in which one really big network can be extremely valuable.

Have network effects always been this strong? No. They seem to be a fairly unique characteristic of the web era due to the way that technology connects us socially.

Advanced explanation

Network effects are mathematically represented by Metcalfe’s Law, which states states that the value of a telecommunications network is proportional to the square of the number of connected users of the system. This equation is not a perfect model, but it does make clear that there are diminishing returns. That is, each additional user adds value, but less value than the previous user.