The More, The Merrier: Competition For Network Effects
The concept of network effects is clear: some services work better and are more useful when they have more users, like video conferencing and social networks. However, we must set the record straight on how network effects play out in competitive marketplaces, particularly:
— History shows that new entrants can successfully compete against companies with perceived network effects.
— Achieving network effect benefits today does not guarantee market dominance tomorrow; consumer preferences and products change, disrupting the competitive landscape.
— Network effects allow companies to provide greater value to consumers, which is a primary focus for competitive marketplaces.
History shows that new entrants can successfully compete against companies with perceived network effects.
Economist David S. Evans highlights a cycle of new companies pushing out legacy players by establishing their own networks. “A few people in a network try a platform. If enough join, and like it, then eventually all of them could switch or drop the initial platform. This phenomenon has happened repeatedly. AOL, MSN Messenger, Friendster, Myspace, and Orkut all rose to great heights, and then rapidly declined, while Facebook, Snap, WhatsApp, Line, and others quickly rose. Nothing about the underlying economics or technology of online platforms has changed that would prevent this same cycle from repeating itself going forward.”
Network effects are not the only factor for success; efficiency and innovation are also key ways for new entrants to compete, per a Competition Policy International paper. “Unfortunately, the simple network effects story leads to naïve armchair theories that industries with network effects are destined to be monopolies protected by insurmountable barriers to entry, and media-friendly slogans like ‘winner-take-all.’ The basic empirical flaw in the simple network effects theory, and the associated slogans, is that it focuses on successful firms, at a point in time, observes they benefited from network effects, and concludes that they won it all and won’t be displaced. Those facts, even if true, don’t show that network effects are the source of their success or provide a moat around them. The ‘winner’ could just be a lot more efficient or innovative than other firms. A true test of the theory would examine whether markets that have network effects have winners that can’t be dislodged.”
Ryan Bourne, economics expert at the Cato Institute, explains that network effects do not prevent new competitors from entering the space, as Facebook’s disruption of MySpace shows. “[T]he MySpace example just serves to show that network effects don’t preclude a new competitor coming in and taking some subsections of the market or acting as competition for the whole lot. That’s what Facebook did to MySpace. Yes, Facebook has endured for longer. Clearly, it’s doing something right that’s maintaining consumers’ attention, but that doesn’t mean that something else can’t come along in the future.”
Zoom entered the video conferencing markets and illustrated that the existing companies’ network effects were not an insurmountable obstacle to Zoom’s success, per Dirk Auer. “To get to where it is today, Zoom had to compete against long-established firms with vast client bases and far deeper pockets. These include the likes of Microsoft, Cisco, and Google. Further complicating matters, the video communications market exhibits some prima facie traits that are typically associated with the existence of network effects. For instance, the value of Skype to one user depends – at least to some extent – on the number of other people that might be willing to use the network. In these settings, it is often said that positive feedback loops may cause the market to tip in favor of a single firm that is then left with an unassailable market position. Although Zoom still faces significant competitive challenges, it has nonetheless established a strong position in a market previously dominated by powerful incumbents who could theoretically count on network effects to stymie its growth.”
Achieving network effect benefits today does not guarantee market dominance tomorrow; consumer preferences and products change, disrupting the competitive landscape.
Network effects “do not necessarily create durable market power,” according to Assistant Attorney General Makan Delrahim. “A recent Harvard Business Review article observed a number of constraints on a digital platform’s success, even in markets characterized by network effects. The article first points out that the strength of network effects can vary dramatically and can change over time. While network effects often lead to competition ‘for the market’ rather than ‘in the market,’ they do not necessarily create durable market power.”
Larry Downes, tech and competition policy expert, argues that network effects are short-term, meaning they do not solidify market power. “Network effects may create temporary market leverage for a platform company at the top of the new adoption curve, but the period during which they can exploit it gets shorter all the time. Even wildly successful technology start-ups have fallen victim to a surprising drop-off in user attention and a failure to prepare in time with a next-generation innovation.”
MIT’s Catherine Tucker explains that network effects “are not the guarantor of market dominance that antitrust analysts had initially feared.” “Shifts in the nature of technology away from hardware towards purely digital platforms reduce the likelihood of a positive feedback loop that can reinforce incumbency. Network effects no longer imply entrenchment but instead can lead to instability.”
Network effects allow companies to provide greater value to consumers, which is a primary focus for competitive marketplaces.
By definition, network effects are benefits for consumers, something that companies are constantly competing to achieve. “Network effects began as a cluster of economic theories defined as ‘the utility that a user derives from consumption of a good increases with the number of other agents consuming the good’ or situations in which ‘one consumer’s value for a good increases when another consumer has a compatible good.’ When products become more valuable to consumers as more people use them, that’s a network effect, or what economists call a ‘network externality.'”
Competition economist Joseph Bell highlights the positive impacts of externalities, such as low costs and operations efficiencies. “Network effects can be beneficial to competition and consumers. Mergers involving service-based platforms have a particular potential to generate efficiencies just by increasing in size and therefore reaching economies of scale and lowering search costs for customers. Moreover, there can be efficiencies on the supply side of the market (in this case, the clients) if transaction costs between the platform and the service provider are reduced. Network effects can also intensify competition, as for small firms the rewards of having a wider network can be large.”