Classroom Companion: Business

9.2 
 Positive and Negative
Network Effects – 124
9.3 
 Characteristics of Network 
Effects – 131
9.4 
 Direct and Indirect Network 
Effects – 135
9.5 
 Same-Side and Cross-Side
Network Effects – 135
9.6 
 Estimating the Value
of Networks – 136
9.6.1 
 Size of Networks – 136
9.6.2 
 Sarnoff’s Law – 137
9.6.3 
 Metcalfe’s Law and Odlyzko-Tilly’s 
Law – 139
9.6.4 
 Reed’s Law – 141
9.6.5 
 Summary and Comparison
of Network Laws – 142
9.7 
 Conclusions – 144
 References – 147
9

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124
9
 
n Learning Objectives
After completing this chapter, you should be able to:
5
Identify network effects associated with a particular digital service and the 
impact the network effects may have on the temporal evolution of the market.
5
Explain how positive network effects may cause slow initial adaptation of new 
services and that this may be mitigated by stimulating early market growth by 
offering the service for free initially.
5
Demonstrate how the value of networks of different types can be estimated and 
use this knowledge in strategic planning.
9.1 
 Introduction
Definition 9.1 Network Effect
The network effect (also called network externality or demand-side economies of 
scale) is the effect that the number of users or amount of usage of a service has on 
the value of that service as perceived individually by each user (Arthur, 
1990
).
The network effect is the value a new user adds to existing users in a network 
(Shapiro & Varian, 
1999
). A related term is supply-side economies of scale, which is 
the effect the number of users or units produced has on the costs of production. 
Supply- side economies of scale are different from network effects—the former 
describes the cost advantages of being large, while the latter des cribes the value of 
having many users. This section considers the demand-side economies of scale—
the network effect.
Sometimes a distinction is made between network effect and network external-
ity. Network externality is then used as the general term referring to all types of 
feedback from the market (i.e., negative or positive), while network effect is only 
used in the case where this feedback causes an increase in value of the network (i.e., 
positive). Since the nature of positive and negative network effects are essentially 
the same, we will use the term network effect referring to both positive and negative 
changes in value and, if a distinction is necessary, refer to them as positive or nega-
tive network effects.