Classroom Companion: Business

9.2 · Positive and Negative Network Effects

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the labor market to fluctuate between surplus and shortage of expertise in certain 
areas: the students choose a particular education based on the observed prospect 
of getting a job in that field at the start of the study. When they finish the education 
several years later, the labor market may have changed considerably.
Definition 9.5 Negative Feedback
Negative feedback, on the other hand, reduces the deviations and tends to bring the 
output toward a stable equilibrium and keep it there. If there is an increase in the 
input A causing an increase in the output B, then this increase in B will cause a 
reduction in A bringing B back close to equilibrium. Similarly, a decrease in A caus-
ing a decrease in B will cause an increase in A again bringing B back close to equilib-
rium. The feedback will then counteract any deviation of the output B away from its 
equilibrium state. Market stability is one of the basic assumptions in traditional 
microeconomic theory where competition leads to perfect market equilibrium. In 
this theory, the market is stabilized by negative feedback loops counteracting any 
deviation from equilibrium.
Most markets for digital goods and services are subject to positive or negative net-
work effects and, hence, subject to positive feedback. This implies that mainstream 
economic equilibrium theory does not apply to such markets.
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The points made above are so important (and sometimes misinterpreted) that it is 
worthwhile to summarize them. Do not confuse the terms “positive (negative) net-
work effect” and “positive (negative) feedback.” Positive and negative network 
effects are both driven by positive feedback from the market. Negative feedback 
from the market results in equilibrium markets, while positive feedback results in 
non-equilibrium markets. Positive network effects will drive the market into satu-
ration such as the mobile market. In this market, everyone sooner or later owns a 
mobile phone. Negative network effect will initiate a vicious spiral, in which cus-
tomers are leaving the market and the company serving it may face bankruptcy.
.
Figure 
9.5
illustrates how positive feedback stimulates positive network effects: 
new users adopting the digital service stimulate other users to do the same, result-
ing in a positive network effect that further stimulates the growth of the service. 
The final state of most of these markets is that every user has adopted the service 
or bought the good—the market ends up being saturated and cannot increase any-
more.
In some markets where competition exists between two or more supplementary 
goods (e.g., VHS and Betamax; see 
7
Chap. 
11
), one of the goods may become the 
good that most customers prefer, generating a negative network effect on the other 
product that finally squeezes it out of the market. Another way of expressing this 
is that positive feedback in a competitive market may imply that the strong gets 
stronger and the weak gets weaker, also called the Matthew effect, a term coined by 
the sociologist Robert K. Merton (Merton, 
1968
). In this way, the network effects 
in competitive markets often produce winner-take-all markets, where one of the