Network Effects

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A network effect, or network externality, is the value that an additional user of a service brings to that service. With a network effect, value comes not just from the supplying firm, but from other consumers.

The biggest example are social media companies. These companies generate a significant amount of their value from user-generated content. Examples of user-generated content are:

  • Youtube videos are uploaded by Youtube users
  • Facebook posts are posted by Facebook users
  • Twitter posts are posted by Twitter users

And so on.

This creates a catch-22 situation. In order to become popular, the service has to get users, but to get users, the service has to get popular. For example, people use Facebook because that is the standard; all of their friends also use Facebook. For all users to change services would constitute a collective action problem due to coordination issues.

A network effect acts as a barrier to entry that gives companies excessive market power, with the ability censor and sell user data without being subject to normal free market competition. This is similar to problems of path dependence.

Network effects are closely linked to the anti-rivalrous nature of information, as it pertains to user-generated content.

A naive assessment is that because there are many social media companies, they all compete with each other. In fact, we need to be careful how we define the "industry." Social media is a property of certain services, but it is not an industry, it is many industries. Each of these industries usually has a single dominant incumbent at a time.

It is naive to tell a Youtuber, "If you're upset about being monetized, just post your work on a competing social network!" Creators need to post their work where the audience is. Large audiences only frequent certain sites because that is where content creators typically post their content. Using this example, large audiences for videos almost exclusively exist on Youtube. Posting elsewhere is poor severance.

Proposed Fixes

The Internet used to be more defined by its peer-to-peer nature. There are still some holdouts (email and podcasts are P2P), but by and large, the Internet has "centralized" around specific services. The Internet is now defined by network effects.

The following are proposed responses to network affects on the Internet

1) Class action lawsuit - seeks to set a precedent that aggregated user-generated content is a public good (due to its anti-rivalrous nature)

2) Direct policy change or enforcement (e.g. regulation) - seeks to regulate, tax and/or break up large tech platforms as payment to society for exploiting the public commons

3) Build non-centralized alternatives - create a paradigm shift in distribution that is incompatible with Big Tech business models (e.g. blockchain protocols, peer-to-peer communication, Urbit)

Non-Internet Examples

  • Road networks and utilities could be described as exhibiting network effects.
  • Cities: Many people live in cities because that's where many jobs are. Many jobs are in cities because that's where many people are.