JARGONALERT Network Effects BY JESSIE ROMERO

n 1907, a group of investors that included J.P. future players, and competition among game developers Morgan took control of the American Telephone drives down the price of games. Iand Telegraph Company and named Theodore Vail Robert Metcalfe, the electrical engineer primarily president. (Vail had also been AT&T’s president in the responsible for inventing Ethernet local networks, is 1880s.) Roughly 6,000 independent phone companies had widely credited with popularizing the idea of network sprung up since Alexander Graham Bell’s original patent effects. In the 1980s, Metcalfe’s sales pitch for his new expired in 1894, and Vail quickly embarked on a new strat- technology stated that the effect would be proportional egy of acquiring them. Had these competitors not become to the square of the number of connected users of the part of the Bell system, Vail wrote in the company’s 1908 system, a formula that came to be known as “Metcalfe’s annual report, “each little system would have been inde- law.” While there’s little empirical evidence to support the pendent and self-contained without benefit to any other.” law specifically, it’s often still used as shorthand to assess A telephone without a connection at the other end, Vail technology companies’ values. explained, “is one of the most useless things in the world. Network effects can contribute to a situation known Its value depends on the connection with the other as “lock in,” in which a particular standard becomes dom- telephone — and increases with the inant and consumers find it very number of connections.” costly to switch. In these situations, The term didn’t exist at the the producer of the standard may be time, but Vail was describing what’s able to exercise monopoly power. In known today as a “network effect” 1998, for example, the Department or, by some economists, as a “net- of Justice sued Microsoft for work externality.” Network effects allegedly abusing Windows’ ubiq- occur when “the utility that a user uity as an operating system to derives from consumption of the promote Internet Explorer. More good increases with the number of recently, critics have contended other agents consuming the good,” as that Google consistently manipu- Michael Katz and Carl Shapiro of the lates its search results to direct users University of California, Berkeley away from competing services in described in a 1985 article in the American Economic other markets that Google serves. Review. (Shapiro later wrote a book about network effects In addition, network effects don’t increase indefinitely. with fellow Berkeley economist Hal Varian, now the chief Take a dating website, which initially becomes more use- economist at Google.) ful as more people sign up and the number of potential In general, there are two types of network effects: matches increases. But after a certain point, there might direct and indirect. Direct effects occur when a good’s be so many users that it’s difficult for people to sort value increases as the number of users goes up. Telephones through the matches — a form of network “congestion.” exhibit direct network effects, as did fax machines before Congestion can also occur if a site or system’s infrastruc- they were supplanted by email. Today, an oft-cited exam- ture is insufficient to support the number of users. Or, ple of direct network effects is social media — the more networks may become “polluted” if they reach a size such friends you have using a given platform, the more enjoy- that the quality of each additional user declines. ment you’ll get from it. An Internet search engine may also It’s also possible for an increase in users to create exhibit network effects; more users enable the company to more value for one side of the market while detracting refine the engine’s algorithm, making it more effective and from the value for the other side. A website whose visi- leading more people to use it. (See “Interview with Jean tors increase will become more attractive to advertisers, Tirole,” Econ Focus, Fourth Quarter 2017.) but the increase in advertisers might then turn away Indirect effects occur when an increase in consumers some of those visitors. By many accounts, the ubiquity using a good leads to the creation of more complementary of advertising contributed to the demise of MySpace, goods, thus making the original good more valuable. This which lost the social networking war to Facebook in the is common in platform situations. For example, as more late 2000s. Today, many Facebook users complain about people use a particular videogame system, companies will intrusive ads, but they continue using the site, in part create more games compatible with that system. Greater because everyone else does — a testimony to the power

availability of games makes the system more attractive to of network effects. EF ILLUSTRATION: TIMOTHY COOK

6 E CON F OCUS | S ECOND Q UARTER | 2018