A network effect occurs for any product when more people utilize it and ultimately increase its value. Do you remember Orkut? Since a few people were using it, it had to be shut down. But why? Well, significantly fewer people were accessing it. Yes, there are other elements in play, but because there were so few consumers, the service didn’t offer anything.
When it comes to Crypto, network effects are considered highly crucial. People are organized ultimately by money and blockchain, so it’s true that the more people deploy on the network, the better utility will be provided as a service.
In this article, let’s dig a little deeper and understand the network effect and its types.
What is the network effect?
A network effect is an economic concept in which the addition of a new user alters how valuable a network is to its existing users. For instance, As more users sign up for a particular messaging application, the number of persons with whom a user can communicate will grow.
They are often positive, which means that a new user improves the network’s value for existing users. New users can enhance the appeal of using the network for other potential users.
Numerous industries experience network effects. For example, network effects on social media sites are highly powerful. Matchmaking services rely significantly on their network effect to outperform competitors like Uber. To keep users from switching to other phones, iMessage leverages the network effect of the iPhone.
Example of network effect
There are numerous product categories in the modern era that demonstrate network effects. One of the common examples is social media, where consumers frequently sign up for services that their existing social networks use. People are encouraged to join the same platforms as a result, and a selected few providers gain monopolistic positions.
It will be challenging for new businesses to build a critical mass for a social network platform. Why? The market leaders have a considerable competitive edge thanks to their developed network effects.
Types of network effects
There are two significant types of network effects, i.e., direct and indirect network effects.
- Direct network effects: They are those where higher usage benefits all other users. Take the telephone, for instance. In the past, a few selected people had telephones in their houses, and their homes should be physically connected to one another to use the network.
More and more people were able to afford telephones as technology advanced, which raised the worth of the whole telephone network. As a result, the value and utility of the existing network increased as the user base grew.
- Indirect network effects: The definition of indirect network effects is more complicated. The phrase describes additional, complementary advantages that result from the initial network effect. For instance, a lot of Cryptocurrencies have open-source code.
Many qualified developers will be more likely to audit the code as high value is at stake (including self) when the project has a strong network effect. Since, initially, the network already has so much value, there is already added value that comes from it. This effect starts accumulating, and we reach the prevalent leaders that build up impactful network effects over their rival organizations.
Network effects and Cryptocurrencies
Network effects are a critical factor to take into account when we talk about blockchain and Cryptocurrencies.
For instance, Bitcoin has a potent network effect and features that appeal to most users.
Think about how Bitcoin miners maintain the network’s security without being concerned about liquidity. Switching to it wouldn’t necessarily be optimal even if another technologically more advanced project appeared out of nowhere and had a comparable use case as Bitcoin.
Although payouts for miners could be substantially more prominent, they might not always have the same liquidity as Bitcoin. Particularly in the case of Bitcoin, the distinctive qualities and features of BTC are difficult to imitate, causing people to persist with it over time.
Although network effects may be significant in the Decentralized Finance (DeFi) space, it is debatable if any smart contract projects have so far successfully created a substantial network effect that positions them as the market leader.
What is the negative network effect?
When additional users reduce the value of the network, this is known as a negative network effect. Gas fees on Ethereum are one instance of a negative network effect.
Ethereum gas fees rise as more users place bids on the amount of gas that should be paid to Ethereum miners.
Network effects are prevalent throughout a wide range of economic sectors, including Cryptocurrency. The notion is that as new users join, they bring value to the network.
Studying the factors that cause network effects can be beneficial for those who construct blockchain and Cryptocurrency networks. They could help brand-new currency and token ventures scale more quickly by being included in the design process.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.