The Network Effect

A network effect is an economic factor that describes a project or service where additional users add value to the network automatically.  When this occurs, each new user adds value to the project by simply connecting to the network.  This incentivizes new users to keep joining the network, thus adding more and more value to the network over time.

Developers may create some innovative and upcoming technology but, if it doesn't have a good market to fit the project at the time of creation, it won't gain traction.  Best solutions don't always become a market leader in their given sector.  In most cases, technologically inferior projects capture the bulk of the market share only because they were available at the perfect time.  In this article, we will take a look at the different types of network effects and how they correlate in the crypto realm.

I am not sponsored by anyone or anything mentioned in this article. 

This is not financial advice.  I am not a financial advisor.

Please do your own research before making any decisions before investing. 

This article is meant for educational purposes only.

The perfect example of a direct network effect is the telephone.  Very few people had telephones in their homes during the early days of technology.  In the early stages of communicating via telephone, homes had to be physically connected to each other utilizing a plethora of wires and cables in order to use the network.  As telephone technology improved, more people could afford a telephone, thus increasing the value of the telephone network as a whole.  This creates a positive feedback loop where as this increased usage led to exponential growth.

We can also compare social media when describing a network effect.  Remember when all your friends left MySpace for Facebook and Twitter?  Well, more and more people left these older platforms for the newer social media sites... and it's only reasonable for the rest of the social media community to follow-suit to stay up-to-date with current trends.

An indirect network effect is actually a bit harder to define.  This refers to the additional, complimentary benefits that stem from there being a network effect in the first place.  It can basically be compared to an add-on benefit to the network.  Take crypto for example... many projects are open-source and the code is able to be viewed by the public.  A crypto project with a strong network effect already in place may draw in other skilled developers to audit the existing code to protect the value at stake.  The auditing is an example of an indirect network effect, as this new added value (the audit) came from there being so much value in the crypto project to begin with.  This allows developers to build up a significant network over their competitors in the market.

A few services can actually get into monopolistic positions from their own network effect.  Take Facebook for example with their platforms, Facebook and Instagram.  Both are social media platforms and are very popular around the entire world.  If a new company wanted to start a new social network platform, they are going to have a very hard time gaining the attention needed to survive in the digital landscape.  The network effects from the market giants have already built up a significant competitive advantage.

This can apply to basically any of the popular platforms we see on a daily basis.  Uber and Lyft for ridesharing programs, Ebay and Amazon for online sales, Google for searching the web.  Who even uses Bing?  Anyways... not all well-defined and for-profit business models can have a significant network effect on the community.  Wikipedia is a good example of an open-source project that has built a network effect as well, relying on donations from website users.

It's important to take into consideration of the network effects when it comes to crypto and blockchain.  Let's take a look at Bitcoin.  Bitcoin has some highly desirable properties and has a strong network effect in place.  Miners support the network security and have a fair amount of liquidity to sustain their operations.  Let's say another network, Bitc0inz, is launched that aims to serve a similar use case as Bitcoin.  The miners could have the potential to receive higher rewards, but liquidity now lacks with their exit positions in the new network.  They can switch over to Bitc0inz and hope that liquidity will improve and they will be rewarded more long-term, or they can stick with Bitcoin mining with [relative] certainty they will be able to remain in operation and continue to receive profit.  The network effect surrounding Bitcoin keeps the community locked into position.

Network effects are also an important aspect in the decentralized finance (DeFi) market as well.  If a product, service, or smart contract builds up an advantage, it will be difficult to overcome for other new projects.  This can be related to the hype generated around SafeMoon.  Have you seen the offshoots of SafeMoon and their tokenomics?  It's all there essentially is in the DeFi market these days.  I am not saying SafeMoon is a market leader by any means, but it is a good example of a network effect in DeFi.

Negative network effects can actually move in the opposite direction, meaning that each new user subtracts value from the network instead of adding to it.  It's important to keep this in consideration when a blockchain is designed.  New users should always add more value to the blockchain in order to increase scale.  Network congestion will happen when each user subtracts value to the platform.  Gas fees will increase and users will clog up the system, making transactions perform at a much slower rate.

Let's take a look at Ethereum gas.  It works on an auction-style system where each user bids on the gas fees to be paid for the Ethereum miners.  As more users are added and the usage of the blockchain increases, gas fees become higher because each of those users are essentially outbidding each other.  Once this occurs, less people will want to use the network and avoid the high fees and long transaction times, lowering the total users utilizing the platform.  This is what Ethereum is trying to solve via Ethereum 2.0, aiming to greatly increase how much throughput the Ethereum network can handle at any given time.

Network effects are present in many different segments of the economy, not just cryptocurrency.  The main idea is that new users will add value to the network as they enter over time.  Developers of blockchain and crypto networks can benefit from studying which best generates positive network effects.  Taking the network effects into consideration, their coin or token projects could scale faster and be beneficial to each user on the platform every single day.

What are some other network effects you can think of?

Let us know in the comments down below!

Thanks so much for reading! 

Please feel free to follow my page for daily blog posts about crypto news, updates, and research! 

Have a wonderful day!