1. 2. 4  Network effects

We say that there are network effects or externalities when the value of a product or system for each person who uses it increases the more people who use it. Network externalities can be of two different types:

1) Direct.

2) Indirect or virtual.

Direct externality is perhaps easier to understand: we often find a product more valuable the more widespread it is, since we can then share its use with more people.

Obvious examples of this are telephones, fax machines, e-mails, etc. Note that to truly take advantage of the mass of people who also have a phone, it is essential that theirs and ours are compatible (they understand each other). It is pointless for us to have a fax and for others to have one too if their fax does not accept or understand the messages sent to them by our machine.

As we will explain in more detail in the next section, potential network effects are not used to advantage unless there is a standardisation process ensuring that the objects in the hands of different people are compatible, since only then can we really communicate with lots of people.

Mobile telephony

In the United States, the various mobile telephony companies could not agree on using the same system. As a result, mobile telephony in the US is much less useful than in Europe, where the European Commission promoted the use of a single standard for all countries. The immediate consequence is that mobile telephony is much less widespread in the United States, to the detriment of the entire industry, companies and clients.

Indirect network externalities are a more subtle economic effect. When a product is actually a system made up of different parts that complement one another and are not very valuable individually, the value of a product depends on its popularity, since we will have more complements (or better quality parts) the more people who become interested in the product.

In any case, direct and indirect effects have one thing in common: again, it is essential for other individuals and companies to have compatible products.

In these cases, to ensure that the markets for these products take off, one of two situations must occur: either the government must intervene or the initiative must be taken by an economic agent with sufficient power to modify the market conditions by itself and sufficient financial resources to withstand years of customer adaptation.

Here are two examples of the importance of these effects for the launch of products with network externalities:

1) The new high-definition video formats. The manufacturers of the new design have secured the commitment of the major film producers, who have said that they will broadcast their new productions in this format. Thus, the customers who use the complement for the new video players will be guaranteed support to make the most of the superior resolution of these appliances.

2) The next example shows that this economic effect is present in other sectors too, not just in ICTs. We will not buy a car that runs on the new biodiesel fuels (i.e. produced from vegetable oils) if we cannot find service stations supplying these; in turn, individual service stations will have little interest in changing their pumps and deposits if they feel that they will not have any customers, manufacturers will not be encouraged to make biodiesel, etc.

In these cases, in contrast to what happens when other people also have fax machines, there is no direct service to be gained from other people having cars that run on biodiesel (i.e. there is no direct effect). Only when there is a considerable mass of people with biodiesel cars will service stations adapt their fuel deposits and pumps to the new fuel. We could say that, indirectly, any person who buys a biodiesel car is doing a favour to other biodiesel car buyers.

Indirect externalities thus explain the importance of the use of this new fuel for growth by the fact that the government subsidises the cost of its manufacture and the importance of the recent agreement between Acciona, currently the most technically advanced company in Spain in the manufacture of biodiesel, and Repsol, with the largest fuel distribution network in Spain. The agreement between the two companies will ensure the supply of biodiesel fuel at service stations in the near future. Manufacturers and dealers will now be encouraged to sell biodiesel cars because they can guarantee buyers a no-nonsense fuel supply.

When the important features of products and services include complementarities and network effects, the most important consequence of this is that a product will not be viable if we do not achieve a sufficient critical mass of users: below a certain number of users, the product will not offer enough benefits to make it valuable, so the potential suppliers of complementary products will not make the necessary investments to make them available to customers.

VHS format

Inertia towards the use of a version can eliminate the viability of alternative versions that are technically feasible. Betamax video recorders disappeared when everybody decided to have VHS video recorders instead. Even though the total number of households with video recorders increased each year and the number of films available on video also grew, the owners of Betamax video recorders did not have access to them because most new titles only came out in VHS format, which was much more popular. After a time, manufacturers only made the effort to improve the VHS versions of video recorders.

Another danger created by these effects is that a consolidated company with a considerable customer base may interrupt the normal operation of competition through strategic actions that make it difficult or impossible for the new products and services of its rivals to obtain a sufficient critical mass.

In software, as we will see shortly, the main anti-competitive strategy is to make the product of the company dominating the market incompatible with the products of its rivals.