A Network Effect exists when the value of a good or service increases as more people use the good/service.
One of the first network effects existed in the Telephone industry. Imagine you are the only person in the world to own a telephone. How valuable is it to you? The answer is that the phone has no value at all. Nothing. Zero. Zip. Why? Because no-one else owns a phone, so there is nobody for you to call.
As more people purchase phones, your phone becomes more valuable to you. If the number of other people in the network grows from 1 to 2, your phone is now twice as useful to you because you can call double the number of people.
Network Effects are particularly important in Online Marketplaces. Examples of these marketplaces are Uber, AirBNB, Amazon, and Google. For Uber to be successful, it needs to have both drivers and passengers. The same applies to AirBNB, Amazon and Google.
Once a business achieves a Network Effect, it becomes increasingly difficult for competitors to achieve scale. A passenger is more likely to use Uber than the new entrant, because Uber has more drivers. A driver is more likely to use Uber than a new entrant, because that’s where all the passengers are. The stronger the network effect, the harder it is for a new entrant to compete.
Our “Ultimate Guide to Pricing in Marketplaces” discusses Marketplaces and Network Effects in more detail, and in particular how Dynamic Pricing can help Marketplaces achieve Network Effects.