Indirect network effects

What Is Indirect Network Effects?

Indirect network effects describe a phenomenon where the value of a product or service for one group of users increases as another, distinct group of users grows. This concept is fundamental within the broader field of economics and business strategy, particularly in the context of platform business models and two-sided markets. Unlike direct network effects, where value derives from the sheer number of users on the same side of a network, indirect network effects arise from the interdependence between different user groups. For example, a video game console becomes more valuable to consumers as more games (a complementary good developed by a different group) become available for it, and vice-versa.

History and Origin

The concept of network effects, including indirect forms, gained prominence with the analysis of industries characterized by increasing returns to scale on the demand side. Early economic models began to formalize how the utility a user derives from a product could depend on the number of other users or the availability of complementary goods. A classic illustration of indirect network effects shaping market outcomes is the historic format war between Betamax and VHS in the home video market. Sony's Betamax format, introduced in 1975, was initially considered technologically superior to JVC's VHS. However, VHS gained a decisive advantage due to its ability to record longer and, crucially, the willingness of more manufacturers and, subsequently, film studios and rental stores to support it by producing a wider array of content⁷. This created a positive feedback loop: more content made VHS more attractive to consumers, which in turn incentivized more content creators and distributors to support VHS, ultimately leading to Betamax's decline. This demonstrated how the growth of one user group (content producers/distributors) significantly increased the value for another group (consumers), highlighting the power of indirect network effects in market dominance. According to Arun Sundararajan, a professor at NYU Stern, network effects were first studied in the context of long-distance telephony in the early 1970s, but they are now widely recognized as a critical aspect of information technology industries⁶.

Key Takeaways

Interdependent Value: Indirect network effects occur when the value of a product or service for one group of users increases as a different, interdependent group of users grows.
Platform Significance: These effects are particularly crucial for platform business models that connect multiple distinct user groups, such as buyers and sellers, or users and developers.
Complementary Growth: The growth often relies on the availability and adoption of complementary products or services that enhance the core offering.
Market Tipping Potential: Strong indirect network effects can lead to "winner-take-all" or "winner-take-most" market scenarios as a platform reaches critical mass and attracts further adoption.
Strategic Importance: Businesses must strategically manage and stimulate the growth of all interconnected user groups to harness the full potential of indirect network effects.

Interpreting Indirect Network Effects

Interpreting indirect network effects involves understanding the dynamics between different user segments within an ecosystem. It's not just about the absolute size of a platform's user base, but how the growth in one segment impacts the utility derived by others. For instance, in an app store, the value for app developers grows with the number of users downloading apps, and conversely, the value for users grows with the number and variety of apps available. A healthy indirect network effect indicates a thriving ecosystem where growth in one area stimulates growth in another, creating a virtuous cycle. Companies often analyze the relative growth rates of each side of their market to ensure a balanced expansion, as an imbalance can weaken the overall effect and lead to stagnation.

Hypothetical Example

Consider a hypothetical online marketplace for handcrafted goods, "ArtisanConnect." Initially, ArtisanConnect has a small number of sellers and even fewer buyers.

Low Value: Buyers find few unique items, and sellers struggle to make sales, limiting the platform's value proposition.
Incentivizing One Side: To stimulate indirect network effects, ArtisanConnect offers free listing fees for new sellers for their first three months. This attracts more artisans to list their products.
Increased Buyer Value: As the number of unique products grows, the platform becomes more appealing to buyers. More buyers join to find a wider selection of handcrafted items.
Increased Seller Value: The growing number of buyers leads to more sales for existing artisans, validating their decision to join and encouraging them to list more items.
Virtuous Cycle: New artisans are then attracted by the larger buyer pool, and new buyers are drawn by the even wider product selection, creating a strong indirect network effect. This strengthens ArtisanConnect's market share.

Practical Applications

Indirect network effects are observed across numerous industries, playing a pivotal role in the success and competitive landscape of many businesses.

Software and Hardware: The value of an operating system (e.g., Windows, iOS) is heavily influenced by the availability of compatible software applications. More applications attract more users to the OS, which in turn encourages more developers to create apps for that OS.
Video Game Consoles: The appeal of a gaming console (e.g., PlayStation, Xbox) is directly tied to the library of games available. A large, diverse game library attracts more players, which incentivizes game developers to produce more titles for that console, generating substantial revenue for the companies⁵.
Online Marketplaces: Platforms like eBay or Etsy thrive on indirect network effects. More sellers attract more buyers by offering greater product variety, and more buyers attract more sellers by providing a larger customer base and sales opportunities.
Ride-Sharing and Food Delivery Apps: The utility of a ride-sharing app for riders increases with the number of available drivers, leading to shorter wait times. Conversely, more riders on the platform attract more drivers due to increased earning potential⁴.
Credit Cards: The value of a credit card network for consumers depends on the number of merchants that accept it. More merchants accepting a card makes it more useful for consumers, and a larger consumer base using the card incentivizes more merchants to accept it. This highlights how companies strategically manage these relationships to maximize their competitive advantage.

Limitations and Criticisms

While powerful, indirect network effects are not without limitations or criticisms. The "winner-take-all" scenario often associated with strong network effects can be oversimplified. Market dominance is not guaranteed indefinitely, and several factors can disrupt the positive feedback loop that indirect network effects create.

One key limitation is the concept of "multi-homing," where users simultaneously engage with multiple platforms or services. For example, a user might have both an iPhone and an Android phone, or use multiple social media platforms. When multi-homing is easy due to low switching costs, the strength of network effects in locking in users can be significantly reduced², ³. This means that even a platform with a large user base might face intense competition if users can easily move between alternatives or use several at once.

Furthermore, negative network effects can emerge if growth leads to congestion, reduced quality, or an undesirable user experience. For instance, too many sellers on a marketplace could lead to fierce price competition, diminishing returns for individual sellers, or a glut of low-quality products. Similarly, an overabundance of content creators on a video platform might make it harder for individual creators to gain visibility, potentially leading some to abandon the platform. Research from MIT Sloan suggests that while network effects are important for multi-sided platforms, the simple winner-take-all notion is often disproven by real-world examples, and that the argument for permanent monopoly power based solely on network effects may be overstated¹. The focus on the sheer size of a network can sometimes overlook the quality of interactions or the actual value derived, especially as markets evolve and user behaviors change.

Indirect Network Effects vs. Direct Network Effects

The distinction between indirect and direct network effects lies in the nature of the interdependence between users.

Direct Network Effects occur when the value of a product or service increases for users directly as more users adopt the same product or service. The utility grows with the size of the network on the same side. Classic examples include telephones, email, or social media platforms where each new user directly increases the potential connections and interactions for every existing user. The value is derived from the expansion of the immediate network of peers.

Indirect Network Effects, by contrast, arise when the value for one group of users increases due to the growth of a different, interdependent group of users. This is characteristic of two-sided markets or platform business models. The growth of one side (e.g., software developers) makes the platform more attractive to the other side (e.g., users of the software), which in turn makes the platform more attractive to the first side. The connection is mediated through a complementary good or service. The confusion between the two often stems from the shared characteristic of "value increasing with more users," but the critical difference is whether those "more users" are on the same side or a different side of the market.

FAQs

How do indirect network effects influence a company's competitive landscape?

Indirect network effects can create significant barriers to entry and enhance a company's competitive advantage. Once a platform achieves a substantial user base on both sides of its market, it becomes very difficult for new entrants to compete, as they lack the established network that provides value. This can lead to market concentration or "tipping" towards a dominant player.

Can indirect network effects be negative?

Yes, indirect network effects can have negative aspects, sometimes referred to as "negative externalities." For example, if a platform becomes overcrowded with too many users or providers, it can lead to congestion, lower service quality, or excessive competition among providers, diminishing the value for some users. Ensuring scalability and managing the user experience are crucial to mitigate these potential drawbacks.

Are indirect network effects relevant only to technology companies?

While indirect network effects are highly prevalent and pronounced in technology-driven industries like software, e-commerce, and digital platforms, they are not exclusive to them. They can be observed in traditional industries that involve interdependent groups, such as real estate (more buyers attract more sellers, and vice versa) or even in media, where the size of an audience attracts advertisers, and a variety of advertisers supports the content consumed by the audience.

How do companies foster indirect network effects?

Companies foster indirect network effects by strategically attracting and retaining both sides of their interdependent market. This often involves subsidies, pricing strategies (e.g., making one side free or very cheap), targeted marketing, and developing strong interoperability or integration to make it easier for both groups to interact and derive value. The goal is to reach a critical mass where the network becomes self-sustaining.