What are Network Externalities?

The premise of network externalities is that the more individuals use the system, the more utility and value it can provide. In virtual communities, trust (and respect obtained) is an intangible asset that can contribute to the success of the business and provide utility to the members.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Network Externalities (wallstreetmojo.com)

Key Takeaways

  • Network externalities definition describes it as the increase in utility of a product for a user in a network as the number of users increases.The two main types are positive and negative network externalities. The outcomes of different situations determine whether they are positive or negative.Externalities are also similar to network effects. However, one cannot use these terms interchangeably as network effects correlate with positive externalities.The perceived size of a network’s user influences the network system’s perceived advantages, values, or utility.

Network Externalities Explained

Network externalities definition, according to Liebowitz and Margolis (1994), is a change in the advantage that one agent (consumer) obtains from a product when the number of other agents (consumers) who purchases the same kind of good increases. Essentially, the theory is concerned with the consumer’s trust in the extranet system’s network of connections.

When deciding which network to join, the number of users, the size, and the perception of who uses the network play a role. On can interpret it as the whole number or depending on the persons in the immediate surroundings of the potential user. The perceived advantages, values, or utility of a network system are influenced by the perceived size of the network’s user. In addition, consumers’ perceptions of the company’s size and reputation, i.e., network externalities, are likely to influence the trust factor. Trust, in essence, is a lower perceived risk of utilizing the system. This might be positive or negative, depending on the industry and product. 

Effects of network externalities

Market outcomes that affect parties other than the direct producers and consumers of a good or service are sometimes labeled as externalities. Externalities are unintentional consequences of economic activities in which those impacted, whether positively or negatively, were not directly involved in the decisions that resulted in those outcomes. For example, those who receive the impact of a dumpsite that pollutes the environment considers it as a negative externality. Or, house owners who boost the value of nearby properties by installing dustbins and maintaining a clean place are a positive externality for their neighbors.

These are side effects of a situation, and they are a type of market imperfection. It is because one does not take it into account when pricing economic transactions. In addition, economists do not include the costs and advantages to third parties in calculating individuals’ seeking to engage in these activities; one cannot conclude if there will be more or less of these activities.

How to solve the problem of network externalities

The solution to the problem of externalities is to find a mechanism to include them in decision-makers financial considerations. The goal is to account for the costs and benefits of actions in economic transactions (i.e., internalization). For example, consider polluter who dumps on cultivable land. They may stop polluting if they face financial penalties or if consumers shun their products. A homeowner may be more likely to install dustbins if their neighbors contribute to the cost of materials or keep their own homes in good condition. Markets can adapt to address such flaws, and internalizing an externality is only beneficial if the costs outweigh the benefits. As a result, it will be best if policymakers assess whether markets are already moving to internalize externalities, as producers or consumers would want to reduce their costs or increase their advantages.

Producers and consumers regularly take externalities into consideration, even if not always at the aggregate level, and market solutions will evolve frequently. However, actions that address network externalities rather than network effects may be counterproductive to policy goals or incur higher costs than gains. The network effect is similar to “network externality,” though the two phrases mean different things. Moreover, it leaves the prospect that an externality will be paid twice: initially by the people who are immediately impacted directly and then by a top-down subsidy plan through which they may be forced to participate.

Positive and Negative Network Externalities

The importance of network externalities is also due to the complementary nature of a network’s components. Therefore, depending on the nature of the network effect, externalities can be two types: positive and negative network externalities.

Positive network externalities:

When individuals, consumer base, or network expects the value of goods and services to be determined by who else utilizes them, it is known as positive network externalities. It exists when the benefits or marginal utilityMarginal UtilityA customer’s marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. It could be calculated by dividing the additional utility by the amount of additional units.read more increase as the number of other users increases. These externalities create a tangibly positive and desirable influence of the number of consumers on the quality of the goods. 

Negative network externality:

Negative network externalities emerge when the advantages decrease as the number of other users increases. Direct physical consequences are not a part of indirect network externalities. However, it also depends on the number of users, same as positive externalities except in a different way. The impact or influence as a consequence of an event’s occurrence is negative here. It results in an undesirable outcome.

Example

Given below are two network externalities examples:

Suppose a company, xyz launched a product, a tablet. The tablet comes with the latest technology and a cool feature that can transfer charge within a few seconds to another device of the same specification. People who are into gaming will have their devices charged frequently. When this feature comes, they can easily charge without missing out on the game. It’s design was to make people’s life easier and safer. This feature will increase the number of people who buy the phone. As new users come in, innovations to existing devices take place. This is an example of positive network externalities.

Similarly, if xyz stocks are listed on the securities exchange market and another company, its competitor, listed its shares bearing the news of high tax dividends given to their shareholders. Naturally, there will be a shift in investors happening. The share prices of xyz are most likely to fall as there is a high chance of investors selling their shares to invest in the other company that is more profitable in the current scenario. This is a negative externality.

This has been a guide to network externalities and its definition. Here we discuss how positive and negative network externalities works along with example.. You can learn more form the following articles – 

They are events where the utility of the product or services increases as the number of users who are part of the network increases.

Externalities occur as part of events. They are desirable or undesirable outcomes that exist as part of certain happenings. However, the type of externalities, whether negative or positive, depends on the situation.

Network externality can be classified as negative and positive. Whether they are good or bad is entirely dependent on the situation. For example, suppose there are more users for a product and the network grows; it is said to be positive and good.

They help in building a strong customer base. In addition, these users or individuals are experienced enough and have expertise through which they will suggest new ideas. The ideas can be creative and help further develop the existing process, products, and services.

  • SubsidyLaissez-FairePetrodollar