What Is a Network Effect?
The network effect occurs when the value of a product increases as more people use it. What do you remember about Orkut? That was shut down for the simple reason that customers were not using it anymore. Do you know why? The reason is that a lot of people were not using it anymore. It's true that there are other factors affecting the situation, but since it had so few users, its value as a service was minimal.
When it comes to cryptocurrencies, it is extremely important to think about network effects. Ultimately, blockchains and money organize people, which means the more people who use a network, the more utility it can provide as a service to that network.
Introduction
What factors are most likely to determine which cryptocurrency projects become market leaders in certain sectors? The market has a tendency to gravitate towards the best solutions in the long run, so we might assume that market forces will tend towards them. However, things are not that simple. Several factors are in play. It's possible that some innovative technologies are shipped from developers, but if they don't have a good market fit at the time of shipping, they may not get any traction.
Sometimes, projects that are not technologically superior are able to capture a majority of market share simply because they were available at the right time. Here, network effects come into play.
What is a network effect?
A network effect can be defined as an economic effect that describes how an additional user adds value to a product or service. The network effect occurs when each user entering the network adds value to the product by adding to the network. In turn, this naturally attracts new users to the network, creating more value, and so on, and so forth.
As one of the classic examples of a network effect, the telephone is a great example. There were very few people living in the early days of the technology who had a telephone in their homes. Additionally, the network had to be physically connected to each of the houses in order to be used.
In order to boost the value of the entire telephone network, as technology matured, people could afford more and more telephones, increasing the value of the whole telephone network. A net gain in value and utility has been observed over time as the number of users increased. In this way, there was a positive feedback loop, whereby the greater the number of members, the greater the added value to the entire network. This led to exponential growth of the whole system.
Types of network effects
Network effects fall into two categories: direct and indirect effects. This is the type of effect we just discussed with the telephone. More users add value to everyone.
However, indirect network effects are harder to define. As a result of the network effect in the first place, there are additional, complementary benefits implied by the term. For instance, there are many cryptocurrencies that are open-source.
Since so much value is at stake (including theirs), a project with a strong network effect may bring together a number of talented developers to examine the code. In the first place, the network has so much value that there is an added value. As a result of this compounding effect, we get to a point where there are some dominant leaders who are building up significant network effects in comparison to their competitors.
Network effect examples
A number of different product categories are demonstrating examples of network effects in the present day. The first one that comes to mind is social media, where users tend to join services that are already actively used by their preexisting social networks. People are thus encouraged to join platforms that provide the same benefits, while a few services enter a monopolistic position.
It will be difficult for new companies to build a new social networking platform that gains critical mass. But why? The market leaders have been able to build up network effects that have given them a competitive advantage.
Ridesharing is another example of a system that exhibits network effects. Unlike Uber and Lyft, newer services with a smaller user base will find it hard to compete with the network effects that these services have built up over the years.
Ebay, Amazon and Google are all doing this with their online sales, Google with their search engine, AirBNB with their rental services, Microsoft with their enterprise operating systems, and Apple with their iPhone. In spite of this, can only businesses with clearly defined business models achieve the so-called network effect? Unfortunately, no. There are many open-source projects that have built up a significant network effect, but Wikipedia is an example of a successful open-source project.
Network effects and cryptocurrencies
When it comes to cryptocurrency and blockchain, network effects are a critical consideration. A good example is Bitcoin. As well as having some highly desirable properties, bitcoins also possess a strong network effect.
The mining industry supports network security and has a large amount of liquidity to sustain its operations. As an example, let us assume that another network is launched that serves a similar use case to Bitcoin in the future. Despite being rewarded higher, the miners may not have the same liquidity to exit their positions. Taking a gamble, they may be able to hope that the liquidity of the market will improve in the future. There is also the option of just continuing to mine bitcoins with a relative certainty that they will remain in business. this is how network effects work. Although the alternative may be technologically superior, or may offer more rewarding opportunities, it would not necessarily be a good idea to switch.
Furthermore, this is not entirely due to Bitcoin's network effects. Since Bitcoin was launched fair. it had properties that can be very difficult to replicate. Due to this, Bitcoin has inherently unique properties. Let us look at the example with a different perspective. Additionally, it is important to consider network effects to be a significant aspect of the Decentralized Finance (DeFi) space as well.
Similarly, if a product, service, or smart contract establishes a significant advantage, it may be challenging to overcome it for other projects. DeFi is still in the early stages of development. Many would argue that no single product has been able to achieve a network effect that could qualify them as a decisive winner.
Negative network effects
The converse is true when it comes to negative network effects. This means that with each new user, the network does not add value to the network, rather it subtracts. In terms of the design of blockchains, this is likewise a very important point to consider. An efficient design should ensure that every new user is adding value to the network. As a result, the network will be scalable. This will lead to network congestion if every user subtracts value from the network.
In the case of Ethereum gas, an auction system is employed. each user is responsible for bidding on gas fees that are paid to miners to mine Ethereum. When gas prices increase due to the addition of more users and increased usage, gas fees tended to increase as well. What's the reason? Because each user attempts to outcompete the other by increasing their bids. But it can't last forever. The excessive gas fees have caused some users to stop using the network altogether, as their activity does not seem to be worthwhile with such high fuel costs. The negative network effect can be seen in this situation.
However, there is a remedy in place to address this issue. An Ethereum proposal, EIP-1559, is an addition to the Ethereum gas system that provides a revamp of the current system. Also, a set of upgrades in ETH 2.0 can also dramatically enhance how much throughput the Ethereum network will be able to handle. There is a possibility that this would address the issue of high gas charges during periods of increased activity.