Cryptonomics: Network Effect Explained

The greater the number of users of a particular product, the more value it tends to attain. This is due to the “Network Effect” concept, which heavily affects the value of projects in cryptocurrency.

By
Utulu Hope
on
April 20, 2021
Category:
Cryptonomics

Introduction

Across the modern financial landscape,  the adoption of cryptocurrency is rising rapidly. With over 4000 cryptocurrencies available at this time, there is always a fight for value supremacy amongst tokens. 

To make their projects sought-after by investors, developers go the extra mile to incorporate innovative features/utility. That alone may not impact the sale or adoption of their cryptocurrencies, as there are a host of other factors present in determining a project’s success.

Despite common conception, it is the less-developed cryptocurrencies that quickly gain traction. With unique characteristics that are still in a developing stage, they take the market by storm. They incur the interest of cryptocurrency enthusiasts in the process, and subsequently, their value increases. How does this happen? One potential answer to this question is the network effect. Let’s dive into how this phenomenon affects the entire market.

What is Network Effect? 

A network effect refers to how the number of individuals using a particular product affects its value. As the number of users of a specific product increases, the value tends to increase as well. The network effect is also referred to as network externality.

Whenever a new user adopts a given product, product value/utility tends to increase. User adoption will increase the product’s value for pre-existing users and draw other investors to the project. The process by which users’ addition to a product increases its value is referred to as the “total effect.” The addition of new users that causes non-investors to have an interest in the product is known as the “marginal effect.”

One of the largest and best explanations of a network effect is the stock exchange. Network effects can be seen in the volatility of the stock market. Prices of stocks are heavily dependent on the demand of users. When users don’t show interest in a given stock, the price drops, attracting many investors in the process as it is traditional to buy during a price dip. Upon investment, the number of users increases because the price steadily increases. However, a decline is seen when people begin to sell off stocks due to the increased price. As such, stock prices eventually drop yet again, forming a cycle of value movement. The network effect is observed when the activity of investors causes people to profit from the price increase.

Economic Importance of Network Effect

As the number of users of a given product increases, market sales are affected positively. If the price of goods and services are lower than the value they bring, the number of consumers will increase rapidly. A network effect is generally perfect for the economy.

There are several ways businesses can leverage network effects to attract several users. Common tactics are rebates or discounts, free trials, etc. The adoption of airdrops is a common way of attracting users in the crypto market.

The Problem of Network Effect

The network effect may be problematic when the addition of new users causes the reduction of value, which is often seen in blockchain technology. It is expected that a good network should attract investors. However, when investors are attracted, instead of the network’s value increasing, it declines surprisingly.

Ethereum’s gas fees are a typical example. It was designed for users to bid on transaction throughput. This bid is used as payment to miners of Ethereum for verifying transactions. The addition of users into the Ethereum network led to an increase in gas fees. This is because users of the network tend to outbid themselves. As the gas fees increased due to bidders’ activities, many users are inclined to leave the network due to the high cost of transactions.

This illustration is one of the cons of the network effect: an increase in users of a given product could end up leading to a decline in its value.


Types of Network Effects

  • Direct Network Effect: We see this type of network effect when an additional user affects pre-existing users. This means that existing users directly profit from the accumulation of new users.
  • Indirect Network Effect: Also known as the cross-side effect. It is a type of network effect by which new users’ addition to a particular product is not influenced by the product’s innovations but by an external body. Users do not use the product because of what they want to gain, instead because of a complementary product that brought about awareness. An example could be: new users adopted the internet because of the availability of cheaper means of accessing the Internet.
  • Bilateral Network Effect: This type of network effect is observed when the increase in a complementary product triggers an increase in the product. Again, the Internet is a good example - for instance, the number of Internet users increased due to an increase in the number of smartphones produced or purchased. The smartphone is a complementary product whose growth influences the actual development, which is the Internet.
  • Local Network Effect: This occurs when new members’ addition is beneficial to some pre-existing users rather than the entire network of users.

Conclusion

Network effects are a beneficial concept that many organizations leverage for rapid growth. A network ensures that its products or services are sold effectively. Networks may have some side effects like congestion, as seen in the Ethereum network or even on the Internet. Many users can lead to a slower network. The network effect is generally a positive phenomenon. The impact of the network effect is readily seen in many sectors of technology and finance. Its impact is well established in crypto markets and can be a strong determinant in how well a cryptocurrency is adopted.

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Utulu Hope

UC Hope is a passionate fan of crypto who could weave the latest event into sparks of inspiration and information. He leaves no stone unturned to get to the core of a story. Aside from writing, he spends his hours poring over algorithms and protocols, preparing for a future career as a computer programmer.