10 Network effects and the digital economy

While companies in the digital economy clearly take advantage of property rights, their success is also explained by the nature of their service. For social media and software innovations, as for other communications technologies, success relies on user adoption. The number of users or consumers who take up the service or product affects its value to other users, creating network effects. To simplify the concept, think of an actual telephone network as in Figure 11. The importance for a user of having a telephone increases the more people it reaches – if it only allowed you to call a single number its value would decrease.

Figure 11: Network effects illustration

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Figure 11 contains three network diagrams illustrating different configurations of mobile phone connectivity. Each diagram uses icons of mobile phones connected by lines to represent communication links.

Diagram 1 (Left Side):

• Shows two mobile phones.
• A single line connects them, representing a direct one-to-one connection.

Diagram 2 (Middle):

• Displays five mobile phones arranged in a pentagonal shape.
• Each phone is connected to every other phone with lines so all devices can communicate directly with one another.

Diagram 3 (Right Side):

• Contains twelve mobile phones arranged in an approximately circular layout.
• Similar to the middle diagram, each phone is connected to every other phone.
• This is also a fully connected network, but with more devices and significantly more connections.

Figure 11: Network effects illustration

When thinking of information technology services and products, the best way to understand and analyse them is through networks. Companies in this industry rely on user interaction and usage to increase their value, for example, social media companies like Facebook. 

Facebook started as a page connecting students at Harvard University in 2004 increasing its number of users gradually firstly allowing other universities to join the platform, adding high schools and then increasing exponentially after it permitted everyone to sign up in 2007 (Hall, 2024). Currently, Facebook (now Meta) has become one of the biggest tech companies in the world with an annual revenue in 2024 of around USD 100 billion (Meta Platforms Inc, 2024). Direct network effects could explain Facebook’s success as a business; these effects occur when the value of using the service or product increases when more users adopt that specific service or product. Firms can also benefit from indirect network effects , which explain the increase in value of industries in the periphery of the main firm. For example, the increase of Facebook users allows the platform to create new apps inside them allowing other firms which create new apps to take advantage of its popularity.

Figure 12: Facebook’s Network effects example

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Figure 12 is a flowchart that illustrates how Facebook user growth, login frequency, and in-app entertainment are interconnected through network effects. It uses three rectangular boxes with icons and coloured arrows to show the relationships.

Boxes and Their Labels:

1. Left Box: ‘Facebook users increase’. Icon: Multiple user avatars connected in a network
2. Top Right Box: ‘Facebook users’ login increases’. Icon: A person with an arrow pointing to the right
3. Bottom Right Box: ‘Facebook in-app entertainment increases’. Icon: A game controller

There are three blue arrows:

• From ‘Facebook users increase’ back to itself 
• From ‘Facebook users’ login increases’ to ‘Facebook in-app entertainment increases’
• From ‘Facebook in-app entertainment increases’ back to ‘Facebook users increase’

There are two orange arrows:

• From ‘Facebook users’ increase’ to ‘Facebook users’ login increases’
• From ‘Facebook in-app entertainment increases’ back to ‘Facebook users’ increase’

Figure 12: Facebook’s Network effects example

Both direct and indirect network effects generate positive feedback, which relates to the increase in value as the number and activity of users increase. To illustrate the concept of positive feedback, think of a concert. The lead person is singing to the mic, producing a soundwave that is replicated through a speaker. But the mic is also picking up the sound made by the instruments and the speaker itself, increasing the soundwaves and volume produced. The same happens in relation to the competitive advantage of firms, making the strong stronger.

Positive feedback in networks can be the effect of three main processes: demand-side economies of scale, supply-side economies of scale and learning by doing.

Supply-side economies of scale occur when producing additional output is cheaper the more you produce. In the case of digital industries, the cost of adding more users is minimal even when their number grows very large, as the infrastructure is already there.

Demand-side economies of scale arise from the increase in benefit the more users the service or product has. For example users have gravitated towards Facebook, as a way to stay connected with childhood friends or family living far away, as many have already linked to it, and this saves them from having to log in to lots of smaller social networks.

Firms in the digital economy can accelerate their growth by using the data generated by users to increase their attractiveness. However, for firms to be able to realise this further effect they require learning by doing.

Learning by doing refers to the capability of firms to innovate taking advantage of the experience of their past activities. Think of an office worker who needs to fill out a report from a database every week. As the database is always the same, they decide to automate the report, so it fills itself. This is an example of learning by doing where the worker realises that there was an easier way to do their job, innovating and giving them time to know how to analyse the numbers and produce a way to improve the firm’s output.