Externalities and network effects (examples, laws and interpretations)

Part 1: Some Interesting Facts, Laws and Observations
Part 2: Externalities and Network Effects

Externalities and Network Effects
(Examples, Laws and Interpretations)

Sumant Kulkarni

International Institute of Information Technology, Bangalore

Sumant Kulkarni Externalities and Network Effects 1/54

Part 1: Some Interesting Facts, Laws and Observations Interesting Facts
Part 2: Externalities and Network Eﬀects Some Interesting Laws

Part 1: Some Interesting Facts, Laws and
Observations



Agenda: Part 1

Some Interesting Facts
The Observation.
Some Interesting Laws.
Some Interesting Arguments.
My Observations on Laws.



Market growth of Maruti Cars

Started in 1981.
Buying a car adds a new car to the group of Maruti cars.
More service stations will be started due to more cars.
Buying a new car with value X ⇒ Having a car with
value X + Better and cheaper service availability
Maruti is the only company in India, which has sold more than
10 million cars.1 In March 2011, Maruti had 45% Indian car
market share2 !!!
1
http://en.wikipedia.org/wiki/Maruti_Suzuki
2
http://articles.economictimes.indiatimes.com/2011-04-10/news/
29403269_1_market-share-car-segment-passenger-car


More vehicles on the Road

When the ﬁrst vehicle comes on the road, there will be full
space for that vehicle.
No need to overtake, give way etc.,
As the number of vehicles increases, they will also start
occupying the space on the road.
The problem of overtaking, giving way to others etc., starts.
At some point, this starts looking like a congestion where,
there is no incentive to drive a vehicle on the road!!!
Adding New Vehicle worth X to the City Traﬃc ⇒
Having Comfort worth X + More Pain to Travel + More
Expensive Travel


Migration of People to USA

When ﬁrst group of people moved to America, there had to
face lot of problems.
As more people moved to USA, they also better life as well as
the social life in USA improved.
New Person Moving to USA ⇒ New Person Having Met
His Expectations + Adding More social Life to USA +
Adding More to Technology



Building Roads

Batter Roads (e.g. National Highways like NH4)
More number of people travelling in a route pressurized
government to make that route betters.
Due to better road and more people using (safety at night) it
attracted more people to use it.
Using Better Roads by paying toll X⇒ Travelling in
Better Road worth X + More Night-time Travel Safety
+ Better Restaurants
Today, you can reach Hubli from Bangalore in 6 hrs in Car without
crossing the speed limit!!! There are no reports of robbery in the
night as well.



Social Networking

Initially few people join.
Every person joining the SN gets more people to interact with
and hence gains in terms of contacts and knowledge.
Every person joining the SN adds one more person to the SN
to interact with. This intern allows already using people to
get more knowledge.
New Persons Spending Time Worth X to Join Social
Network ⇒ More People worth X to Interact With +
More Knowledge



Mobile Network

More users prompted more number of towers in the areas.
More towers increased the quality of service.
Also, more users offered low tariff.
Better QoS and Tariff attracted more users.
Spending value worth X to buy a Mobile connection ⇒
More People to Interact With (worth value X) + Low
tariff + Critical Communication Possibility



356CW

Initially by the end of 2011, they started around one bus/hour.
People started liking it.
More number of people using the bus prompted to run more
buses.
This might be helpful to reduce some amount of traﬃc.
New Person using 356CW ⇒ Less Money Spent on
Travel for him + Lesser Congestion
Today, in prime time, there is a bus every 5 min!!!



Many more ...

People forming villages.
People buying more Nokia phone in early 2000s.
People buying Hero Honda vehicles in mid 90s.
Internet.
Arrival of IT Companies in Bangalore.
Plantations.
Electricity Consumption.
Mobile Network Congestion.
........



What Did We Observe?

Joining the group of Product/Service users ⇒ Having the
the Product/Service + Change in the Welfare of the
System/Third Party (and hence in own welfare).



Some Laws Trying Explain the Above Observations.



Metcalfe’s Law -1980

First proposed by Metcalfe in the context of Ethernet 3

devices (not in terms of users).
He hypothesized that the network the cost of adding new
elements increases linearly with each elements. But, the value
of the network increases in proportion to the square of
elements.
The reason for high values is the number of connection
possible in the network with n nodes is n(n-1) = O(n2 )

3
Metcalfe’s Law, Web 2.0, and the Semantic Web


Metcalfe’s Law - 1993

George Gilder, a writer and techno-utopian intellectual,
formulated Metcalfe’s Law for all networks (in 1993).
Highly important and accurate in small networks like LAN.
There are question about its accuracy to bigger networks.
The mathematical model only takes care of number of
possible connections. But, it does not take care of the
possibility of those many connections.
As number of users increase, it becomes diﬃcult to believe
that the law holds good.
It is an approximation law(like Moors Law). Hence, does not
have any hard bindings!


Reed’s 3rd Law

David P. Reed proposed 3 laws4 to comment on “how the
information architecture of our world interacts with the people who
inhabit (live in) it”.
3rd Law (a scaling law for network value): “As networks
grow, value shifts: Content (whose value is proportional
to size) yields to Transactions (whose value is
proportional to the square of size), and eventually
Aﬃliation (whose value is exponential in size)”
Content ⇒ Number of participants in the network.
Aﬃliation ⇒ a social or business relationship.
4
http://www.reed.com/dpr/locus/dprpapers.html


Reed’s 3rd Law

The Reed’s (3rd ) law5 gives the following insight:
The value of network is much higher than the one proposed
by Metcalfe.
If there are n user in a network, then the value of the network
is 2n − n − 1 (O(2n ))
2n is due to the number of elements in the power set of the
set having n elements.
Power set represents the diﬀerent Group-Forming-Networks
(GFN).

5
http://spurspectives.com/why-reed%E2%80%
99s-law-powers-social-networks/


Reed’s 3rd Law

According to Reed, the value of a network is equal to the
number of group-forming-networks (GFN) it can form from
the available set of nodes/users.
“Even Metcalfes Law understates the value created by a
group-forming-network as it grows. Lets say you have a GFN
with n members. If you add up all the potential two-person
groups, three-person groups, and so on that those members
could form, the number of possible groups equals 2n. So the
value of a GFN increases exponentially, in proportion to 2n . I
call that Reeds Law. And its implications are profound.”6

6
David. P. Reed,The Law of the Pack


Reed’s other Laws (Optional)

Reed proposed 3 laws7 to comment on “how the information
architecture of our world interacts with the people who inhabit it”.
1st Law (on Long-term Data Storage): “If you want to keep
information for a long time, never separate the head
from the recording.”
With removable storage, ha a drive to read the data from it.
Example: Floppy and Floppy Drive
2nd Law (on communications): “Communications media
exist to conﬁrm the prejudices of their audience.”
Most of the information given out on the media is already
know!!! They repeat it to satisfy the prejudices of people.

7
http://www.reed.com/dpr/locus/dprpapers.html


Sarnoﬀ’s Law

“The value of a broadcast network is proportional to the the
number of views”.
Talks only about the broadcast networks, where only one way
channel exists.
We see that the value attributed to the network is linearly
proportional to the number of participants.



Beckstrom’s Law - 2009

“The value of a network equals the net value added to each
users transactions conducted through that network, summed
over all users”8 .
Rod Beckstrom
Talks about value only in terms of transactions of the users in
the network.
The value of the transaction decays over time. Hence newer
transactions add more value.
The number of users/nodes in the network do not have any
impact on the value of the network unless they participate in
transaction.
8
http://en.wikipedia.org/wiki/Beckstrom%27s_law


Questioning Matcalfe’s and Reed’s Laws (Dunbar’s
Number)

Both Matcalfe’s law and Reed’s Law have been criticized9 by many
computer scientists for their ignorance of limitations.
Dunbar’s Number is used to highlight the limitations of the
laws.
The research on Dunbar’s Number argues that
There is a cognitive limitation to the number of stable social
connection a person can have.
The limit on the number of stable social connection is a direct
function of relative neocortex size of the human being.
9
http://en.wikipedia.org/wiki/Reed’s_law,
http://en.wikipedia.org/wiki/Dunbar%27s_Number


Questioning Matcalfe’s and Reed’s Laws (Dunbar’s
Number) Cont..

The research on Dunbar’s Number more insights like
What happens if all the people in network are full in terms of
Dunbar’s Number?
There can be a clique of maximum size N with stable social
connection as the edge between people. In such a condition, N
is the smallest Dunbar’s Number in the group.
Matcalfe’s law and Reed’s law overstate the network value by
ignoring the cognitive inability of people to form networks of
larger size than Dunbar’s Number.
Hence Matcalfe’s law and Reed’s law are not scalable
beyond some point.



Questioning Matcalfe’s and Reed’s Laws (Cont..)

Bob Briscoe, Andrew Odlyzko, Benjamin Tilly10 argued that the
quantiﬁcation of value of a network by Matcalfe’s law and Reed’s
law is wrong.
Quadratic value growth is unrealistic. Exponential is even
more unrealistic.
Similar to Moore’s Law the Metcalfe’s law is also not
immutable.

10
http:
//spectrum.ieee.org/computing/networks/metcalfes-law-is-wrong


Questioning Matcalfe’s and Reed’s Laws (Cont..)

They hypothesized that the connections distribution in a
network is a Zipf’s law11 .
The number of connections are inversely proportional to the
rank (simplest form of Zipf’s law).
1 1 1 1
Connections distribution looks like 1 + 2 + 3 + 4 + ... + n−1
which approaches log (n).
As there are n users in the network, the value of the network
is n·log(n).

11
Benford’s Law and Zipf’s Law -
http://www.cut-the-knot.org/do_you_know/zipfLaw.shtml, INFINITE
SERIES - www.math.uconn.edu/~kconrad/blurbs/analysis/series.pdf


What Can We Derive From This?

We can not simply reject these laws as they talk about very
basic nature of the networks.
Metcalfe’s law - Small LAN
Sarnoff’s Law - Broadcast TVs, Radios etc.,
These laws are very very loosely (vaguely) defined. Hence, it
is very difficult to accept them as they are.
Though intuitions are clear, no real proof that the laws work
like they are stated.



What Can We Derive From This? - Beckstorm’s Law

Beckstrom’s Law looks to be more realistic law.
It realistically assumes that value of a network is the total
value of the transactions between the users.
It can also give negative value as it deducts the cost of the
transaction from the beneﬁt of the transaction to give the
value.
The value generated rightly decays over time.
But, it ignores the kind of transaction on the network.
There can be value add to the system just by being a part of
a network. The law ignores this factor.




Each of these laws is deﬁned based on one or few of the
properties (facets) of a network. I do not see any law covering
all the properties of the network.
Matcalfe’s Law and Reed’s Law ignore the probability of the
connection.
Sarnoﬀ’s Law ignore the kind of programs for which there are
audience. There will not be uniform value addition for all kinds
of programs.




These laws do not look into the kind of network. Many
networks might be homogeneous, but still will have properties
related to their kind. Many other times, the network itself
may be highly heterogeneous (like Internet), which makes the
problem of identifying properties more complex.



My Observations/Hypothesis - Saturation of Network
Effect in Finite Resource Environments

Figure: In a finite resource network having network effect, initially the
welfare of the users increase. But, after all the resources are efficiently
used by the incoming users, more users will reduce the welfare of the
users.


My Observations/Hypothesis - Saturation in the Increase
in Welfare of Individual Users

Figure: In a network, initially the welfare of the individual users increases.
But, after the number of connection of the individual user reaches the
Dunbar’s Number, it saturates.

Externality
Network Externalities
Network Eﬀects

Externalities and Network Eﬀects.


Externality
Network Effects

Agenda

Externality.
Network Externalities.
Types of Network Externalities.
Network Effects.
Compensated Effect.


Externality
Network Effects

Externality

Two parties do business willingly only if there is a profit for
both of them12 .
Business may be the exchange of financial value (like renting
house) or social welfare (like marriage).
Externality either puts some cost or provide some benefit to
the people not involved in the business.
For example:
Renting out a house to a night club in the residential complex
(assume that it is legal).
Renting out a house to a very influential politician with
mindset of helping people.
12
Kelvin Hartnall, Externalities and Network Effects

Externality
Network Effects


We are part of many networks. For example,
Network of same company car users.
Network of same telephone service.
Network of people using same social network.
Network Externality is a phenomenon in which entry of new
user into the network, has either benefit or cost to the
other user of the network.
If the entry costs something to other users, then it is
Negative Externality.
If the other users are benefited, it is Positive Externality.


Externality
Network Eﬀects


In the networks showing network externality, the users have
two separate sub part in the value he receives by being a part
of the network13 .
1 Autarky value: The value from the product/service he is
using (consumer has paid for it). User gets this even if there is
no other person using the same product/service.
2 synchronization value: The value from the network as the
result of joining it (complementary but not optional).
The latter part of the value decides whether it is Positive
Externality or Negative Externality.

13
Network Externalities (Eﬀects) by S. J. Liebowitz and Stephen E. Margolis

Externality
Network Effects

Negative Externalities

If the entry of a new user into the network costs something to
other users of the network, then it is Negative Externality.
A classic example is the traffic congestion.
The negative externalities can often be seen in the later stage
of networks, where resources are finite.
What other reasons can be there for a network to have
negative externality?
Can their be a network which is having negative externality
from the first user of the network?
Is negative externality a manifestation of the indication of
resource crunch?

Externality
Network Effects

Positive Externalities

If the other users are benefited by the entry of a new user into
the network, then it is Positive Externality.
In positive externality, “The value of the service or product
will increase as its installed base expands14 ”.
Positive externality is many times known as Network Effect.
Though many networks have Network Effect initially, once
they start facing resource crunch and once they scale above a
level, they might start showing negative externality.

14
Network Effects and the Impact of Free Goods: An Analysis of the Web
Server Market

Externality
Network Effects

Subtle differences between Network Effect and Externality

Network Effect may not be Positive Externality always15 .
Network Effect becomes positive externality only when other
members of the network reap some benefit out of a new
member joining.
In other terms, old members should internalize the benefit of
new member joining.
If the benefit is reaped by only a centralized entity like owner
of the network, then it is not externality. But, it is Network
Effect.

15

Externality
Network Effects

Types of Network Effects

Direct network effects
Indirect network effects
Two sided Network Effects
Local Network Effect


Externality
Network Effects

Direct network effects

Increase in size of network directly increases the value16 .
Indirectly, increase in usage of network directly increases the
value.
They are most influential Network Effects as the addition of
the value is evident.
In terms of economics, they can also be defined as the value
generated through a direct physical effect of the number
of purchasers on the value of a product.
Examples:
Fax and Telephone Connections.
Social Networks17 and Email.
16
http://oz.stern.nyu.edu/io/network.html, Network Externalities
(Effects) by S. J. Liebowitz and Stephen E. Margolis
17
http://en.wikipedia.org/wiki/Network_effect

Externality
Network Effects


Increase in size of the network increases the value of another
complementary network18 .
Increase in the value of complementary network, in turn
increases the value of the original network.
There is a indirect increase in the value of the network.
This is also called market mediated effects.
Both the network is usually formed due to same good/service.

18
http://en.wikipedia.org/wiki/Network_effect, Network
Externalities (Effects) by S. J. Liebowitz and Stephen E. Margolis

Externality
Network Eﬀects


Examples:
DVD ⇔ DVD Player.
Program ⇔ Channel.
Player ⇔ Sports.
Jobs ⇔ Schools


Externality
Network Eﬀects

Two-sided Network Eﬀects

Increase in size of one network increases the value of another
network19 .
These two networks need not be not formed due to a single
Good/Service.
But, they have found a common platform in which both
networks can gain.
There is a indirect increase in the value of both the networks.

19
http://en.wikipedia.org/wiki/Network_effect,
http://oz.stern.nyu.edu/io/network.html

Externality
Network Eﬀects

Two-sided Network Eﬀects

Examples:
Hardware ⇔ Software.
Reader Software ⇔ Writer Software.
New Technology ⇔ New Social Needs
Credit Card Holder ⇔ Merchant
Students ⇔ University


Externality
Network Effects

Local Network Effects

Members of the network may not always be benefited by the
addition of more members globally.
They might get benefited only by the connected members.
Here, members get benefits if one more member gets added
to their local connection.
Example:
Gtalk (or any other messengers).
Chain marketing (like Amway).
Students registered from same course (get benefited only when
they are in same institute/university).
People travelling to same destination (localized by the medium
they use).
People joining Facebook.

Externality
Network Effects

Importance of Compatibility between Networks

Compatibility increases the benefit from network effect.
If multiple networks are compatible, then they will be able to
deliver better network effect.
Examples: Email, Telephone, Mobile
We observe some value missing out in Social Network due to
their incompatibilities


Externality
Network Effects

Importance of Shared Standards between Networks

There is always a trade off between openness of the
technology and core proprietary technology.
Development of open standards help to build better Network
Effect.
But, that will also make firms to loose on their monopoly.
Open standards will help in building bigger stable markets
compared to the many small markets built by proprietary
technologies.
How much of the technology standers should be open for a
firm to exist as well as to make maximum of of network
effects??

Externality
Network Eﬀects

Compensated Eﬀects

Diet Coke example
Is it really compensated?
Who compensates for the resources used?
Who compensated for the trust built in Coke due to the
number of consumers?
Is there something which can be absolutely compensated?


Externality
Network Eﬀects

Advantages of Network Eﬀects

Can be used to promote a product.
Can make a market sustainable for a product/service.
Encourages a community to grow and stay together.
....


Externality
Network Eﬀects

Disadvantages of Network Eﬀects

Believed to be endemic to new, high-tech industries20 .
Markets may adopt an inferior product or network.
Barrier to Enter the Market.

20

Externality
Network Eﬀects

End Of Part 2

Any Questions?


Externality
Network Effects

References

Network, Crowds and Markets - book
Network Effects, http://www.moreno.marzolla.name/
teaching/CS2011/NetworkEffects.pdf
The Economy with Network Effects,
http://www.systems.ethz.ch/education/fs11/
struct-social-inf-networks/lectures/Lecture%209.
pdf
Reverse Network Effect,
http://www.readwriteweb.com/archives/is_there_a_
reverse_network_effect_with_scale.php


Externality
Network Effects

Network effects: related pages
Barriers to entry - Anything that makes it difficult for a new entrant to
break into a market.
First mover advantage - The competitive advantage that the first
company to launch a new type of product should have over those that
start later.
Natural monopoly - A monopoly that arises from the nature of the
industry, rather than being imposed by law or resulting from
anti-competitive practices.
Product differentiation - Making a product or service look different in the
eyes of consumers.
Submarine patent - A patent that is deliberately kept quite, in the hope
of extracting money later from those who use an idea believing it not to
be patented.
Cross licensing - Exchange rights to patent portfolios, which reduces
litigation and R & D costs, while simultaneouslyand Network Effects 54/54 entry.
Sumant Kulkarni Externalities erecting barriers to

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