externalities and network effects (examples, laws and interpretations)

Part 1: Some Interesting Facts, Laws and ObservationsPart 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


Interesting FactsSome 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.1In March 2011, Maruti had 45% Indian car

market share2!!!

1http://en.wikipedia.org/wiki/Maruti_Suzuki2http://articles.economictimes.indiatimes.com/2011-04-10/news/

29403269_1_market-share-car-segment-passenger-car


http://en.wikipedia.org/wiki/Maruti_Suzuki

http://articles.economictimes.indiatimes.com/2011-04-10/news/29403269_1_market-share-car-segment-passenger-car

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 withoutcrossing the speed limit!!! There are no reports of robbery in thenight 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 thethe Product/Service + Change in the Welfare of theSystem/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)

3Metcalfe’s Law, Web 2.0, and the Semantic WebSumant Kulkarni Externalities and Network Effects 14/54



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.

4http://www.reed.com/dpr/locus/dprpapers.html


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).

5http://spurspectives.com/why-reed%E2%80%

99s-law-powers-social-networks/


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

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 agroup-forming-network as it grows. Lets say you have a GFNwith n members. If you add up all the potential two-persongroups, three-person groups, and so on that those memberscould form, the number of possible groups equals 2n. So thevalue of a GFN increases exponentially, in proportion to 2n. Icall that Reeds Law. And its implications are profound.”6

6David. P. Reed,The Law of the PackSumant Kulkarni Externalities and Network Effects 18/54



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.

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


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.8http://en.wikipedia.org/wiki/Beckstrom%27s_law


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.

9http://en.wikipedia.org/wiki/Reed’s_law,

http://en.wikipedia.org/wiki/Dunbar%27s_Number


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.

10http:

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


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

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).

Connections distribution looks like 1 + 12 + 1

3 + 14 + ... + 1

n−1

which approaches log(n).

As there are n users in the network, the value of the network

is n·log(n).

11Benford’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.pdfSumant Kulkarni Externalities and Network Effects 25/54

http://www.cut-the-knot.org/do_you_know/zipfLaw.shtml

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.Sumant Kulkarni Externalities and Network Effects 30/54



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.



ExternalityNetwork ExternalitiesNetwork Effects

Externalities and Network Effects.




Agenda

Externality.

Network Externalities.

Types of Network Externalities.

Network Effects.

Compensated Effect.




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.

12Kelvin Hartnall, Externalities and Network EffectsSumant Kulkarni Externalities and Network Effects 34/54



Network Externalities

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.




Network Externalities

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.

13Network Externalities (Effects) by S. J. Liebowitz and Stephen E. MargolisSumant Kulkarni Externalities and Network Effects 36/54



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?




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.

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

Server MarketSumant Kulkarni Externalities and Network Effects 38/54



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.




Types of Network Effects

Direct network effects

Indirect network effects

Two sided Network Effects

Local Network Effect




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.16http://oz.stern.nyu.edu/io/network.html, Network Externalities

(Effects) by S. J. Liebowitz and Stephen E. Margolis17http://en.wikipedia.org/wiki/Network_effect


http://oz.stern.nyu.edu/io/network.html

http://en.wikipedia.org/wiki/Network_effect




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.

18http://en.wikipedia.org/wiki/Network_effect, Network

Externalities (Effects) by S. J. Liebowitz and Stephen E. MargolisSumant Kulkarni Externalities and Network Effects 42/54





Examples:

DVD ⇔ DVD Player.

Program ⇔ Channel.

Player ⇔ Sports.

Jobs ⇔ Schools




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.

19http://en.wikipedia.org/wiki/Network_effect,







Two-sided Network Effects

Examples:

Hardware ⇔ Software.

Reader Software ⇔ Writer Software.

New Technology ⇔ New Social Needs

Credit Card Holder ⇔ Merchant

Students ⇔ University




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.




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




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??




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?




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.

....




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.




End Of Part 2

Any Questions?




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


http://www.moreno.marzolla.name/teaching/CS2011/NetworkEffects.pdf

http://www.moreno.marzolla.name/teaching/CS2011/NetworkEffects.pdf

http://www.systems.ethz.ch/education/fs11/struct-social-inf-networks/lectures/Lecture%209.pdf



http://www.readwriteweb.com/archives/is_there_a_reverse_network_effect_with_scale.php

http://www.readwriteweb.com/archives/is_there_a_reverse_network_effect_with_scale.php



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 simultaneously erecting barriers to entry.

Razor-blade model - A razor-blade model is a business model based on

selling a product at a loss in order to profit from the sale of consumables

necessary for its use.

Regulatory capture - The dominance of regulators by those they regulate

rather than the public good they ostensibly serve.


externalities and network effects (examples, laws and interpretations)

Documents

interesting lawsmobile

interesting lawsagenda

interesting laws356cwinitially

interesting arguments

network eectsexamples

network eectsexternalities

interesting lawsmore

people worth x