Network Effects and the Rise of Big Tech: Analyzing Market Dominance in the Digital Economy

They say everyone wants to be popular.  In Economics, network effects are the increases in demand experienced by a good or service as the number of users increases.  In terms of benefits, it is similar to the concept of economies of scale.  However, because it is looking at demand rather than supply, the effect on market price can be opposite.  With network effects, consumers are willing to pay more to access a broader network, with which they can accomplish more.

Historically, network effects helped consolidate firms and markets after a technological breakthrough created many small companies.  This occurred with telephone coverage in the early 1900s, about thirty years after the telephone was invented.  At the time, there were many small telephone companies, but they did not work well together and telephone owners could be very limited in who they could call.  Quickly, a group of investors was able to purchase most rival firms as their coverage increased - telephone owners wanted to switch to the network that actually let them call their friends.  This snowball effect helped reduce the market to an oligopoly, with only a few large firms.

Loss of Suitable Substitutes = Rising Demand

Over time, goods or services with shrinking networks will move from being suitable substitutes to be unsuitable substitutes, or even inferior goods.  As a result, they no longer “pull” demand away from the remaining competitors.  This helps consolidate the market: customers switch from shrinking networks to growing networks, enhancing the snowball effect.  Thus, even though nothing changes in terms of the good or service, it becomes more popular (the famous demand determinant of consumer tastes and preferences) simply by being more widespread.

Direct Network Effects

Some networks are literal, in which consumers are paying for a service that covers a geographic area.  Examples are cell phone carriers, Internet providers, and health insurance.  Going back to the pre-cell phone era, researchers found that people were willing to pay more for telephone carriers that could access more areas and more individuals.  People would pay a premium to access the network that had a greater likelihood of conveniently reaching others they wanted to reach.

Health insurance is another area where the network effect is significant, due to the substantially higher costs incurred by patients who inadvertently use out-of-network care.  Customers may be willing to pay significantly higher monthly premiums for a health insurance plan that has broad coverage, such as throughout their entire state or province, and makes it unlikely that any emergency care received during a domestic trip will be out-of-network.  

Direct Networks and Fees

While most digital networks today work with each other, unlike early telephone networks that involved physical connections, users may incur higher fees when trying to work in other networks.  This can be seen with banking and finance: customers pay no fees when in-network, but have to pay fees when using services from another bank.  A common example is ATM access - any bank’s debit card is accepted, but only cards from the owning bank (or owning network of banks) avoid a transaction fee.  As a result, customers have greater demand for banks that have larger networks.

Indirect Network Effects

Indirect networks often involve complementary goods.  An example from yesteryear was the relationship between VCRs and VHS tapes and DVD players and DVDs.  As each became more common, it increased demand for the complementary good.  For example, as the number of VCRs increased in the late 1980s and 1990s, demand for VHS tapes rose as people found them easier to play.  Similarly, as the number of DVD players increased in the early 2000s, demand for DVDs also increased.

Results of Network Effects

Network effects can turn monopolistically competitive markets into oligopolies by reducing the number of firms.  This can have varying effects on price: the lack of competition can drive prices upward, but economies of scale can drive prices downward due to increased efficiency of production.  Many people assume that oligopolies tend to set higher prices due to lack of competition, maintained through high barriers to entry, but this is not necessarily the case.

Oligopoly Pricing

Oligopolies can set higher prices than other markets, but this often depends upon a degree of collusion.  When there are only a handful of large firms, they can collectively set higher prices…but only if they all agree.  This must be done informally or by assumption, lest the companies be accused of illegal price fixing.  In an oligopoly, firms that do not collude may use game theory to determine the best pricing action when they do not know what their competitors will do.  They want to anticipate how actions of their rivals will affect their own revenue.

Because it is dangerous for an oligopolist to be undercut by a rival on price, due to the fact that its rivals are all large enough to accommodate its customers, oligopolists tend to set a relatively low price.  In a monopolistically competitive market, firms are too small for one that lowers its price to take all, or even most, of its competitors’ customers.  In fact, most customers in the competitive market may not even know that one firm has lowered its price.  Oligopolists can swiftly damage each other by undercutting on price, which often triggers a price war.  To avoid a price war, which could bankrupt an oligopolist, all oligopolists tend to price lower than one might think.

Product and Market Standardization

People like networks because they standardize things.  Consumers that like features of a good or service will seek out complementary goods and services that are part of the same network.  In electronics, this can be seen with suites of software or hardware, such as Microsoft Office or Apple’s range of devices.  As consumers become familiar with one product, they are willing to pay a premium for others that look and behave similarly and require less learning.  People will even begin to seek out additional products that fit with their existing ones, such as additional tools that fit with the same battery pack.

In the digital economy, this can be seen with websites that conveniently work together and allow users to move content from one to another.  An example would be Facebook and Instagram, which are both owned by Meta.  Users who already use one of these sites are more likely to join the other rather than move to a site owned by a different company; they can easily transfer their existing profile and content.  Advertisers are also more likely to buy ads with Meta if their ads can be sent to both Facebook and Instagram - they reach a larger network.  

Across firms in the oligopoly, market standardization also occurs as competing firms come to recognize which features consumers like most.  In order to provide these common features, competing firms’ products become similar overall but with key differences in features.  This can be seen in both the digital economy and physical economy, with social media websites, online shopping sites, automobiles, and airlines having similar structures and features.  On virtually all social media sites, for example, users have the ability to like and comment on posts and videos they enjoy.  Sites also keep their available content options within a similar range, as content that is too long may dissuade visitors from engaging.  

As markets become dominated by a few large networks, their competing products become similar enough to try to lure away members of the other networks.  Full-size pickup trucks are similar enough across automakers to try and appeal to all pickup truck buyers, and social media sites have enough common features to be seen as easily usable by all netizens.  Over time, competition intensifies around small features, as these are the only differences among competing products!