Networking Externalities

Network externalities occur when the value to the user of a good or in this case the digital good increases when the number of other users of the same good increases. In the digital goods markets there are both direct and indirect network externalities.

Direct networking externalities: the success of a platform that has become the “standard” where success is

Indirect networking externalities: A complimentary goods that “locks-in” to the standard reducing overall

Direct Externalities:

The initial and continuing success of a product establishes it as the “standard” among its users and those considering its purchase due to its perceived lower cost and functional advantages. The lower cost includes the cost of the product and the opportunity cost surrounding the decision to adopt a particular product. The opportunity cost has two components: buying a non-standard product platform bears the risk of excessive upgrade costs (there is an insufficient number of users to absorb the development, production and distribution costs) and switching costs (a failed product forces the user to switch to the standard). A product’s functional advantages are those characteristics that contribute to its success. The specific functionality of the product attracts users, and as more users purchase the product its functionality eventually becomes the standard.

For digital products, a significant characteristic that has generally led to its overall success is the ability of its technology to minimize or avoid the conversion costs that is often associated with the adoption of a new technology.

Indirect Externalities:

Upon the establishment of the standard, complementary products are offered as a means to leverage upon the success of the platform. Users who continue to invest in these complementary products are in affect “locked-in” to the standard, as the possibility to switch to a new standard becomes too costly. Digital complements within a platform are potentially compatible with the range of products provided in that market. This compatibility reduces the overall costs of every product in the market. For instance if wireless cards for PCs had to be built differently for each brand of PCs the costs for a wireless card would be higher due to design and component costs, and the cost of the PC would be higher for the same reasons.

Microsoft is a leader in leveraging the advantages of positive networking effects through their software. They have forced standardization in the personal PC market for operating system software and more, making the general population realize the huge advantages of compatibility. This has increased the ability of novice PC users to blindly install and use products without understanding the specific architectural needs behind running software. Ease of use when implementing change is the main human psychological factor for not accepting new things into their day to day lives. Microsoft uses the following statement when upgrading your software to the next version to communicate the networking advantages of using their software.

“We hope you enjoy your experience with Microsoft Outlook, the most integrated e-mail program available today!”

Positive networking externalities provide a framework for the digital goods market to follow when dealing with their customer base. The main factor driving the strategy of an organization, or the reason consumers purchase a product revolves around the positive networking externalities associated with that product. correlated to number of users.


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