A network effect is an economic effect that describes a product or service where additional users add value to the network. When a network effect is present, each new user adds value to the product by entering the network. This, in turn, incentivizes new users to join the network, adding more value to it, and so on.
Types of network effects
There are two main types of network effects — direct and indirect network effects.
Direct network effects are increased usage adds value for all other users.
Indirect network effects are less easily defined. The term refers to additional, complementary benefits that stem from there being a network effect in the first place.
Negative network effects
Negative network effects work in the opposite direction. This means that each new user subtracts value from the network instead of adding it. This is also an important consideration when it comes to the design of blockchains. Good design should dictate that each new user should add value to the network. Why? This helps the network achieve scale. However, if each user subtracts value, that will lead to network congestion.
For example, Ethereum gas works with an auction-style system. Each user essentially bids on gas fees to be paid for Ethereum miners. As more users are added and usage increases, gas fees tend to become higher. Why? Each user attempts to essentially outbid each other. This, however, can’t go on forever. As gas fees become too high, some users stop using the network altogether as their activity wouldn’t be worth it with such high costs. This is an example of a negative network effect.
Network effects are present in many different segments of the economy, including cryptocurrencies. The idea is that new users add value to the network as they enter.