Question

What are network externalities? For what types of products are network externalities likely to be important? What is path dependence?

Short answer

Network externalities occur when a product's value increases as more people use it, and they're common in digital goods and communication services. Path dependence is the influence of historical events on the current status, even if those events are no longer relevant.

Step-by-step solution

Define Network Externalities

Network externalities occur when the value of a product or service increases for both new and existing users as more people use it. This concept is often observed in digital and communication goods. For example, the value of owning a phone increases as more people have phones, because there are more people you could potentially call.

Identify Products with Network Externalities

Products or services that exhibit network externalities are usually those that rely on a critical mass of users. They include social networks (like Facebook or Instagram), communication devices and services (like telephones and email), digital platforms (like Amazon or Airbnb), and software systems (like Windows or iOS). In each case, the utility of the product or service increases as more people use it.

Define Path Dependence

Path dependence is the idea that the state of things in the present is heavily influenced by the events that led up to it, even if those past events are no longer relevant. In the context of network externalities, path dependence could mean that certain technology that may not be the absolute best survives because it was adopted by a larger number of users early on. A good example is the QWERTY keyboard, which was designed to slow down typists and prevent typewriter keys from jamming - even though there's no need for that design today, it's the standard due to path dependence.

Key concepts

Path Dependence

Path dependence is an interesting concept that highlights how past events can shape present and future outcomes even when the original circumstances are no longer relevant.
This is particularly common in technology and products influenced by network externalities. Essentially, path dependence means our current choices are limited by decisions made in the past, which is something we see often in digital goods and platforms.
For example:

• The QWERTY keyboard layout, which was crafted during typewriter days to prevent mechanical jamming, remains popular even though it's not the most efficient layout available today.


• Operating systems like Windows dominate because they captured early market share, despite other systems potentially offering better performance.

Path dependence often points to resilience of early-adopted technologies, influencing ecosystems of products and services - making new choices challenging.

Digital Goods

Digital goods are products or content that exist in digital form rather than physical. They can be downloaded, streamed, or accessed online, and often experience network externalities. As more users adopt and use these digital goods, their value and utility increase exponentially.
Common examples include:

• Software applications like Microsoft Office and Adobe Creative Suite, where an extensive user base ensures ongoing improvement and compatibility.


• Music and video streaming services such as Spotify and Netflix, which grow more attractive as they secure more content deals and user feedback expands their library.


• Online gaming networks, where a larger community enhances the multiplayer experience.

Users often rely on digital goods due to their convenience and increasingly integrated nature in modern life, and their growth is closely tied to network effects.

Critical Mass

The concept of critical mass is crucial in understanding how products and services, especially those relying on network externalities, become successful. Critical mass refers to the initial number of users needed for a product to start experiencing significant growth and inherent value.
Important aspects include:

• Achieving critical mass often requires substantial adoption to spark a heatwave of popularity and utility.


• Technology and digital goods like Facebook and WhatsApp had to reach a pivotal user base for their platforms to gain widespread appeal.


• Once critical mass is hit, the growth often becomes self-sustaining, as new users are attracted by the growing network's value.

Understanding and achieving critical mass can be the cornerstone for success in today's interconnected world.

Communication Devices

Communication devices, such as smartphones and email systems, are great examples of products that benefit significantly from network externalities. This is because they rely on connecting people, so the more people using them, the more valuable they become to each user.
Key points on communication devices include:

• Early telephones illustrate classic network effects, as they initially offered little value with few users but became indispensable as adoption widened.


• Modern communication platforms like Zoom or Skype provide immense connectivity benefits heightened by massive global adoption.


• With network externalities, these devices prove their worth by connecting individuals across distances, forming a critical foundation for personal and business communication today.

Communication devices thrive in networked environments, where each new connection builds more value for everyone involved.