Network externalities are defined as
|“||the effects on a user of a product or service of the use of the same or compatible products or services by others (e.g. other family members and friends). It is usually said that a network industry such as mobile communication has positive externalities because the benefit of a user increase with the number of other users.||”|
Network externalities arise when the value, or utility, that a consumer derives from a product or service increases as a function of the number of other consumers of the same or compatible products or services. They are called network externalities because they generally arise for networks whose purpose it is to enable each user to communicate with other users; as a result, by definition the more users there are, the more valuable the network.
These benefits are externalities because a user, when deciding whether to join a network (or which network to join), only takes into account the private benefits that the network will bring her, and will not consider the fact that her joining this network increases the benefit of the network for other users. This latter effect is an externality.
Network externalities can be direct or indirect. Network externalities are direct for networks that consumers use to communicate with one another; the more consumers that use the network, the more valuable the network is for each consumer. The telephone system is a classic example of a system providing direct network externalities. The only benefit of such a system comes from access to the network of users. Network externalities are indirect for systems that require both hardware and software in order to provide benefits. As more consumers buy hardware, this will lead to the production of more software compatible with this hardware, making the hardware more valuable to users. A classic example of this is the compact disc system; as more consumers purchased compact disc players, music companies increased the variety of compact discs available, making the players more valuable to their owners. These network externalities are indirect because consumers do not purchase the systems to communicate directly with others, yet they benefit indirectly from the adoption decision of other consumers.
One unique characteristic of the Internet is that it offers both direct and indirect network externalities. Users of applications such as email and Internet telephony derive direct network externalities from the system: the more Internet users there are, the more valuable the Internet is for such communications. Users of applications such as the World Wide Web derive indirect network externalities from the system: the more Internet users there are, the more Web content will be developed, which makes the Internet even more valuable for its users. The ability to provide direct and indirect network externalities to customers provides an almost overpowering incentive for Internet backbones to cooperate with one another by interconnecting their networks.
- Overview section: The Digital Handshake: Connecting Internet Backbones, at 3-4 (citations omitted).