This chapter starts with a broad description of what network effects are: we distinguish between direct and indirect network effects, we compare network effects to switching costs and we report a number of empirical studies that have estimated the importance of network effects for various products (Section 20.1). We then proceed by characterizing demand and supply in network markets, looking first at a single good (Section 20.2) and next, at several incompatible goods (Section 20.3). We will see that demand decisions may lead to multiple equilibria, leading to potential coordination problems, while supply decisions crucially depend on the level of compatibility between competing goods.

Network effects

Like instant messaging software, a large majority of information products and technologies exhibit network effects. Loosely defined, network effects refer to the idea that, other things being equal, it is better to be connected to a bigger network. In this section, we first make this idea more precise by distinguishing between direct and indirect network effects. We then draw the similarities and differences between network effects and switching costs. Finally, we provide some empirical evidence about the strength of network effects in various markets.

Direct and indirect network effects

Network effects can be formally defined as follows: a product is said to exhibit network effects if each user's utility is increasing in the number of other users of that product or of products compatible with it. Network effects are observed on two types of markets.