Blockchain and network effect
And this is really so. But the Internet is also developing. As an alternative to it, advanced technological options such as Web3 already exist. However, most people are skeptical about the benefits of Web3 or any other alternative to the Internet due to the lack of a mass consumer base. Simply put, cases where consumers evaluate the reliability of a service based on a huge number of existing customers are a network effect.
According to Coinmarketrate.com the network effect is an increase in the reputation of a service based on the large community it serves. The description also states that enterprises that cannot gain a critical mass of users, often cannot maintain their business model for quite a long period of time even if they offer some good service or tecnhologies.
Wikipedia, the largest information resource with an open source code, explains the network effect as the value of a service provider or manufacturer that increases along with the number of users. It also explains that involving a larger group of people using the same service allows users to feel more confident when shopping on the same network which explains the phenomenon.
Economists define network effect as network externality which refers to high demand for a certain product or service. The simple demand and supply dynamics implies that when a demand for a service or a good increases, its price or market value is also growing.
Kinds of network effect
There are two main kinds of network effect, that are direct and indirect network effects taking into account the user or service provider:
- Direct network effect
When an increase in the number of product or service users causes an increase in the value of its supplier, this is called a direct network effect. Smartphones are a good example of a direct network effect. When more people are buying smartphones of a certain company, Apple or Samsung, for example, then the demand for them increases and more people want to buy them.
- Indirect network effect
When a larger stream of user engagement creates a greater craving for a related service or product, this is called indirect network effect. This type of network effect is a little more complicated. Let us consider a scenario when people buy and use product “A”, in the result of which the popularity and demand for product “B” increases.
The indirect network effect is relevant in the case of online ticket booking services, as more and more users join some website to buy tickets. There are many other examples of indirect network effects, such as Uber, Foodpanda, yelp, etc.
From the point of view of corporate dynamics, there are two more types of network effects.
- Two-way network effect
There are cases when the involvement of both buyers and sellers leads to an increase in the cost of a particular product or service. Currently, this example is demonstrated by countless e-commerce sites. Take, for example, Amazon, eBay or Alibaba. On all these platforms, as the number of sellers increases, the value for the end user increases due to a greater variety of products. At the same time, the additional flow of buyers making purchases on the platform encourages more buyers to place new orders.
- The LAN effect
The LAN effect is an increase in business value, but on a smaller scale. Being part of the international community is great. However, each user is primarily part of a smaller community, for example, his hometown, his education, culture, etc. Many people want to create local and smaller communities where they could feel at home and communicate with like-minded people.
There are thousands of micro-communities on social media platforms. Most users belong to groups related to their profession. Meanwhile, they are also members of many smaller communities, such as their alumni or college buddies, workplaces, cities, towns, and others. Although these communities are comparatively smaller than international circles, the more users join a group, the more value it acquires.
Blockchain and Network Effect
So far we have talked about various aspects of the network effect and what it is. However, in order to understand the connection of the network effect with the blockchain, it is best to first understand what this technology is.
Blockchain technology is a digital registry that is hosted and verified by millions of users around the world without the presence of any centralized authority. Traditionally, people entrust their money and other financial deposits to the bank. Most regional banks operate under the supervision of a centralized state regulator.
The presence of a centralized authority requires people to share their personal information, such as user ID, residential address, etc. In addition, both private and public centralized regulatory authorities reserve the right to revoke access to the user’s account at any time and track all his financial records. Therefore, many people prefer decentralized financial environments such as blockchain.
However, without the presence of a significant number of blockchain users, most people will still be skeptical about its use. Take, for example, Bitcoin, which was met with skeptical comments when it was first introduced 13 years ago. However, at its peak, Bitcoin prices reached $65,000 per unit in 2021 in the bull market. The incredible market value is the result of its popularity among users, creating a positive network effect for it.
Positive and Negative Network Effects in Cryptocurrencies
- Positive Network Effect for Cryptocurrencies
As mentioned above, Bitcoin is a good example of a positive network effect. This means that as more and more users buy a token, its demand and value among users grow. Another aspect of the BTC network effect is mining. Miners are developers who, for a fee, decrypt encrypted transactions in the Bitcoin blockchain.
Bitcoin miners benefit from its universal liquidity due to its international prominence. They can also choose other cryptocurrencies to get a higher reward for mining. However, if miners pay attention to other cryptocurrencies, they may not find such a comprehensive liquidity pool as the BTC, which will provide them with greater autonomy.
Therefore, it is correct to assume that the presence of countless users in the Bitcoin ecosystem adds another layer of positive network effect, providing Bitcoin miners with an extensive pool of liquidity. Since its creation, the asset has managed to remain the most popular and in-demand cryptocurrency with the largest market value.
- Negative Network Effect for Cryptocurrencies
Sometimes an increase in the number of users can lead to a decrease in the value of a particular business. In the case of some cryptocurrencies, such as Ethereum, the network effect can be observed in the opposite direction. Ethereum is another blockchain network that depends on miners. However, the network requires users to pay ETH miners a block mining fee, also called a gas fee.
As a result, users try to bid higher than others in order to attract miners. Accordingly, the more users are present on the network, the higher the gas fee they have to pay. As a result, the Ethereum network suffers from prohibitively high gas tariffs. Many users may leave the network altogether due to the ever-increasing cost of the transaction itself.
Therefore, the developers of the Ethereum network are working on implementing solutions to this problem, such as the EIP-1559 update. The Ethereum improvement proposal number 1559 or EIP-1559 can rebuild the mechanism of bidding for gas on the network. CoreDev Ethereum recently held a meeting on the transfer of the network to the PoS consensus model, which works without mining using smart contracts.
How blockchain can Create a Positive Network Effect
The high demand and market popularity of Bitcoin is due not only to the network effect, but also to several factors.
Currently, there are more than 4 thousand cryptocurrencies available on the Internet, with which you can make financial transactions. However, a significant part of these cryptocurrencies are just being launched, and most investors are unaware of their existence.
While the BTC is an open source project that any developer can edit without any legal barriers and base their new project on it. However, the main reason for Bitcoin’s massive popularity is its popularity among technology heavyweights and the largest financial enterprises in the world. The Bitcoin network was presented to the masses with glowing reviews from the leaders of the IT sector.
Since the creation of the network, Bitcoin has never been hacked until now. Despite problems such as environmental issues and high energy costs, it continues to dominate the cryptocurrency sector. It is impossible to create a good digital product on a global scale without making it resistant to all types of security threats.
For any good cryptocurrency project, the network must first pass a strict technological audit. Millions of people around the world have been able to entrust their savings and income to Bitcoin due to its undeniable reliability. On the other hand, the Bitcoin network also creates a huge incentive for its operators or miners.
Independent Bitcoin miners can work for random people around the world for a fee. People who receive incentives have big stakes in promoting Bitcoin in a positive light. Thus, Bitcoin miners and users benefit from a two-way network effect beneficial to both parties.
Advantages of the network effect
Having a network effect can offer stakeholders many benefits that would otherwise be impossible to collect. Here are some of the biggest benefits that this effect gives:
- Natural selection
The theory of natural selection is an idea that favors the survival of the fittest. Thanks to the network effect, the community automatically weeds out erroneous and lagging business models or blockchain projects. As more and more people join the platform, its inherent qualities such as resilience, safety and adaptability are being put to the test. If a network can withstand the pressure of a mass audience, it automatically becomes a reliable platform.
- Creation of international communities
The network effect creates a sense of community and unity among its users. People who have joined the Bitcoin network share collective interests. Therefore, members of the Bitcoin community are likely to join forces to make the best decisions for the growth and prosperity of the platform and ignore their differences. As a result, the forces of the network effect can unite people in addition to factors such as race, age, gender, nationality, etc.
- Creating financial prospects
Thanks to the network effect, some of the largest technology companies, such as Google and Facebook, have achieved their current success. These companies, in turn, have created countless jobs around the world and opened up many opportunities for international and local businesses. In addition, these tech giants were able to contribute to the economic development of their countries by paying millions in taxes.
- Best backup
The network effect allows the business to become more universal among users. Under such circumstances, users are likely to receive the best after-sales support related to the specified service or product. For example, people all over the world prefer to buy Toyota rather than Audi. This is due to the fact that car owners can find several dealerships for maintenance and the availability of spare parts for Toyota models, compared to Audi.
Disadvantages of the network effect
Thanks to the network effect, a particular platform can become so large and popular that it will eventually acquire the status of a monopoly. In such conditions, any other competitors cannot stay on the market for a long time, offering an alternative to the end user. Monopolies also have the right, at their discretion, to dictate terms of service, such as tariffs and quality for their users.
- Conflict of interest
The network effect is the fastest way to make a business profitable. Therefore, many companies use manipulative and harmful methods to simulate this effect at the expense of their users. The Facebook Papers leaks of former FB employee Francis Haugens are a prime example of such harm.
In 2021, Haugens presented documentary evidence of FB’s involvement in provoking violence, hate crimes and unjustified psychological experiments on its users to preserve its user base. There are many examples where companies have resorted to illegal or unethical means to expand their network effect.
- Return to innovation
Marketing and advertising are powerful tools that allow companies to reach more people and increase their positive network effect. However, in some cases, companies with a huge marketing budget can outshine companies that offer consumers more value.
Thus, users cannot learn about a more advanced technology or service. There is a well-known proverb in the business community that says: “Money begets money”. This may mean that innovative companies with smaller budgets may find themselves in the shadow of their inefficient counterparts.
The network effect is characterized by a constant increase in the value of a service or product by attracting a large number of users. The network effect uses several aspects of human life, such as psychology, economics, business and technological innovation. Blockchain is a revolutionary technology that inherently uses the network effect, acting as a decentralized financial ecosystem.
For Bitcoin, the network effect works positively due to its universal presence and powerful liquidity pool. For other blockchain projects, such as Ethereum, the network effect becomes negative due to the bidding-based gas payment mechanism, which creates strong inflationary pressure for retail investors.
Network effects can provide great benefits, for example, contribute to the development of better business models, support the economy and create favorable communities. On the other hand, network effects have several negative sides, such as monopolies, unfair practices and lack of user independence.