rstanding of the concept network effects is byRohlfs. In his publication A Theory of Interdependent Demand for a Communications Service he does not formulate the term network effects, but instead talks about a theory for a communications service with a demand that characterizes as interdependent. This interdependency implies that a change in one of the components of the system might result in a change in behavior or performance of the users of that system, according to Majumdar and Venkataraman. Rohlfsargues that a user obtains an increased utility from a communications service when other users join that same. In their work Systems Competition and Network Effectskey thinkers Shapiro and Katz define this idea asnetwork effects.Shapiro and Katz imply that when used in isolation, many products have little to no value, as there is no interaction possible. Therefore, according to David and Bunn, one of the most important characteristics for a network is some form of increasing.
In their research, Shapiro and Katz introduce the concept of forming systems. These are collections of two (or more)components that, when linked to an interface, result inthe components efficiently working together.Haucap and Heimeshoff articulate that in Internet system markets the network effects and switching costsoften drive competition. Tellis identifies two common perspectives regarding network effects, which are the direct and indirect network effects.
A direct network effect is when the utility of a product increases as the ‘amount of users in one’s immediate network increases’.An example is the video chatting platform Skype, as the appeal of this service expands when the quantity of users to video chat with does as well. These effects are directly connected to the size of a network. And, according to Allen, the more dense and diverse the network, the greater advantage that a singular user gains by using thatnetwork. Tellis further explains that an indirect network effect is when the utility of a product increases as does the number of correlating appurtenance to that product. An example for an indirect network effect is an operating system with software programs that can run on this system. Haucap and Heimeshoff point out that a market in which indirect network effects are of considerablesignificance is typically called a two-sided market.When the quality of a new product is greater to alternatives in the market, a few informed and aware adopters can lead to a fast adoption of this new product because of before mentioned network effects.
Theseearly adopters increase the utility and attractiveness of the new product for others, indicate its quality and valuevia the network, and provide counsel to those hesitant to adopt the new system, as stated by Tellis. In such cases,he mentions, network effects complement rather than delay the adoption of the new product. However, network effects could also cause some issues. Shapiro and Katz emphasize that the competition between these markets of forming systems highlight at least three important issues: expectations, coordination, and compatibility.
In many cases, like a gaming console and its games, the purchase of components for a distinctsystem is spread over time. This results in buyers having to research the availability, price and quality of components they might be interested in buying in the future. Choosing a particular brand of console, may lead to large investments in additional software, which will only be compatible to one type of console. Lam argues that once the buyer chooses and purchases a certain system, the switching costs to another supplier will be high, as the user has to invest in new relation specific software. In this situation, systems that are expected to be the favorite, and therefore have easily accessiblecomponents, will be more popular for this very reason.The system markets also poses challenges for coordination amongst firms. A firm considering whether to develop and release new software, must know whether supporting software will be provided for their new software to be able to work.
Or there would be no use for this new software. The last issue acknowledged by Shapiro and Katz is compatibility, as a component designed for a specific system, might not be able to work in a different system. Despite compatibility showingapparent benefits, obtaining and maintainingcompatibility often results in limitations in terms of product variety and restricts innovation.Grant states this last issue can lead to a technological lock-in, as, once established, users tend to stick with the standard technology. The example he givesis the QWERTY typewriter lay out, with its design invented to slow the speed of typing, to prevent the keys from jamming. Even though the jamming problem was soon resolved, the QWERTY layout has been kept the same.
Shapiro and Katz find that today’s consumers may be hesitant to adopt a new technology if there’s a highswitching cost.