Introduction

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Network Externalities Cause Positive Feedback

A common characteristic of a market economy is that of positive feedback, or the Winner-Take-All effect. The industry leader has an intrinsic advantage over competitors and tends to gain even greater market share over time. Sometimes, this effect is caused by a phenomenon known as network externalities, or demand-side economies of scale. This means that the value of a good to consumers increases with the number of others who use it. In other words, consumers place greater value on a product that is in use by a larger network. An example of a network externality was introduced in the previous slide, where a larger telephone network is valued higher by potential customers.

Notice that a network externality depends only on how consumer demand changes as a function of sales. This is different from a conventional economy of scale, or supply-side economy of scale, in which production costs decrease as a function of sales.

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