Network Effect (Externality)

A network effect, or externality, is said to exist when the benefit to a node in a network changes as a result of the change in the number of links in that network caused by increasing the number of nodes. (Remember that a network is defined as a set of nodes and links. The nodes are the things connected and the links are the interstices between the nodes.)

Let's assume you live in a state of nature. You get a fax machine, but you're the only person on earth that has a fax machine. Your fax machine has 0 value because you have no one to fax anything to.

Then a friend of yours buys a fax machine and you can now fax back in forth. Now your fax machine is worth 1 unit of something because there is someone to fax something to.

Then another friend of yours and a friend of your first friend's gets a fax machine. Now, there are 3 people to fax things to, your second friend, your first friend, and your first friend's friend. If a friend of each of theirs gets a fax machine, the benefit to you increased even though you didn't do anything to increase it.

A silly example, but you see the point. The network becomes more valuable with more people in it.

That's a network effect. It's also called an externality.

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