Around 1980 Robert Metcalfe, the inventor of the Ethernet standard and founder of 3Com, developed a simple but powerful model to describe how networks become more important as they grow. He observed that a network’s value lies in the number of links it enables among members and that the quantity of links increases as the square of the total of the network’s members. Result: The value of a network increases in proportion to the square of the number of people using it.
This observation came to be known as Metcalfe’s Law. It was similar to an idea developed by economists about “network effects” — meaning that some resources become more valuable to a person using them according to the number of other people also using them. The telephone system long ago demonstrated the validity of this idea, but at the dawn of the Internet era, network effects became the Holy Grail for many business builders, who wanted to “get big fast” in order to exploit them before the competition did. Many Internet-era business models and technologies, including online marketplaces and communities, person-to-person auction sites, and instant messaging, are based on the assumption that network effects will profitably apply.
A few examples, however, show that Metcalfe’s Law doesn’t always hold. The average American’s telephone service, for instance, would not become much more valuable if everyone in China and India suddenly owned a telephone. And some users can actually make a network less valuable for others, as everyone who receives daily junk e-mail knows. Metcalfe himself recognized the limits of his idea; as he once pointed out, “The law may be optimistic as the number of people on a network gets very large.”1 The good news is that there are strategies that managers can use to maintain the power — or at least halt the decline — of network effects.
It’s important to understand the phenomena that can put the brakes on Metcalfe’s Law, slowing or even reversing network effects. They include:
In some networks, users add value by bringing resources such as song files or physical goods to be shared or traded. Since the number of different resources that users can provide is finite, the network is eventually saturated once most possible resources are available on it. After that, a new user is unlikely to add value. Napster, for example, had about 5 million users in early 2000.
1. Interview in Context Magazine, September 1998. Available at http://www.contextmag.com/setFrameRedirect.asp?src=/archives/ 199809/feature0lawanddisorder.asp.
2. Interview in Red Herring, June 1998. Available at http://www.redherring.com/mag/issue55/economics.html.