The Handbook of Technology and Innovation Management

9.2. Definitions

9.2.1. Network effects

Standards are important in markets with network effects, which can be thought of as complementary relationships in value creation among market participants.^[] The most straightforward instances of markets with network effects are those where consumers and firms form literal communication networks that connect consumers and firms. Email, telephones, and fax machines, for example, are goods that involve information flows from one party to another. In these communication networks operating on a common network allows communication with more users, which is valuable. This is a direct network effect, in that the value of the network to any user is directly proportional to the total number of users on the network. It can become a network externality if users do not incorporate the effect their adoption has on the decision of others.

^[] For a comprehensive survey of the broader literature on network effects, see Farrell and Klemperer (2003).

Another sort of network effect is an indirect network effect. This type of network effect arises in markets for video game consoles and games, computer hardware and software, audio/visual equipment, or any market in which buyers purchase and consume system goods. Buyers assemble these system goods by purchasing components, often from different sellers. For example, the audio/visual system consists of components (receiver, CD player, speakers, etc.) purchased separately and then assembled by the consumer. There ...