Palgrave defines network externality or network effects as follows:
Network externality has been defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes.
In layman’s language your value of using something is dependent on how many others are using it. Most technology companies are critically dependent on network effects. An example is a telephone. You get the most value out of a telephone only when there are many others who own a telephone and you can use yours to get in touch with them. Although the network effects can be both positive and negative (where you lose value from higher usage by others like in exclusive luxury items), in this post I focus on positive network effects only.
Network effects can be categorized as
1) direct where you get the benefit of a product directly because others are using it. An example is telephones.
2) indirect where you get the benefit of a product not from the usage of the same product by others but because of the peripheral products that are developed because of the consumption of others. This sounds complicated but it is not. For example, when you use an Internet browser it doesn’t matter how many others are using the same browser. However, if you consider that a higher adoption makes a browser dominant and leads to more developers creating third-party add ons (like in Firefox and Chrome), you obtain more benefits from added functionalities because others are using the same browser.
Apple until the beginning of the last decade was at the losing side of network effects. Windows even today dominates the PC operating system markets worldwide because of the indirect network externalities created by its widespread adoption. Nobody really cares whether the person sitting next to you is using a PC or a Mac. But several software developers have designed their systems to run on Windows alone. Since there is a small market of Mac users, the software makers may find it unprofitable to write codes for OsX Lion, Apple’s operating system for computers. For example, last year I was told by a friend that she couldn’t install SAS, the statistical software package, on her Mac and therefore had to buy and use a Windows-based machine.
However, with the introduction of iPod, Apple changed that game to make network externalities work for them. iPod-iTunes present a classic case of indirect network externality. Again, it perhaps doesn’t matter much whether the next person is using the same brand of music player as you do. (In fact, there might be some negative network externality if you derived exclusivity due to your shiny iPod in early 2000s!) But iTunes revolutionized the way music is made available to people. Of course it makes a lot of sense to buy a music player that runs iTunes because that’s the world’s largest online music store! Apple continued their triumphant march into the complex world of network effects by launching iPhone and App Store. There is no direct benefit people derived by using an iPhone that is also used by millions. However, it was the App Store that is predominantly the crowd puller. Again, the indirect network effect is at play here. Today the situation is that most app developers want to design apps only for iPhone or Android [Audio].
Lately Apple has started looking into taking advantage of direct network externalities as well. FaceTime was one such attempt. If you have enough people on Apple devices, it perhaps makes sense to buy an Apple product and use FaceTime to communicate with them. More your network uses iOS devices and communicates using FaceTime, more valuable Apple products are to you. However, we don’t know how well it is doing (Check the comments in this article). Just the last week, Apple decided to take another shot at direct network effects by introducing iMessage, the new service in iOS 5, which lets you send messages to another iOS 5 device. This perhaps makes iPhone more compelling for the people who have other friends using iPhones. I personally know several BlackBerry users who preferred it due to the BBM feature. (Here is a comparison between the two services.) It’s is certainly difficult to know to what extent Apple will benefit due to this direct network effect. However, it is likely to assist it in increasing the adoption.