According to Wikipedia:
A network effect […] is the effect that one user of a good or service has on the value of that product to other people. When a network effect is present, the value of a product or service is dependent on the number of others using it.
In essence, if more people using a system makes the system more valuable, a network effect is at play.
The archetypal example of a system that benefits from the network effect is telephony. The value of owning a telephone increases as more of your network own one themselves. Social networks provide another example. The more people use one, the more valuable they are to others.
In both of these examples each additional user represents an additional connection for each existing user. The more users the system has, the more connections an individual user has.
- Two users have one connection each (each other).
- Three users have two connections each.
- Four users have three connections each.
- Five users have four connections each.
This idea charts the amount of connectionss each user has as one unit less than the amount of users the system has.
As the network grows, the value of the network to each user grows equally.
Whilst this is true, calculating the value of a network from the perspective of an individual user dramatically undervalues the network as a whole.
Consider it in terms of the total amount of connections between users:
- Two users have a total of one connection.
- Three users have a total of three connections.
- Four users have a total of six connections.
- Five users have a total of 10 connections.
This idea charts the amount of connections a system has as n(n-1)/2 where n is the amount of users.
As the amount of users grow (blue line), the amount of connections, and the value of the network as a whole, grow exponentially (red line). By the time the network has reached 100 users, 4950 connections are in place.
When designing, systems should be optimised to capitalise on network effects. This is why social networks are free. A cost would act as a barrier, restricting the networks ability to scale and thus limiting the networks value to others.