Network Effects and Externalities

Abstract

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 (Katz and Shapiro 1985). As fax machines increase in popularity, for example, your fax machine becomes increasingly valuable since you will have greater use for it. This allows, in principle, the value received by consumers to be separated into two distinct parts. One component, which elsewhere we have labelled the autarky value, is the value generated by the product even if there are no other users. The second component, which we have called synchronization value, is the additional value derived from being able to interact with other users of the product, and it is this latter value that is the essence of network effects.

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