Abstract

The network effect means that as the number of users increases, the value of the product will continue to increase. Remember Orkut? Today, it has very few users and has no choice but to shut down the service. why? Not many users use this service anymore. Of course there are other reasons, but as the number of users decreases, the value of its services does decline.

When it comes to cryptocurrencies, network effects are also a crucial factor. The ultimate goal of funds and blockchain is to gather users. The more users there are, the more practical the network service will be.

Introduction

What factors can determine whether a cryptocurrency project can become a market leader in a specific field? We can assume that in the long run the market generally moves towards the best solution. However, the actual situation is often complex. There are many more factors at play.

A developer may develop an innovative technology, but it will be slow to integrate into the market after its release, and naturally it will not be favored by users.

In some cases, a few projects with backward technology have seized the right time to go to market and successfully captured most of the market share. This is why network effects have such a big impact.

What are network effects?

The network effect is an economic effect, that is, as the number of users increases, the value of the network, product or service will continue to increase. Driven by network effects, new users join the network one after another to create value for products. In turn, this will encourage other new users to join and increase the value of the network.

The classic example of network effects is the telephone. In its early days, only a few people had telephones in their homes. Their houses must be physically connected to each other in order to use the telephone network.

As technology matures, more and more people are able to afford phones, which in turn drives up the value of the entire phone network. As the number of users continues to increase, so does the value and utility of the entire network. This forms a virtuous cycle, with more and more users joining and the entire network continuing to increase in value. Increased usage drives exponential growth in phone value.

Network effect types

Network effects are mainly divided into two categories: Direct and indirect network effects.

The telephone case discussed above is actually a direct network effect. Increased usage also creates added value for all other users.

Indirect network effects are not easy to define, and usually refer to other supplementary benefits indirectly generated by the first network effect. For example, many cryptocurrencies are open source products.

Projects with strong network effects are expected to attract many experienced developers to review the code, because the network involves all aspects of value (including their own value). This added value first comes from the high-value attributes of the network, and then continues to generate compound interest. Analyzing the key leaders in each field, we conclude that they generate extremely important network effects among their competitors.

Network effect examples

Today, there are application cases of network effects in different fields and products. The most typical example is social media, where users tend to follow the social networks they have previously used and choose the services they launch. This can also attract more new users to join the same platform and promote the monopoly of some services in the market.

Even if a company wants to launch a new social networking platform, it will be difficult to attract users on a large scale. Why? This is because the network effects established by market leaders create a huge competitive advantage for them.

Another common network effect is car sharing. Over the years, Uber or Lyft have accumulated network effects that make it difficult for new service providers with smaller user bases to compete.

Ebay and Amazon, two large e-commerce companies, Internet search giant Google, Airbnb, which is deeply involved in online rental business, enterprise operating system leader Microsoft and Apple, which produces iPhone mobile phones, are all unshakable leaders in their respective fields. enterprise. Could it be that only for-profit companies with clear business models and clear strategic positioning can have network effects? the answer is negative. A good example is Wikipedia, an open source project that has built huge network effects.

Network Effects and Cryptocurrency

In the field of cryptocurrency and blockchain, network effects are also very important the elements of.

Let’s take Bitcoin as an example. Bitcoin has extremely excellent characteristics and has powerful network effects.

Miners can ensure network security and have sufficient liquidity to maintain operations. Suppose we develop a new network that we hope will have features comparable to Bitcoin. Miners may be paid more, but the new network is less liquid than Bitcoin, allowing miners to sell in a timely manner. They can choose to gamble and hope that the liquidity of the new network will continue to increase in the future. Alternatively, they can choose Bitcoin mining with fewer variables in order to be consistently profitable. This is how network effects work. Even if the new solution has more technical advantages or can create huge profits for the miners, they may not "change the industry."

Having said that, the above situation is not a unilateral result of the Bitcoin network effect. The fair issuance mechanism and unique inherent properties determine that Bitcoin is difficult to copy from the beginning. We treat this case more as a thought experiment.

Network effects are also an important factor that must be considered in the field of decentralized finance (DeFi). If a product, service or even smart contract establishes a huge advantage, other projects may be unable to match it. However, DeFi is still in its infancy. Many would also argue that no product has yet become a decisive winner due to network effects.

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Negative network effects

Negative network effects are counterproductive. This suggests that all new users cause the value of the network to decrease, not increase. Negative network effects must be fully considered when designing blockchains. Good design should mean that "every new user can help add value to the network." Why? Because this helps the network reach a certain scale. If all users can only play a negative role, it will eventually lead to network congestion.

The combination of Ethereum gas fees and an auction-style system is a typical example. Users participate in bidding to pay for gas for Ethereum miners. As the number of users increases, usage continues to rise, and so do fuel costs. Why? Because users are essentially trying to compete with each other through bidding. However, this won't last forever. If gas fees remain high, some users will abandon the network and their activities will not be worth the high fees. The above is a typical example of negative network effects.

That said, we are currently taking remedial measures. EIP-1559 is an Ethereum proposal that proposes improvements to the gas fee system. In addition, a series of upgrades to Ethereum 2.0 can also significantly improve the throughput of Ethereum network processing. This helps resolve the issue of higher fuel bills when activity increases.

Summary

Network effects exist in different areas of the economic system, including cryptocurrencies. The arrival of new users adds value to the network.

Developers designing blockchain and cryptocurrency networks will benefit greatly from a deeper look at the mechanisms that trigger network effects. By incorporating this into the overall design, new token projects can scale faster.

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