Week 6 Lecture 4

Question 1

What is network effect?

Answer 1

Network effect is a phenomenon whereby an
increased number of participants (buyers or
sellers) improves the value of a good

Question 2

Explain the differences between same-side and cross-side network effects

Answer 2

• Same-side effects are when a users utility becomes larger as the number of other uses increases
• Cross-side effects is the idea that if there are at least two independent groups of participants, the utility of one group increases as the size of the group grows

Question 3

What is the bandwagon effect?

Answer 3

The bandwagon effect is the idea that if the value of a good is increasing with the number of users, every
additional purchase delivers a positive externality in consumption (herd behaviour,
trends, etc.)

Question 4

What is the snob effect?

Answer 4

The snob effect is the idea that if the value of a good is
decreasing with the number of users, every
additional purchase delivers a negative
externality in consumption (congestion,
exclusivity, uniqueness)

Question 5

What do marketplaces do and what characteristics do they exhibit?

Answer 5

Marketplaces combine buyers and sellers and
exhibit strong indirect (cross-side) network
effects

Question 6

Explain how the demand for network goods works

Answer 6

• Demand for a network good is a function of
  price P and the size of the network Q
• Demand is decreasing in price, but an increase
  in Q shifts the demand curve upwards

Question 7

What is critical mass?

Answer 7

Critical mass is the size of a network at which
the value of the good is equal to or greater
than its price

Question 8

Explain how to effectively use the network effect

Answer 8

1- Be first in capturing a critical mass: Once you reach the critical mass, the network attracts new users by itself
2- Pricing strategies: Freemium involves offering free basic services for all and monetise through premium features. Dynamic pricing which involves subsidised pricing or free access at the beginning to capture the critical mass and then charging more as the value of the good grows. Price discrimination
3- Lock-in and switching costs: This deters users from switching to other networks
4- Maintain capacity to avoid congestion: Users will leave if network size leads to depreciation
5- Avoid network pollution

Question 9

Explain how the network effect can act as a source of power

Answer 9

• If the network effect is strong, consumers
  tend to coordinate their adoption of a single network good
• The network effect reduces the available
  residual demand for new entrants and raises entry barriers
• New firms fail to reach a critical mass if
  established firms have large networks
• High switching costs and costly multihoming intensify consumer loyalty

Question 10

What is a two-sided market and give some examples of them

Answer 10

• Two-sided markets involve two or more groups of participants interacting via platforms and have at least one group exposed to a network effect
• Examples include:
  1: Sellers - Marketplace - Buyers
  2: Retailers - Shopping centre - Customers
  3: Airlines - Airports - Travelers