Internet Economics Homework #2

Forces of Network Economics

And their impacts on doing business

Michael Kruk 9104120120 2012/10

Table of Contents

1. Introduction .......................................................................................................... 3 2. Network Economics ............................................................................................. 3 2.1 2.2 Principles ....................................................................................................... 3 Value of a Network ........................................................................................ 4 Metcalfes Law ........................................................................................ 4 Zipfs Law ................................................................................................ 5

2.2.1 2.2.2

3. Social Network Services ...................................................................................... 7 3.1 3.2 SNS today ..................................................................................................... 7 Value of SNS ................................................................................................. 9

4. Conclusion ......................................................................................................... 10

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1. Introduction
Whereas the old economy was driven by economies of scale, the new one is driven by the economies of networks. (Shapiro,1999) Since the late 1980s, when computers became constantly more present in our daily lives, people became more and more part of an network where country borders and location dont matter. Personal computers, smartphones and the internet give us the opportunity to connect with anyone around the world at any time. This circumstance also changed the dynamics of doing business and economics. Networks became a big and important factor in the economies of our time. This paper will focus on the principles of network economics and how they can affect businesses. Furthermore a real world example will be given to better understand the functioning of network economics. This real world example will be based on a small comparison of Social Network Services, as they perfectly demonstrate some of the principles of network economics.

2. Network Economics
This chapter will focus on the basics of network economics and explain the ways of evaluating a networks value.

2.1

Principles

Basically speaking, a network is a system of objects connected with each other. The amount of connected objects can be infinite, but the minimum number of network participants is 2. It can be also distinguished between two types of networks: real networks and virtual networks. Real networks exist in the real world and are physical. Those networks can be telecommunication networks, physical computer networks or railroad/highway networks. The connection between those networks is physical. In contrast to that, virtual networks have no physical existence. Those networks can be for example users of a certain internet platform or social network services like Facebook or cyworld.

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According to the basic theory of economics, the value of a good or product decreases with the rising number of consumers, or the value of a product increases as the amount of available products decreases. But the system of internet economics works differently, as the value of the network or service rises with the rising number of consumers. The more people are part of a network, the higher is the value of the network. These days most people in our modern society are part of one or more physical or virtual network. Therefore it is very important and a big challenge for companies to attract customers to their own networks in order to increase their value. The following part will now explain how the value of a network can be defined.

2.2

Value of a Network

As mentioned before, the increasing number of consumers of a network or service, the value for all other consumers of the same network or service increases. In this context there are two different ways of evaluating the value of a network. The Metcalfes law and the Zipfs law. Both will be described in this chapter. 2.2.1 Metcalfes Law Metcalfes law is often being used to measure the value of a network based on the number of connected objects in the given network. This law states the following: V = n V = Value of the network n = Number of participants of the network

This means that the value of a network is n if n is the number of participants in the network. This situation can easily be illustrated with the following picture, demonstrating the value of a telephone network based on the number of participants:

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As the above picture shows, the number of connections in the network increases with the rising number of participants. Two phones have one connection, five phones have ten connections and 12 phones have 66 connections. The value of those networks would be 2 for the network with two phones, 25 for 5 phones and 144 for the network with 12 phones (n). In a real world context Metcalfes law can be shown as in the following illustration:

The picture above shows that the value of a network increases exponentially, but the costs of operating the system show a linear growth depending on the number of participants (N). This results in the conclusion, that the network becomes profitable after the network value becomes higher than the costs of operating the network. This point is also called critical mass crossover. 2.2.2 Zipfs Law The IT bubble burst of 2001 demonstrated that Metcalfes law cant be always applied to evaluate the value of communication networks, especially when it comes to internet based networks. Before 2001 the value of networks was evaluated by Metcalfes law, which led to a big overestimation of the actual value of networks. This

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situation will be explained in more detail in the third chapter. The principle of Zipfs law is the following: V = n log(n) V = Value of the network n = Number of participants of the network

These days Zipfs law is taken to evaluate the value of social media networks, because experts share the opinion that the value of a network grows much slower. This idea is also based on the research result of Robin Dunbar, an anthropologist who did research on the extent of connectivity in effective social organization. His research indicates that the human brain is able to maintain meaningful relationships to a maximum 150 people. This means that if a single person has more than 150 connections in a network, the benefit doesnt increase. The difference between Metcalfes and Zipfs law can be illustrated with the following graph:

As Metcalfes law grows in a very high speed, it is easy to see that according to Zipf the value is much lower. The actual value of the network lies between Zipfs and Metcalfes law. The calculation process of this value includes many complex factors
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and is not relevant in this paper at this point. A more detailed overview about the differences between Metcalfes law and Zipfs law can be seen in the following table:

As shown in the table above the difference between the two laws becomes bigger and bigger with the increasing number of connection nodes in the network. The calculated value represents the most accurate value of a social network.

3. Social Network Services

In recent years social network systems experienced a huge rise on users, and people spend daily many hours of their time on those networks for communication, business or entertainment. Many companies already recognized the importance of social network systems (SNS) and realized that they can be a very effective distribution and marketing channel.

3.1

SNS today

Today Facebook is the biggest social network service with now more than 1 billion users (since October 2012). Automatically it is the most valuable social network service. Other important SNS are Twitter (> 500 million users), the business and professional networking platform LikedIn with more than 160 million users and the Chinese platform Weibo with over 300 million users in China. Google tried to break the success of Facebook with introducing its own SNS called Google+, but with only 400 million users it is not as nearly as successful as Facebook.

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One of the reasons of Facebooks success can be explained with the fact, that Facebook was the first truly international social network service that also fitted all tastes and needs of the average person. Before the introduction of Facebook most SNS were limited to countries like the Korean cyworld or the German studiVZ. The limitation to only one country and language automatically limits the number of network participants and therefore the value of the network. In contrast to that, Facebook became a platform where everyone can connect with everyone, no matter which country the participants are from or which language they are speaking. Similar as with other products and services, the success is depending on the number of early adopters who become convinced of the product and recommend it to others. This is also applicable with social media and internet services, as the following illustration shows, using the Rogers bell curve:

In the upper image the first 15%, called the Innovators and early adaptors are more likely to take risks and try new things. They are willing to spend extra money to do so. People in the early majority are also open for new ideas and technologies, but balance positive and negative aspects of it. Laggards will only adapt to a certain technology or standard if it is mainstream and a standard. The illustration above shows that for example after Facebook was made popular by early adopters it became a standard for the mass market. Google tried to introduce
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its new SNS platform Google+ when Facebook was already a standard in the mass market. Currently Google+ only reached the early adopters and a little bit of the early majority, but it didnt really reach the tipping point where the SNS becomes a standard in the mass market. Facebook has already such a high number of network participants, so that most users are not ready to switch from Facebook to Google+ because the value for each individual is higher while using Facebook.

3.2

Value of SNS

As mentioned before there are two ways of evaluating the value of a network. When it comes to social network services the Zipfs law is generally seen as more accurate and realistic. The earlier mentioned Dunbars number sets the size of a meaningful social group for humans at about 150. Beyond that size, additional members add diminishing value. But even within that 150 there is considerable range in affinity and sentiment. An example of the difference in valuation between Metcalfes law (n) and Zipfs law (n log (n)) is illustrated in the following 2006 IEEE article: Imagine a network of 100,000 members that we know brings in $1 million. We have to know this starting point in advancenone of the laws can help here, as they tell us only about growth. So if the network doubles its membership to 200,000, Metcalfes Law says its value grows by (200,000/100,002) times, quadrupling to $4 million, whereas the n log( n ) law says its value grows by 200,000 log(200,000)/100,000 log(100 ,000) times to only $2.1 million. Although the example is being calculated with only 100,000 users, the difference of evaluation between Metcalfes law and Zipfs law is very significant (4 million vs. 2.1 million). If more realistic numbers would be taken (Facebook has 1 billion users) the difference of evaluation will be extremely high. Thats why usually a value between Zipfs law and Metcalfes law is taken to evaluate the actual value of a social network. This big difference demonstrates that the evaluation of networks should be done carefully and that Metcalfes law can lead to a severe overestimation of a networks value. This is especially important for companies that use social network services for

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reaching customers or promoting their products, trying to evaluate the actual value of a given network.

4. Conclusion
The fact that these days almost everyone is member of networks changed the principles of doing business and made it essential to understand the dynamics and functioning of network economics. Especially in internet-based businesses or social network services the knowledge about the functioning of network economics is important. As mentioned before, it also shows for example how and why Google+ failed to gain a similar popularity as Facebook. The wrong evaluation led to the big internet bubble in 2001 which severely damaged the internet services industry and decreased peoples trust in it. Thats why the way of evaluating this kind of networks was adapted and improved to be more accurate and realistic. Still today the evaluation of social services may be too high, as the recent stock market launch of Facebook showed, as its stock market value is decreasing.

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