What is the 'Network Effect'
The network effect is a phenomenon whereby a good or service becomes more valuable when more people use it. The internet is a good example. Initially, there were few users of the internet, and it was of relatively little value to anyone outside of the military and a few research scientists. As more users gained access to the internet, however, there were more and more websites to visit and more people to communicate with. The internet became extremely valuable to its users.
BREAKING DOWN 'Network Effect'
The chief hurdle for any good or service which uses the network effect is to get enough users initially so that the network effects take hold. The amount of users required for significant network effects is often referred to as critical mass. After the critical mass is attained, the good or service should be able to obtain many new users since its network offers utility.
If too many people use the good or service, negative network effects can occur, such as congestion. In the internet analogy, having too many users on the internet can hypothetically cause the speed to deteriorate, decreasing utility for users. Thus providers of goods and services which use a network effect must ensure that capacity can be increased sufficiently to accommodate all users.