Network effects are another vital part of the cryptocurrency ecosystem. It deals with the services offered and how attractive those are to the customers. 

It is common knowledge that consumers buy what they want or what they need. If a certain product or service doesn’t fit into either category, then there is no business. 

This blog post will explain about network effects and its role in cryptocurrency.

Network Effect Defined

A network effect occurs when a product increases its value among consumers because more and more people start using it. 

This is an economic concept that refers to how the continuous addition of users makes the product more attractive and profitable.

For example, when a new mobile application launches, an initial group of users download it. As positive feedback increases, more people download and utilize the mobile app. This is how a network effect works for various businesses.

Accordingly, it was first witnessed in the early 20th century, the beginning of telephone usage. 

Different Types of Network Effect

There are four different kinds of network effects: direct, indirect network effect, bilateral network effect, and local.

Direct Network Effect

Similar to the example of a newly-launched mobile application, the value of a product or service when its customer base expands. The increase of its customers benefits everyone because its utilization becomes more widespread. 

Indirect Network Effect

This type is a bit more complex. It involves complementary and supplementary benefits coming from the network effect itself.

For instance, if a cryptocurrency project has an excellent network effect, it may catch the attention of some developers to perform an audit on the code because it can increase the value of their own stake. When this begins, expert developers will start joining. Thus, the crypto project’s value amplifies. 

Bilateral Network Effect

A bilateral network effect happens when a corresponding item causes an increase in the primary product’s usage. For example, the proliferation of laptops and smartphones caused an exponential rise in the number of people using the Internet.

Local Network Effect

This kind of network effect has restricted benefits. It increases the product’s benefits for the pre-existing users only and not the whole consumer base.

Cryptocurrency and Network Effect

The cryptocurrency with the strongest network effect is no other than Bitcoin. 

When it started out as a peer-to-peer and open-source payment system, Bitcoin heavily relied on the confidence of investors in using it. Years after its first launch, it is now known as the number one cryptocurrency. 

Because people saw its benefit, they willingly tried it. With the help of social media platforms, its value greatly increased over the years. Although it is not without issues, Bitcoin is now widely-accepted as a digital currency and considered as a crypto market leader.

Similarly, decentralized finance will benefit from network effects. Defi has decentralized applications and smart contracts. If its business model gives it a chance to build a strong network effect, a large number of users will help heighten its presence and usage. 

Advantages

Enhances Creativity and Innovation

When business owners succeed in launching their first product, they become inspired to think of more innovations that can meet the different needs of people. Entrepreneurship is transformed into a greater industry than just buying and selling. It becomes a venue to express one’s helpful and lucrative ideas. 

Consumers Have More Choices

Different people have different purchasing powers. When there are more products and services to choose from, people have the freedom to choose what they will buy at a price they can afford. In the case of cryptocurrency, they can select which crypto provides the most benefit for them in terms of investment and trading.

Achieving Critical Mass

Critical mass is a huge goal for any company or business. It is the state wherein they are capable of sustaining themselves and no longer need additional external funding or investment. 

Through a successful network effect, a corporation or business will achieve critical mass because of the continuous influx of customers who want to use their service or product. 

Disadvantages

Overcrowding

When the population grows big quickly, network congestion is bound to happen. There is delay in accessibility and communication between the buyer and the seller. 

Capability to Meet Demand Might Fall Short

One issue that a business provider can encounter is their ability to cater to the increased demand. They might have a shortage in supply or production. This can cause customer dissatisfaction and can negatively affect their business’ reputation. 

For instance, if the blockchain of a certain crypto project has frequent crashes and investors cannot withdraw efficiently, the developers will receive complaints from the users and some of them might withdraw their investments. 

Complacency

After critical mass has been reached, some companies no longer find ways to be more creative. They continue marketing the same product without paying attention to the trend. People’s needs tend to change rapidly in a short span of time. Business owners, or crypto developers must be ready to meet these changes quickly. 

Metcalfe’s Law

This is used to analyze the features of network effects. Metcalfe’s Law states that a telecom company’s value is proportional to the square of the number of active phone users. 

Timothy F. Peterson, an analyst of Cane Island Alternative Advisors, concluded in a 2019 research paper that “Bitcoin’s price in the medium- to long-term, appears to follow Metcalfe’s law, depending on periods used.” 

Using Metcalfe’s Law to measure the cryptocurrency network effects requires more research and development because as Peterson puts it in his paper, “Metcalfe’s law is well known in the computer sciences, it is virtually unheard of in economics.”

Summary

Cryptocurrency is open source and offers a great range for utilization. We can see that many crypto start-ups take advantage of social networking to attract a huge user base. This is how this concept can work for crypto. Developers and innovators harness the power of social media sharing.

In conclusion, network effect can help cryptocurrencies in the long-term if there is proper management and implementation. Crypto companies should be careful of network congestion since scalability is a huge problem for many crypto coins.