e-business basics - Metcalfe's Law and the Networked Economy
One key determinant of the success of networks is the umber of users connected to the network. Originally proposed as a rule of thumb to explain the value of a telecommunications network;
Metcalfe's law states that the value of a telecommunications network is proportional to the square of the number of users of the system (n2). First formulated by Robert Metcalfe in regard to Ethernet, Metcalfe's law explains many of the network effects of communication technologies and networks such as the Internet and World Wide Web.
The law has often been illustrated using the example of fax machines: A single fax machine is useless, but the value of every fax machine increases with the total number of fax machines in the network, because the total number of people with whom each user may send and receive documents increases.
This diagram from Wikipedia shows how the nmber of possible connnections grows rapidly as more users adopt a network.
Others have suggested that the formula significantly underestimates the value of adding new users to a network and have refined Metcalfe’s Law. Nevertheless, it is the principle that is important, that on-line networks and communities derive more value, the more users they have.
This principle also helps to give an economic reason why there can be a benefit in one technology vendor or standard dominating a marketplace – because otherwise, the potential users can be split across multiple incompatible platforms.
Social networking and peer-to-peer systems such as eBay, Youtube and MSN derive considerable benefit from being more or less the de facto standard for their particular on-line service.
This represents a direct challenge to certain principles of economics with regard to monopoly; the benefits of users adopting one standard technology may far outweigh any disadvantages that may accrue from the monopoly power of the firm that controls the standard. In fact, these benefits might justify the existence of a natural monopoly.
Author: Steve Whiteley, January 2007
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