Understanding ‘Network Effect’

Abhishek Tripathy, 4th year law student, Nirma University

Network effect can be defined as a consumer’s effect from using a good or service on the total perceived value of that product or service for others. The number of users/consumers who use a product or service is directly proportional to the value of the network. Let’s take the example of an online messenger, suppose X no. of people join the messenger, it will attract Y no. of people who are not on the platform but want to access X through the services provided by the messenger. The e-commerce scenario in India is majorly a two-sided market, wherein there is a user network, a seller network and they both are connected through an intermediary.

E-retailing platforms, food delivery applications, etc act as an intermediary to connect the supplier to the consumer. In a two-sided market, an increase or decrease in the number of users on either side of the market will affect the other side of the market i.e. more the no. of users, more the sellers would get attracted to the platform and vice versa (indirect network effect). This determines the value of the platforms and dominance in a certain sector which results in the market tipping in favor of the one with a greater number of users.

Thus, there is a need to keep a check on entities with an existing network effect to prevent anti-competitive practices such as predatory pricing, unfair trade practice, etc. In the case of MCX v. NSE, the concept of network exchange was extensively discussed, perhaps for the first time in Indian competition jurisprudence. The dissenting opinion in the case laid down certain characteristics of network effect; 

  • The network effect creates an inverted U demand curve, equilibrium of which show variance in network sizes.  
  • The pace of market expansion is greater in industries with network effect as compared to no-network industries.  
  • Strong network effect creates natural oligopolies. Network industries are characterised by high inequalities of market shares and profits.  

It should be noted that there are two kinds of competition, one type of competition is “in the market” whereas the other type of competition is “for the market.” Network effect plays an important role in the later, as the network industries try to attract more users to gain a dominant position in the market. In such determination, it is important that the competition regulators take the market structure into equation before deciding on the relevant market. A Chicken-Egg problem, on the other hand, is stated as one in which a participant on one side of the market will be willing to participate to the platform activity only if he expects an adequate number of participation from the other side. For example, consumers would like to go for those credit cards, which are accepted by more merchants; similarly, merchants would like to join those platforms which have a large number of consumers. However, there are several two-sided markets that only perform the job of matching buyers and suppliers. Till the time enough number of both the participants are attracted to the platform, market makers are required, who try to resolve the temporary imbalance by standing in between the two parties i.e. they are willing to find out the existing problem to ensure smooth functioning of the platform.  

The rise of e-commerce has again raised the age-old debate of inclusion of structural aspects of the market in the ambit of competition supervision. The first major school of thought to develop emerged at Harvard University when, in the 1930s, researchers conducted analyses of specific industries. In the middle of 20th century Harvard economists such as Edward Chamberlain, Edward Mason, Joe Bain argued that structure of an industry is essential to be looked into in order to examine competitiveness in the economy.

The original insight of Harvard school developed a general theory that linked market structures to market performances, known as Structure-Conduct-Performance (SCP) paradigm stating that performance is determined by firms’ conduct, which is in turn determined by the market structure. According to the Harvard School approach, the regulators have to apply the presumption of illegality irrespective of the nature of the transaction. It is irrelevant if the said transaction is causing any benefits to the consumers, as the assessment is done on the performance of the entity and the existing structure in the market.

On the other hand, the proponents of Chicago school consider consumer welfare as the utmost parameter in addressing competition concerns. With the advent of Chicago and the Post-Chicago school of thought, SCP had slowly lost its importance. Now as the markets get tangled and trickier, it is important that factors such as network effect should be considered as a relevant factor in tackling varied issues. 

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