Network Externalities and Compatibility

Takeaway

When a product’s value grows with the number of users, early advantages can snowball; compatibility and standards shape market structure and welfare.

The problem (before → after)

Before: Treat consumer utility as independent.
After: Utility includes network size; tipping, lock-in, and coordination problems emerge.

Mental model first

Phones are only useful if others have them; once a network gains momentum, it attracts more users, which attracts more developers, and so on—a feedback loop.

Just-in-time concepts

Direct vs indirect network effects; two-sided markets.
Compatibility and switching costs.
Expectations and coordination equilibria.

First-pass solution

Model demand with utility u = v + α n (or platform cross-side effects). Analyze equilibria and welfare under compatibility vs incompatibility.

Platform pricing: subsidize one side to attract the other.
Multi-homing and exclusivity.
Antitrust concerns: foreclosure via incompatibility.

Principles, not prescriptions

Seed both sides; build complements; manage switching costs ethically.

Common pitfalls

Overestimating inevitability of tipping; interoperability and regulation matter.
Ignoring multi-homing and heterogeneity.

Connections and contrasts

See also: [/blog/two-sided-markets], [/blog/diffusion-of-innovation].

Quick checks

Why tipping? — Positive feedback in adoption.
Why subsidize one side? — Cross-side elasticities.
Why compatibility matters? — Expands effective network size.