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Network Effects Meaning

Jan 12, 2024 | Updated Jan 12, 2024
Network effects is the phenomenon through which a product or service becomes more valuable or useful as more people use it.

What are Network Effects in Cryptocurrency Networks?

In the context of Blockchain, network effects occur when the value of a cryptocurrency increases as more people use it. For instance, the market value and acceptance of Bitcoin increases as more people adopt it.

Here is how it works:

Initially, a cryptocurrency gains traction through grassroots efforts and early adopters who recognize its potential. As more and more people adopt the digital asset, the effect is reflected in its increasing value and utility. 

For instance, as more people buy Bitcoin, the supply of it decreases and thus, its value increases. This can potentially create a virtuous cycle as the increasing value of Bitcoin makes it more appealing to more people. More people buy Bitcoin, its value increases, making it more appealing to new users, and so on. At the same time, the increasing user base also makes Bitcoin more tenable as a payment method, thus increasing its utility.  

Network effects also play a similarly crucial role in the growth and adoption of Non-Fungible tokens (NFTs) and decentralized finance (DeFi). In both cases, a larger user base means increased liquidity and demand for assets, thereby increasing their value and utility. 

Types of Network Effects

Network effects can further be classified into two – direct and indirect.

  • Direct network effects result from increased usage. For instance, Bitcoin’s value appreciated as more new users adopted the network and coin as a payment method.
  • Indirect network effects refer to the supplementary advantages stemming from a direct network effect.  For instance, when developers create popular decentralized applications (DApps), the value of the applications increases along with their user bases. This, in turn, attracts more developers who would like to tap into the growing audience, resulting in an indirect network effect.

What are Negative Network Effects?

A negative network effect happens when new users cause the utility or value of a product or service to decrease rather than increase. We can see this kind of network effect on blockchains that are not optimized to scale. 

As these networks become more popular and the number of users grows, so does the number of transactions happening on the network. Since network validators can only process so many transactions at a time, these increases in usage can lead to network congestion and increased transaction costs. 

The fact that network validators and miners often prioritize transactions with higher fees only exacerbates this issue. Of course, this situation hurts the overall ecosystem of a blockchain, as it discourages users and developers from engaging with the network. 

Decentralized Application

A decentralized application is a software program operating on a peer-to-peer network. It runs independently on the internet using smart contracts, outside the control of a single entity or authority.

Full definition

Testnet

A testnet is like a practice version of the main blockchain network. It lets developers test new ideas and features without affecting the main network.

Full definition

Proof of Work (PoW)

Proof of Work (PoW) is a method that cryptocurrency networks use to verify and validate transactions in a blockchain.

Full definition