Network Effects = Network Externalities

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Network Effects = Network Externalities

Wikipedia:

A network effect is a characteristic that causes a good or service to have a value to a potential customer which depends on the number of other customers who own the good or are users of the service. In other words, the number of prior adopters is a term in the value available to the next adopter.

One consequence of a network effect is that the purchase of a good by one individual indirectly benefits others who own the good — for example by purchasing a telephone a person makes other telephones more useful. This type of side-effect in a transaction is known as an externality in economics, and externalities arising from network effects are known as network externalities. The resulting bandwagon effect is an example of a positive feedback loop. […]

Network effect business examples

Financial exchanges

Stock exchanges and derivatives exchanges feature a network effect. Market liquidity is a major determinant of transaction cost in the sale or purchase of a security, as a bid-ask spread exists between the price at which a purchase can be done versus the price at which the sale of the same security can be done. [*] As the number of buyers and sellers on an exchange increases, liquidity increases, and transaction costs decrease. This then attracts a larger number of buyers and sellers to the exchange.

The network advantage of financial exchanges is apparent in the difficulty that startup exchanges have in dislodging a dominant exchange. For example, the Chicago Board of Trade has retained overwhelming dominance of trading in US Treasury Bond futures despite the startup of Eurex US trading of identical futures contracts. Similarly, the Chicago Mercantile Exchange has maintained a dominance in trading of Eurobond interest rate futures despite a challenge from Euronext.Liffe. […]

[*] Niall O&#8217-Connor should report on bid-ask spreads, not just on dollar value of matched bets, when comparing BetFair with its competitors.

4 thoughts on “Network Effects = Network Externalities

  1. Byrne Hobart said:

    Has anyone formalized network effects to account for how the early adopters probably have higher marginal utility? I would expect that the first practical phones (used, I think, to rapidly re-route trains) added a lot more wealth per phone than, say, a recently-purchased cell phone.

  2. Niall O'Connor said:

    Having compared two hundred and fifty horse race betting markets on Betfair and Betdaq, I am moving towards the notion that in the case of these two betting exchanges, bid-ask spreads are pecuniary externalities; that is, a class of externality that does not constitute market failure.

    I have observed a number of situations in which liquidity, measured in terms of depth (the size of the bet on offer), tightness (the spread between the back and lay sides) and immediacy (the availability of the bets on offer), is signifciantly worse on Betdaq’s markets compared with Betfair. However, in terms of total bets matched, Betdaq actually outguns its rival.

    There may be any number of reasons for this, but what I am beginning to observe, is that the majority of this money is being matched on the favourite in each race, at the expense of the rest of the field (on which the spread between the back and lay sides is large). This would suggest that the largest traders on Betdaq, are big bookmaking companies, who are using the exchange to offload liabilities that they have on heavily backed favourites.

    The Betfair exchange, whilst populated by some bookmakers, is also home to thousands of traders, who are actively involved in spreading liquidity across all the runners in each race. However, as on Betdaq, the favourite in each race still accounts for a significant proportion of the total bets matched.

  3. Byrne Hobart said:

    Has anyone formalized network effects to account for how the early adopters probably have higher marginal utility? I would expect that the first practical phones (used, I think, to rapidly re-route trains) added a lot more wealth per phone than, say, a recently-purchased cell phone.

  4. Niall O'Connor said:

    Having compared two hundred and fifty horse race betting markets on Betfair and Betdaq, I am moving towards the notion that in the case of these two betting exchanges, bid-ask spreads are pecuniary externalities; that is, a class of externality that does not constitute market failure.

    I have observed a number of situations in which liquidity, measured in terms of depth (the size of the bet on offer), tightness (the spread between the back and lay sides) and immediacy (the availability of the bets on offer), is signifciantly worse on Betdaq’s markets compared with Betfair. However, in terms of total bets matched, Betdaq actually outguns its rival.

    There may be any number of reasons for this, but what I am beginning to observe, is that the majority of this money is being matched on the favourite in each race, at the expense of the rest of the field (on which the spread between the back and lay sides is large). This would suggest that the largest traders on Betdaq, are big bookmaking companies, who are using the exchange to offload liabilities that they have on heavily backed favourites.

    The Betfair exchange, whilst populated by some bookmakers, is also home to thousands of traders, who are actively involved in spreading liquidity across all the runners in each race. However, as on Betdaq, the favourite in each race still accounts for a significant proportion of the total bets matched.

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