How Important Are Bitcoin’s Network Effects?

Analysts often speak of the possibility that Bitcoin, Ethereum, or another entrant will become the dominant cryptocurrency. But are we taking for granted that there must be a single winner?

Analysts often speak of the possibility that Bitcoin, Ethereum, or another entrant will become the dominant cryptocurrency. But are we taking for granted that there must be a single winner?

Much of the mental model of a single dominant cryptocurrency comes from the idea of network effects: the idea that a network such as Bitcoin’s becomes more valuable to users as it grows. Certainly, value from using the currency increases as more sellers accept it. In some cases, network effects necessitate a single dominant winner, and in others they simply confer an advantage to market leaders or first movers. Which type is Bitcoin?

One classic example of network effects yielding a dominant firm or standard is the VHS standard’s defeat of Betamax in the early VCR market, despite having no quality or cost advantages. The two types of VCRs were not interoperable, and most consumers were willing to buy only one VCR. And once a VCR is purchased, another won’t be purchased in the short term, a concept called lock-in. As Betamax lost market share, video stores stocked less of its tapes, causing a vicious cycle all the way to near-zero market share.

But cryptocurrencies are different from VCRs in some important ways. Most cryptocurrencies are designed to not have high fixed costs associated with starting to own, spend, and accept them. In cases where it’s more feasible for individuals to use multiple products or systems, network effects will still provide an advantage to market leaders but need not stomp out all competition. Social media provides a good example.

Facebook, due in part to network effects, has become the most widely used social media site in most of the world. However, many individuals are willing to enter other networks alongside Facebook, such as Instagram and Twitter, when the purpose of the network overlaps partially but not fully with Facebook itself. For example, Facebook can share text or photos, but Twitter and Instagram have provided networks that specialize in each and attract many users.

That type of world might be possible: Bitcoin as the cryptocurrency used by most people, with sizable groups using other cryptocurrencies with distinct features alongside Bitcoin. A few but not an unlimited number of competitors would gain some market share. We’re used to a single currency in the world of fiat money where one currency is accepted everywhere to the exclusion of others, but there’s nothing in the world of cryptocurrencies stopping businesses from accepting a few, and keeping individuals from holding their money as different digital currencies depending on their needs. And the creators of Bitcoin, in love with decentralization, should welcome such “neighbors” in their space.

 


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