Network effects are a phenomenon whereby the value to the user or consumer of a product or service increases as its user base grows. Facebook, for example, is more compelling to potential users (including Harvard undergraduates) today than it was when it was limited to only Harvard undergraduates; there are more people to connect to, making it a more useful product.

Network effects can only be leveraged if users are able to interact on the same network. So even if the overall market for a networked product is very large, it will have less value if that market is segmented. For example, early on in the telephone industry, even if a friend had a telephone, you would not be able to call them unless the two of you were connected to the same provider. Such fragmentation decreased the value of having a phone.

Economists have long argued that network effects lead to natural monopolies for exactly this reason; the overall value delivered to users will exponentially grow if instead of having competing networks, everyone uses the same one. While it has become apparent that digital platforms such as Facebook and Uber aren’t necessarily monopolies, there is no doubt that increasing returns to scale give these platforms with tremendous market power.

Market power arises when users or customers have few comparable alternative options for sources of the good or service being provided. This gives the seller the ability to raise prices, or in the case of some internet giants to charge transaction fees, compile and sell user data, all as a condition for giving users access to the platform.

Each of the aforementioned monetization strategies, using market power as a tool, creates inefficiencies. These inefficiencies emerge in the form of users opting out of a platform that would deliver them value above the marginal cost incurred by the supplier. They also come at the cost of some transactions that would otherwise result in gains from trade not occurring because fees outweigh the benefit.