The Myth of Metcalfe's Law

By: Warren Packard

Aug. 1, 2000

The Industrial Revolution was characterized by a series of technological and business innovations that resulted in the exponential growth in manufacturing productivity. The concepts of mass production, assembly lines, and component standardization were all borne out of the realization that huge economies of scale could be realized by fabricating goods en masse using standardized parts. The trade-offs for adopting mass production techniques were a significant loss of creativity and individuality. On the flip side, the Industrial Revolution brought about huge increases in productivity, including much needed cost reductions and more rapid design iterations. An analysis of the growth in the productivity of the manufacturing workforce during this time would reveal exponential improvements, characteristic of the increasing scale economics of industrial innovations at that time.

Over the decades, the increasing gains resulting from the Industrial Revolution have slowed considerably. If one were to analyze the relative productivity of the manufacturing workforce as a function of time over the past century, one would not describe it as exponential, but rather as an "S" curve. In other words, the exponential gains of the early years of the revolution ultimately gave way to a slow, linear growth phase that characterizes the pace of efficiency gains in mature industries.

Fortunately, the Industrial Revolution was not the last revolution to have had an impact on the world economy. In the sixties and seventies, we witnessed the mainframe revolution. In the eighties, we experienced the PC revolution. As PCs proliferated throughout the office environment, laser printers and other computer peripherals began to show up. Companies began to network their computers to allow these expensive devices to be shared. At the same time, person-to-person communication was augmented by e-mail, resulting in further gains to the productivity of the information workforce.

The power of the computer network was immediately apparent and a "law", named in honor of Bob Metcalfe, was established. Metcalfe�s Law states that the value of a network grows with the square of the number of participants. In other words, each additional member of a network adds an incremental amount of value to every other member, thus growing the aggregate value of the network in an exponential fashion. The proliferation of PCs, servers, and e-mail all communicating over office networks and the Internet contributed to make Metcalfe�s Law a reality.

With the advent of the browser and the commensurate emergence of the World Wide Web, Metcalfe�s Law has taken on a second dimension. The combination of technologies that boast increasing economies of scale and the web�s massive communication efficiencies have led to the emergence of businesses that have grown at unprecedented rates. Hotmail, ICQ, and, recently, Napster, are perfect examples of these viral businesses. As a consequence of these and other web success stories, it is not surprising that industry pundits have waxed poetic on the veracity of Metcalfe�s Law and its role in validating the ever-increasing value of the Internet economy.

Unfortunately, this conclusion is wrong. Metcalfe�s Law is just a temporal anomaly. While it would be great to believe that Metcalfe�s Law will hold up for generations, it fundamentally isn�t possible. Networks saturate for a variety of reasons. As the population of a network increases, the value of each additional member diminishes. How much value was gained when the 200 millionth individual jumped on to the Internet? In addition, technologies mature and become obsolete causing once healthy networks to atrophy.

Can this possibly be the explanation for the performance of the market over the past few months? Could the market simply be reacting to the maturing of the Internet economy?

Absolutely not.

While the markets are extremely efficient and accurate in the long run, they are completely incapable of keeping up with the pace of technological and business innovations that we are currently experiencing. The Internet economy moves at a pace that is much too fast for the public markets, which, in general, view snapshots of companies and industries based on quarterly reporting periods.

Moreover, the value of the Internet economy continues to expand at a fantastic rate. Looking beyond the markets to the level of technological and business innovation that continues at this time, it is clear that we are still in the very early stages of the Internet revolution. Fueling the revolution are a host of public and private companies that are building out a ubiquitous, broadband network that will make today�s Internet appear trivial. Companies such as Lightwave Microsystems and Bookham Technology are fabricating mass-producible optical networking components. Systems companies such as Brightlink Networks and Cyras Systems are architecting the next-generation hardware through which our data will flow at breakneck speeds.

As the Internet begins to appreciate the benefits of these network advances, a transformation will take place throughout the web. Web-based businesses that were designed for a narrowband, disconnected world will be reinvented for the broadband, connected environment. New companies will emerge that will challenge the old economy companies, as well as the Internet incumbents, propelled by their operational nimbleness and sharpness of focus. In the final analysis, we will bear witness to the dawning of a new "S" curve, one that, once again, yields exponential productivity gains for the global information workforce. In fact, one can imagine yet another set of technology innovations fueling a subsequent "S" curve, and then another, and so on, until we realize that a series of technological and business dislocations yields cascading "S" curves that, in aggregate, actually appear to be one giant hockey stick of growth. Thus, while Metcalfe�s Law does not hold up when looking at networks in isolation, from a macro perspective, Metcalfe is right on target: exponential productivity growth will result from a series of innovations that leverage and transform the Internet over time.

The lesson for start-up companies and their more mature brethren is apparent: constant innovation is the key to fueling the Internet economy. Yet as start-up companies find success in a particular market and grow to become larger businesses, it is much too easy for them to become complacent and assume that they will be rewarded for holding their ground. Companies that fall into this trap will languish at the top of an aging "S" curve. New ventures and visionary companies will create technology and business dislocations that will characterize the beginning of a new "S" curve. So, while the public markets are out of synch with the current state of the Internet Revolution, there is no better time for firms to reinvent their industries and propel themselves onto the next "S" curve that emerges as the new wave of the Internet economy.