Bitcoin and Ethereum Follow Metcalfe’s Law of Network Effects New Study Says

Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of its users, applies to bitcoin and ethereum according to a new study published at the journal of Electronic Commerce Research and Applications.

The study measured the value of the network based on the price of relevant digital currencies and compared it to the number of unique addresses that engage in transactions on the network each day, according to the abstract.

The results show that “the networks were fairly well modeled by Metcalfe’s Law, which identifies the value of a network as proportional to the square of the number of its nodes, or end users,” the study says.

The findings can be useful to identify bubbles, with the study stating that “value bubbles show up where repeated extremely high value increases are not accompanied by any commensurate increase in the number of participating users, or any other development that could give rise to the higher value.”

Which means that once the bubble is inflated beyond fundamentals, the fundamentals eventually catch up, causing the bubble to burst with sentiment then potentially moving too far in the opposite direction, until fundamentals catch up again.

The application of Metcalfe’s law towards transaction numbers specifically has long been suggested, with a fairly strong correlation between the price of digital currencies and their transaction numbers observed over many years.

Ethereum, for example, was barely handling 20,000 transactions at the beginning of the year. Now it manages nearly 300,000 a day. Likewise, price has risen some 10x during the same time period.

The reason for this relationship is fairly intuitive. As more projects build on ethereum, more users find it useful as there are more things they can do with it, which in turn makes ethereum more useful for new projects as it allows them to tap into more users.

The same can be said about merchants. As more of them accept eth for payments, more think eth can be useful for everyday things, which means more merchants want to accept it to tap into the increased number of users, so forming a virtuous cycle.

Metcalfe’s law of network effects can be applied to developers too, or investors, including speculators. The more that use it, the more useful it becomes, with the reverse applying too. The fewer individuals that use it or the more that stop using it, the less useful it becomes.

This exponential function has been used by some to even try and predict the unpredictable future, with bitcoiners creating a fancy chart to try and extrapolate price movements in longer time frames:

However, Metcalfe’s law does not necessarily have any predictive quality regarding the future as it only measures the value between two known and current parameters.

That is, Metcalfe’s law can not predict how user numbers would grow or fall, but only how value would react to the change in user numbers in either directions.

Because network effects, like price, can go up and down. No one uses MySpace any longer, for example, making it far less useful than when everyone was using it. Likewise, we do not know whether more people will use ethereum’s or bitcoin’s network.

Instead, all we can say somewhat objectively is that the price increase in bitcoin or ethereum needs to correspond with an increase in the user base or some other aspect, such as number of projects or merchants.

And, conversely, if the number of transactions – as a proxy for the number of users – or the number of projects, or its overall use, increases, then a corresponding increase in price should be expected sooner or later, with the reverse applying too.

So the law is useful as an objective measure with its predictive qualities applicable to known facts, rather than to future extrapolations, making it a handy, albeit somewhat limited, tool to keep yourself grounded.