Network Effects in the Early Electricity Industry

In early 1882, the financier J. P. Morgan had electric lighting installed at his private residence at 219 Madison Avenue in New York. He was one of the first individuals to benefit from such an innovation, thanks to the fact he was one of the angel investors in the company founded by the inventor Thomas Alva Edison. However, on the first night that the lights were switched on, the wiring at Morgan’s library sparked a fire that destroyed his desk. He also had to deal with his neighbors’ complaints about the noise, vibration, and smoke generated by the dynamo installed in a cellar below the stables at the rear of Morgan’s property. However, such events did not discourage his support for electric lighting; in fact, he threw a party in his residence for 400 guests as a demonstration of the product and stated: “I hope that the Edison Company appreciates the value of my house as an experimental station.”1

Morgan rarely invested in startups. He built his fortune by “morganizing” railways, telephony, and shipping; that is, consolidating existing competitors, reducing competition, and building scale and network effects. However, electricity, and electric lighting in particular, was an exception.2 Morgan came to know about the experiments under development by Edison, the already famous “Wizard of Menlo Park.” It is coincidental that Edison’s laboratory was located in Menlo Park, New Jersey, just a few miles away from New York City, and that the headquarters of Facebook and venture capital firms Sequoia and Andreessen Horowitz are in Menlo Park, California.

Edison had invented the electric lightbulb in October 1879. After testing more than 3,000 possibilities, Edison identified the right carbon material to produce the wire filament to be heated by electricity to a high temperature to glow to produce the perfect light for households.

However, Edison did not only invent the lightbulb; he envisaged a whole electricity network to feed lightbulbs.3 He envisioned a whole system formed with dynamos to produce the electricity in a central station, the copper wires to transport the electricity from the central station to the houses and offices, the meters to measure electricity consumption and bill the customer, and the equipment to regulate the voltage of the system. Edison’s idea was to connect to the network not only electric lightbulbs, but all electric appliances. It may seem now like an obvious solution, but at that time electric motor devices such as elevators and electric trams often worked with batteries and were not connected to a network.

Electricity would not be produced at the customer’s premises, as it was in Morgan’s stables, but in a central station that supported hundreds of customers. The first central station started operations in Pearl Street, in downtown New York. It comprised four large coal-powered steam boilers, six stream engines, and six thirty-ton dynamos. The central station was connected with 18 miles of copper wire to a maximum of 7, 200 lamps half a mile around the stations. The whole network had a cost of $500,0004 (around $12 million in today’s money). On the afternoon of 4 September 1882, the system was switched on from the offices of J.P. Morgan at Wall Street.

Edison’s proposal was a centralized network, contrary to the distributed model of private systems like the one installed in Morgan’s residence. A centralized network could generate electricity more efficiently by using larger plants, and would save customers the hassle of managing their own generating system, as they would simply rely on the provision of electricity by a specialized company. At the same time, however, a centralized system would need a coordinator of the whole system, which could also be the company managing all of it and constitute the opportunity to grow a multimillion business out of electric lighting.

Edison’s electricity network had a limited commercial success when it was launched. The number of customers was lower than expected, as was the revenue generated by the system. The second central station in New York, expected to be operative within months, only opened six years later. Even worse, competitors started to emerge, sparking the so-called “war of the currents.”

The main challenge that Edison faced was the high cost of transporting electricity over copper wires. Edison’s network was using low-voltage direct current (DC), running at 110 volts. Electricity transmission at low voltage was perfect for feeding lightbulbs, but proved to be very expensive to transport. $uch an expense increased the cost of the centralized system, diminishing its competitiveness against private decentralized systems. Consequently, private systems were initially more popular than centralized systems. Edison installed more than 300 private systems while his central stations were growing at a very slow pace. Distributed generation was beating the centralized system.

A solution was developed outside Edison’s system thanks to the work of engineers such as Nikola Tesla, a former employee of Edison. The solution was to increase the voltage for the transportation of electricity. Since the capacity of a wire is proportional to the square of the current traveling on it, each doubling of the voltage allows the same-sized cable to transmit the same amount of power four times as far, at the same cost. However, in order to safely use electricity in private premises, it was necessary to transform the current down to lower voltage once it reached the customer’s premises. The solution was named alternating current (AC).

Edison was reluctant to switch to alternating current, for good reasons such as the fact that transformers were not a mature technology and AC motors were not available, so the network mostly lay idle during the day. The main reason for not switching was that meters for AC were not available, so the service could not be billed to customers. Edison started a crude campaign exaggerating the dangers of high-voltage electricity.

New competitors entered the market making use of AC technology. Up to 15 companies entered the market providing equipment and know-how to local licensees, often participating in the capital of such local utilities. From a regulatory perspective, the centralized model required local permits to install the wires distributing electricity from the power plant to the customer premises. Such permits were usually granted under exclusive rights, which led to the creation of local monopolies. The permits defined the terms of operation, such as the fee to be paid to the city and, often, the tariffs to be charged to customers.

As the technology matured, the new companies outgrew Edison’s venture. Companies such as Westinghouse and Thomson-Houston were particularly efficient in low- and medium-density areas, as they could transport the electricity over longer distances at a low cost to reach the scattered population. Edison’s company was stronger in dense urban areas where efficiency in transportation was not so relevant.

Over time, AC networks proved to be more efficient than DC ones. AC not only reduced transmission costs, but it also empowered companies to generate the electricity further away, benefiting from the most efficient electricity-generating opportunities. For instance, AC made it possible to use Niagara Falls to produce electricity for consumption in New York City.

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