Network effects
Sector Deep DivesWhen a product becomes more valuable to each user as more people use it, creating self reinforcing advantage.
A network effect exists when additional users make the product better for existing users. A marketplace with more buyers attracts more sellers, which attracts more buyers; a messaging app is worthless alone and valuable to everyone once adopted.
It is the strongest form of competitive moat because it strengthens with scale rather than eroding, and it makes late entry extremely hard: a competitor must overcome not just the product but the entire installed base.
Direct network effects come from users of the same type, as in a social network. Indirect or two sided effects come from users of different types, as in a marketplace or an operating system with developers and users.
The claim is made far more often than it is true. Many businesses described as having network effects simply have scale economies or high switching costs, which are real advantages but behave quite differently.
Worked example
A payments network with 1,000 merchants and 50,000 consumers: each new merchant makes the network more useful to every consumer, and vice versa.
A competitor launching with 10 merchants cannot win on product, because the product is the network. That is why late entry is so hard and why these markets tend toward one or two winners.
Contrast a business with high switching costs but no network effect: its customers are locked in, but a new entrant can still win each customer one at a time.