The network effect is defined as an entity getting more valuable the more people who use it. This can equate to a “winner-takes-all” position for businesses and a “moat”, as Warren Buffett and Charlie Munger like to say, to defend your castle (business).
Let’s look at a few examples of The Network Effect:
A key to Amazon’s success is that it:
Thus, the more people who use Amazon the more valuable it becomes to buyers (lower prices and more reviews) and to 3rd party sellers (who are attracted to the high level of buyers).
The more people who search Google the more data Google has (search queries) to help make its search even better.
And then the more users Google attracts (along with the data Google knows about them) the more attractive Google becomes to its paying customers: the advertisers willing to reach those searchers.
The more people who use Facebook, the more likely a Facebook user will choose to add their latest content (photos, videos, articles, etc.) to Facebook which in turn makes it the go-to place to see what’s up with your friends.
Similar to Google, Facebook then has a larger audience to sell ads to and more data on each user to help advertisers target their ads better (which Facebook can charge more money for).
Microsoft gained a network effect by providing the operating system (first DOS and later Windows) to 80% of computer users (interestingly, this was done through personal computer manufacturers (not directly). Because DOS/Windows became the dominant OS, it became the first OS that most application software companies (Lotus, Wordperfect, Autodesk, etc.) would write their software for.
The more application software on DOS/Windows there were, the more people there were who wanted to buy a DOS/Windows-based computer to use that software.
Microsoft eventually jumped in and provided software applications itself on their own DOS/Windows platform, providing further advantage.
The phone itself was an early opportunity for the network effect — the more people who used it, the more valuable it became. But the winners weren’t the phone manufacturers — it was the company connecting all the phones: AT&T — they were able to create a monopoly through owning the connections of the most phone users.
The Network Effect is closely related to “The Law of Scale”.
This article on The Network Effect continues my quest to list out The Top 100 Mental Models Needed to Succeed in Business.Tweet Comment