Course 205: Economic Moats
The Network Effect
In this course
1 Introduction
2 How to Build a Moat
3 Low-Cost Producer or Economies of Scale
4 High Switching Costs
5 The Network Effect
6 Intangible Assets
7 The Bottom Line

The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. It can also occur when other firms design products that complement an existing product, thereby enhancing that product's value. The network effect is arguably one of the most potent competitive advantages, and it can also quickly catapult firms to the lead in new industries.

Like Autodesk, AdobeADBE actually enjoys two economic moats. The firm's Acrobat software has become the standard for reading and creating documents electronically. Because customers, such as graphic designers, are trained early in their careers to use products like Photoshop and Illustrator, it's nearly impossible for competitors to take meaningful market share. High switching costs make it tough for customers to get comparable products elsewhere or do their job without Adobe.

As if switching costs weren't enough, Adobe also benefits from the network effect. With more than 500 million copies downloaded, Acrobat has a foothold on computer desktops everywhere. As its network effect increases, and more designers and readers use Adobe's software, its position as a standard-bearer grows.

When the online auction market was just getting started, eBayEBAY was the largest. As the site with the most sellers, it had the widest selection of products. This attracted the most buyers. Because it had the most buyers, it attracted more sellers.

The cycle just continued to feed on itself, and now eBay is essentially the only real online auction site of size. It was able to capture this position even though some large, well-known, and well-financed Internet companies such as YahooYHOO and AmazonAMZN tried to make a frontal assault on eBay in the late 1990s with very little success.

Next: Intangible Assets >>

Print Lesson |Feedback | Digg! digg it
Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.
Copyright 2015 Morningstar, Inc. All rights reserved. Please read our Privacy Policy.
If you have questions or comments please contact Morningstar.