Course 109: Finding Economic Moats
The Network Effect
In this course
1 Introduction
2 About Economic Moats
3 High Customer Switching Costs
4 Economies of Scale
5 Intangible Assets
6 The Network Effect

Perhaps the strongest type of economic moat is the network effect. For those rare companies that successfully take advantage of this phenomenon, the reward is often a legal monopoly. A common trait among these types of companies is that they are the first, or one of the first, to enter an emerging industry or business niche.

Let's take a trip back to March 7, 1876, the day Alexander Graham Bell was awarded a patent on a new invention called the telephone. Even though this marked one of the most important inventions in the history of the world, many people saw it as a mere curiosity. The telephone didn't immediately catch on for one reason: Since no one else had access to a telephone, there was no one to call. Who wants to buy something that can't be used?

But slowly, more and more people gained access to a telephone, giving them the ability to communicate with friends, family, and associates. As more people gained access to a telephone, the more valuable telephones became and the faster phone usage grew. This is a classic example of the network effect (or winner-take-all effect): The more people that are within a network, the more valuable the network becomes to new and existing users.

A more recent example is eBay EBAY. Because it was the first to connect individual buyers and sellers over the Internet in an auctionlike format, it grew very quickly. It had (and still has) the most sellers, which attracted the most buyers, and vice versa. EBay gained a critical mass and retains a near-monopoly position in the online-auction market.

One final thought about economic moats: It is possible for some companies to have more than one type of economic moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has--and the wider those moats are--the better.

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