Ever since Facebook first emerged in the mid-2000s, the concept of network effects has become one of the most powerful and often most misunderstood drivers of value in the modern economy. Defined as the phenomenon where the value or utility of a product, service or platform increases as more people use it, each additional user makes the network more valuable for all existing users. Understanding network effects has become crucial for unlocking a company’s growth potential and, consequently, its ability to achieve market dominance.
The Liontrust Global Equities team continually hunts, monitors and measures network effects in companies. How can we fully understand this phenomenon to ensure we stay ahead of the curve?
What are network effects?
A network effect occurs when a product or service becomes more valuable as more people use it. This self-reinforcing loop can lead to exponential growth and the creation of strong competitive advantages, known as moats. These moats, established by network effects, make it exceptionally difficult for competitors to dislodge market leaders, providing a sense of security and confidence for investors. The network effect often results in a “winner takes most” scenario.
The two main types of network effects
Direct network effects, also known as same-side effects, occur when the value of a product or service increases directly with the number of users. Classic examples include social networks and messaging apps – each new user adds value for everyone else by expanding the pool of possible connections. For instance, WhatsApp becomes more useful as more friends and contacts join, making communication easier and more comprehensive.
Indirect network effects, sometimes called cross-side or two-sided effects, occur when users on one platform attract users from another and vice versa. This is typical of marketplaces and platforms connecting distinct user groups, such as Uber’s drivers and riders or eBay’s buyers and sellers.
Uber: Poster child example
Uber’s ascent is a textbook case of leveraging network effects to achieve scale and defensibility. By rapidly onboarding both drivers and riders in new cities, Uber hit critical mass faster than its rivals. As more drivers joined, wait times dropped and coverage improved, attracting more riders. This, in turn, made driving for Uber more attractive, creating a virtuous cycle. Today, Uber’s entrenched network of drivers and riders forms a powerful economic moat, making it extremely difficult for new entrants to compete without massive investment and subsidies.
How the market misunderstands network effects
Despite their prevalence, markets often fail to understand network effects. Many investors focus on a company’s early growth metrics, failing to recognise whether that growth is underpinned by true network effects or aggressive marketing spend. The distinction is critical; only genuine network effects create a durable economic moat, making it increasingly hard for competitors to catch up as the network scales.
A common misconception is that all fast-growing platforms have network effects. In reality, only those where each additional user increases value for others—either directly or indirectly—enjoy the compounding benefits that lead to long-term dominance. Without this, growth can stall or reverse as competition intensifies. Crucially, companies achieving rapid growth through aggressive marketing spend does not necessarily indicate the presence of network effects.
Network effects enable growth, while high switching costs keep customers on side
High switching costs are a significant barrier to exit, enabling companies like Microsoft, Amazon and Apple to maintain their dominance, even after network effects have helped them scale to new heights.
For users of Microsoft, the idea of moving platforms becomes intimidating once a business has integrated its operations into the Office 365 and Windows ecosystem, becoming dependent on its interconnected workflows, proprietary file formats and extensive user training. Transitioning to a competitor would involve substantial costs, including retraining, data migration and potential compatibility issues with partners and clients who use Microsoft systems.
Similarly, Amazon’s Prime ecosystem keeps customers tied to the platform. Years of accumulated purchase history, personalised recommendations and exclusive services like Prime Video and fast shipping make it inconvenient for consumers to switch to another retailer, even if lower prices are available elsewhere. Which brings us to Apple’s walled garden. Users who have invested in iPhones, iPads, Macs and a collection of apps and media are not only faced with technical challenges in moving their data, but also the loss of seamless device integration and exclusive features.
Examples today
Intuitive Surgical, the manufacturer of the da Vinci robotic surgery system, benefits from indirect network effects. As more hospitals adopt the da Vinci system, an increasing number of surgeons receive training on it, leading to the collection of more data that enhances surgical procedures, making the da Vinci system even more effective.
This growth creates an ecosystem of trained professionals, support staff and third-party tool developers. As a result, training, support and compatibility improve, making the system more attractive to new adopters and reinforcing Intuitive Surgical’s leadership in robotic surgery.
Omnicell, a leader in automated medication management, benefits from indirect network effects. As more hospitals, healthcare providers and pharmacies adopt Omnicell’s solutions, the platform becomes more valuable due to improved data sharing, workflow integration and the dissemination of best practices.
Omnicell creates significant network lock-in, making it hard for institutions to switch providers without disrupting operations. Its cloud-based analytics and SaaS offerings further enhance predictive tools, benefiting all users. This integration and data-driven approach ensures that Omnicell’s network becomes increasingly essential and increasingly hard to exit.
Atlassian, the enterprise software company behind collaboration tools such as Jira and Confluence, benefits from a direct network effect as more teams and organisations adopt its products. The platform’s value increases with the number of integrations, plug-ins and shared workflows across teams. High switching costs arise because businesses deeply embed Atlassian tools into their project management processes, with custom configurations, historical data and employee training making migration to a rival platform complex and costly. These companies illustrate how network effects, when reinforced by high switching costs, can create durable competitive advantages even for firms outside the tech mega-cap club.
The economic moat of network effects: A competitive advantage
Network effects are the hidden engine behind many of today’s most successful companies. They drive exponential growth, create formidable barriers to entry and underpin the enduring dominance of market leaders. For analysts and investors, recognising genuine network effects is essential to identifying companies with the potential for long-term success in an increasingly interconnected world.
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