Network Effects, Deep-Dive: Direct, Indirect, and When They Reverse

A network effect is one of the strongest moats out there. Unlike most competitive advantages, it gets better simply by being successful. More users mean more value, which draws in even more users. There are two types to consider. A direct network effect happens when value increases as more people join the same side of the network. For example, a messaging app becomes more useful when more of your contacts are using it. An indirect, or two-sided, network effect occurs when value grows for one group as another group expands: a gaming console gets more valuable to players as more developers create games for it, and it benefits developers as more players buy the console.

Two-sided networks create a real barrier for new competitors. A newcomer has to attract both sides of the market at once. Each side is hesitant to join unless the other side is already there. This is often referred to as the "cold-start problem." That's why established app stores, gaming consoles, and marketplaces are tough for newcomers to challenge directly.