Network Effect | Value Research The network effect differs markedly from achieving the economies of scale, which are supply-side driven and limited by production capacity
Companies with Moat

Network Effect

The network effect differs markedly from achieving the economies of scale, which are supply-side driven and limited by production capacity

Network Effect

This source of moat is built by firms when other firms design products that complement an existing product, thereby enhancing that product's value. For example, the fact that there are literally millions of people using eBay is the thing that both makes eBay's service incredibly valuable and makes it all but impossible for another company to duplicate its service. This also makes it difficult for rivals to enter the market.

By definition, the network effect is an economic condition created by a company that produces a particular product or service in which the more its perceived value increases the more it is adopted by other users. And as long as the perceived value exceeds the price paid for the product or service, more people will want to own or use it.

Such entry barriers could arise from regulations, say, via licences or patents. Patents also create strong economic moats. Once a drug has received all regulatory approvals, the regulator grants the pharmaceutical company the exclusive right to manufacture and sell that drug molecule for 20 years. Since no other company can manufacture the same molecule, the patent holder has limited or no competition and enjoys high profits. Patents account for the consistently high profits of pharma majors such as Pfizer.

Firms also create high entry barriers for rivals by using the network effect to their advantage. A network creates a virtuous cycle: As more members join the network, the latter becomes more valuable and as it becomes more valuable, more members get attracted to it. Facebook owes its success to the network effect. The network effect is also created through superior distribution and quality after-sales network.

Many Indian players are able to sustain their lead by the virtue of the powerful countrywide distribution networks they have built over the years. New entrants can't develop them overnight as doing so requires both time and money. Exide, the leader in batteries, has a distribution reach that is twice as large as that of the no. 2 player, Amara Raja.

Likewise, in the automobile sector, Maruti, Hero MotoCorp and Mahindra and Mahindra all owe their dominance partly to their product suite but also largely to a strong network of sales and service centres that extends even to semi-urban areas across the country.

Indian case
Entry barriers, as we said, could get created by regulations, such as the need to obtain a licence to run a particular business. Players in the Indian telecom sector have benefited from this type of entry barrier. Only a limited number of licences are issued in each telecom circle, which limits competition.

Similarly, ITC enjoys a competitive advantage that is government mandated because foreign tobacco brands such as Rothmans or Benson & Hedges can't come into India and start manufacturing cigarettes as the Indian government will not permit them.

So, between bidis at the lower end and imported cigarettes at the top end, ITC has the entire market to itself. Its brands are so powerful that whenever the government hikes excise duty rates during the budget time, it is able to pass these on to customers without losing market share. The company has further cemented its leadership position by building up a powerful distribution network.

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