Network Effects are Software’s Defensible Moat

This idea is important. This is also the complex language version — I have not attempted to simplify the language here or make it understandable by a general audience. I may do so in another post or upon request in the comments.

I’ve been trying to understand why it is that there hasn’t been a large push for creating patents and copyrighting code as there has been for physical objects that are engineered.

The reason why we have patents for physical objects is to stop a chilling effect for innovation. Patents ensure that the original creator of the product has time to build their distribution channels and capture a sizable portion of the market before new players with stronger distribution channels step in.

Note, however, that we don’t let patents last forever, because that would limit the beneficial market effects of competition for consumers (alongside other reasons that I’m less familiar with).

My current theory is that network effects act as a modern-day patent for software. Many of the largest software companies today have built up networks of products and users where their software services gain more value the more users there are and the more of their products the users use. Apple is a great example of this with building network effects around physical products. Using your iPhone is much easier if you also have a Mac.

These network effects provide very similar benefits to the creators of the software. Assuming that the software is developed essentially in stealth mode, network effects allow software developers to build communities around their product. These communities, and the loyalty of people to the product, provide a network effect, causing the value of the product to increase. Think Facebook, YouTube, TikTok: if no one else used them, they wouldn’t be that fun. Then, since the original software creators were the first movers, they have the defensible moat of a “community” that even an exact duplicate of their code with a different name could not recreate.

Thus, they essentially have a patent. No one can really copy their product, because even if they copied the code, they can’t really copy the community.

However, what’s slightly worrying to me is that there’s no lifetime attached to the length of these network effects. Unlike patents, communities and users don’t tend to go away as long as your product continues to provide the services they want.

This means that once the big players are established, the only way to create a new product in that market will be to create a similar product that users don’t immediately recognize as competition and therefore don’t feel loyalty to the original software. Your product would have a different brand and appear to provide a (slightly) different service. Then, you would need to start building features of the original software into your own product, slowly capturing the market of the other big player.

Note that this is exactly what is happening. Snapchat creates a market for erasable media transfer. It seems like it’s doing something new and different, but manages to capture part of the younger demographic advertising market. Instagram, which also is a large player in that market, duplicates Snapchat’s story feature. TikTok (an infinite short video scroller) takes over the market previously held by Vine but does so in a more community-centric algorithm-driven manner. In response, Snapchat releases Snapchat Spotlight, an infinite short video scroller and YouTube then releases YouTube Shorts for short videos. Right now, I’m curious to see what aspects of Clubhouse start popping up in the other big players’ apps.

But notice a theme here. Very rarely does a new player come in (Snapchat, TikTok, and now Clubhouse) and take over a part of the market with a new idea. And, even when they do, the other software companies, which already have communities, quickly copy their product and provide it to their users.

I’m worried that this is stopping people from starting businesses that create community-driven sites. If the big players can always copy your software and have a bigger market faster than you, building a new site is always going to be a risky play.

Overall, there are two core issues. One (which I just discussed) is that this environment makes it difficult for entrepreneurs to start new community-driven software, given that bigger players may just duplicate their product with a much larger audience. The second is that this environment makes it nearly impossible for competition to take place, since unless there’s multihoming (as is the case with Uber and Lyft), selling the “same” product at a cheaper price can’t actually happen because the new product won’t have the community (and therefore won’t attract the community).

However, the second issue isn’t just monetary. For example, DuckDuckGo has managed to sell a search engine that’s “cheaper” than Google in the sense that it gives you more privacy — you aren’t paying by giving up your data. I don’t know how they managed to do this, given that search engines often rely on communities to help provide relevant searches, and people rarely stray from Google as a search engine. My hunch is that the cultural movement behind privacy is so strong that it enabled DuckDuckGo to attract a community even when their product was weak.

What this eventually leads to is a world in which large cultural shifts can eventually lead to a change in the main players if the main players either don’t react fast enough, or their brand is too closely tied to previous cultural beliefs.

But what I don’t think we’ll end up seeing is customization by different players to the level that we’ve seen in physical products. I don’t think you’ll see many commonly-used social media sites in the same way that there are many commonly-used companies that sell vacuums. There will be a few big players who will customize a lot, and the rest will be small sites that are driven primarily by cultural values are aren’t aligned with the big sites.

RIP regular, small, independent communities.

In case it’s not obvious, I love hearing from people about ideas like this! Feel free to leave a comment down below if you have any thoughts on these sorts of topics. I want to hear from you.

Example Case: AirTags

This update was added on October 2nd, 2021.

An interesting recent move around physical hardware has been Apple’s decision to release AirTags in direct competition with Tile. Tile’s main selling point was their large network effects; many people had the Tile app, so you could find your lost items as long as anyone with the app was nearby. Now, Apple moves into the exact same space with their pre-existing network, meaning that anyone with an iPhone can help find lost items.

The worry that this article tries to get at is that moves like this from companies like Apple might make it so that companies like Tile never exist in the first place, because the would-be founders realize that something like this could happen and it would ruin their business, so they don’t create the business in the first place.