http://www.fool.com/investing/general/2008/04/24/i-like-big-moats-and-i-cannot-lie.aspx

In his article “I Like Big Moats and I Cannot Lie,” Rich Greifner explains how Warren Buffett was able to amass such a huge fortune by investing in the stock market. According to Greifner, the key to Buffett’s success is the emphasis he puts on an “economic moat” when evaluating companies. An economic moat, as defined by Buffett, “refers to a business’ competitive advantages that keep other companies at bay.” Companies that have “wide, sustainable moats” will outperform their competitors even in the long run, which benefits its investors.

Greifner cites an article by Mark Sellers (http://www.beearly.com/pdfFiles/Sellers24102004.pdf) which states that there are only four sources of sustainable competitive advantage. These four sources: economies of scale, the network effect, intellectual property rights, and high switching costs, form the “economic moat.” The two sources that are most relevant to our course are network effects (obviously) and high switching costs.

Basically, if a company increases in value as the number of people using its product increases, network effects are present. Examples given by Greifner are eBay and Discover Financial Services. Network effects create a sort of perpetual cycle. As more people use the service, the company becomes more valuable, which leads to even more people using the service.

High switching costs also contribute greatly to the success of a company. If customers are using your company’s service or product already, they are less likely to switch to another product if it incurs costs on their part. Greifner uses Microsoft as an example, describing how most people use Microsoft even though people have often complained about the software. Greifner gives a very good explanation of this, saying how “it would be an enormous effort to retrain employees and transfer files… and besides, everyone else uses Microsoft’s software, too.”

The network effect and high switching costs can be discussed using several models that we have learned about in class. To model these effects, imagine a graph in which most nodes are using System A. A small portion of the nodes are using System B. System B is superior in every way, but it is new, and very few people have started using it. Since there are network effects in place, the threshold is very high. Unless a large proportion of the nodes switched over at once, the payoff for switching to B is lower than the payoff for staying with A. Furthermore, switching from System A to System B will incur costs, since staff will need to be retrained, there will be installation costs, etc. This lowers the payoff for switching even more.

Clearly, the two sources of competitive advantage discussed above contribute greatly to the long term success of a company. Even if a competitor has a system or product that is technically superior, network effects and high costs of switching may be enough to prevent them from cutting into your customer base.