In short, network effects are created when the addition of a new member to the network increases the value of the network and as well as the value for each of its existing members. An example of one of the most powerful network effects is Microsoft and its Windows operating system. The more users installing windows on their computers, the more powerful Microsoft and the Windows network becomes because Windows enables compatibility among files, applications, and more.

Consider Apple and the iPhone applications. Apple opened up the iPhone to software developers to create additional applications specifically for the iPhone because Apple knew that the more applications available for the iPhone, the more valuable the iPhone would become to consumers. Apple’s strategy enabled them to create a strong network effect that makes it very difficult for competitors to penetrate. Network effects are defined by the number of unique user groups that the network serves. Networks are traditionally served through a platform that connects independent users and user groups, also known as platform-mediated networks.

One-sided networks are defined as networks that connect users seeking to use a platform or network for a similar purpose. There is only one unique user group on a one-sided network, however each user, as well as the network, benefit each time a new user joins the network by using the platform. Famous examples of one-sided networks include fax machines, connecting users seeking to transmit information. Skype, is another one-sided network that connects people wishing to talk. Skype users benefit the more people that use Skype since this enables the user to communicate with more people, although this has limited network value since individuals are physically limited by the number of people whom they can speak with.

Two-sided networks are networks that connect two distinct user groups, each looking to use the network for a different purpose. Each user group benefits from the other user group within the network and benefits more so as the number of users on the other side of the network increases. Examples of two-sided networks include EBay, where you have buyers and sellers connecting to buy and sell goods. As the number of buyers on EBay increases, it attracts additional sellers looking to sell their products and vice-versa as the number of sellers increase, EBay attracts more buyers seeking to purchase seller’s goods.

Creating network effects enables firms to create durable competitive advantages by creating a more valuable firm as the network grows and by increasing the customer switching cost of leaving your network. This is why Microsoft has had the dominant market share since day 1 and hasn’t been seriously challenged. The Windows network effect is simply too large and too strong.