MappingTheWeb //

In this post, we will take a look at how the network effect can lead to monopolies. To facilitate this discussion and provide clarity around the matter, we will look deeper at two specific companies - Microsoft and Walmart. In one instance, we examine a tech company, and in the other, we step outside of the Internet/tech world to see how basic principles and underlying fundamentals stay true across numerous disciplines.

Firstly, we will take a look at an itsy-bitsy software company that came about in the late 70s - the company everybody loves to hate - Microsoft. During the early 80s, the personal computer (PC) boom began. Computers became more affordable and accessible. Now we step back for a second. What do all computers need in order to run properly, or even boot for that matter? An operating system (OS). This is where Microsoft came about. After buying a fundamental chunk of code, Bill Gates and Paul Allen began a journey to conquer the PC operating system market, when few OS’s were available to choose from. Microsoft developed MS-DOS, then went on to essentially steal Apple’s concept of a graphical user interface (GUI). So where does the network effect come into play? Be patient…

As Microsoft’s OS caught on, became more and more popular, and more PCs began using the system, it became the industry standard. Coders and programmers alike began developing software for the Microsoft operating system (which later went on to become Windows). As more and more software products were being created for the Microsoft system, other OS’s were getting left in the dust. And the cycle continues. As more software product became available for the MS OS, it soon became apparent that if you were developing code, you might as well design for the system that has the widest distribution channel (i.e. maximizing your potential target audience). Programmers began to wonder, “Why would I develop for any other system, as the audience and money just aren’t there?” I’m obviously over-exaggerating a lot of these ideas, themes, and concepts, but my goal is simply to showcase the magnitude of Microsoft in comparison to the smaller guys. Obviously Apple was there all along, receiving much less exposure and market share, as well as several other smaller OS’s. Essentially, Microsoft hit a critical mass, which led the company into the snowball effect, further catapulting it ahead of potential competitors.

At a point where Microsoft has over 90% market share of the world’s OS market, why would anyone develop software for another platform (forget Macs for just a second here)? More importantly, why would anyone try to create a new operating system from scratch, then have the impossible task of getting programmers to develop software for that system. It doesn’t make sense. Microsoft was light years ahead - so far ahead that it almost seems impossible for anyone else to step in and put up a challenge. Good luck to a willing rival.

Now can you guess how Walmart is exploiting the network effect to its favour? Well, the situation in this case is much simpler to explain and understand:

Walmart:

1. Buys wholesale from suppliers.
2. Optimizes inventory turn-over.
3. Expands by adding more stores.
4. Buys larger and larger quantities from suppliers, demanding a deeper discount with every increase in demand.
5. Repeat cycle.

In other words, Walmart has such wide distribution and power over its suppliers that it can dictate all terms of the relationship, including pricing and payment terms. Walmart sucks every last penny out of its suppliers, as it knows they rely on the consumer giant for survival. It’s sad really. And as Walmart continues to grow through expansion and economies of scale, the problem will only get worse and worse. The network effect forces Walmart’s suppliers to operate under its rules. And I haven’t even mentioned Walmart’s world-class logistics and inventory management systems, which includes satellites and sophisticated inventory control software. Walmart forces people with a low (even medium or high) income to shop there, as they are basing their purchasing decisions solely on price. Good luck to all the little guys out there and the mom-and-pop retail stores.

If I had to pick one company to be around at the end of the world, it would be Walmart as I cannot see them slowing down or losing market share unless something very drastic happens. 

Click here for part 1 or part 2 of the Network Effect series.