The most basic definition of the network effect is the indirect value goods and services gain as more people use them. The world's most popular social network, Facebook, is a fairly obvious example of a company that benefits from this durable competitive advantage. Simultaneous growth of its user base and operating profit is hardly a coincidence.

The network effect

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In order to remain profitable amid intense competition, businesses must be able to command higher prices from their customers, or lower their operating costs. Let's take a closer look at different ways the network effect can make this happen.

Benefits of the network effect

To earn higher profits, a business can raise prices or lower costs, and Facebook's network effect helps with both. On the price-raising side of the equation, more users gives its advertising clients a larger audience to target with specific ads. What makes this such a powerful advantage is the incremental expense associated with adding each new user is much smaller than the value they create.

FB Revenue (TTM) Chart

FB Revenue (TTM) data by YCharts.

Bob Ross couldn't illustrate this concept any better than Facebook's third-quarter 2016 results. As usual, the number of active users rose across the board. More importantly, though, advertising revenue soared 59%, compared to a 28% increase in total costs and expenses over same period during the previous year.

Beyond the internet

Finding companies poised to benefit from the network effect is a great way to pick market-thumping stocks, and they can turn up in unexpected places. You might be surprised to learn companies that pre-date the internet have enjoyed this advantage for generations.

For example, green and yellow tractors sold by Deere & Co. command a higher resale value in regions where it sells enough to support a viable network of dealers and service centers. This in turn allows it to charge a higher price for equipment otherwise comparable to that of its smaller competitors. This advantage helped make it the most profitable farm equipment manufacturer of all time.

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