The Leaky Bucket Theory of Network Effects

A framework for understanding the strength of a marketplace’s network effect

We all know that network effects power the top marketplaces in the world - Amazon, Alibaba, Airbnb. But you know what else has network effects? Every other marketplace, including the thousands that failed.

At their best, network effects are a source of deep defensibility that make markets winner-take-all. At their worst, they’re trivially easy for anyone else to replicate, leading to zero-sum competition for market share. What’s the difference?

Any defensive moat can be overcome with enough capital. If someone was willing to give you hundreds of billions of dollars without expecting a return on their investment for twenty years, you could build a viable Amazon competitor. But no one will do that, because it would be too expensive and risky. So the question is not can a moat be overcome, but at what price.

In the case of a marketplace network’s effect, that price is closely approximated by how much it would cost to acquire and retain all of the supply needed to make customers happy.

There are three dimensions which determine that price: geographic reach of a market, heterogeneity of supply, and multi-tenanting. We’ll unpack them using the analogy of a bucket. The more water (supply) it is holding, the more it would cost someone else to fill their own, and the less likely they are to try.

1. Breadth (geographic reach)

The more narrowly a market is defined, the easier it is to aggregate enough supply to deliver a good experience to customers, and the less defensible it will be long term.

At the smallest end of the scale, you have local marketplaces like food delivery (Doordash) and local services (Thumbtack). Their markets are defined at the city or even neighborhood level because customers only care about the supply in their area. The best way to think about these businesses is not a single marketplace, but instead a collection of smaller, independent marketplaces running on shared infrastructure.

At the other end of the spectrum, you have national or global marketplaces, where a customer is selecting from supply across a much wider area. Most of e-commerce is at least national, and always expanding as cross-border freight gets easier and cheaper. For travel marketplaces like Airbnb, choosing between options in any country is a core part of the value.

The other important factor is whether customers move between markets or not. In the case of Thumbtack, they usually don’t - most customers probably only have a home in one area, so all they care about is whether or not coverage is good there. But for Lyft, it’s valuable for the product to work anywhere you travel, which makes it a competitive advantage to have many individual markets aggregated in one product. These markets are local, with a cross-market benefits.

2. Depth (heterogeneity of supply)

Once we’ve defined the size of the market, we have to determine how much supply it takes in that market to make customers happy. Again, the less it takes, the less defensible a network effect is.

On one end of this spectrum, you have a marketplace like Lyft. Supply is homogenous, meaning they all essentially provide the same thing, and customers don’t care much about who the supplier is. They care about wait times and price, and it doesn’t take much supply before wait times are less than five minutes and pricing is pretty efficient.¹

On the other end of the spectrum is a marketplace like Amazon where supply is heterogeneous. Customers shop across thousands of categories, millions of brands, and hundreds of millions of products, and everyone wants them at different price points, quality levels, and aesthetics. The core benefit is selection and convenience - and that continues to improve even as you add large amounts of supply.

In the middle of the spectrum are markets that are heterogenous, but shallow. The customer cares who the supplier is, but is usually satisfied with <10 good options for a given search - think grocery stores on Instacart² or home painters on Thumbtack.

Taken together, breadth and depth determine how much supply you need at any given time to make customers happy. The further up and to the right, the more defensible a network effect is.

3. Holes (multi-tenanting)

The final dimension is how feasible it is for suppliers to multi-tenant, i.e. use multiple marketplaces at one time.

If multi-tenanting is easy, a new marketplace can get traction even if someone else has already aggregated a lot of the supply in a market. Everyone will have to spend a lot to re-acquire or re-engage supply over time.³

It’s actually even worse than that sounds. As the first mover in an industry, a marketplace has to do a lot of work to vet supply, convince them of the value of the marketplace, and onboard them onto the product. If suppliers can easily switch, the next marketplace can draft off of all of that work and just acquire the same suppliers who are high quality and already bought in. This is part of what fueled the capital bonfire in the food delivery space.

There are natural dynamics in markets that make it harder for suppliers to multi-tenant. For example, if a supplier has a larger or more complex operation (truckers, manufacturers) it’s less likely they will use many platforms than simpler ones (drivers, landscapers). But unlike the other two dimensions, most markets aren’t inherently very different on this dimension.

Instead, the best marketplaces intentionally make it harder to multi-tenant over time. To do this, they find features that simultaneously add a lot of value for suppliers and increase switching costs.

For example, they could build integrations into the supplier’s business, such as with their accounting software. This saves them time, but also makes it less likely they’ll also integrate with someone else. Or they could go even further and take on a part of the value chain altogether. This is what Amazon did by spending billions of dollars to build the logistics network that powers Fulfilled by Amazon. That makes it much easier for suppliers to sell on Amazon, and also a lot less likely that they’ll use other marketplaces because a bunch of their inventory is actually sitting in Amazon warehouses.

The defensibility of network effects is the difference between incredible and brutal businesses

Pulling all of these dimensions together, we can see that network effects range from the deepest moats in the world to virtually no moat at all.

Amazon has aggregated an exceptionally heterogeneous long tail of supply across the world. And it has built programs like Fulfilled by Amazon and Prime that make it very hard for suppliers to engage in other marketplaces in the same way. The result is both an incredible customer experience and a very deep moat.

Contrast that with “Uber for X”, which failed almost everywhere it was tried. That is because those businesses all had a few things in common: they were hyper-local, focused on one or a handful of homogenous service categories, and didn’t provide an opportunity to build enough value for suppliers to keep them from switching.

If you’re considering founding, joining, or investing in a marketplace, first assess how much water their bucket can hold. It will tell you a lot about how defensible the business will turn out to be.

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Thank you to Casey Winters and Lenny Rachitsky for their feedback on this essay.

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1. If you take this argument to the extreme, you start to see that marketplaces with homogenous supply are unlikely to remain marketplaces long term. For example, when autonomous vehicles arrive, the Uber model will flip to a business that owns and operates its own supply. But Amazon is likely to stay in marketplace mode for much longer because the heterogeneity that long-tail suppliers bring to the product is part of its core value.

2. Instacart moved up on this dimension. They initially built a network effect between grocery stores and consumers, but it was not highly defensible because the markets is not deep: grocery stores are relatively consolidated and thus do not require much aggregation. But Instacart’s advertising product has CPG brands on the supply side instead of stores. This market is much deeper and harder for someone else to aggregate, which makes their ad product more defensible and gives them dollars to spend that competitors don’t have.

3. Supply in a marketplace doesn’t typically “churn” in the traditional sense. They’re still there, and if you send them an order they’re probably happy to take it. But they do disengage meaningfully in a way that hurts the customer experience - they stop uploading new products, they stop responding to customer inquiries quickly, and so on. This is an expensive (and sometimes impossible) problem to fix.