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First-time entrepreneurs are curious to know what an economic moat is. The term economic moat was first theorized by Warren Buffet. An economic moat is usually an advantage that an organization has over its competitors. The advantage allows the organization to cover and protect its market share and profits. This edge that the organization has is difficult to mimic. It could be a trade secret, a patent, a secret ingredient or even a brand identity. This helps the organization create effective market barriers for new entrants.
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What Is An Economic Moat?
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Origins Of Economic Moats
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Creating Economic Moats
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Types Of Economic Moats
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Conclusion
What Is An Economic Moat?
An organization at the pinnacle of its success knows that the primary threat to its success is its competitors. Keeping the competition at bay is important. With time, the bottom line is likely to get impacted by new entrants into the market. That’s why organizations must have a distinct advantage, or an economic moat.
This paves the way for the organization to continue earning above-average profits and establish its market presence. One example of an economic moat is a wide economic moat. It’s an extremely high competitive advantage that the competition can’t surpass. In a wide economic moat, the organization has an immense advantage and is more sustainable.
So, what constitutes an economic moat? It could be anything—a well-known brand name (Adidas), a pricing power edge, cost advantages, a secret ingredient (Coca-Cola) or an efficient scale. These are all examples of wide economic moats. A wide economic moat gives an organization an edge in the form of strong, consistent returns and large amounts of cash flow.
Origins Of Economic Moats
A classic example of an economic moat is an organization that can sell at very low or minimal operating costs. It can thwart competition by its cost advantage and can sell its products at a very low price, keeping rivals at bay. For instance, Walmart stores have voluminous sales. They negotiate with their suppliers for low-cost products. As a result, their offerings are hard to mimic by the competitors.
Then there are intangible economic moats, such as brand value, patents and licenses. Patents allow an organization to protect its ingredients or production processes. In case they lease their license, they can charge a high premium for it. While the brand is developed over time with a strong reputation and quality offerings, a patent is usually filed with governments to protect a production process for a stipulated period of time.
Excellent examples of an economic moat are the patents on COVID-19 drugs and vaccinations, which have given pharmaceutical organizations a competitive edge. They’ve earned extremely high profits from such patents.
There are markets that have a limited number of organizations with unique offerings. This, also called an efficient scale, gives organizations a monopoly and prevents the entry of other players. An example of economic moat is a utility that provides electricity and water in a geographic region.
A very effective economic moat is switching costs. Any switch-over is very expensive for the consumer. For example, Autodesk designs software solutions that are difficult to grasp by its engineers. However, they’re unique, so customers don’t switch. This allows Autodesk to charge a very high price for its software solutions.
Amazon has established itself as a leading e-commerce seller through a network effect—numerous people buying and selling products from its platform. This gives its platform mass appeal. A network effect is an economic moat example.
Creating Economic Moats
Here are some ways in which an organization can create an economic moat:
- Cost advantages that allow organizations to undercut the price of any new entrant in the market
- Economies of scale, which allow goods and services to be produced at very low costs and curtail marketing and production costs
- Intangibles such as patents and licenses
- Soft moats, an organization’s unique corporate culture or managerial style
Economic moats have become a very successful model for organizations to build long-term profits and market share.
Types Of Economic Moats
The most common type of moat is a wide economic moat such as that of cost monopoly. An example of this is Walmart, as explained above. The organization has access to such a large retail space that it can demand products at very low prices from suppliers. Another example is the brand image of Coca-Cola, which is so popular that it can continue to charge high prices only because of its brand value.
A narrow economic moat is more dangerous because an organization holding a narrow economic moat can only sustain itself for the short haul. Inevitably, its competitors cross over, eroding profitability. For example, Palm’s hand-held devices had a large market share in the 1990s. However, they were soon surpassed by HP, which came out with better hand-held devices.
A rating is often given to organizations holding an economic moat. This is referred to as a morning star economic moat rating. The higher the rating, the easier it is for an organization to fend off competition and grow sustainably in the years to come.
An organization that can make its competitive advantage last for more than 20 years has a wide economic moat. An organization that can keep the competition away for 10 years has a narrow economic moat, while an organization that quickly dissipates has no moat. Morning star also includes a moat trend rating that determines if an organization’s moat is positive, negative or stable. The morning star rating allows investors to quickly decipher which organization to invest in.
Conclusion
Now that the theory and concept of economic moats are clear, it’s time for you to take decisive action. For entrepreneurs who are looking at executing solutions, try Harappa’s Executing Solutions course. This strategy execution course will help you seamlessly execute your idea. Knowing your organization’s economic moat, as well as that of your rivals, will help steer your organization to a better competitive advantage. Be a dynamic doer with Harappa.
