At its core, entrepreneurship is about getting things done, so many entrepreneurs adopt a “talk is cheap” attitude regarding theory. In their minds, real-life experience beats a degree any day. In fact, some business owners even pay budding young innovators not to go to college.
But experience doesn’t always trump knowledge. Theory can help people understand the world systematically. Even highly theoretical sciences, such as economics, can help prevent many common startup errors.
We’ll explain economic theory, how it affects your business and what you can learn from essential economic truths.
What is economic theory?
Your memories of your high school or college economics class likely include flashbacks of intimidating graphs and convoluted, abstract theories. But the study of economics is actually about so much more – and it holds many powerful truths for your business.
Economics studies the production, consumption and transfer of wealth; it applies to business organically. Economic theories explain and predict why and when certain things will occur, including inflation, unemployment, wage increases or decreases, and changes in supply or demand.
There are many different economic theories. Some discuss macroeconomics, which is the study of how a society’s economy works as a whole. Others focus on microeconomics, which is how economic forces impact individual consumers and producers (businesses).
These are the primary microeconomic theories that can guide businesses:
- Classic microeconomic theory
- Neoclassical microeconomic theory
- Behavioral economics
We’ll discuss each theory in more detail.
Classical microeconomic theory
Adam Smith, the founder of classical microeconomics, started the study of economics. In his book Wealth of Nations, published in 1776, he mentioned “the invisible hand of the market.” He theorized that consumers and producers act in their own self-interest and that the two balancing forces are the supply of goods (controlled by the producers) and demand for goods (controlled by the consumers).
When supply meets demand, there is market equilibrium. But when supply is higher, producers sell the goods at a discount. Once supply is diminished and the market is flooded with goods, the price returns to the equilibrium level.
Conversely, when demand is higher, prices rise and some consumers will not be able or willing to pay the higher prices. This, combined with the increased supply of producers trying to cash in on the bonanza, eventually brings the price down to the equilibrium level.
Economists Jeremy Bentham and John Stuart Mill enhanced classical microeconomic theory by adding the concept of utility maximization. This states that consumers buy goods based on the marginal utility (satisfaction or usefulness) they get from the good.
Neoclassical microeconomic theory
Subsequent economists built upon classical economic theory by incorporating some other ideas.
- Monopolies: Some incorporate an awareness of monopolies and how their outsized market power can lead to excessive prices.
- Imperfect competition: Some account for imperfect competition, where markets are a blend of producers with the same relative power and those with significantly more power.
- Externalities: Some consider externalities – when a free market leads to overconsumption of certain goods or services, positively or negatively affecting third parties. An example is the overconsumption of fossil fuels causing climate change that affects people in other countries.
- Game theory: Some incorporate game theory, recognizing that not all decisions are linear or simple but depend on many variables and parties.
Classical and neoclassical economic theories assume that producers and consumers have all the necessary information to make decisions and do so based on a logical assessment of their best interests.
Behavioral economics, on the other hand, uses psychological insights. It argues that producers and consumers don’t always act rationality; instead, they can act based on biases and emotions. Behavioral economics can explain economic bubbles like the housing bubble in 2007 that led to the 2008 recession, as well as the trend of conspicuous consumption for status in the 1980s.
How economic theory affects small businesses
Consider these six basic economic principles and how you can apply them to your business.
1. Economic truth: Value is subjective.
Entrepreneurial truth: You don’t define your product’s value; your customers do.
Subjective doesn’t mean “random” – it means “in the eyes of the beholder.” The customer always determines a product’s or service’s market value. Unless you know your customer, you won’t understand how they value your offering, and you won’t know how to price it.
To avoid product failure, you must have an offering that customers want and can pay for.
When pricing a product, you must think about your costs, but that’s not your only pricing consideration. Many companies use a cost-plus pricing method, calculating their unit costs and adding an arbitrary profit margin to get the total price.
If they don’t consider market forces – including what the customer is willing to pay and the price of competitive and substitute products – this price may lead to overpricing and depressed sales or underpricing and depressed profits.
Tip: Conduct a break-even analysis to price your products correctly and ensure adequate cash flow.
2. Economic truth: Demand curves slope downward.
Entrepreneurial truth: Generally speaking, the higher the price, the lower the demand.
Also known as the “law of demand,” this age-old economic truth means the higher the price, the fewer goods get sold – and vice versa. This is why schemes like price skimming work. You target different market segments at different price points and, consequently, different customers. Be aware that this practice is illegal in some places; unless you offer additional value at higher prices, it may be considered unethical.
This concept, while generally true, doesn’t apply to luxury or perceived high-status goods. In that case, a higher price along with luxury features or scarcity indicates value and can actually spur increased demand.
Manufacturers and retailers tend to sell high-tech goods at different prices as time passes and tech becomes outdated. When new technology is first released, it has a high price, and early adopters snatch it up. However, as newer models come out, the price drops.
Businesses benefit from the higher per-unit selling price early in the product life cycle; if they continue to innovate and release newer versions, they can keep reaping profits this way while selling older tech at lower prices to price-conscious customers.
3. Economic truth: Price elasticity is relative to demand.
Entrepreneurial truth: You need to find your “pricing sweet spot.”
This concept means there’s an ideal position on the demand curve between elasticity and inelasticity. If a price is too high, you sell so few products that you’d make more money by lowering the price. If the price is too low, you’d make more money by increasing it.
Entrepreneurs generally know the former – of course you can sell more at a lower price. But they tend to forget that sometimes a higher price means more revenue. Your product’s price elasticity depends on where you are on the demand curve.
Tip: Many consumers spend time online hunting for the best deals. When crafting your e-commerce marketing strategy, remember that customers have a ready supply of choices. High supply means prices should be on the low side.
4. Economic truth: Opportunity costs must be considered in terms of both competitors and customers.
Entrepreneurial truth: Your customers define value in satisfaction, not dollars and cents.
Opportunity cost is the trade-off we all make but sometimes forget to consider rationally. You’re not only competing with other entrepreneurs; you’re also competing with substitute products and the possibility that customers will forgo purchasing anything. For example, if your product makes life more convenient but is priced too high – even if it’s the going market rate – customers may decide the cost isn’t worth the added convenience.
Unless you offer greater value than all other available options, your customers won’t buy your product. That’s why you must understand your unique selling proposition – what sets you apart in the market – and why this matters to your customers.
You must also assess precisely what’s stopping customers from buying your product. Is it too expensive, difficult to get or hard to use compared to other products? If so, you’ll need to make a change to succeed.
FYI: You can use customer analytics to gain insights into your customers’ behavior that help you improve your products and pricing.
5. Economic truth: Comparative advantages must be maximized to create an overall advantage.
Entrepreneurial truth: Do what you’re (relatively) good at.
Renowned economist Paul Krugman calls comparative advantage a “difficult idea,” but it doesn’t need to be. It just means that if you are – relatively speaking – a little better at doing one thing than another, you should perform the task you do better.
If you have two team members, allow each to do what they’re relatively better at to make the total outcome of their efforts higher. If you let the least productive members of your team do what they’re relatively best at, you’ll all be better off.
6. Economic truth: Not all business or purchasing decisions are rational.
Entrepreneurial truth: It’s easy for companies and customers to get carried away by emotions or biases.
Getting outside perspectives and data is essential when making decisions about your business. Typically, entrepreneurs are passionate about their companies and products. But that doesn’t mean they’ll be successful. Base your decisions on thorough analysis and market research, and bounce your ideas off other people inside and outside your company. This way, you’ll ensure your offering makes sense before committing money toward turning it into reality.
Likewise, you should understand that customers aren’t always rational either. Customers are human and often make decisions based on emotions and subconscious feelings. Conduct customer outreach and research, and gather survey data to discover people’s needs and how they feel about your product and brand as well as your competitors’ products. Use this customer feedback to hone your marketing messages and sales process for maximum effectiveness.
Did you know? Facts and emotions are both sales tactics. Logical selling works best for straightforward or low-cost products, while customers tend to rely on emotions when buying complex products and solutions.
Simple insights to make informed decisions
Doing definitely beats talking in an entrepreneurial startup that struggles daily to make ends meet. However, this doesn’t mean you should turn a blind eye to established knowledge. Many facts taught in Economics 101 are as accurate today as they were 250 years ago. These straightforward insights can help you make more informed decisions, avoid costly mistakes and better plan for growth.
Per Bylund contributed to the writing and research in this article.