Theory to Practice: 5 Ways Economic Theory Directly Affects a Small Business

Business.com / Finances / Last Modified: February 22, 2017

It's time to get theoretical. Applying economic theory to your SMB might open a new realm of possibilities. Get ready to learn!

At its core, entrepreneurship is about getting things done — so it follows that most entrepreneurs have a “talk is cheap” attitude when it comes to the world of theory.

Real-life experience beats a degree any day in their minds, and some business owners even pay budding young innovators to not go to college. However, experience doesn’t always trump knowledge.

Theory is meant to help people understand the world in a systematic way. Even highly theoretical sciences, such as economics, can help prevent many common startup errors.

Related Article: Popular Management Theories Decoded

Your personal memories of economics class likely include flashbacks of intimidating graphs and convoluted, abstract theories. But the study of economics is actually about much more, and it contains many powerful truths for your business. Consider these five basic economic principles and what they mean for your company.

Economic Truth #1: 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 market value of a product or service is always whatever the customer sees in it. Unless you know your customer, you won’t be able to figure out how he values what you have to offer — and, therefore, how to price it. The only way to properly sell your product is to offer what customers want. Your cost has nothing to do with it.

Economic Truth #2: Demand Curves Slope Downward.

Entrepreneurial truth: It’s important to match price points with customer segments.

Also known as the “law of demand,” this age-old economic truth really just means that the higher the price, the fewer goods get sold, and vice versa. This is the reason that schemes like price skimming work. At different price points, you target different segments of the market and, consequently, different customers.

Economic Truth #3: Price Elasticity Is Relative to Demand.

Entrepreneurial truth: You need to find your “pricing sweet spot.”

Many students struggle with this concept, but it simply means that there is an ideal position on the demand curve between elasticity and inelasticity. 

To put it simply: If the 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 really depends on where you are on the demand curve.

Economic Truth #4: Opportunity Costs Must Be Considered in Terms of Both Competitors and Customers.

Entrepreneurial truth: Your customers define value in satisfaction, not in dollars and cents.

Opportunity cost is the trade-off all of us are always making but sometimes forget to consider rationally. You’re not competing just with other entrepreneurs, but also with the customers themselves.

Unless you offer greater value than all the other options available to them, your customers won’t buy your product. It’s really that simple. That’s why you need to know what sets you apart in the market — and why this matters to your customers.

Economic Truth #5: 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 really just means that if you are, relatively speaking, a little better at doing one thing over another, you should do the one you’re better at.

If Team Member A is better than Team Member B at doing two things, each is better off doing the thing he is relatively better at. That makes 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 for it.

Related Article: Boom or Bust? The Impact of an Economy Driven by Startups

Maybe talk is cheap. Doing definitely beats talking in an entrepreneurial startup that struggles every day to make ends meet — but it doesn’t mean you should turn a blind eye to what’s already known. Many economic truths taught in Economics 101 courses are as true today as they were 250 years ago. These simple insights can help you make more informed decisions, avoid costly mistakes, and better plan for future growth.

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