Economics is a social science that studies human and societies and touches every corner of a life from managing fiscal policies to local businesses. Many of us are aware of the basic concepts and terms of economics but are not sure how it applies in real life. Economics is about human behavior and therefore, all business activities and productions should be in line with it. In this blog, we are going to discuss some economic concepts and principles that will help you gain insight into human behavior and markets and better serve your customers as well as your company.
The term “entrepreneur" has two separate meanings in contemporary English, both of which are reflected in the economics literature. Kirzner interprets entrepreneurship as a search process, which involves discovering, and profiting from, imperfect market system trends and data. This implies that there are both sellers charging less than the true market price for a particular commodity and at the same time, buyers paying more for such commodity at some other place.
Schurnpeter, on the other hand, had defined entrepreneur as an innovator, whose initiatives lead to economic development and social progress.
Microeconomics and Macroeconomics
There can be two approaches to Economics; one from the perspective of individual trees and the second from a larger perspective of the forest. Microeconomics, on one hand, is concerned with the behavior of individual people, households, firms, and geographies operating inside the economy and measures the supply and demand situations in these narrow ranges to allocate scarce resources. It deals with a bottom-up approach.
Analyzing such micro factors could help discover a potential gap in the market for your target customer base, for example working men or working women.
Macroeconomics, on the other hand, is the study of aggregate factors of the whole economy, such as inflation, aggregate demand and output, economy-wide policies, GDP, national income, and price levels, which help control the development and stability of an entire economy. It is concerned with a top-down approach looking at the bigger structure and underlying factors inside.
Understanding the macroeconomics trends, fluctuations, employment statistics, tax and bureaucracies, financial environment, labor market, etc. help businesses spot the right opportunities, however, microeconomic factors are more “immediately relevant”. Still, it is nearly impossible to study one of these economic perspectives without considering the other simultaneously. For example, inflation in a country would increase the cost of production for an individual firm functioning inside the economy. To summarize, both micro and macro economic factors help businesses:
Identify price of products/services depending on the equilibrium point. For example, surge in demand for a particular product triggers price increase.
Understand consumer behavior analyzing the trends of supply and demand, and economic cycles.
In depth microeconomic research can help startups invest in the right sector and gain competitive advantage by anticipating how others in the cycle would behave.
Produce maximum output with minimal additional cost.
Supply and demand
Ignoring the law of supply and demand could be a big mistake for your business. It helps determine a product's or service's price at a point of economic equilibrium, which is when supply and demand become equal. Supply is the quantity of goods brought into the market at a given time. It depends on the quantity demanded, which is the amount of goods that consumers want to and are able to purchase at a given time. Businesses need to invest in the right amount of supply; any miscalculation could drown them in products which they cannot sell due to lack of demand. It is advised to focus on limited quantities of your product at first and create a feeling of exclusivity around your brand, and then gradually increase the supply as early customers start adopting. Studying the shortage and surplus scenarios of the market will help you adjust your prices and be prepared for a particularly low or high volume of sales accordingly.
Read more to know more about economic equilibrium and perfect competition
Price elasticity of demand
Elasticity of demand is the percentage change in demand of a good when a variable such as price changes. If a product is said to be elastic its demand will decrease significantly if it's price increases and inelastic when price changes do not impact the demand much. Price elasticity, in particular, is very important for businesses to determine what level they can price their products and services at.
Think of it this way, if you are operating in a very niche market with less number of competitors then the price should be kept a little higher but in case the good offered is very common and with a lot of substitutes, the price has to be kept comparatively low in order to survive the competition.
Marginalism
Marginal utility is defined as the additional benefit received from consuming an extra unit of product or service. Marginal cost, on the other hand, is the expense made for that extra unit. By producing until a level where marginal benefit and marginal cost are equal, businesses can achieve the highest amount of profit, whereas, loss will occur on further increasing the production level. It is, therefore, important to analyse the marginal benefits received from each activity to maximize profits and plan the production levels accordingly.
Opportunity cost
Opportunity cost is the lost potential gain when one opportunity is chosen over the other missed opportunity.
Simply put, these costs are associated with not making the next best choice'. Startups need to rationalize their decision making by analyzing which of the resource allocations could have yielded better results. With an improper allocation, you are not only facing tremendous losses with that choice but also losing potential gains by not choosing the other one.
Not only the direct monetary payments, explicit costs but also the opportunity cost of resources, or implicit costs are considered while calculating the actual economic profit.
Sunk cost
As a lot of entrepreneurs are aware of, sunk cost refers to the money already spent on forward planning and which can no longer be recovered back. An example could be continuously spending money on a failed business idea, just because there is a slight motivation and hope of it working in future. Some examples are rent, overheads, salaries, which are incurred despite less sales or revenue of any sort. Business owners should understand that such fixed expenses should not be considered and hence, deducted from overall costs while making key financial as well as operational decisions.
Cost-benefit analysis
Cost-benefit analysis is a proficient method of systematically analyzing potential derived revenues and whether or not they are sufficient to cover costs and realize additional benefits for the business; whether or not the existing project is feasible enough. Viable comparison of 'how much money will a particular course of action cost' and 'how much money will I make out of it' helps businesses identify strengths and weaknesses of such steps and take informed decisions at the end of the day.
Benefit-cost ratio = ∑PV of all the Potential Benefits / ∑PV of all the projected Costs
Differential pricing
Differential pricing is a pricing strategy under which different prices are charged for the same product, to different customers based on their purchasing pattern, geographies, difference in product features, and brand image in different markets. It can be useful for businesses in establishing prices strategically, by identifying the value of products that consumers at different situations perceive. Offering group and volume discounts come under this differential pricing tactic.
Absolute advantage and comparative advantage
Absolute advantage implies that one country is more efficient in producing a particular goods, with lesser resources or so without considering economic costs. Now, a country is said to have comparative advantage over other countries when it is able to produce a particular product at a lower opportunity cost than the others and it would still be mutually beneficial for both. Having absolute and comparative advantages helps countries become self-reliant and make important trade decisions. Entrepreneurs should use these concepts of theory of trade in decision making. Trade can benefit all the parties involved as long as the relative costs are different.
Reduce Transaction costs
Transaction cost refers to the cost incurred by businesses to maintain the daily process of exchanging currency for goods and services. Some of the ways to reduce transaction costs are-
Optimizing the process and channels for customer service by increasing online presence and chat responsiveness.
Taking out the middlemen by using electronic market and means for making transactions.
Using mobile financial services for completing major transactions without paying any credit card fees or vendors' charges.
Discover some other applicable economic principles here.
Scarcity of resources, which is a key economic problem today, arises out of unlimited consumer desires and limited resources to satisfy those. This is why businesses need to choose option A over option B, be it technology related or labor related, making smart allocation of resources, after analyzing the above concepts relevant to their environment. In order to make balanced, informed business decisions, it is important to take local and global economic trends into account, as well as relevant data and interactions with your customers. Flyboat aims at strengthening the startup ecosystem and entrepreneurial knowledge. Hope this blog helps you in understanding relevant key concepts of economics, which can be applied to your operational and market strategies and ensure long-term success.