Basic Economic Lessons that Growth Entrepreneurs Should Heed

OVERVIEW [top]

Entrepreneurs must understand basic economic principles to grow their companies successfully. In some cases, they may have established their businesses and even become profitable without understanding the rationales — or even possibly by contravening them. But as business expands, flaws in understanding of the basics can magnify and overwhelm the company. To ensure long-term success, owners must apply key economic principles to their market strategy. These fundamental rules form the basis for any economic analyses and choices for growth.

In this Quick-Read you will find:

• The key economic principles that make businesses succeed.
• How to apply those principles to your own business.

SOLUTION [top]

A few key principles lie at the heart of economic analysis. Understanding these concepts and why they work as they do will answer many doubts as you analyze your business’s prospects. Every aspect, including setting prices, marketing to customers, expansion of product lines and strategic planning, is affected by these principles.

The seven most important principles to understand are:

1. Risk and return. With any financial asset, the higher the risk assumed, the higher the expected return must be to gain investors. And there is no riskier commercial enterprise than a small business. The largest number of bankruptcies and shutdowns occur with small businesses. The cash flows and returns for a small business owner have much more variance than those of large companies.

   But the highest returns also historically accrue to the small-business investor. The nominal average annual returns of small-company stocks have been 17.7% over the past 70 years, compared with 12.5% for common stocks of large companies. To grow and attract capital, business owners must set up their business plans to weigh the possibilities for failure against the higher rate of return that will be achieved if the business succeeds.

2. Marginal benefits and marginal costs. The marginal benefit of an activity is the benefit from choosing to supply an additional amount of that service or good. The marginal cost is the expense for adding that extra amount. When marginal benefits of an activity are greater than or equal to marginal costs, there is profit. When the marginal benefit of an activity is equaled by rising marginal cost, the total benefit of the activity is at its highest level and increasing production further will result in a loss.

   

   When a new product is being developed, the per-unit cost of production exceeds the marginal benefit. Once mass production lowers the marginal cost, the greater marginal benefit results in profit. When so much is produced that a market is saturated and the price must be lowered to sell more, or when it is necessary to add production space, equipment and workers, marginal cost can again exceed marginal benefit.

   The marginal benefit-cost relationship pervades a business’s operations and requires that companies accurately analyze what marginal benefits could result from each activity. For instance, upgrading packaging can provide a significant benefit to a consumer-products company but not for one making industrial products used as replacement parts. Increasing pay rates may retain or attract better employees, reduce recruitment or training expenses and improve customer service.

3. Opportunity costs. The opportunity cost of any decision is the difference between the cost and the return for that activity compared to those for the best alternative. For a small-business owner, a key opportunity cost is the interest foregone from the money used to start and run the business. Opportunity costs must be considered when deciding to grow a business. Before investing in a new product, service, or activity, consider not only the cost of creation but also other ways that money could be invested, and which option provides the greatest opportunity.

   For instance, having a salesperson take one day to file invoices may seem cost-effective because it saves having to hire a part-time clerical person. But if that person’s sales diminish by more than the cost of the clerical staffer, the opportunity cost is too high to have the salesperson perform that task.

4. Sunk costs. These are expenses that are unrecoverable once a decision has been made, and they should have no bearing on later decisions. Sunk costs include payments, such as rent, general overhead and salaries, that will continue regardless of whether the company sells many or few products. They also include past R&D expenditures for a potential new product. Fixed costs must be removed from any expense consideration in a decision because they cannot be recouped. This often is a difficult factor for owners to understand completely. They sometimes erroneously include these costs in decision-making analyses of the expenses for taking a course of action. For instance, expenses for stocking a new product should not include warehouse rent if the product is stored in an existing warehouse for which rent payments already are being made.
5. Supply and demand. Demand is the relationship between quantity needed of a good and its price, as well as the marginal benefit of a good perceived by customers. Quantity demanded is determined by price, and it changes when price changes. Consumers will purchase more of a good the lower its opportunity cost, or price. The total demand for a good or service is determined by taste and preferences, number of buyers in the market, prices of related goods, income levels and buyer expectations, among other things.

   Supply reflects how much of a good is brought to the market within a given time. The cost for the business owner to supply the good is a factor. The total supply is affected by the cost of resources, number of sellers in the market, prices of related goods, technology levels and expectations, among other things.

   A key point is to differentiate between a change in quantity demanded and demand itself. Quantity demanded changes only when price changes. When demand itself changes, there is an actual increase or decrease in demand at all price levels. Determining which type of demand is occurring with a product affects production levels and expansion analyses. Only price will change quantity demanded and supplied. A host of other factors cause the total demand or supply to change.

6. Elasticity of demand. This defines how much quantity demanded changes when price changes. When price increases, quantity demanded declines — but by how much? If demand is elastic, it may decline a lot, as it is sensitive to price increases. If demand is inelastic, a price rise doesn’t reduce demand much. The demand for most medical services, for instance, is inelastic, as there are no or few substitutes. The demand for bananas is elastic, as much higher prices will lead consumers to other options. Pricing patterns for entrepreneurs must be based on how much value consumers put on the product or service and what substitutes exist.

7. Differential pricing. This is based on the fact that elasticity of demand can be different for different customer groups. It requires the company to have some monopoly power as well as to b
   e able to segment its market according to different elasticities of demand. A company also must be able to prevent those who buy at lower prices from selling to those who buy at higher ones. Airlines, for instance, can charge business people higher rates because those customers have fewer travel options (and are spending company funds, not their own money). Business travelers have less elastic demand than vacation travelers, who can more easily change to auto trips or other travel options.

   If companies can identify the value that consumers place on their goods, they can price differentially. By focusing on value-based pricing rather than cost-based pricing, they can increase their profits.

REAL-LIFE EXAMPLE [top]

State-of-the-art technology is what gives a competitive edge to Victoria Court Reporting Service Inc., a Chicago, Ill.-based firm that provides court reporting, video conferencing, imaging and document repository services to law firms, corporations and other businesses nationwide. That’s why CEO Victoria Rock invested $20,000 in what she believed was the best video conferencing network available when she moved VCRS to new office space in mid-1998.

Six months later, a dismayed Rock learned that the system she’d counted on to take her business (which has gross annual revenues between $1 million and $2 million) into the future was out-of-date.

"The person I’d trusted to tell me what to get came back and said there was a new system that would give me a clearer picture — one that looks more like TV and doesn’t look choppy," recalls Rock, who founded the company in 1981. "I thought I was supposed to get top-of-the-line equipment and within six months, I found out it would cost about $9,000 to upgrade." Her current video conferencing line runs at a speed of 128K; the new one races along at 384K, she notes.

As tough as the news was to swallow, Rock realized she couldn’t recoup the $20,000 she’d already invested. It was a sunk cost she would never rescue. So she started reworking budgets to incorporate money for the new system, which she hopes to have up and running by the end of 2001.

"I asked myself, ‘How much more do I need, and can I afford it?’" Rock says. "I have to have it to be able to attract the business I need to go to the next level. I know I have to do this because I want to be on the leading edge."

DO IT [top]

1. Consider whether incremental changes to your business — in packaging, pay rates, training expenses, shopping bags, store d
   
   TJ Becker

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