Just Enough Microeconomics to Keep the Business Owner on Track

Some questions for every entrepreneur and business owner:

Have You Mastered a Good Basic Understanding of Microeconomics? Understanding microeconomics is essential to business success. I often tell people wanting to go into business to take two courses at the college level: microeconomics and financial accounting. As boring as microeconomics sounds, an understanding of it is essential. You must wrap your head around the principles of supply, demand, and pricing, and understand how they apply to your situation.

What is the Supply Situation? What are the other sources of supply for the product or service you want to produce or sell? Well, if there are no others, you may be in a good position, provided there is demand for the product or service. If there is no discernible demand, you have two choices. You can hope, like in Field of Dreams, that if you build it they will come. This is very risky and, nine times out of ten, the demand is a mere fraction of what you project - or let’s be honest, hope - it will be. Or you can walk away and look for another idea with some data to support your demand assumptions.

If there are other supply sources, then you must examine why buyers will walk past the competition and buy from you. Is it that you can offer the same product or service at a lower price? And then, why is that? What gives you a cost advantage and is it sustainable?

Is it that you can offer a higher quality of product or service than your competitors? If so, why is that? And is that advantage sustainable? This may be a good reason to start or buy a business in a competitive environment. You can simply deliver a better product or service than the competition. That means you will be able to capture your fair share of the demand in the market.

What is the Demand Situation? If this is a new product lacking demand data, you are in very risky territory. Not to say you shouldn’t launch this business, but make sure your eyes are wide open. You are risking a lot of time and money based solely on your hunch that demand exists.

If this is an existing product or service category, then you can usually get some data on the demand (i.e., market size). Your biggest questions should be around how and why you think you can capture your fair share or more of the market. Are you priced lower? Will you offer more value (e.g., a more valuable feature set for the money than competitors)?

What Are the Pricing Dynamics? All other things being equal, when supply increases, prices decrease. When supply decreases, prices increase. When demand increases, prices increase. When demand decreases, prices decrease.

If, in this unrealistic world where all other things are held constant, you decide to increase prices, demand can be expected to decrease. If you decide to lower prices, demand can be expected to increase. 

Is the Market in Equilibrium? This condition rarely exists in a perfect state, but it is a very useful concept to understand for the simple reason that markets generally push and move toward equilibrium. This is the condition where the pressure for higher prices is balanced by the pressure for lower prices, allowing the current state of exchange between buyers and sellers to persist.

How Much Elasticity Exists? Elasticity describes how responsive supply, demand, and pricing are to each other. Price elasticity of, say, 1.5 means that for every 1% change in price, the demand will change by 1.5%. Raise prices by 1% and demand will decrease by 1.5%. Lower prices by 1% and demand will increase by 1.5%.

You can’t really understand and then apply your knowledge of supply, demand, and pricing without understanding elasticity. For example, say you are looking at a concrete supplier. You find that the market is very inelastic. If you enter the market as a new competitor, intending to undercut the competition by 10% on pricing, this inelasticity may work against you within a range of pricing. Perhaps, dissuaded by switching costs of changing to a new supplier, no one wants your product unless and until you undercut the competition by 20%. Maybe your cost structure is such that you can’t make any money at those price levels. If, on the other hand, you found the market to be very elastic, you’d likely find that undercutting the competition by a percentage point or two might generate great demand.

GROW and SELL Advisors, wholly-owned by Traversi & Co., LLC, is a premier sell-side M&A advisory firm – a boutique investment bank – serving the lower middle market.  Visit us here.

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