Principles of Economics for Entrepreneurs
Economists love theories. Sometimes they love theory so much they forget about the applications. As an entrepreneur and an expert in practicality, you can enjoy the fruits of economic theories. Below are five principles of economics for people of action:
1. People respond to incentives
As long as you fully understand this principle, the rest of economic theories will seem redundant. The casual reader of popular economics knows that people respond to incentives and the rest is commentary.
New parents often learn this principle painfully when trying to pacify their toddlers’ tantrums with cookies, only for their children to throw even more tantrums.
Self-interest, as Charles Wheelan (American author and politician) puts it, “makes the world go round”. People respond even better to specific incentives – time-sensitive projects with time-specific rewards work better than vague promises. As an entrepreneur, don’t let yourself forget this.
Sure; people sometimes help you out of good-heartedness (or because of their unsaid future expectations). But when you depend on people to give off their time, energy and money without reward, you put yourself at the risk for shoddy work, misleading help, ignored deadlines and the end results, you get controlled, etc. Make it a point to offer something in exchange whenever you ask for anything. Consequently, give back whenever someone does something for you. Thinking in terms of incentives will give you realistic expectations for others’ behaviour. But there is a more important aspect to this rule – an aspect so important, it stands as a principle of its own: “What’s in it for me?”
2. Not all incentives are tangible
In a simple economic model, the quantity of a product demanded by buyers decreases when its price rises and then increases when its price falls. Low prices incentivise people to buy more. Great! The lower your price, the more you’ll sell until you run short. But some goods defy the law of demand – people do things for non-monetary and non-physical reasons.
For instance, the heavy ‘sin tax’ on tobacco aims to ‘disincentivise’ tobacco consumption but multiple studies show, people purchase almost the same amount of tobacco regardless of its price. Funny nee?
Sometimes, people even buy more of a product when it costs more. Affectionately called ‘goods with snob value status’, we call these products ‘Veblen goods’ in marketing. A 50% discount on Rolex watches would actually decrease the number of buyers - people purchase these products in order to obtain social statuses.
In all these cases, people make choices based on non-monetary incentives. You can and should take advantage of this knowledge – establish intangible incentives and keep clients coming back for something they can’t get elsewhere.
3. People face tradeoffs (opportunity cost)
As an entrepreneur, outsource what you can. This common-sense idiom comes from the financial principle of ‘opportunity cost’.
Every time you choose to spend your resources (time, money) to gain one thing, you must subtract the things you haven’t spent your resources on from your profit. If you have $15 to spend either on a book or a lamp and you choose the lamp, you trade the opportunity to buy the book for the opportunity to buy the lamp. The book represents your opportunity cost.
The same concept applies to time management. If you choose to use your time toward one task, you incur the opportunity cost of another task: The more time you spend on a task that your associate can do better, the less time you can devote to projects at which you excel. Minimise your opportunity cost by placing value on your time. Do the things you’re good at and outsource the things you aren’t.
4. Specialisation helps
Theorists have championed the benefits of specialisation since 400 B.C. In ‘The Republic’, Plato outlines a society in which people divide the production of goods and distribution of services for a more stable society. Today, most people see prominent flaws in Plato’s system but division of labour and product specialisation remain central devices for economic growth.
Imagine a simple economy in which two producers (John Wa’ and Confidence) manufacture two products (hats and shoes). If both John Wa’ and Confidence tried to produce both hats and shoes, they would waste resources. However, if John Wa’ produced hats and Confidence produced shoes, they could trade and benefit from each other’s specialties. The more specialised your product or service, the better the psychological effect on potential buyers as well.
Google, the classic example, succeeded as a search engine in part, because of its specialised design. It started as a search engine that didn’t claim to do anything else. People know that a company that only advertises one service must deliver the service better than a company that claims a variety of services.
5. Take rational risks
Over coffee, economists and statisticians trade stories about people’s inability to discern probability. One such statistician (and philosopher), Nassim Taleb, wrote several books about the power of randomness (and counterintuitive statistics) to make people into “suckers”. “Suckers” impose their small-scale conceptions of reality on life (a huge set of potential events with many variables). More importantly, they take irrational risks.
People misunderstand improbable and random events in two major ways. First, they forget that these events are possible. Second, people overestimate the role of specific random scenarios, especially those on which the media choose to focus. Let’s highlight two well-known instances of this logical error.
Statistically, you’re more likely to die in a car accident on the way to purchase a lottery than you are to win the lottery. Yet, some people profit immensely off lottery ticket sales. Don’t let randomness fool you. Take your time when you take a risk and evaluate it rationally. At the same time, don’t let fear cloud your judgment – some risks are well worth it. The risk of doing your business will never be more rewarding.